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.

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.

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            Nine months ended
                                              September 30,                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.

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.

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.

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.

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.