** **

**UNITEDSTATES**

**SECURITIES AND EXCHANGE COMMISSION**

## **Washington, D.C. 20549**

 

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**FORM 10-Q**

 

**(MarkOne)**

 

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

 

**For the quarterly period ended October 2,2005**

 

**or**

 

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

 

**For the Transition Period From                  to**

 

**Commission file number 0-26786**

 

**APAC Customer Services, Inc.**

(Exact name of registrant as specified in its charter)

 
| **Illinois**(State or other jurisdiction  of incorporation or organization) | ** ** | **36-2777140**(I.R.S. Employer  Identification No.) |
|-----------------------------------------------------------------------------|------------|-----------------------------------------------------|

 

**Six Parkway North, Deerfield,Illinois 60015**(Address of PrincipalExecutive Offices, Zip Code)

 

Registrant’s telephone number, including areacode:   **(847) 374-4980**

 

Indicate by check markwhether registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter periods that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.

Yes ý                                                             Noo

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in rule 12b-2of the Exchange Act).

Yes ý                                                             Noo

 

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

Yes o                                                             Noý

 

There were 49,454,654 common shares, $0.01 par valueper share, outstanding as of November 10, 2005.

 

 

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## **Index**

## ** **

| **Part I. Financial Information**                                                                                                           |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                             |   |
| Item 1. Consolidated  Condensed Financial Statements (Unaudited):                                                                                |   |
|                                                                                                                                             |   |
| Consolidated  Condensed Balance Sheets as of October 2, 2005, and January 2, 2005                                                      |   |
|                                                                                                                                             |   |
| Consolidated Condensed  Statements of Operations for the Thirteen and Thirty-Nine Weeks Ended October 2,  2005, and September 26, 2004 |   |
|                                                                                                                                             |   |
| Consolidated Condensed  Statements of Cash Flows for the Thirty-Nine Weeks Ended October 2,  2005, and September 26, 2004              |   |
|                                                                                                                                             |   |
| Notes  to Consolidated Condensed 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                                                                              |   |
|                                                                                                                                             |   |
| Item 4. Controls and Procedures                                                                                                                  |   |
|                                                                                                                                             |   |
| **Part II. Other Information**                                                                                                              |   |
|                                                                                                                                             |   |
| Item 1. Legal Proceedings                                                                                                                        |   |
|                                                                                                                                             |   |
| Item 6. Exhibits                                                                                                                                 |   |

 

2

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## **Part I. Financial Information**

## ** **

# **Item1.**ConsolidatedCondensed Financial Statements

# ** **

## **APAC Customer Services, Inc.and Subsidiaries**

**Consolidated Condensed BalanceSheets**

**(Unaudited)**

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

 
| ** **                                                                                                                                                  | ** ** | **October 2,  2005** | ** ** | **January 2,  2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------|------------|---------------------------|------------|
| **Assets**                                                                                                                                                  | ** ** | ** **                | ** ** | ** **                | ** ** |
| **Current assets:**                                                                                                                                         |       |                      |       |                      |       |
| Cash and cash equivalents                                                                                                                                   |       | $                         | 859        |                      | $          | 271 |   |
| Accounts receivable, net                                                                                                                                    |       | 33,278                    |       | 41,002                    |       |
| Other current assets                                                                                                                                        |       | 11,592                    |       | 11,253                    |       |
| Total current assets                                                                                                                                        |       | 45,729                    |       | 52,526                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Property and equipment, net**                                                                                                                             |       | 21,827                    |       | 24,214                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Goodwill**                                                                                                                                                |       | 13,338                    |       | 23,876                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Other intangible assets, net**                                                                                                                            |       | 10,928                    |       | 12,688                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Deferred taxes**                                                                                                                                          |       | 12,994                    |       | 5,748                     |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Other assets**                                                                                                                                            |       | 931                       |       | 481                       |       |
| Total assets                                                                                                                                                |       | $                         | 105,747    |                      | $          | 119,533 |   |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Liabilities and Shareholders’ Equity**                                                                                                               |       |                      |       |                      |       |
| **Current  liabilities:**                                                                                                                                   |       |                      |       |                      |       |
| Current maturities of long-term debt                                                                                                                        |       | $                         | 5,361      |                      | $          | 313 |   |
| Accounts payable                                                                                                                                            |       | 3,991                     |       | 3,544                     |       |
| Income taxes payable                                                                                                                                        |       | 17,196                    |       | 16,629                    |       |
| Accrued payroll and related items                                                                                                                           |       | 14,602                    |       | 15,048                    |       |
| Accrued liabilities                                                                                                                                         |       | 10,299                    |       | 8,481                     |       |
| Total current liabilities                                                                                                                                   |       | 51,449                    |       | 44,015                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Long-term debt, less current maturities**                                                                                                                 |       | —                    |       | —                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Other liabilities**                                                                                                                                       |       | 1,163                     |       | 1,355                     |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Commitments and contingencies**                                                                                                                           |       | —                    |       | —                    |       |
|                                                                                                                                                        |       |                      |       |                      |       |
| **Shareholders’ equity**                                                                                                                               |       |                      |       |                      |       |
| Common shares, $0.01 par value; 200,000,000 shares  authorized; 49,695,699 shares issued and outstanding at October 2, 2005,  and January 2, 2005 |       | 497                       |       | 497                       |       |
| Additional paid-in capital                                                                                                                                  |       | 99,598                    |       | 99,598                    |       |
| Accumulated deficit                                                                                                                                         |       | (45,814                   | )          | (24,912                   | )          |
| Accumulated other comprehensive loss                                                                                                                        |       | (299                      | )          | (173                      | )          |
| Treasury shares: 241,045 shares, at cost at October 2,  2005, and January 2, 2005                                                                 |       | (847                      | )          | (847                      | )          |
| Total shareholders’ equity                                                                                                                             |       | 53,135                    |       | 74,163                    |       |
| Total liabilities and shareholders’ equity                                                                                                             |       | $                         | 105,747    |                      | $          | 119,533 |   |

 

See notes to consolidated condensed financialstatements

 

3

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**APAC Customer Services, Inc. andSubsidiaries**

**Consolidated Condensed Statementsof Operations**

**(Unaudited)**

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

 
| ** **                                          | ** ** | **Thirteen  Weeks Ended**   | ** ** | **Thirty-Nine  Weeks Ended**   | ** ** |
|-----------------------------------------------------|------------|-----------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **October 2,****2005** | ** ** | **September 26,****2004** | ** ** | **October 2,****2005** | ** ** | **September 26,****2004** | ** ** |
| ** **                                          | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net revenue**                                     |       | $                           | 56,343     |                           | $          | 64,626 |   | $ | 180,176 |   | $ | 204,036 |   |
| Cost of services                                    |       | 50,966                      |       | 58,060                         |       | 165,275 |   | 176,686 |   |
| **Gross Profit**                                    |       | 5,377                       |       | 6,566                          |       | 14,901 |   | 27,350 |   |
|                                                |       |                        |       |                           |       |   |   |   |   |
| **Operating expenses:**                             |       |                        |       |                           |       |   |   |   |   |
| Selling, general and  administrative expenses       |       | 8,082                       |       | 9,967                          |       | 27,054 |   | 30,468 |   |
| Restructuring and other  charges                    |       | 2,074                       |       | 159                            |       | 3,211 |   | 2,009 |   |
| Asset impairment charges                            |       | 10,762                      |       | —                         |       | 10,886 |   | 2,234 |   |
| Total operating expenses                            |       | 20,918                      |       | 10,126                         |       | 41,151 |   | 34,711 |   |
| **Operating loss**                                  |       | (15,541                     | )          | (3,560                         | )          | (26,250 | ) | (7,361 | ) |
| Other income                                        |       | (582                        | )          | (25                            | )          | (644 | ) | (219 | ) |
| Interest expense, net                               |       | 305                         |       | 140                            |       | 1,006 |   | 431 |   |
|                                                |       |                        |       |                           |       |   |   |   |   |
| **Loss before income taxes**                        |       | (15,264                     | )          | (3,675                         | )          | (26,612 | ) | (7,573 | ) |
| Income tax benefit                                  |       | (1,757                      | )          | (1,397                         | )          | (5,710 | ) | (2,878 | ) |
|                                                |       |                        |       |                           |       |   |   |   |   |
| **Net loss**                                        |       | $                           | (13,507    | )                              | $          | (2,278 | ) | $ | (20,902 | ) | $ | (4,695 | ) |
| ** **                                          | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Net loss per share:**                             | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                          | ** ** | ** **                  | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic                                               |       | $                           | (0.27      | )                              | $          | (0.05 | ) | $ | (0.42 | ) | $ | (0.10 | ) |
| Diluted                                             |       | $                           | (0.27      | )                              | $          | (0.05 | ) | $ | (0.42 | ) | $ | (0.10 | ) |
|                                                |       |                        |       |                           |       |   |   |   |   |
| **Weighted average number of  shares outstanding:** | ** ** | ** **                  |       |                           |       |   |   |   |   |
| Basic                                               |       | 49,455                      |       | 49,455                         |       | 49,455 |   | 49,452 |   |
| Diluted                                             |       | 49,455                      |       | 49,455                         |       | 49,455 |   | 49,452 |   |

 

See notes to consolidated condensed financial statements.

 

4

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**APAC Customer Services, Inc. andSubsidiaries**

**Consolidated Condensed Statementsof Cash Flows**

**(Unaudited)**

**(In thousands)**

 
| ** **                                                                   | ** ** | **Thirty-Nine Weeks Ended** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                   | ** ** | **October 2,  2005**   | ** ** | **September 26,  2004** | ** ** |
|                                                                         |       |                        |       |   |   |
| **Operating  activities:**                                                   |       |                        |       |   |   |
|                                                                         |       |                        |       |   |   |
| Net loss                                                                     |       | $                           | (20,902    | ) | $ | (4,695 | ) |
| Depreciation and amortization                                                |       | 9,054                       |       | 8,127 |   |
| Non-cash restructuring charges                                               |       | 197                         |       | 279 |   |
| Asset impairment charges                                                     |       | 10,886                      |       | 2,200 |   |
| Deferred income taxes                                                        |       | (5,356                      | )          | 758 |   |
| Gain on sale of property and equipment                                       |       | (398                        | )          | — |   |
| Change in operating assets and liabilities                                   |       | 8,224                       |       | (565 | ) |
| Net cash provided by operating activities                                    |       | 1,705                       |       | 6,104 |   |
|                                                                         |       |                        |       |   |   |
| **Investing  activities:**                                                   |       |                        |       |   |   |
| ** **                                                                   |       |                        |       |   |   |
| Purchases of property and equipment, net of  disposals                       |       | (6,023                      | )          | (6,646 | ) |
| Net proceeds from sale of property and equipment                             |       | 626                         |       | — |   |
| Net cash used by investing activities                                        |       | (5,397                      | )          | (6,646 | ) |
|                                                                         |       |                        |       |   |   |
| **Financing  activities:**                                                   |       |                        |       |   |   |
|                                                                         |       |                        |       |   |   |
| Borrowings under revolving credit facility                                   |       | 5,361                       |       | — |   |
| Payments on long-term debt                                                   |       | (313                        | )          | (289 | ) |
| Financing fees                                                               |       | (768                        | )          | — |   |
| Stock and warrant transactions                                               |       | —                      |       | 24 |   |
| Net cash provided (used) by financing activities                             |       | 4,280                       |       | (265 | ) |
| **Net  change in cash and cash equivalents**                                 | ** ** | 588                         |       | (807 | ) |
|                                                                         |       |                        |       |   |   |
| **Cash  and cash equivalents:**                                              |       |                        |       |   |   |
|                                                                         |       |                        |       |   |   |
| **Beginning  balance**                                                       |       | 271                         |       | 11,428 |   |
|                                                                         |       |                        |       |   |   |
| **Ending  balance**                                                          |       | $                           | 859        |   | $ | 10,621 |   |
|                                                                         |       |                        |       |   |   |
| **Supplemental  Disclosures:**                                               |       |                        |       |   |   |
| Cash flow information:                                                       |       |                        |       |   |   |
| Increase in other receivables as a result of sale of  property and equipment |       | $                           | 650        |   | — |   |

 

See notes to consolidated condensed financial statements

 

5

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**APAC Customer Services, Inc. and Subsidiaries**

**Notes to Consolidated CondensedFinancial Statements**

**(Unaudited)**

**(Dollars in thousands, except as otherwiseindicated)**

 

**1.   Basis of Presentation**

 

The accompanying unaudited consolidated condensed financial statementsof APAC Customer Services, Inc. and its subsidiaries (collectively, the “Company”)have been prepared in accordance with generally accepted accounting principlesfor interim financial information and the instructions to Form 10-Q and Article 10of Regulation S-X.  Accordingly, they donot include all of the information and footnotes required by generally acceptedaccounting principles for complete financial statements.  In the opinion of management, all adjustments(consisting of normal recurring accruals) considered necessary for a fairpresentation have been included. Operating results for the thirteen and thirty-nine week periods ended October 2,2005, are not necessarily indicative of the results that may be expected forthe fiscal year ending January 1, 2006. The balance sheet at January 2, 2005, has been derived from theaudited financial statements at that date but does not include all of theinformation and footnotes required by generally accepted accounting principlesfor complete financial statements.  Foradditional information, refer to the financial statements and footnotes theretoincluded in the Company’s Annual Report on Form 10-K for the year ended January 2,2005.  Copies of the Company’s filingsare available on a web site maintained by the SEC at http://www.sec.gov.

 

The Company has sustained significant losses in fiscal 2004 and in thefirst nine months of fiscal 2005. In particular, the Company incurred a netloss of $20.9 million for the first nine months of fiscal 2005, compared to anet loss of $4.7 million for the same period in fiscal 2004, and an overall netloss of $6.5 million for the fiscal year ended January 2, 2005.  In an effort to return the Company toprofitability, the Company initiated a restructuring plan to exit virtually allof its outbound customer acquisition business, close over half of its CustomerInteraction Centers, eliminate 400 salaried positions and pursue otheroperational improvements as discussed in Note 9**. **To facilitate itsrestructuring plan, the Company entered into a waiver and amendment of itsCredit Agreement with LaSalle Bank National Association (“LaSalle”) on July 27,2005, as discussed in Note 8.

 

Subsequentlyon October 31, 2005, the Company entered into an Amended and Restated Loanand Security Agreement (the “Restated Credit Agreement”) with LaSalle, asdescribed in Note 8. The Company expects that its cash balances, cashflows from future operations and available borrowings under the Restated CreditAgreement will be sufficient to meet normal operating needs, fund any plannedcapital expenditures, fund any expenditures related to the Company’srestructuring plan and repay debt obligations as they come due.  A significant change in operating cash flowor a failure to successfully implement its restructuring plan could negativelyimpact the Company’s ability to meet its cash requirements and comply with thecovenants in the Restated Credit Agreement.

 

**2.   AccruedLiabilities**

 

The components of other accrued liabilities included in theconsolidated condensed balance sheets are as follows:

 

| ** **                         | ** ** | **October 2,** | ** ** | **January 2,** | ** ** |
|------------------------------------|------------|---------------------|------------|---------------------|------------|
| ** **                         | ** ** | **2005**            | ** ** | **2005**            | ** ** |
|                               |       |                |       |                |       |
| Accrued workers’ compensation |       | $                   | 3,074      |                | $          | 3,122 |   |
| Short-term restructuring charges   |       | 1,119               |       | 391                 |       |
| Current deferred income            |       | 1,289               |       | 279                 |       |
| Accrued severance                  |       | 683                 |       | 294                 |       |
| Accrued professional fees          |       | 625                 |       | 1,007               |       |
| Accrued property tax               |       | 595                 |       | 752                 |       |
| Other                              |       | 2,914               |       | 2,636               |       |
| Total                              |       | $                   | 10,299     |                | $          | 8,481 |   |

 

6

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**3.   Goodwill and Other Intangible Assets**

 

Under the provisions ofStatement of Financial Accounting Standards No. 142, “Goodwill and OtherIntangible Assets” (“SFAS No. 142”), the Company is required to test allexisting goodwill and intangible assets for impairment at least annually.  The Company’s policy is to test goodwill forimpairment as of the end of the fiscal year or more frequently if events occurthat would necessitate a more frequent review. Given the restructuring plan described in Note 9, the Company performedan interim impairment test of goodwill in the third quarter.  The Company obtained a third-party valuationof the Company and compared that valuation to the carrying cost of theCompany.  The comparison indicated thatgoodwill was impaired.  The Companymeasured the amount of impairment by allocating the valuation to the assets andliabilities of the Company and comparing the unallocated residual to thecarrying cost of goodwill.  Thecomparison resulted in an impairment charge of $10,538.  The remaining carrying value of goodwill,after the impairment charge, is $13,338. The Company will perform its annual impairment test in the fourthquarter of 2005.

 

The identifiable otherintangible assets of the Company represent acquired customer relationships witha gross carrying value of $28,493 and accumulated amortization of $17,565 and$15,805 as of October 2, 2005, and January 2, 2005,respectively.  Under SFAS No. 142,identifiable intangible assets with finite lives are amortized.  The customer relationship intangible assetsare amortized on a straight-line basis over the expected period of benefit of12 years. Total amortization expense related to intangible assets for theperiods ended October 2, 2005, and September 26, 2004, was $587 forthe quarter and $1,760 year to date. Annual amortization expense is expected tobe $2,348 for fiscal 2005 through 2009 and $958 in fiscal 2010.

 

**4.    New Accounting Pronouncements**

 

In the fourthquarter of 2004, the Financial Accounting Standards Board (“FASB”) issuedStatement No. 123 (revised 2004), “Share-Based Payment”, (“SFAS No. 123(R)”)which replaces SFAS No. 123 “Accounting for Stock-Based Compensation”, andsupersedes Accounting Principles Board Opinion No. 25, “Accounting forStock Issued to Employees” (“APB 25”). SFAS No. 123(R) establishes accounting standards for equityinstruments that an entity exchanges for goods or services. It also addressestransactions where an entity incurs liabilities in exchange for goods orservices that are based on the fair value of the entity’s equity instruments orthat may be settled by the issuance of those equity instruments. This Statementfocuses primarily on accounting for share-based payment transactions as itrelates to employee services. SFAS No. 123(R) requires a public entity tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the grant-date fair value of the award. That costis to be recognized over the period during which an employee is required toprovide service in exchange for the award (usually the vesting period). Nocompensation cost is recognized for equity instruments for which employees donot render the requisite service. The grant-date fairvalue of share options and similar instruments is to be estimated usingoption-pricing models adjusted for the unique characteristics of thoseinstruments.

 

SFAS No. 123(R)eliminates the option to use APB 25’s intrinsic value method of accounting thatwas provided in Statement No. 123 as originally issued. Under APB 25,issuing stock options to employees generally resulted in recognition of nocompensation cost. Statement No. 123 also required pro forma disclosureshowing the effect on net income and earnings per share as if the Company hadapplied the fair value recognition provision of Statement No. 123. After aphase-in period for Statement No. 123(R), this type of disclosure will nolonger be allowed.

 

7

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Although alternativephase-in methods are allowed under Statement No. 123(R), the Company hasnot yet determined the phase-in method it will use.  The Company believes that whatever phase-inmethod is selected, the adoption of SFAS No. 123(R) is likely to have amaterial effect on the Company’s results of operations and financial position.On April 14, 2005, the Securities and Exchange Commission (SEC) announcedthe adoption of a rule that defers the required effective date of SFAS123(R).  The SEC rule provides that Statement 123(R) is now effectivefor registrants as of the beginning of the first fiscal year beginning after June 15,2005, instead of at the beginning of the first fiscal quarter after June 15,2005 (as prescribed originally by the FASB Statement).

 

**5.  Accounting for Stock-Based Compensation**

 

For stock-based employeecompensation plans, the Company has elected to use the intrinsic value methodprescribed by APB No. 25.  Inaccordance with APB No. 25, no compensation expense is recognized forstock options issued to employees when the option price equals or exceeds thefair market value of the Company’s common shares at the date of grant.  Stock-based compensation expense fornon-employees is recognized in accordance with SFAS No. 123.

 

The following tableillustrates the effect on net income and earnings per share if the Company hadadopted the fair value recognition provisions of SFAS No. 123.

 
| ** **                                                             | ** ** | **Thirteen Weeks Ended**  | ** ** | **Thirty-Nine Weeks Ended**  | ** ** |
|------------------------------------------------------------------------|------------|---------------------------|------------|------------------------------|------------|
| ** **                                                             | ** ** | **October 2,  2005** | ** ** | **September 26,  2004** | ** ** | **October 2,  2005** | ** ** | **September 26,  2004** | ** ** |
|                                                                   |       |                      |       |                         |       |   |   |   |   |
| Net loss as reported                                                   |       | $                         | (13,507    | )                            | $          | (2,278 | ) | $ | (20,902 | ) | $ | (4,695 | ) |
| Less-compensation expense on stock options, net of  income tax benefit |       | (162                      | )          | (306                         | )          | (776 | ) | (1,051 | ) |
| Net loss pro forma                                                     |       | $                         | (13,669    | )                            | $          | (2,584 | ) | $ | (21,678 | ) | $ | (5,746 | ) |
| Loss per share – basic                                            |       |                      |       |                         |       |   |   |   |   |
| As reported                                                            |       | $                         | (0.27      | )                            | $          | (0.05 | ) | $ | (0.42 | ) | $ | (0.10 | ) |
| Pro forma                                                              |       | $                         | (0.28      | )                            | $          | (0.05 | ) | $ | (0.44 | ) | $ | (0.12 | ) |
| Loss per share – diluted                                          |       |                      |       |                         |       |   |   |   |   |
| As reported                                                            |       | $                         | (0.27      | )                            | $          | (0.05 | ) | $ | (0.42 | ) | $ | (0.10 | ) |
| Pro forma                                                              |       | $                         | (0.28      | )                            | $          | (0.05 | ) | $ | (0.44 | ) | $ | (0.12 | ) |

 

In order to calculate the pro forma information set forth above, thefair value of each option is estimated on the date of grant based on the Black-Scholesoption-pricing model.  Assumptionsinclude no dividend yield, risk-free interest rates ranging from 4% to 7%,expected volatility ranging between 45% and 90%, and an expected life rangingfrom 7 years to 10 years.

 

8

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**6.   Comprehensive Loss**

 

Comprehensive loss is asfollows:

 
| ** **                        | ** ** | **Thirteen Weeks Ended**  | ** ** | **Thirty-Nine Weeks Ended**  | ** ** |
|-----------------------------------|------------|---------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **October 2,  2005** | ** ** | **September 26,  2004** | ** ** | **October 2,  2005** | ** ** | **September 26,  2004** | ** ** |
|                              |       |                      |       |                         |       |   |   |   |   |
| Net loss                          |       | $                         | (13,507    | )                            | $          | (2,278 | ) | $ | (20,902 | ) | $ | (4,695 | ) |
| Foreign currency translation loss |       | (148                      | )          | (8                           | )          | (126 | ) | (55 | ) |
| Total comprehensive loss          |       | $                         | (13,655    | )                            | $          | (2,286 | ) | $ | (21,028 | ) | $ | (4,750 | ) |

 

Foreign currency translation gains and losses relate to the impact of achange in exchange rates on net assets located in the Philippines.

 

**7.   LegalProceedings**

 

The Company is subject to occasionallawsuits, governmental investigations and claims arising out of the normalconduct of its business.  Management doesnot believe the outcome of any such pending claims will have a material adverseimpact on the Company’s consolidated financial position, annual results ofoperations or liquidity.  Although theCompany does not believe that any of these proceedings will result in amaterial adverse effect, no assurance to that effect can be given.

 

**8.   Long Term Debt**

 

On June 2, 2005, the Company enteredinto a Loan and Security Agreement (“Credit Agreement”) with LaSalle, as Agent,and the Financial Institutions from time to time parties thereto as Lendersreplacing the Company’s previous credit facility. The terms of the CreditAgreement provides for up to a $40.0 million revolving credit facility thatwill expire in June 2008. The outstanding revolving loan commitment underthe Credit Agreement is $25.0 million based on the Company’s anticipated cashrequirements. Borrowing availability is based on accounts receivable and issubject to certain restrictions and limitations set forth in the CreditAgreement.

 

 On July 27,2005, the Company entered into Waiver and Amendment No. Three (“Amendment”)to the Credit Agreement.  Under the termsof the Amendment, LaSalle agreed to waive certain existing and anticipatedevents of default under the Credit Agreement, amend the financial covenantscontained in the original Credit Agreement and provide an overadvance facilityin an amount not to exceed $11.0 million. Theodore G. Schwartz, the Chairman of the Board of Directors of theCompany, guaranteed $5.5 million of the overadvance facility, plus certaincosts and expenses.

 

On October 31, 2005, the Company enteredinto an Amended and Restated Loan and Security Agreement (the “Restated CreditAgreement”) with LaSalle, as Agent, and the Financial Institutions from time totime parties thereto as Lenders.  TheRestated Credit Agreement amends and restates the Credit Agreement, as amended.  Under the terms of the Restated CreditAgreement, LaSalle agreed, among other things, to provide the Company with a$25 million revolving loan facility which expires in October 2008, reducethe interest rates and other fees, amend the financial covenants and releasethe guarantee that had been provided by Theodore G. Schwartz.  Other restrictive covenants which limit theCompany’s ability to incur additional indebtedness, repurchase outstandingcommon shares, create liens, acquire, sell or dispose of certain assets, engagein certain mergers and acquisitions, pay dividends and to make

 

9

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certain restricted payments remain ineffect.  The Restated Credit Agreement issecured principally by a grant of a security interest in all personal propertyand fixtures of the Company.  Borrowingsunder the Restated Credit Agreement incur a floating interest rate based on theLIBOR index rate or an alternate base rate defined in the Restated CreditAgreement.  In addition, the Company paysa commitment fee on the unused portion of the revolving facility as well asfees on outstanding letters of credit.  Hadthe Restated Credit Agreement been in place on October 2, 2005, theCompany would have had approximately $8.4 million of unused borrowing capacity.

 

# **9.  Restructuring and Other Charges/Asset Impairment Charges**

 

For the first nine monthsof fiscal 2005, the Company recorded restructuring and other charges of $3.2million which included $2.7 million of restructuring charges and $0.5 millionof other charges.  The restructuringcharges related to the closure of seven Customer Interaction Centers and theelimination of certain positions.  Of the$2.7 million of charges, $2.1 million related to the elimination of over 200administrative and support positions and $0.6 million for the write-down ofproperty and lease termination and other costs.  Cash restructuring charges from the 2005restructuring plan totaling $1.7 million have been paid through October 2,2005, and the remaining $0.9 million of cash charges, primarily related tolease costs, are payable over the next year.

 

The Company recorded$10.8 million of asset impairment charges during the first nine months offiscal 2005 including a write-down of goodwill of $10.5 million as previouslydiscussed in Note 3.

 

The Company recorded $2.1million of restructuring and other charges (which included the reversal of $0.1million of unutilized prior year charges) in the first nine months of fiscal2004 related to the closure of three Customer Interaction Centers, thetransition of one center to a client and the elimination of certainadministrative and support positions. These charges included severance costs of$1.6 million resulting from the elimination of approximately 40 administrativeand support positions and $0.6 million for the write-down of property and leasetermination and other costs.  The Companyalso recorded $2.2 million of asset impairment charges during the first ninemonths of fiscal 2004 relating to the write-off of unutilized software andtelecommunications equipment.

 

Following is a summary ofthe fiscal 2005 year-to-date activity in the reserves established in connectionwith the Company’s restructuring initiatives:

 
| ** **                          | ** ** | ** **                | ** ** | **2005**                 | ** ** | **October 2,  2005** | ** ** |
|-------------------------------------|------------|---------------------------|------------|--------------------------|------------|---------------------------|------------|
| ** **                          | ** ** | **January 2,  2005** | ** ** | **Charges  (Reversals)** | ** ** | **Asset  Write-off**      | ** ** | **Cash  Payments** | ** ** | ** ** |
|                                |       |                      |       |                     |       |                      |       |   |   |   |   |
| 2002  Restructuring Initiatives     |       |                      |       |                     |       |                      |       |   |   |   |   |
| Lease obligations and other         |       | $                         | 12         |                     | $          | (10                       | )          | $ | — |   | $ | (2 | ) | $ | — |   |
|                                |       |                      |       |                     |       |                      |       |   |   |   |   |
| 2003  Restructuring Initiatives     |       |                      |       |                     |       |                      |       |   |   |   |   |
| Employee severance costs            |       | 302                       |       | —                   |       | —                    |       | (119 | ) | 183 |   |
| Lease obligations and other         |       | 4                         |       | (4                       | )          | —                    |       | — |   | — |   |
|                                |       |                      |       |                     |       |                      |       |   |   |   |   |
| 2004  Restructuring Initiatives     |       |                      |       |                     |       |                      |       |   |   |   |   |
| Employee severance costs            |       | 260                       |       | (1                       | )          | —                    |       | (127 | ) | 132 |   |
| Lease obligations and other         |       | 65                        |       | (5                       | )          | —                    |       | (56 | ) | 4 |   |
|                                |       |                      |       |                     |       |                      |       |   |   |   |   |
| 2005  Restructuring Initiatives     |       |                      |       |                     |       |                      |       |   |   |   |   |
| Employee severance costs            |       | —                    |       | 2,124                    |       | —                    |       | (1,526 | ) | 598 |   |
| Write-off of property and equipment |       | —                    |       | 197                      |       | (197                      | )          | — |   | — |   |
| Lease obligations and other         |       | —                    |       | 437                      |       | —                    |       | (176 | ) | 261 |   |
| Total                               |       | $                         | 643        |                     | $          | 2,738                     |       | $ | (197 | ) | $ | (2,006 | ) | $ | 1,178 |   |

 

10

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# **10.   Other Income**

# ** **

Other income of $0.6million is primarily due to the sale of the assets of four Customer InteractionCenters and unutilized office space, as a result of the announcement that theCompany was exiting most of its outbound customer acquisition business.  The Company received an irrevocable letter ofcredit for $0.7 million due and payable December 30, 2005, as part of theproceeds of the sale of the unutilized office space.

 

# **11.   IncomeTaxes**

# ** **

The Company accounts for income taxes using the assetand liability approach.  Under the assetand liability method, deferred tax assets and liabilities are recognized forthe future tax consequences attributable to differences between the financialstatement carrying amounts of existing assets and liabilities and their respectivetax bases.  Valuation allowances arerecorded when management believes it is more likely than not that some portionor all of the deferred tax assets will not be realized in the future.  The Company records a reserve for taxcontingencies until management believes it is probable that the deductionsgiving rise to these contingencies will not be successfully challenged.  The Company’s effective incometax rate is 21.5% and 38.0% for the nine months ended October 2, 2005, andSeptember 26, 2004, respectively.

 

In October 2003, theCompany received an $11.6 million cash tax refund as a result of carryingback against prior years’ taxable income a $48.1 million loss reported onits 2002 tax return. This loss resulted from the Company taking a$59.9 million deduction to write-off, for tax purposes, its remaininginvestment in ITI Holdings, Inc. (“ITI”) (for book purposes the Companyrecorded appropriate impairment charges related to ITI in previous fiscalyears). The total combined liquidity benefit to the Company from this deductioncould be as much as $20.9 million, which includes the $11.6 millioncash tax refund already received, $3.3 million of cash tax savings relatedto the 2002 tax year and the release of $6.0 million of tax creditsgenerated and utilized in prior years to be used in future periods.

 

The Internal RevenueService has audited the 2002 tax return. On September 29,2005, a field agent for the Internal Revenue Service issued a report, whichdisallowed the deduction related to the Company’s investment in ITI.  The Company believes that it hassufficient support for the deduction and intends to contest the proposedadjustment and pursue its available administrative remedies. Although theCompany has not recognized the income tax benefit related to this deduction andhas previously recorded a liability for the amount of the refund, should theCompany not prevail in this matter, the repayment of the previously receivedrefund of $11.6 million, as well as interest related thereto, could have a materialadverse effect on the liquidity of the Company.

 

# **Item2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

The Company is a leading provider of customerinteraction solutions for market leaders in the communications, financialservices, health care, logistics, publishing, insurance and travel andhospitality industries. To help its clients better manage their customerrelationships, APAC Customer Services develops and delivers customer care andcustomer acquisition programs. At the end of the third quarter, the Companyoperated and managed approximately 6,467 workstations in 14 Customer Interaction Centers in the United Statesand the Philippines. The Customer Interaction Centers are managed centrallythrough the application of telecommunications and computer technology topromote the consistent delivery of quality service.  The Company consists of a single operatingsegment that offers customer interaction solutions to its clients.

 

The Company is currently implementing therestructuring plan previously announced on July 26, 2005.  Pursuant to that restructuring plan, theCompany is exiting virtually all of its outbound customer acquisition business,restructuring operations and focusing on profitable client relationships in alimited number of industries in an effort to improve its near

 

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term financial performance and position the Companyfor long-term growth.  As a result of therestructuring plan, the Company expects to incur a total of $8 to $13 millionin cash and non-cash restructuring charges, including approximately $3 to $4million in one-time termination benefits charges, approximately $3 to $6million in lease termination charges, and approximately $2 to $3 million inasset impairment charges.  The resultsfor the third quarter of fiscal 2005 have been materially impacted by therestructuring plan.  The Company expectsthe restructuring plan to be completed over the next several quarters.  The Company expects that approximately $5 to$9 million of such costs will result in future cash expenditures. 

 

The following discussionof the Company’s results of operations and liquidity and capital resourcesshould be read in conjunction with the Consolidated Condensed FinancialStatements of the Company and related notes thereto appearing elsewhere in thisreport.

 

**Resultsof Operations**

 

The following table setsforth the Consolidated Condensed Statements of Operations data as a percent ofnet revenue for the thirteen week and thirty-nine week periods ended October 2,2005, and September 26, 2004, respectively.

 
| ** **                                   | ** ** | **Thirteen Weeks Ended**  | ** ** | **Thirty-Nine Weeks Ended**  | ** ** |
|----------------------------------------------|------------|---------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **October 2,  2005** | ** ** | **September 26,  2004** | ** ** | **October 2,  2005** | ** ** | **September 26,  2004** | ** ** |
|                                         |       |                      |       |                         |       |   |   |   |   |
| **Net  revenues**                            |       | 100.0                     | %          | 100.0                        | %          | 100.0 | % | 100.0 | % |
| Cost of services                             |       | 90.5                      |       | 89.8                         |       | 91.7 |   | 86.6 |   |
| **Gross  Profit**                            |       | 9.5                       |       | 10.2                         |       | 8.3 |   | 13.4 |   |
|                                         |       |                      |       |                         |       |   |   |   |   |
| **Operating  expenses:**                     |       |                      |       |                         |       |   |   |   |   |
| Selling, general and administrative expenses |       | 14.3                      |       | 15.5                         |       | 15.0 |   | 14.9 |   |
| Restructuring and other charges              |       | 3.7                       |       | .2                           |       | 1.8 |   | 1.0 |   |
| Asset impairment charges                     | ** ** | 19.1                      |       | —                       |       | 6.0 |   | 1.1 |   |
| Total operating expenses                     |       | 37.1                      |       | 15.7                         |       | 22.8 |   | 17.0 |   |
| **Operating  loss**                          |       | (27.6                     | )          | (5.5                         | )          | (14.6 | ) | (3.6 | ) |
| Other (income) expense                       |       | (1.0                      | )          | —                       |       | (.4 | ) | (.1 | ) |
| Interest (income) expense, net               |       | .5                        |       | .2                           |       | .6 |   | .2 |   |
|                                         |       |                      |       |                         |       |   |   |   |   |
| **Loss  before income taxes**                |       | (27.1                     | )          | (5.7                         | )          | (14.8 | ) | (3.7 | ) |
| Income tax  benefit                          |       | (3.1                      | )          | (2.2                         | )          | (3.2 | ) | (1.4 | ) |
|                                         |       |                      |       |                         |       |   |   |   |   |
| **Net  loss**                                |       | (24.0                     | )%         | (3.5                         | )%         | (11.6 | )% | (2.3 | )% |

 

**Comparisonof Results of Operations for the thirteen weeks ended October 2, 2005, andSeptember 26, 2004**

 

Netrevenue decreased 12.8% to $56.3 million in the third quarter of fiscal 2005from $64.6 million in the same period of fiscal 2004, a decrease of $8.3million. The revenue decline from the third quarter of fiscal 2004 is primarilyattributable to reduced revenue from outbound customer acquisitionbusiness.

 

Cost of servicesdecreased $7.1 million in the third quarter of fiscal 2005, or 12.2%, to $51.0million from $58.1 million in the same period of fiscal 2004.  This decrease is primarily due to lowerdirect labor costs and lower center overhead expenses associated with thedecline in revenue.

 

Gross profit marginsdecreased to 9.5% in the third quarter of fiscal 2005 versus 10.2% in thecomparable period of fiscal 2004.  Thisdecrease is principally due to higher center overhead costs as a percent ofrevenue and higher information technology costs as a result of investments innew technologies, partially offset by improved labor efficiencies.

 

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Selling, general andadministrative expenses decreased to $8.1 million in the third quarter offiscal 2005 from $10.0 million in the same period of fiscal 2004, a decrease of$1.9 million or 18.9%.  Theseexpenses declined from the prior year primarily due to reductions in employeerelated expenses.  As a percent of netrevenue, selling, general and administrative expenses decreased to 14.3% in thethird quarter of fiscal 2005 from 15.5% in the same period of fiscal 2004 dueto cost reduction initiatives associated with the Company’s restructuring plan.

 

The Company recorded $2.1million of restructuring and other charges in the third quarter of fiscal 2005related to the closure of five Customer Interaction Centers and the eliminationof certain positions. The restructuring charges of $1.7 million includeseverance and other costs of $1.2 million primarily related to the eliminationof approximately 150 administrative and support positions and $0.5 million forthe write down of property and lease termination and other costs. Cash restructuringcharges totaling $0.9 million have been paid through October 2,2005.  The remaining $0.6 million of cashrestructuring charges, primarily related to lease costs, are payable over thenext year.

 

The Company recorded $0.2million of restructuring charges in the third quarter of fiscal 2004 related tothe closure of one Customer Interaction Center. These expenses were paid duringthe fourth quarter of fiscal 2004.

 

The Company recorded$10.8 million of asset impairment charges in the third quarter of fiscal 2005including a write-down of goodwill of $10.5 million as previously discussed inNote 3.

 

Other income increased by$0.6 million primarily due to the sale of assets related to four CustomerInteraction Centers and unutilized office space in the third quarter of fiscal2005.

 

Interest expense of $0.3 millionin the third quarter of fiscal 2005 increased from $0.1 million in fiscal 2004.  The $0.2 million increase was primarily as aresult of interest related to borrowings under the current and previous creditagreements in fiscal 2005.

 

The Company generated anet loss of $13.5 million in the third quarter of fiscal 2005 compared to a$2.3 million loss for the same period of fiscal 2004. The increase in the netloss from the prior year is primarily due to higher asset impairment andrestructuring charges.

 

**Comparisonof Results of Operations for the thirty-nine weeks ended October 2, 2005,and September 26, 2004**

 

Net revenue decreased 11.7% to $180.2 millionin the first nine months of fiscal 2005 from $204.0 million in the sameperiod of fiscal 2004, a decrease of $23.8 million. The revenue decline fromthe first nine months of fiscal 2004 is primarily attributable to reducedrevenue from outbound customer acquisition business.

 

Cost of servicesdecreased $11.4 million in the first nine months of fiscal 2005, or 6.5%, to$165.3 million from $176.7 million in the same period of fiscal 2004. Thisdecrease is primarily due to lower direct labor costs associated with thedecline in revenue.

 

Gross profit marginsdecreased to 8.3% in the first nine months of fiscal 2005 from 13.4% in thecomparable period of fiscal 2004.  Thisdecrease is principally due to higher center overhead and labor costs as apercentage of revenue and higher information technology costs as a result ofinvestments in new technologies.

 

Selling, general andadministrative expenses decreased to $27.1 million in the first nine months offiscal 2005 from $30.5 million in the same period of fiscal 2004, a decrease of$3.4 million or 11.2%. Expenses declined from the prior year primarily due tolower employee related expenses. As a percent of net revenue, selling, generaland administrative expenses were relatively unchanged in the first nine monthsof fiscal 2005 compared to the same period of fiscal 2004.

 

For the first nine monthsof fiscal 2005, the Company recorded restructuring and other charges of $3.2million which included $2.7 million of restructuring charges and $0.5 millionof other charges.  The restructuringcharges related to the

 

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closure of seven CustomerInteraction Centers and the elimination of certain positions.  Of the $2.7 million of charges, $2.1 millionrelated to the elimination of over 200 administrative and support positions and$0.6 million for the write-down of property and lease termination and othercosts.  Cash restructuring charges fromthe 2005 restructuring plan totaling $1.7 million have been paid through October 2,2005, and the remaining $0.9 million of cash charges, primarily related tolease costs, are payable over the next year.

 

The Company recorded $2.1million of restructuring and other charges (which included the reversal of $0.1million of unutilized prior year charges) in the first nine months of fiscal2004 related to the closure of three Customer Interaction Centers, thetransition of one center to a client and the elimination of certainadministrative and support positions. These charges included severance costs of$1.6 million resulting from the elimination of approximately 40 administrativeand support positions and $0.6 million for the write-down of property and leasetermination and other costs.  The Companyalso recorded $2.2 million of asset impairment charges during the first ninemonths of fiscal 2004 relating to the write-off of unutilized software andtelecommunications equipment.

 

The Company recorded$10.9 million of asset impairment charges in the first nine months of fiscal2005 including a write-down of goodwill of $10.5 million as previouslydiscussed in Note 3.

 

Other income increased to$0.6 million in the first nine months of fiscal 2005 from $0.2 million in thesame period in fiscal 2004, an increase of $0.4 million which was due to thesale of assets related to four Customer Interaction Centers and unutilizedoffice space in the third quarter of fiscal 2005.

 

Interest expense increasedto $1.0 million in the first nine months of fiscal 2005 from $0.4 million inthe first nine months of fiscal 2004. This $0.6 million increase was primarily due to the write-off, in thesecond quarter, of $0.2 million of financing fees related to the previouscredit agreement and interest related to borrowings under the current andprevious credit agreements in fiscal 2005.

 

The Company generated anet loss of $20.9 million in the first nine months of fiscal 2005 comparedto a $4.7 million loss for the same period of fiscal 2004. The increase in netloss from the prior year period is primarily due to higher asset impairment andrestructuring charges and a reduction in gross profit from lower revenue,partially offset by a reduction in selling, general, and administrativeexpenses.

 

The Company’s effectiveincome tax rate is 21.5% for the nine months ended October 2, 2005, comparedto 38.0% in the prior year period primarily as a result of an increase inpermanent differences affecting taxable income.

 

**CriticalAccounting Policies and Estimates**

 

The preparation of theCompany’s financial statements in conformity with generally accepted accountingprinciples requires management to make estimates and assumptions that affectthe amounts reported in the consolidated financial statements and accompanyingnotes. The Company believes its estimates and assumptions are reasonable;however, actual results and the timing of the recognition of such amounts coulddiffer from those estimates. The Company has identified the following criticalaccounting policies and estimates utilized by management in the preparation ofthe Company’s financial statements: revenue recognition, accounting forlong-lived assets, allowance for doubtful accounts, accounting for employeebenefits and income taxes. Any deviation from these policies or estimates couldhave a material impact on the financial statements of the Company.

 

## **Revenuerecognition**

## ** **

The Company recognizescustomer services revenue as services are performed for our clients. Clientcontracts generally require that clients be billed for the Company’s serviceson the basis of time spent by Company representatives providing services. TheCompany’s services are also increasingly priced on a pay-for-performance basis,pursuant to which the Company typically receives fees that are a combination ofbase-rate plus fee per sale. The Company is generally subject to varying clientperformance standards such as average handle time, occupancy rate, abandonmentrate

 

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and sales per hour.  The Company’s performance against suchstandards may provide bonus opportunities, or conversely, may subject theCompany to penalties, which are recognized as earned or incurred.

 

## **Accounting forlong-lived assets**

 

The Company’s long-lived assets consist primarily of property andequipment, capitalized software and intangible assets. In addition to theoriginal cost of these assets, their recorded value is impacted by a number ofestimates made by the Company, including estimated useful lives and salvagevalues. In addition, any decision by the Company to reduce capacity by closingCustomer Interaction Centers or to abandon software may result in a write-offof the net book value of the affected assets. In accordance with SFAS No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” the Companyrecords impairment charges on long-lived assets used in operations when eventsand circumstances indicate that the assets may be impaired and the undiscountedcash flows estimated to be generated by those assets are less than the carryingamount of those assets. In this circumstance, the impairment charge isdetermined based upon the amount the net book value of the assets exceeds theirfair market value. In making these determinations, the Company utilizes certainassumptions, including, but not limited to, the estimated fair marketvalue of the assets, which are based on additional assumptions such as assetutilization, length of time the asset will be used in the Company’s operationsand estimated salvage values.

 

Under the provisions ofSFAS No. 142, “Goodwill and Other Intangible Assets,” the Company isrequired to test all existing goodwill and intangible assets for impairment atleast annually.  The Company’s policy isto test goodwill for impairment as of the end of the fiscal year or if eventsoccur that would necessitate a more frequent review.  Given the restructuring plan described in Note9, the Company performed an interim impairment test of goodwill assets in thethird quarter.  The Company obtained a third-partyvaluation of the Company and compared that valuation to the carrying cost ofthe Company.  The comparison indicatedthat goodwill was impaired.  The Companymeasured the amount of impairment by allocating the valuation to the assets andliabilities of the Company, and comparing the unallocated residual to thecarrying cost of goodwill.  Thecomparison resulted in an impairment charge of $10.5 million.  The remaining carrying value of goodwill,after the impairment charge, is $13.3 million. The Company will perform its annual impairment test in the fourthquarter of 2005.

 

Under the provisions ofSFAS No. 142, the Company evaluates the remaining useful life of thecustomer relationships balance at least annually to determine whether events orcircumstances warrant a revision to the remaining period of amortization.  The amortization expense related to customerrelationships for the periods ended October 2, 2005, and September 26,2004, was $0.6 million for the quarter and $1.8 million year to date.  Annual amortization expense is expected to be$2.3 million for fiscal years 2005 through 2009 and $1.0 million in fiscal2010.

 

## **Allowance fordoubtful accounts**

## ** **

The Company records an allowance for doubtfulaccounts based on a quarterly assessment of the probable estimated losses intrade accounts receivable. This estimate is based on specific allowances foridentified problem receivables and an additional allowance for estimated losseson all other receivables based on their age and the Company’s collectionhistory.

 

## **Accounting foremployee benefits**

## ** **

The Company records anaccrued liability for group health and workers’ compensation claims based on anestimate of claims incurred, but not reported, as well as asserted claims atthe end of the period. This estimate is derived from an analysis performed byactuaries hired by the Company who have expertise in this area.  Although these estimates are generallyreliable, changes in the employee mix and unforeseen events could result in anadjustment to these estimates.

 

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Thebalances of these accounts at October 2, 2005, and September 26,2004, were:

 
| ** **                 | ** ** | **(in thousands)** | ** ** |
|----------------------------|------------|--------------------|------------|
| ** **                 | ** ** | **2005**           | ** ** | **2004** | ** ** |
| Group Health Insurance     |       | $                  | 2,388      |   | $ | 2,665 |   |
| Workers’ Compensation |       | $                  | 3,074      |   | $ | 3,149 |   |

 

The decrease in grouphealth insurance from September 26, 2004, is primarily due to a reductionin the level of employee participation in the health insurance plan offered bythe Company.

 

**Incometaxes**

 

The Company accounts for income taxes using the asset and liabilityapproach.  Under the asset and liabilitymethod, deferred tax assets and liabilities are recognized for the future taxconsequences attributable to differences between the financial statementcarrying amounts of existing assets and liabilities and their respective taxbases.  Valuation allowances are recordedwhen management believes it is more likely than not that some portion or all ofthe deferred tax assets will not be realized in the future.  The Company records a reserve for taxcontingencies until management believes it is probable that the deductionsgiving rise to these contingencies will not be successfully challenged.

 

**Liquidity and Capital Resources**

 

The following table setsforth consolidated statements of cash flow data for the Company for thethirty-nine week periods ended October 2, 2005, and September 26,2004, respectively.

 
| ** **                                       | ** ** | **2005**           | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|----------|------------|
| ** **                                       | ** ** | **(In thousands)** | ** ** |
|                                             |       |               |       |     |       |
| Net cash provided by operating activities        |       | $                  | 1,705      |     | $          | 6,104 |   |
| Net cash used by investing activities            |       | (5,397             | )          | (6,646   | )          |
| Net cash provided (used) by financing activities |       | 4,280              |       | (265     | )          |
| Net change in cash                               |       | $                  | 588        |     | $          | (807 | ) |

 

Net cash provided by operating activities in the first nine months offiscal 2005 decreased $4.4 million versus the first nine months of fiscal 2004,primarily due higher net losses offset by a reduction in working capital.

 

Net cash used byinvesting activities was $5.4 million in the first nine months of fiscal 2005,primarily due to expenditures related to the buildout of additional seats inthe Company’s Customer Interaction Center in the Philippines.  Net cash used by investing activities of $6.6million in the first nine months of fiscal 2004 was primarily due toexpenditures related to the buildout of additional seats in the Philippines andcomputer equipment upgrades.

 

Net cash fromfinancing activities primarily related to the borrowings under the revolvingcredit agreement in fiscal 2005, partially offset by capital leasepayments.  Cash used for financingactivities in fiscal 2004 related to capital lease payments.

 

OnJune 2, 2005, the Company entered into a Loan and Security Agreement (“CreditAgreement”) with LaSalle Bank National Association, as Agent (“LaSalle”) andthe Financial Institutions from time to time a party thereto as Lendersreplacing the Company’s previous credit facility. The terms of the CreditAgreement provides for up to a $40.0

 

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millionrevolving credit facility that will expire in June 2008.  The outstanding revolving loan commitmentunder the Credit Agreement is $25.0 million based on the Company’s anticipatedcash requirements. Borrowing availability is based on accounts receivable and issubject to certain restrictions and limitations set forth in the CreditAgreement.

 

On July 27, 2005, the Company enteredinto Waiver and Amendment No. Three (“Amendment”) to the CreditAgreement.  Under the terms of theAmendment, LaSalle agreed to waive certain existing and anticipated events ofdefault under the Credit Agreement, amend the financial covenants contained inthe original Credit Agreement and provide an overadvance facility in an amountnot to exceed $11.0 million.  Theodore G.Schwartz, the Chairman of the Board of Directors of the Company, guaranteed$5.5 million of the overadvance facility, plus certain costs and expenses.

 

On October 31, 2005, the Company enteredinto an Amended and Restated Loan and Security Agreement (the “Restated CreditAgreement”) with LaSalle, as Agent, and the Financial Institutions from time totime parties thereto as Lenders.  TheRestated Credit Agreement amends and restates the Credit Agreement, as amended.  Under the terms of the Restated CreditAgreement, LaSalle agreed, among other things, to provide the Company with a$25 million revolving loan facility which expires in October 2008, reducethe interest rates and other fees, amend the financial covenants and releasethe guarantee that had been provided by Theodore G. Schwartz.  Other restrictive covenants which limit theCompany’s ability to incur additional indebtedness, repurchase outstandingcommon shares, create liens, acquire, sell or dispose of certain assets, engagein certain mergers and acquisitions, pay dividends and to make certainrestricted payments remain in effect. The Restated Credit Agreement is secured principally by a grant of asecurity interest in all personal property and fixtures of the Company.  Borrowings under the Restated CreditAgreement incur a floating interest rate based on the LIBOR index rate or analternate base rate defined in the Restated Credit Agreement.  In addition, the Company pays a commitmentfee on the unused portion of the revolving facility as well as fees onoutstanding letters of credit.  Had theRestated Credit Agreement been in place on October 2, 2005, the Companywould have had approximately $8.4 million of unused borrowing capacity.

 

In October 2003, theCompany received an $11.6 million cash tax refund as a result of carryingback against prior years’ taxable income a $48.1 million loss reported onits 2002 tax return. This loss resulted from the Company taking a$59.9 million deduction to write-off, for tax purposes, its remaininginvestment in ITI Holdings, Inc. (“ITI”) (for book purposes the Companyrecorded appropriate impairment charges related to ITI in previous fiscalyears). The total combined liquidity benefit to the Company from this deductioncould be as much as $20.9 million, which includes the $11.6 millioncash tax refund already received, $3.3 million of cash tax savings relatedto the 2002 tax year and the release of $6.0 million of tax creditsgenerated and utilized in prior years to be used in future periods. Although ithas not yet done so, the Company intends to recognize the income statement benefitof this deduction and eliminate the associated income tax liability once itbelieves it is probable the deduction will not be successfully challenged.

 

The Internal RevenueService has audited the 2002 tax return. On September 29,2005, a field agent for the Internal Revenue Service issued a report, whichdisallowed the deduction related to the Company’s investment in ITI. TheCompany believes that it has sufficient support for the deduction and intendsto contest the proposed adjustment and pursue its available administrativeremedies. Although the Company has not recognized the income tax benefitrelated to this deduction and has previously recorded a liability for theamount of the refund, should the Company not prevail in this matter, therepayment of the previously received refund of $11.6 million, as well asinterest related thereto, could have a material adverse effect on the liquidityof the Company.

 

The Company expects thatits cash balances, cash flows from future operations and available borrowingsunder the Restated Credit Agreement will be sufficient to meet normal operatingneeds, fund any planned capital expenditures, fund any expenditures related tothe Company’s restructuring plan and repay debt obligations as they come due.  A significant change in operating cash flow ora failure to successfully implement its restructuring plan could negativelyimpact the Company’s ability to meet its cash requirements and comply with thecovenants in the Restated Credit Agreement.

 

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**Forward-LookingStatements**

 

The Private SecuritiesLitigation Reform Act of 1995 provides a “safe harbor” for certain forward-lookingstatements. This Report on Form 10-Q and other documents that the Companyfiles with the SEC contain forward-looking statements that reflect the Company’scurrent views with respect to future events and financial performance. Theseforward-looking statements are subject to certain risks and uncertainties,which could cause future results to differ materially from historical resultsor those anticipated. The words “believe,” “expect,” “anticipate,” “intend,” “estimate,”“goals,” “would,” “could,” “should,” and other expressions which indicatefuture events and trends identify forward-looking statements. Readers arecautioned not to place undue reliance on these forward-looking statements,which speak only as of the date made.  Ifno date is provided, such statements speak only as of the date of this Reporton Form 10-Q. Except as required under the federal securities laws and rules andregulations of the SEC, the Company undertakes no obligation to publicly updateor revise any forward-looking statements in connection with new information orfuture events or otherwise. Factors that could cause future results to differmaterially from historical results or those anticipated include, but are notlimited to, the reaction of the Company’sclients and employees to the announcement of its restructuring including,without limitation, the exit of non-strategic and unprofitable clientrelationships, the closing of Customer Interaction Centers and the reduction inthe number of employees; the Company’s ability to successfully manage therestructuring and the costs and expenses associated with these****activities and generate sufficient cashflow from operations during the transition; the Company’s ability to complywith the various covenants under the Restated Credit Agreement in order tomaintain its borrowing capacity thereunder; the impact of the restructuring onthe Company’s need for telephone and data services which it purchases undermulti-year contracts containing volume commitments; reliance by theCompany on a small number of principal clients for a substantial proportion ofits total revenue; possible changes in or events affecting the business of theCompany’s clients, including changes in customers’ interest in, and use of,clients’ products and services; the effect of the Company’s operating losses onthe Company’s future prospects; fluctuations in quarterly results of operationsdue to timing of clients’ initiation and termination of large programs; risksin conducting business internationally; changes in competitive conditionsaffecting the Company’s industry; the ability of the Company’s clients toterminate contracts with the Company on a relatively short notice; fluctuations in revenue associated with theCompany’s new Medicare Part D enrollment and customer care programs;changes in the availability and cost of qualified employees; variations in theperformance of the Company’s automated system and other technologicalfactors; additions or changes to government regulations such as do not callregistries, disclosure requirements or other regulations affecting theteleservices and telecommunications industries and competition from otheroutside providers of customer interaction solutions and in-house customerinteraction operations.

 

See the Company’sfilings with the SEC for further discussion of the risks and uncertaintiesassociated with the Company’s business, in particular, the discussion under thecaption “Information Regarding Forward-Looking Statements” in Item 7(Management’s Discussion and Analysis of Financial Condition and Results ofOperations) of the Company’s Annual Report on Form 10-K for the fiscalyear ended January 2, 2005.

 

**Item 3.Quantitative and Qualitative Disclosures About Market Risk**

 

Historically, the Companyhas been exposed to the impact of U.S. interest rate changes directly relatedto its normal operating and funding activities. From time to time, the Companyhas entered into derivatives in order to minimize these risks, but not fortrading purposes. The Company does not have any derivative agreements at thistime.

 

The Company prepared asensitivity analysis of its average debt for the quarter ended October 2,2005, assuming a one-percentage point adverse change in interest rates. Holdingall other variables constant, the hypothetical adverse change would notsignificantly increase interest expense. The sensitivity analysis assumes nochanges in the Company’s financial structure.

 

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# **Item4. Controls and Procedures**

# ** **

# **Disclosure Controls and Procedures**

# ** **

The Company’s management,with the participation of the Company’s Chief Executive Officer and ChiefFinancial Officer, has evaluated the effectiveness of the Company’s disclosurecontrols and procedures (as such term is defined in Rules 13a-15(e) underthe Securities Exchange Act, as amended (the “Exchange Act”)) as of the end ofthe period covered by this report.  Basedon such evaluation, the Company’s Chief Executive Officer and Chief FinancialOfficer have concluded that, as of the end of such period, the Company’sdisclosure controls and procedures are effective in recording, processing,summarizing and reporting, on a timely basis, information required to bedisclosed by the Company in the reports that it files or submits under theExchange Act.

 

**InherentLimitations on the Effectiveness of Controls**

 

The Company’s management,including its Chief Executive Officer and Chief Financial Officer, do notexpect that the Company’s disclosure controls and procedures or internalcontrols will prevent or detect all errors and all fraud.  A control system, no matter how wellconceived and operated, can provide only reasonable, not absolute, assurancethat the objectives of the control system are met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatmisstatements due to error or fraud will not occur or that all control issuesand instances of fraud, if any, within the Company have been detected.

 

These inherentlimitations include the realities that judgments in decision-making can befaulty and that breakdowns can occur because of simple error or mistake.  Controls can also be circumvented by theindividual acts of some persons, by collusion of two or more people or bymanagement override of the controls.  Thedesign of any system of controls is based in part on certain assumptions aboutthe likelihood of future events, and there can be no assurance that any designwill succeed in achieving its stated goals under all potential futureconditions.  Projections of anyevaluation of controls effectiveness to future periods are subject to risks.  Over time, controls may become inadequatebecause of changes in conditions or deterioration in the degree of compliancewith policies or procedures.

 

**InternalControl Over Financial Reporting**

** **

There have not been changes in the Company’s internal control overfinancial reporting (as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act) during the quarter to which this reportrelates that have materially affected, or are reasonably likely to materiallyaffect, the Company’s internal control over financial reporting.

 

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## **Part II. Other Information**

## ** **

**Item 1.  Legal Proceedings**

 

The Company is subject to occasionallawsuits, governmental investigations and claims arising out of the normalconduct of its business.  Management doesnot believe the outcome of any such pending claims will have a material adverseimpact on the Company’s consolidated financial position, annual results ofoperations or liquidity.  Although theCompany does not believe that any of these proceedings will result in amaterial adverse effect, no assurance to that effect can be given.

 

**Item 6. Exhibits**

 

The exhibits required by Item 601 of Regulation S-Kare listed in the Exhibit Index attached hereto.

 

 

**Signatures**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 

 
|                          |   | **APAC Customer Services, Inc.**                                                                                          |   |
|-------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------|--------|
|                          |   |                                                                                                                           |   |
|                          |   |                                                                                                                           |   |
| Date: November 10,  2005 | By:    | /s/ Robert J. Keller                                                                                                           |   |
|                          |   | President and                                                                                                                  |   |
|                          |   | Chief Executive Officer  (Principal Executive Officer  and duly authorized officer)                                            |   |
|                          |   |                                                                                                                           |   |
|                          |   |                                                                                                                           |   |
| Date: November 10,  2005 | By:    | */s/*George H. Hepburn III                                                                                                     |   |
|                          |   | Senior Vice President and  Chief Financial Officer  (Principal Financial and  Accounting Officer and duly  authorized officer) |   |

 

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# **Exhibit Index**

# ** **

| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                                                    |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                               |
| 3.1                 |       | Articles of  Incorporation of APAC Customer Services, Inc., incorporated by reference  to APAC Customer Services, Inc.’s Quarterly Report on Form 10-Q for  the Quarter ended October 3, 1999.                                                                                                                                                                                            |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                               |
| 3.2                 |       | Certificate of  Amendment of the Amended and Restated Bylaws of APAC Customer Services, Inc.  as amended March 10, 2004, incorporated by reference to APAC Customer  Services, Inc.’s Quarterly Report on Form 10-Q for the quarter  ended March 28, 2004.                                                                                                                           |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                               |
| 10.1                |       | Amended and  Restated Loan and Security Agreement by and among LaSalle Bank National  Association, as Agent, the Financial Institutions from time to time parties  thereto as Lenders, and APAC Customer Services, Inc. as Borrower, dated  as of October 31, 2005, incorporated by reference to APAC Customer  Services, Inc.’s Current Report on Form 8-K dated November 3,  2005. |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.1                |       | Certification of  Chief Executive Officer, as adopted pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                               |
| 31.2                |       | Certification of  Chief Financial Officer, as adopted pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                             |
|                |       |                                                                                                                                                                                                                                                                                                                                                                                                               |
| 32.1                |       | Certification of  the Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C.  Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                    |

 

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