UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2002

OR

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

Commission File Number 0-28488

ZONES, INC
(Exact name of registrant as specified in its charter)

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

707 South Grady Way
Renton, Washington
(Address of Principal Executive Offices) 98055-3233
(Zip Code)

(425) 430-3000
(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 [X]    No [  ]

The number of shares of the registrant’s Common Stock outstanding as of May 9, 2002 was 13,581,169.

1

ZONES, INC.

INDEX

PART I. FINANCIAL INFORMATION

Item 1. Consolidated Financial Statements:

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

Item 3. Quantitative and Qualitative Disclosures About Market Risk

PART II. OTHER INFORMATION

Item 1. Legal Proceedings

Item 6. Exhibits and Reports on Form 8-K

2

Part I.

Item 1. Financial Statements

ZONES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)

	March 31, 2002			December 31, 2001
ASSETS
Current assets:
Cash and cash equivalents	$	9,423		$	12,141
Restricted cash		930			930
Receivables, net		32,393			32,120
Inventories, net		13,329			16,896
Prepaid expenses		536			979
Deferred tax asset		1,743			1,743
Total current assets		58,354			64,809
Property and equipment, net		7,130			7,543
Deferred tax asset		5,155			5,207
Other assets		335			342
Total assets	$	70,974		$	77,901
LIABILITIES AND SHAREHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	31,968		$	37,994
Accrued liabilities		5,663			6,126
Current portion of capital lease obligations		1,047			1,412
Total current liabilities		38,678			45,532
Capital lease obligations, net of current portion		146			226
Other liabilities		493			585
Total liabilities		39,317			46,343
Commitments and contingencies
Shareholders’ equity:
Common stock		39,518			39,500
Accumulated deficit		(7,861	)		(7,942	)
Total shareholders’ equity		31,657			31,558
Total liabilities and shareholders’ equity	$	70,974		$	77,901

See notes to consolidated financial statements

3

ZONES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except earnings per share)
(unaudited)

	Three months ended March 31,
	2002			2001
Net sales	$	99,848		$	161,169
Cost of sales		89,297			145,691
Gross profit		10,551			15,478
Selling, general and administrative expenses		10,432			15,199
Income from operations		119			279
Interest expense		33			148
Other income, net		(47	)		(36	)
Minority interest					(2	)
Other (income) expense		(14	)		110
Income before taxes		133			169
Provision for income taxes		52			65
Net income	$	81		$	104
Basic earnings per share	$	0.01		$	0.01
Shares used in computing basic earnings per share		13,564			13,438
Diluted earnings per share	$	0.01		$	0.01
Shares used in computing diluted earnings per share		13,578			13,438

See notes to consolidated financial statements

4

ZONES, INC.
STATEMENTS OF SHAREHOLDERS’ EQUITY
(in thousands, except share data)
(unaudited)

	Common Stock				Accumulated
	Shares		Amount		Deficit			Total
Balance, January 1, 2002		13,536,406	$	39,500	$	(7,942	)	$	31,558
Issuance of common stock		27,414		18					18
Net income						81			81
Balance, March 31, 2002		13,563,820	$	39,518	$	(7,861	)	$	31,657

See notes to consolidated financial statements

5

ZONES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

	Three months ended March 31,
	2002			2001
Cash flows from operating activities:
Net income	$	81		$	104
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Depreciation and amortization		1,063			1,503
Deferred tax asset		52			(65	)
Minority interest					(2	)
Changes in assets and liabilities:
Receivables, net		(272	)		1,345
Inventories, net		3,567			(232	)
Prepaid expenses and other assets		451			136
Accounts payable		(6,652	)		9,194
Accrued and other liabilities		(555	)		(1,411	)
Net cash (used in) provided by operating activities		(2,265	)		10,572
Cash flows from investing activities:
Purchases of property and equipment		(651	)		(1,180	)
Net cash used in investing activities		(651	)		(1,180	)
Cash flows from financing activities:
Net change in book overdraft		626			(5,962	)
Net proceeds from sale of common stock		18			38
Net proceeds from capital lease					445
Payments on capital leases		(446	)		(517	)
Net cash provided by (used in) financing activities		198			(5,996	)
Net increase (decrease) in cash and cash equivalents		(2,718	)		3,396
Cash and cash equivalents at beginning of period		12,141			3,816
Cash and cash equivalents at end of period	$	9,423		$	7,212

See notes to consolidated financial statements

6

ZONES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. Description of Business

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

The Company was incorporated in November 1988 as a Washington corporation. The Company’s headquarters are located in Renton, Washington. Company and buying information is available at http://www.zones.com, or by calling 800-258-2088.

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. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial position and operating results for the interim periods. 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 the Company’s Annual Report on Form 10-K for the year ended December 31, 2001 as filed with the Securities and Exchange Commission on February 26, 2002.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of the Company and its subsidiaries. Intercompany transactions have been eliminated in consolidation.

Property and Equipment

Property and equipment is recorded at cost. Depreciation is computed based on the straight-line method over the estimated useful lives of the related assets. Useful lives for computer hardware and software range from 3 to 5 years and other property and equipment from 3 to 10 years. Capital leases are amortized based on the straight-line method over the estimated useful lives of the related assets or lease life, whichever is shorter, generally 3 to 10 years. Expenditures for maintenance and repairs are charged to expense as incurred, while additions, renewals and betterments are capitalized. Gains or losses from sales or retirements are included in other income and expense. The Company evaluates the carrying value of long-lived assets based upon current and anticipated undiscounted cash flows, and recognizes an impairment when it is probable that such estimated future net cash flows will be less than the asset carrying value.

In January 2002, the Company revised its estimate of the useful lives of certain technology assets. These changes were made to better reflect the estimated periods during which the assets will remain in service. The impact was primarily due to the Company’s planned investment in a new enterprise system that was delayed due to the economic environment. Therefore, the Company reevaluated the useful life of its existing enterprise system, in conjunction with the estimated life of its investment in web development. The change had the effect of reducing depreciation expense for the three months ending March 31, 2002 by approximately $354,000.

Revenue Recognition

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

7

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. The Company excludes all options to purchase common stock from the calculation of diluted net loss per share if such securities are antidilutive.

Recent Accounting Pronouncements

In August 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards 144 “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). SFAS 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. SFAS 144 supersedes SFAS 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of”, and the accounting and reporting provisions of APB Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions”, for the disposal of a segment of a business. The provisions of SFAS 144 will be effective for fiscal years beginning after December 15, 2001. The adoption of SFAS 144 on January 1, 2002 did not have a material impact on the Company’s results of operations and financial position.

3. Earnings Per Share

The Company has 45,000,000 common shares authorized. The Company has granted options to purchase common shares to employees and directors of the Company. The options may have a dilutive effect on the calculation of earnings per share. The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations (in thousands).

	Three months ended March 31,
	2002		2001
Basic earnings per share:
Net income	$	81	$	104
Weighted-average shares used in computing basic
earnings per share		13,564		13,438
Basic earnings per share	$	0.01	$	0.01
Diluted earnings per share:
Net income	$	81	$	104
Weighted average shares outstanding		13,564		13,438
Stock options		14
Total commons shares and dilutive securities		13,578		13,438
Diluted earnings per share	$	0.01	$	0.01

4. Commitments and Contingencies

Legal Proceedings

Various legal claims and actions considered normal to the Company’s business have been asserted and are pending against the Company. The Company believes that such claims and actions will not have a material adverse effect upon the Company’s financial position or results of operations.

The Washington State Department of Revenue (the “Department”) is currently examining the Company’s state tax returns for the years 1996, 1997, 1998 and 1999. The Company has received a final report, and the Department has assessed $2.1 million plus interest. Based on discussions with the Department, the Company disagrees with substantially all of the deficiencies and has contested such deficiencies through the administrative appeals process and is pursuing further litigation. There can be no assurance that the Company will be successful, in whole or in part, in challenging the proposed deficiencies. Additionally, the Department may also make a similar assessment for 2000 and 2001. An unfavorable decision could have a material effect on the Company.

8

Liquidity

The Company believes that its existing available cash and cash equivalents, operating cash flow and existing credit facilities will be sufficient to satisfy its operating cash needs for at least the next 12 months at its current revenue level. However, if the Company’s future revenues decline below the current level, or if working capital erodes and other capital requirements are greater than currently anticipated, the Company could be required to seek additional funds through sales of equity, debt or convertible securities or increased credit facilities. There can be no assurance that additional financing will be available or that, if available, the financing will be on terms favorable to the Company and its shareholders.

5. Segment Information

SFAS 131, “Disclosures About Segments of an Enterprise and Related Information,” requires that public companies report profits and losses and certain other information on their reportable operating segments. These segments are based on the method of internal reporting used by the decision-maker of the Company to allocate resources and assess performance.

In the third quarter of 2001, the Company replaced its operating unit approach with a single segment approach. The Company’s one reportable segment is a single-source, multi-vendor direct reseller of name-brand information technology products to small to medium sized businesses, enterprise, and the government and education markets.

Substantially all of the Company’s net sales for the three months ended March 31, 2002 were made to customers located in the United States. All of the Company’s assets at March 31, 2002 and December 31, 2001 were located within the United States. Sales to one of the Company’s customers represented over 16.7% and 28.9% of total sales for the three months ended March 31, 2002 and 2001. Net sales to this customer were $16.7 million for quarter ended March 31, 2002 compared to $46.5 million for the quarter ended March 31, 2001. The Company believes that sales to this customer over future quarters may see further decline.

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

The matters described below contain forward-looking statements which involve known and unknown risks, uncertainties, and other factors that may cause actual results, performance, achievements of the Company or industry trends, to differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements may be identified by the use of forward-looking terminology such as “may,” “will,” “expect,” “estimate,” “anticipate,” “continue,” or similar terms, variations of such terms or the negative of those terms, but the absence of such terms does not mean that a statement is not forward-looking. Potential risks and uncertainties that may cause actual results to differ materially from those expressed or implied include, among others, those set forth in this document those contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001, which was filed on February 26, 2002 with the Securities Exchange Commission. Particular attention should be paid to the cautionary statements involving a possible delisting of the Company’s securities from the Nasdaq National Market, state sales or use tax uncertainties, the industry’s rapid technological change and exposure to inventory obsolescence, availability and allocation of goods, reliance on vendor support and relationships, competitive risks, pricing risks and economic risks.

As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms “the Company” and “Zones” refer to Zones, Inc., a Washington corporation, and its subsidiaries.

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, or other factors of which we may not yet be aware.

9

Possible Delisting of Securities from Nasdaq National Market.  The Company’s common stock is currently quoted on the Nasdaq National Market.  However, in order to continue to be included in the National Market, a company must maintain, among other things, a minimum closing bid price of $1.00 per share.  Since January 9, 2002, our common stock has consecutively failed to maintain a minimum closing bid price of $1.00 per share.  The Company has until May 15, 2002, to regain compliance with these standards. Under National Market rules, the Company may demonstrate compliance by maintaining a $1.00 minimum closing bid price per share for a minimum of ten consecutive trading days by that date. If the Company is unable to demonstrate compliance by that date, it may appeal a determination by Nasdaq that the common stock be delisted from the National Market, or it may decide to file an application to be transferred to the Nasdaq SmallCap Market. If such an application were filed and accepted, the Company would have another 90 days, or until approximately August 13, 2002, to comply with the minimum bid price requirement. In order to maintain compliance with the National Market listing requirements, the Company may be required to take various measures including, but not limited to, raising additional capital and effecting a reverse split of its common stock.  Certain of such measures, including any reverse stock split, would require shareholder approval.  If the Company is unable to demonstrate compliance by May 15, 2002 and does not appeal a determination by Nasdaq, its common stock will be delisted from the National Market.  The delisting of its common stock would have an adverse impact on the market price and liquidity of the Company’s securities and may adversely affect the ability to obtain additional financing.  As a result of such delisting, a shareholder may find it more difficult to dispose of, or to obtain accurate quotations as to the market value of, the Company’s common stock.

State Sales or Use Tax Uncertainties. The Company currently collects sales taxes or similar taxes on sales to customers in the States of Washington, Nevada, Tennessee, Illinois and Ohio. Various states have sought to require direct marketers to collect sales taxes on sales shipped to residents of those states. 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 mail order company whose contacts with the state are 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 interstate common carrier. However, legislation that would expand the ability of states to impose sales tax collection obligations on direct marketers has been introduced in Congress on many occasions. Due to its presence in various forms of electronic media and other factors, the Company’s current contact with various states may exceed the level of contact involved in the Supreme Court case. The Company cannot predict the level of contact that is sufficient to permit a state to impose a sales tax collection obligation on the Company. If legislation is passed to overturn the Supreme Court decision, the requirement to collect sales taxes or similar taxes on sales would result in additional administrative expenses for us, could result in increased prices to customers and could have a material adverse effect on the Company’s business, financial condition, cash flows or results of operations.

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

The Washington State Department of Revenue (the “Department”) is currently examining the Company’s state tax returns for the years 1996, 1997, 1998 and 1999. The Company has received a final report, and the Department has assessed $2.1 million plus interest. Based on discussions with the Department, the Company disagrees with substantially all of the deficiencies and has contested such deficiencies through the administrative appeals process and is pursuing further litigation. There can be no assurance that the Company will be successful, in whole or in part, in challenging the proposed deficiencies. Additionally, the Department may also make a similar assessment for 2000 and 2001. An unfavorable decision could have a material effect on the Company.

Future Growth. If the Company does not successfully manage growth in the future, it could significantly limit its ability to meet customer demand and business could be harmed. The current business strategy is to pursue additional growth and expand customer base through increased profitability and productivity in the Company’s account executives and targeted marketing tools for acquisition of new customers, retention of its current customers and reactivation of our previous customers. The Company’s future success will depend, in part, on our ability to manage this growth.

10

Pressure on Margins. The computer products industry has experienced intense price competition. The Company believes that its competition may aggressively price their product offerings to gain market share.  The Company may be required to reduce its profit margins to remain competitive in the future.  The slowdown in U.S. corporate IT spending has created a more intense competitive landscape that is disrupting the stability of pricing and exerting downward pressure on profit margins across all product lines.  Additionally, a number of manufacturers are providing their products direct to customers.  There can be no assurance that the Company will be able to maintain its gross margins in the future. If it is unable to maintain gross margins in the future, it could have an adverse effect on business, financial condition, cash flows and results of operations.

Variability of Operating Results. The Company has experienced significant fluctuations in its operating results from quarter to quarter as a result of many factors, including investment in activities to increase the productivity of its sales team, general economic conditions, the condition of the computer products industry, shifts in demand for computer products and industry announcements of new products or upgrades. For this reason, period to period comparisons of the Company’s financial results may not accurately forecast future performance.  If the Company is not profitable on a quarterly or annual basis, or if future operating results fall below the expectations of securities analysts or investors, its common stock price may decline.

Competition. The computer products industry is highly competitive. The Company believes that product selection, availability and price are the three most important competitive factors. The Company competes with other national direct marketers, including CDW Computer Centers, Inc., Insight Enterprises, Inc., PC Connection, and PC Mall, Inc. The Company also competes with product manufacturers, such as Dell and Gateway, that sell direct to end-users and large manufacturers, such as Compaq and IBM which are developing a customer direct model; specialty computer retailers; computer and general merchandise superstores; and consumer electronic and office supply stores. Many of these competitors rely heavily on the Internet as a marketing and sales channel. Some of the Company’s larger competitors compete principally on the basis of price and may have lower costs than the Company. The Company believes that competition may intensify in the future due to market conditions and consolidation. In the future, the Company may face fewer, but larger and better-financed competitors as a consequence of such consolidation. Additional competition may also arise if other methods of distribution emerge in the future. The Company competes not only for customers, but also for co-op advertising support from computer product manufacturers. There can be no assurance that the Company will be able to compete effectively with existing competitors or new competitors that may enter the market, or that the Company’s business, financial condition, cash flows and results of operations will not be adversely affected by intensified competition.

Vendor Support. The Company has various relationships with its vendors, whose programs contribute to profitability. The Company relies on its vendor partners for co-op advertising, which is a pass-through of expenses associated with catalogs, e-vehicles and direct mail pieces. In addition, certain manufacturers and distributors provide the Company with incentives in the form of rebates, discounts and trade allowances. Vendors also help offset the cost of returned inventory with discretionary return privileges. If any of these relationships are terminated, there can be no assurance that the Company’s business, financial condition, cash flows or results of operations will not be adversely affected.

Reliance on Vendor Relationships. The Company acquires products directly from manufacturers, such as Apple and IBM, as well as from distributors such as Ingram Micro, Tech Data and others. Certain hardware manufacturers limit the number of product units available to direct marketers such as the Company. Substantially all of the Company’s contracts and arrangements with its vendors are terminable without notice or upon short notice. Termination, interruption or contraction of the Company’s relationships with its vendors could have a material adverse effect on the Company’s business, financial condition, cash flows or results of operations.

Changing Methods of Distribution. The market for computer products is evolving rapidly in terms of product offerings and methods of distribution. New methods of distribution, such as on-line shopping services and electronic distribution of software, have emerged. Additionally, some manufacturers sell their hardware and software products directly to individual end-users or corporate accounts. These methods of distribution have resulted in increased patronage and other new methods of distribution may emerge in the future. The Company will be required to remain competitive with existing and evolving distribution channels and methods, and may be required to develop or adopt new methods for distribution in the future. Failure by the Company to do so could have a material adverse effect on its business, financial condition, cash flows or results of operations.

11

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

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

Major Customer. One of the Company’s customers represented 16.7% of total sales for the three-month period ended March 31, 2002. Net sales from this customer were $16.7 million the first quarter of 2002. The Company’s relationship with this customer has changed, and sales to this customer may continue to decline throughout 2002. Additionally, the Company is currently designated as a minority-owned business. This designation has contributed to the Company’s total net sales. There can be no assurances that this designation will contribute to future growth or that the Company will continue to hold this designation.

Reliance on Outsourced Distribution. Airborne Logistics Services, an affiliate of Airborne Express, provides and operates a warehouse and distribution center for the Company in Wilmington, Ohio under a renewable contract that expires in August 2003. Any limitation or interruption of the service being provided by Airborne Logistics could have a material adverse effect on the Company’s business, financial condition and results of operations. Certain distributors also participate in the Company’s logistics through electronic data interchange (“EDI”). Failure to develop and maintain relationships with these and other vendors that would limit the Company’s ability to obtain sufficient quantities of merchandise on acceptable commercial terms could have a material adverse effect on the Company’s business, financial condition, cash flows and results of operations.

Dependence on Key Personnel. The Company’s future success will depend to a significant extent upon the ability to attract and retain skilled personnel. Although the Company’s success will depend on its ability to hire, train and retain competent personnel in all areas of its business, there are certain individuals that play a key role within the organization. Loss of any of these individuals could have an adverse effect on the Company’s business, financial condition, cash flows and results of operations.

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

General

The Company’s revenues consist primarily of sales of computer hardware, software, peripherals and accessories, as well as revenue associated with freight billed to its customers. Net sales are product sales only, and reflect the effects of product returns. Gross profit consists of net sales less product and freight costs. Selling, general and administrative (“SG&A”) expenses include advertising expense net of vendor co-op, warehousing, selling commissions, order processing, telephone, credit card fees, and other costs such as administrative salaries, depreciation, rent, and general overhead expenses. Other (income) expense represents interest expense and net non-operating expenses.

12

Results of Operations

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

	Three months ended March 31,
	2002			2001
Net sales		100.0	%		100.0	%
Cost of sales		89.4			90.4
Gross profit		10.6			9.6
Selling, general and administrative expenses		10.4			9.4
Income from operations		0.2			0.2
Other (income) expense		0.0			0.1
Income before income taxes		0.2			0.1
Provision for income taxes		0.1			0.0
Net income		0.1	%		0.1	%
Selected domestic operating data:
Catalog circulation		3,663,000			3,200,000
E-media circulation		3,622,000			3,065,000
Number of orders		131,000			183,000
Average order size		$775			$888
Number of account executives, end of period		152			281

Comparison of Three Month Periods Ended March 31, 2002 and 2001

Net Sales. Net sales for the quarter ended March 31, 2002 decreased 38.0% to $99.8 million compared to $161.2 million in the first quarter of 2001. The decrease in sales resulted primarily from the impact of the sluggish economy that has reduced IT spending by businesses, and as a result of the anticipated decline in sales to a major customer. Sales to this major customer decreased 64.1% to $16.7 million for the quarter ended March 31, 2002 compared to $46.5 million in the same period of 2001. Total outbound driven sales to the SMB, enterprise and government and education accounts decreased 38.8% to $84.2 million in the first quarter of 2002 from $137.7 million in the first quarter of 2001. However, the Company had a sequential sales increase in its core SMB market, which increased 7.6% to $43.8 million in the first quarter of 2002 from $40.7 million in the fourth quarter of 2001. One of the Company’s current goals is to expand its portfolio of enterprise accounts, and focus on the productivity of its commercial accounts sales force. Sales by the Company’s Mac division decreased 33.3% to $15.6 million for the three months ended March 31, 2002 compared to $23.5 million in the comparable period in 2001.

The Company’s average order size decreased to $775 for the three months ended March 31, 2002 from $888 in the first quarter of 2001. This is primarily due to a decline in the Company’s enterprise sales division: enterprise sales generally have larger per order shipments. PC platform sales accounted for 71.4% of total sales for the quarter ended March 31, 2002 compared to 76.1% in the first quarter of 2001.

Gross Profit. Gross profit dollar contribution decreased to $10.6 million for the first quarter of 2002, down 31.8% from the first quarter of 2001, which corresponds to the decline in sales volume. However, gross profit as a percentage of net sales increased to 10.6% in the quarter ended March 31, 2002 compared to 9.6% in the first quarter of 2001, and sequentially from 10.3% in the fourth quarter of 2001. This increase in gross profit margin percentage has been primarily due to customer mix, product mix and related vendor programs as well as taking advantage of early pay discounts.

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Selling, General and Administrative (“SG&A”) Expenses. SG&A expense dollars decreased 31.4% to $10.4 million for the quarter ended March 31, 2002 from $15.2 million in the first quarter of 2001, and sequentially, SG&A expense dollars decreased 13.6% from $12.1 million in the fourth quarter of 2001. The Company maintained tight controls on discretionary spending throughout the first quarter of 2002 and trimmed personnel costs associated with the support of a major customer. In addition, the Company reassessed the estimated useful lives of selected technology assets and extended the depreciation period resulting in an expense reduction of approximately $354,000. The impact was primarily due to the Company’s planned investment in a new enterprise system that was delayed due to the economic environment. Therefore, the Company reevaluated the useful life of its existing enterprise system, in conjunction with the estimated life of its investment in web development. As a percent of sales, SG&A increased to 10.4% for the quarter ended March 31, 2002 from 9.4% in the first quarter of 2001 due to the decline in sales volume.

The Company produces and distributes catalogs at various intervals throughout the year. The Company’s net cost of advertising decreased to $202,000 in the three month period ended March 31, 2002 from $757,000 in the comparable 2001 period. This decrease in net cost is primarily due to the discontinuation of the on-line advertising expense associated with the PC consumer customer segment.

Other Income/Expense. Other income was $14,000 for the quarter ended March 31, 2002 compared to other expense of $110,000 in the first quarter of 2001. The change was primarily due to a decrease in interest expense incurred in the first quarter of 2002 compared with the same period of 2001.

Provision for Income Taxes. The provision for income taxes for the quarter ended March 31, 2002 was $52,000 as compared to a provision of $65,000 in the comparable period of the prior year. The Company’s effective tax rate expressed as a percentage of income before taxes was 39.1% for the quarter ended March 31, 2002 compared to 38.5% for the quarter ended March 31, 2001.

Net Income. Net income for the quarter ended March 31, 2002 was $81,000 compared to net income of $104,000 in the first quarter of 2001. Basic and diluted earnings per share was $0.01 for the quarter ended March 31, 2002 and basic and diluted earnings per share was $0.01 in the first quarter of 2001.

Trends

The Company has been affected by the pervasive slowdown in U.S. corporate information technology (“IT”) spending over the past several quarters. The Company is still operating in an intensely competitive environment, and customer-purchasing trends continue to be difficult to forecast. While there are some encouraging signs in certain sectors, it is unclear whether the second quarter will show meaningful improvement in overall sales. In response to the static environment, the Company continued to focus on the key elements of its business: diversification of sales, initiatives to improve margin, and continued control of discretionary expenses.

The Company markets its products across several sectors to drive sales growth, while striving to become one of the leading business to business direct marketers of IT infrastructure solutions. The Company is building a niche in the enterprise business arena, and believes it is in a position to fulfill enterprise business level needs efficiently and profitably. Its outbound sales force, in conjunction with the small business group, which is the training ground for less tenured account executives, actively pursues the small to medium sized business customer. The Company believes there is growth potential and has recently invested in its Public Sector division by bringing in strong new leadership. Lastly, the Company’s legacy is in the Mac market. As previously noted, increasing Mac market share is a key objective and the Company will continue to promote Mac-platform product to both businesses and consumers.

The competitive landscape in the IT market has led to an intense focus on the key drivers of gross profit margin. This focus has led to several initiatives intended to grow the Company’s gross profit margin percentage. An increase in gross profit margin percentage is a company-wide initiative and will be primarily driven by customer mix, product mix and related vendor programs, attach rates, freight, purchasing power, account executive education, pricing strategies as well as taking advantage of early pay discounts.

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The Company constantly reviews all internal processes to create efficiencies and reduce waste. It continues its efforts to maintain tight controls over all discretionary expenses, which has been a focal point for the past several quarters in light of the existing economic conditions. Additionally, the Company’s advertising expenditures are constantly reviewed in an effort to maintain a positive return on investment through the varying advertising venues. The Company invests in programs that have historically driven revenue growth, or are directed at lead generation.

The Company remains hopeful that a rebound in technology spending and accelerating profitability will occur during the latter half of 2002. The Company believes it is in a position to leverage its existing infrastructure as technology spending rebounds, while utilizing these initiatives to create opportunities for growth in the currently unstable market.

Industry

The market for computer products is characterized by rapid changes and frequent introductions of new products and product enhancements. These changes result in rapid price fluctuations and have led to continued average selling price reductions and lower margin dollars per transaction. In order to remain competitive, the Company may be required to reduce its prices. Such a reduction in prices could have a material adverse effect on the Company’s future results of operations.

Inflation

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

Liquidity and Capital Resources

As of March 31, 2002, the Company had total assets of $71.0 million, of which $58.4 million were current assets. At March 31, 2002 and December 31, 2001 the Company had cash and cash equivalents, and restricted cash of $10.4 million and $13.1 million, respectively, and working capital of $19.7 million and $19.3 million, respectively. The Company continued to utilize its cash position to take advantage of favorable discount terms offered by certain vendors. The Company’s accounts receivable days outstanding increased to 36 days at March 31, 2002 compared to 32 days at December 31, 2001. The Company expects the days outstanding to increase to approximately 45 days by the end of the second quarter of 2002 due to a change in payment terms with a major customer.

Net cash used by operating activities was $2.3 million for the three months ended March 31, 2002 compared to cash provided by operating activities of $10.6 million for the three months ended March 31, 2001. Cash outflows for the three months ended March 31, 2002 were primarily due to decreases in accounts payable partially offset by a decline in inventories. In the three months ended March 31, 2002, accounts payable decreased $6.7 million while inventories decreased by $3.6 million from December 31, 2001.

Cash outlays for capital expenditures were $651,000 and $1.2 million in the three months ended March 31, 2002 and 2001, respectively. These expenditures were primarily for continued improvement, and other enhancements, of the Company’s information systems.

The net amount of accounts payable outstanding at March 31, 2002 was $32.0 million, of which $12.2 million was drawn from a $35.0 million flooring facility and working capital line, collateralized by inventories and accounts receivable. This credit facility expires June 30, 2002 and is subject to annual renewals. At this time, the Company expects to renew this facility. The facility contains various restrictive covenants relating to profitability, tangible net worth, leverage, dispositions and use of collateral, other asset dispositions, and merger and consolidation of the Company. At March 31, 2002, the Company had no outstanding borrowing amount on the working capital line of credit. Additionally, at March 31, 2002, the Company had restricted cash representing an unused standby letter of credit of $930,000.

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The Company believes that its existing available cash and cash equivalents, operating cash flow and existing credit facilities will be sufficient to satisfy its operating cash needs for at least the next 12 months at its current revenue level. However, if the Company’s future revenues decline below the current level, or if working capital erodes and other capital requirements are greater than currently anticipated, the Company could be required to seek additional funds through sales of equity, debt or convertible securities or increased credit facilities. There can be no assurance that additional financing will be available or that, if available, the financing will be on terms favorable to the Company and its shareholders.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

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

Part II.

Item 1. Legal Proceedings

Various claims and actions of a type commonly encountered in the Company’s industry have been asserted and are pending against the Company. The Company believes that such claims and actions will not have a material adverse effect upon the Company’s financial position or results of operations.

The Washington State Department of Revenue (the “Department”) is currently examining the Company’s state tax returns for the years 1996, 1997, 1998 and 1999. The Company has received a final report, and the Department has assessed $2.1 million plus interest. Based on discussions with the Department, the Company disagrees with substantially all of the deficiencies and has contested such deficiencies through the administrative appeals process and is pursuing further litigation. There can be no assurance that the Company will be successful, in whole or in part, in challenging the proposed deficiencies. Additionally, the Department may also make a similar assessment for 2000 and 2001. An unfavorable decision could have a material effect on the Company.

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Item 6. Exhibits and Reports on Form 8-K

(a) Exhibits

None.

(b) Reports on Form 8-K

No Reports on Form 8-K were filed during the quarter ended March 31, 2002.

Signatures

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:

Date: May 15, 2002

By: ZONES, INC.

/S/ FIROZ H. LALJI
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Firoz H. Lalji, Chairman and Chief Executive Officer

/S/ RONALD P. MCFADDEN
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Ronald P. McFadden, Chief Financial Officer