##### Table of Contents

 

 

 

##### **UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C.  20549**

 

##### **FORM 10-Q**

 

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

 

**For the quarterly period ended January 24,2009**

 

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

 

**For the transition periodfrom              to              **

 

**Commissionfile number 000-24990**

 

**WESTAFF, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                       | ** ** | **94-1266151**         |
|------------------------------------|------------|------------------------|
| (State or other  jurisdiction      |       | (I.R.S. employer       |
| of incorporation or  organization) |       | identification number) |

 

##### **298 NorthWiget Lane**

##### **WalnutCreek, California  94598-2453**

##### (Address of registrant’sprincipal executive offices, including zip code)

#####  

**(925)930-5300**

(Registrant’s telephone number, including areacode)

 

Securities registered pursuant to Section 12(b) ofthe Act:

**CommonStock, $0.01 par value per share**

** **

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90days.    Yes x    No o

 

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

 
| Large accelerated filer o                     |   | Accelerated filer o         |
|-----------------------------------------------|--------|----------------------------------|
|                                          |   |                             |
| Non-accelerated filer o                       |   | Smaller reporting company x |
| (Do not check if a smaller reporting company) |   |                             |

 

Indicate by check mark whether the registrant is a shell company (asdefined in Rule 12b-2 of the ExchangeAct).    Yes o    No x

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 

| **Class**                                | ** ** | **Outstanding at March 12, 2009** |
|------------------------------------------|------------|----------------------------------------|
| Common Stock, $0.01 par  value per share |       | 16,702,651 shares                      |

#####  

#####  

#####  

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Table of Contents

 

##### **WESTAFF,INC.**

#####  

FORM 10-Q

For the quarterly period ended January 24,2009

 

**INDEX**

 
| ** **        | ** **                                                                                                                           | **Page** |
|-------------------|--------------------------------------------------------------------------------------------------------------------------------------|----------|
|              |                                                                                                                                 |     |
| **Part I.**  | **Financial  Information**                                                                                                           | 3        |
|              |                                                                                                                                 |     |
| Item 1.           | Condensed  Consolidated Financial Statements (Unaudited)                                                                             | 3        |
|              |                                                                                                                                 |     |
|              | Condensed Consolidated Balance Sheets (Unaudited) as  of January 24, 2009 and November 1, 2008                             | 3        |
|              |                                                                                                                                 |     |
|              | Condensed Consolidated Statements of Operations  (Unaudited) for the 12 Weeks Ended January 24, 2009 and January 26,  2008 | 4        |
|              |                                                                                                                                 |     |
|              | Condensed Consolidated Statements of Cash Flows  (Unaudited) for the 12 Weeks Ended January 24, 2009 and  January 26,2008  | 5        |
|              |                                                                                                                                 |     |
|              | Notes to Condensed Consolidated Financial Statements  (Unaudited)                                                                    | 6        |
|              |                                                                                                                                 |     |
| Item  2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                          | 18       |
|              |                                                                                                                                 |     |
| Item  3.          | Quantitative  and Qualitative Disclosures About Market Risk                                                                          | 24       |
|              |                                                                                                                                 |     |
| Item 4.           | Controls  and Procedures                                                                                                             | 25       |
|              |                                                                                                                                 |     |
| **Part II.** | **Other Information**                                                                                                                | 26       |
|              |                                                                                                                                 |     |
| Item 1.           | Legal  Proceedings                                                                                                                   | 26       |
|              |                                                                                                                                 |     |
| Item 1A.          | Risk Factors                                                                                                                         | 27       |
|              |                                                                                                                                 |     |
| Item  2.          | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                         | 33       |
|              |                                                                                                                                 |     |
| Item  3.          | Defaults  Upon Senior Securities                                                                                                     | 33       |
|              |                                                                                                                                 |     |
| Item  4.          | Submission  of Matters to a Vote of Security Holders                                                                                 | 33       |
|              |                                                                                                                                 |     |
| Item 5.           | Other  Information                                                                                                                   | 33       |
|              |                                                                                                                                 |     |
| Item 6.           | Exhibits                                                                                                                             | 34       |
|              |                                                                                                                                 |     |
|              | Signatures                                                                                                                           | 35       |

 

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**Part l. Financial Information**

**Item 1. Financial Statements (Unaudited)**

**Westaff, Inc.**

**Condensed Consolidated Balance Sheets(Unaudited)**

** **
| ** **                                                                                                                                           | ** ** | **January 24,  2009**                                                            | ** ** | **November 1,  2008** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                           | ** ** | **(In thousands, except  share and per share amounts)** | ** ** |
| **ASSETS**                                                                                                                                           |       |                                                                                  |       |                       |       |
| Current assets:                                                                                                                                      |       |                                                                                  |       |                       |       |
| Cash and cash equivalents                                                                                                                            |       | $                                                                                     | 4,325      |                       | $          | 86 |   |
| Restricted cash                                                                                                                                      |       | 10,014                                                                                |       | 5,048                      |       |
| Trade accounts receivable, less allowance  for doubtful accounts of $797 and $979                                                                    |       | 23,240                                                                                |       | 35,812                     |       |
| Prepaid expenses                                                                                                                                     |       | 1,859                                                                                 |       | 1,845                      |       |
| Other current assets                                                                                                                                 |       | 4,097                                                                                 |       | 1,733                      |       |
| Current assets held for sale                                                                                                                         |       | —                                                                                |       | 13,930                     |       |
|                                                                                                                                                 |       |                                                                                  |       |                       |       |
| Total current assets                                                                                                                                 |       | 43,535                                                                                |       | 58,454                     |       |
|                                                                                                                                                 |       |                                                                                  |       |                       |       |
| Property and equipment, net                                                                                                                          |       | 8,518                                                                                 |       | 9,583                      |       |
| Intangible assets                                                                                                                                    |       | 3,500                                                                                 |       | 3,504                      |       |
| Other long-term assets                                                                                                                               |       | 1,250                                                                                 |       | 1,923                      |       |
| Long term assets held for sale                                                                                                                       |       | —                                                                                |       | 1,527                      |       |
| Total assets                                                                                                                                         |       | $                                                                                     | 56,803     |                       | $          | 74,991 |   |
|                                                                                                                                                 |       |                                                                                  |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                        |       |                                                                                  |       |                       |       |
| Current liabilities:                                                                                                                                 |       |                                                                                  |       |                       |       |
| Current portion of capital lease  obligations                                                                                                        |       | $                                                                                     | 494        |                       | $          | 587 |   |
| Notes payable to related parties                                                                                                                     |       | 4,799                                                                                 |       | 4,150                      |       |
| Accounts payable                                                                                                                                     |       | 905                                                                                   |       | 1,431                      |       |
| Accrued expenses                                                                                                                                     |       | 13,057                                                                                |       | 16,499                     |       |
| Short-term portion of workers compensation  obligation                                                                                               |       | 8,022                                                                                 |       | 7,975                      |       |
| Income taxes payable                                                                                                                                 |       | 396                                                                                   |       | 379                        |       |
| Current liabilities held for sale                                                                                                                    |       | —                                                                                |       | 8,956                      |       |
| Total current liabilities                                                                                                                            |       | 27,673                                                                                |       | 39,977                     |       |
|                                                                                                                                                 |       |                                                                                  |       |                       |       |
| Long-term capital lease obligations                                                                                                                  |       | 122                                                                                   |       | 165                        |       |
| Long-term portion of workers compensation  obligation                                                                                                |       | 15,000                                                                                |       | 15,300                     |       |
| Other long-term liabilities                                                                                                                          |       | 310                                                                                   |       | 805                        |       |
| Long-term liabilities held for sale                                                                                                                  |       | —                                                                                |       | 125                        |       |
| Total liabilities                                                                                                                                    |       | 43,105                                                                                |       | 56,372                     |       |
|                                                                                                                                                 |       |                                                                                  |       |                       |       |
| Commitments and contingencies (Notes 8 and  10)                                                                                                      |       |                                                                                  |       |                       |       |
|                                                                                                                                                 |       |                                                                                  |       |                       |       |
| Stockholders’ equity:                                                                                                                           |       |                                                                                  |       |                       |       |
| Preferred stock, $0.01 par value;  authorized and unissued: 1,000,000 shares                                                                         |       |                                                                                  |       |                       |       |
| Common stock, $0.01 par value; authorized:  25,000,000 shares; issued and outstanding:16,697,010 at January 24, 2009  and November 1, 2008 |       | 167                                                                                   |       | 167                        |       |
| Additional paid-in capital                                                                                                                           |       | 39,779                                                                                |       | 39,727                     |       |
| Accumulated deficit                                                                                                                                  |       | (26,248                                                                               | )          | (21,943                    | )          |
| Accumulated other comprehensive income                                                                                                               |       | —                                                                                |       | 668                        |       |
| Total stockholders’ equity                                                                                                                      |       | 13,698                                                                                |       | 18,619                     |       |
| Total liabilities and stockholders’ equity                                                                                                      |       | $                                                                                     | 56,803     |                       | $          | 74,991 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**Westaff, Inc.**

**Condensed Consolidated Statements ofOperations (Unaudited)**

 
| ** **                                                      | ** ** | **12 Weeks Ended**                                          | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                      | ** ** | **January 24,  2009**                                            | ** ** | **January 26,  2008** | ** ** |
| ** **                                                      | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                                            |       |                                                                  |       |   |   |
| Revenue                                                         |       | $                                                                     | 51,548     |   | $ | 81,048 |   |
|                                                            |       |                                                                  |       |   |   |
| Costs of services                                               |       | 42,806                                                                |       | 66,515 |   |
|                                                            |       |                                                                  |       |   |   |
| Gross profit                                                    |       | 8,742                                                                 |       | 14,533 |   |
|                                                            |       |                                                                  |       |   |   |
| Franchise agents’ share of gross profit                    |       | 2,200                                                                 |       | 3,397 |   |
| Selling and administrative expenses                             |       | 10,438                                                                |       | 12,106 |   |
| Restructuring expense (benefit)                                 |       | 52                                                                    |       | (150 | ) |
| Depreciation and amortization                                   |       | 1,118                                                                 |       | 1,144 |   |
|                                                            |       |                                                                  |       |   |   |
| Operating loss from continuing operations                       |       | (5,066                                                                | )          | (1,964 | ) |
|                                                            |       |                                                                  |       |   |   |
| Interest expense                                                |       | 593                                                                   |       | 598 |   |
| Interest income                                                 |       | (7                                                                    | )          | (9 | ) |
|                                                            |       |                                                                  |       |   |   |
| Loss from continuing operations before  income taxes            |       | (5,652                                                                | )          | (2,553 | ) |
| Income tax benefit                                              |       | —                                                                |       | (487 | ) |
| Loss from continuing operations                                 |       | (5,652                                                                | )          | (2,066 | ) |
|                                                            |       |                                                                  |       |   |   |
| Discontinued operations:                                        |       |                                                                  |       |   |   |
| Income (loss) from discontinued operations                      |       | (400                                                                  | )          | 171 |   |
| Gain on sale, net of income taxes                               |       | 1,747                                                                 |       | — |   |
|                                                            |       |                                                                  |       |   |   |
| Total income from discontinued operations,  net of income taxes |       | 1,347                                                                 |       | 171 |   |
|                                                            |       |                                                                  |       |   |   |
| Net loss                                                        |       | $                                                                     | (4,305     | ) | $ | (1,895 | ) |
|                                                            |       |                                                                  |       |   |   |
| (Loss) earnings per share:                                      |       |                                                                  |       |   |   |
| Continuing operations - basic and diluted                       |       | $                                                                     | (0.34      | ) | $ | (0.12 | ) |
| Discontinued operations - basic and diluted                     |       | $                                                                     | 0.08       |   | $ | 0.01 |   |
|                                                            |       |                                                                  |       |   |   |
| Loss per share:                                                 |       |                                                                  |       |   |   |
| Basic and diluted                                               |       | $                                                                     | (0.26      | ) | $ | (0.11 | ) |
|                                                            |       |                                                                  |       |   |   |
| Weighted average shares outstanding - basic                     |       | 16,697                                                                |       | 16,697 |   |
| Weighted average shares outstanding -  diluted                  |       | 16,697                                                                |       | 16,697 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**Westaff, Inc.**

**Condensed Consolidated Statements of CashFlows**

**(Unaudited)**

** **
| ** **                                                                                                                              | ** ** | **12 Weeks Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                                                              | ** ** | **January 24,**         | ** ** | **January 26,** | ** ** |
| ** **                                                                                                                              | ** ** | **2009**                     | ** ** | **2008** | ** ** |
| ** **                                                                                                                              | ** ** | **(In thousands)**      | ** ** |
| **Cash flows from operating activities**                                                                                                |       |                         |       |   |   |
| Net loss                                                                                                                                |       | $                            | (4,305     | ) | $ | (1,895 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities:                                              |       |                         |       |   |   |
|                                                                                                                                    |       |                         |       |   |   |
| Depreciation and amortization                                                                                                           |       | 1,125                        |       | 1,375 |   |
| Stock-based compensation                                                                                                                |       | 42                           |       | 74 |   |
| Provision for losses on doubtful accounts                                                                                               |       | 417                          |       | 389 |   |
| Amortization of deferred gain on  sale-leaseback                                                                                        |       | (172                         | )          | (177 | ) |
| Amortization of debt issuance costs                                                                                                     |       | 123                          |       | 68 |   |
| Deferred income taxes                                                                                                                   |       | —                       |       | (656 | ) |
| Gain on sale of discontinued operations,  net of income taxes                                                                           |       | (1,747                       | )          | — |   |
| Amortization of deferred gain from sales of  affiliate operations                                                                       |       | —                       |       | (618 | ) |
| Loss on sale or disposal of assets                                                                                                      |       | 1                            |       | 159 |   |
| Changes in assets and liabilities:                                                                                                      |       |                         |       |   |   |
| Trade accounts receivable                                                                                                               |       | 12,291                       |       | 3,968 |   |
| Other assets                                                                                                                            |       | (15                          | )          | 820 |   |
| Accounts payable and accrued expenses                                                                                                   |       | (4,230                       | )          | (5,456 | ) |
| Income taxes payable                                                                                                                    |       | 17                           |       | 13 |   |
| Other liabilities                                                                                                                       |       | (638                         | )          | (1,441 | ) |
|                                                                                                                                    |       |                         |       |   |   |
| Net cash provided by (used in) operating  activities                                                                                    |       | 2,909                        |       | (3,377 | ) |
|                                                                                                                                    |       |                         |       |   |   |
| **Cash flows from investing activities**                                                                                                |       |                         |       |   |   |
| Capital expenditures                                                                                                                    |       | (10                          | )          | (710 | ) |
| Proceeds from sale of discontinued  operations, net of cash acquired by purchaser of $1,113 and net of cash  funded by seller of $2,052 |       | 7,553                        |       | — |   |
| Expenses related to sale of discontinued  operations                                                                                    |       | (533                         | )          | — |   |
| Payments received on notes                                                                                                              |       | 25                           |       | 31 |   |
| Issuance of notes receivable                                                                                                            |       | (39                          | )          | (5 | ) |
| Other, net                                                                                                                              |       | —                       |       | 49 |   |
|                                                                                                                                    |       |                         |       |   |   |
| Net cash provided by (used in) investing  activities                                                                                    |       | 6,996                        |       | (635 | ) |
|                                                                                                                                    |       |                         |       |   |   |
| **Cash flows from financing activities**                                                                                                |       |                         |       |   |   |
| Restricted cash under line of credit                                                                                                    |       | (4,966                       | )          | — |   |
| Net borrowings (payments) under line of  credit agreements                                                                              |       | (5,172                       | )          | 3,363 |   |
| Principal payments on capital lease  obligations                                                                                        |       | (136                         | )          | (118 | ) |
| Payment of debt issuance costs                                                                                                          |       | (9                           | )          | (2 | ) |
| Proceeds from notes payable - related parties                                                                                           |       | 500                          |       | — |   |
|                                                                                                                                    |       |                         |       |   |   |
| Net cash provided by (used in) financing  activities                                                                                    |       | (9,783                       | )          | 3,243 |   |
|                                                                                                                                    |       |                         |       |   |   |
| Effect of exchange rate changes on cash                                                                                                 |       | 77                           |       | (62 | ) |
|                                                                                                                                    |       |                         |       |   |   |
| Net change in cash and cash equivalents                                                                                                 |       | 199                          |       | (831 | ) |
| Cash and cash equivalents at beginning of  period                                                                                       |       | 4,126                        |       | 3,277 |   |
| Cash and cash equivalents at end of period                                                                                              |       | $                            | 4,325      |   | $ | 2,446 |   |
|                                                                                                                                    |       |                         |       |   |   |
| **Supplemental disclosures of cash flow  information**                                                                                  |       |                         |       |   |   |
| Cash paid during the quarter for:                                                                                                       |       |                         |       |   |   |
| Interest                                                                                                                                |       | $                            | 200        |   | $ | 447 |   |
| Income taxes paid, net                                                                                                                  |       | 36                           |       | 23 |   |

 

See accompanying notes to condensedconsolidated financial statements.

 

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**Westaff, Inc.**

**Notes toCondensed Consolidated Financial Statements (Unaudited)**

 

**1.     Basis of Presentation**

 

Westaff, Inc. and its subsidiaries (the “Company” or “Westaff”)provide staffing services primarily in suburban and rural markets (“secondary markets”), as well as in the downtown areasof certain major urban centers (“primary markets”) in the United States (“US”).  OnNovember 10, 2008, the Company sold its former Australia and New Zealandsubsidiaries and, in the second quarter of fiscal year 2008, the Companysold its former United Kingdom operations and related subsidiary.  The accompanying condensed consolidatedfinancial statements of Westaff, Inc. and its domestic and discontinuedforeign subsidiaries as of January 24, 2009 and for the 12-week periodsended January 24, 2009 and January 26, 2008 are unaudited.

 

The Company provides staffing solutions, including permanent placement,replacement, supplemental and on-site temporary programs to businesses andgovernment agencies through its network of Company-owned and franchise agentoffices.  Westaff’s primary focus is onrecruiting and placing clerical/administrative and light industrial personnel.Its corporate headquarters provides support services to the field offices inmarketing, human resources, risk management, legal, strategic sales,accounting, and information technology.

 

The condensed consolidated financialstatements, in the opinion of management, reflect all adjustments, which are ofa normal recurring nature, necessary for a fair presentation of the financialposition, results of operations and cash flows for the periods presented.  The condensed consolidated balance sheet asof November 1, 2008 presented herein, has been derived from the auditedconsolidated balance sheet included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended November 1, 2008 filed with the Securities andExchange Commission (the “SEC”) on February 13, 2009 (the “2008 Form 10-K”).

 

The Company’s critical accounting policiesare described in Item 7, “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and in the notes to the auditedconsolidated financial statements included in the 2008 Form 10-K.  Except as disclosed herein, there were nochanges to these policies during the 12-week period ended January 24,2009.  Certain financial informationnormally included in annual financial statements prepared in accordance withaccounting principles generally accepted in the United States that are notrequired for interim reporting purposes have been condensed or omitted.  The accompanying condensed consolidatedfinancial statements should be read in conjunction with the audited consolidatedfinancial statements and notes thereto included in the 2008 Form 10-K.

 

The Company’s fiscal year ends on theSaturday nearest the end of October and consists of either 52 or 53weeks.  For interim reporting purposes,the Company’s first three fiscal quarters consist of 12 weeks each, while theCompany’s fourth fiscal quarter consists of 16 or 17 weeks.  The Company’s results of operations for the12-week period ended January 24, 2009 are not necessarily indicative ofthe results to be expected for the Company’s full fiscal year or for any futureperiod.

 

*Discontinued operations and assets held forsale*

 

On November 10, 2008, the Company soldits former Australia and New Zealand subsidiaries and on March 31, 2008,the Company sold its former United Kingdom (U.K.) operations and relatedsubsidiary. See Note 4. In accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 144 “Accounting for the Impairment orDisposal of Long-Lived Assets”, the results of operations of the discontinuedoperations are separately stated in the accompanying consolidated statements ofoperations for the 12 weeks ended January 24, 2009 and January 26,2008. The assets and liabilities for the Company’s former Australia and NewZealand subsidiaries as of November 1, 2008 are shown in the balance sheetas held for sale. The cash flows from discontinued operations are notseparately classified in the Company’s condensed consolidated statements ofcash flows for all periods presented.

 

Asset and liability balances as of November 1,2008 and the statement of operations for the 12-week period ended January 24,2009 and for the same period of fiscal year 2008 pertaining to the Company’sformer United Kingdom, Australia, and New Zealand subsidiaries are set forth inNote 4.

 

*Going concern considerations*

 

The accompanying financial statements havebeen prepared assuming that the Company will continue as a going concern and donot include any adjustments that may result from this uncertainty. Through January 24,2009, the Company has experienced significant loss of revenue in its businessoperations and continues to experience operating losses.  Additionally, the Company is in default ofcertain covenants under its primary credit facility, which is a financingagreement, dated as of February 14, 2008, by and among the Company’swholly-owned subsidiary Westaff (USA), Inc. (as borrower), the Company (asparent guarantor), U.S. Bank National Association, as a lender, agent andletter of credit issuer (“U.S. Bank”) and Wells Fargo Bank, NationalAssociation, as a lender (“Wells Fargo”), as amended (the “Financing Agreement”).  The Financing Agreement currently providesfor a five-year revolving credit facility. As discussed in Note 8 and 18,the Company is currently in default under certain covenants of the FinancingAgreement and, subsequent to the end of the first quarter of fiscal year 2009,on February 18, 2009, the Company entered into a new Third Amended andRestated Forbearance Agreement with U.S. Bank and Wells Fargo that provides fora forbearance period ending on April 7, 2009 (the “Third Amended andRestated Forbearance Agreement”).

 

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Among other things, pursuant to the ThirdAmended and Restated Forbearance Agreement, the Company’s ability to borrowunder the Financing Agreement (other than forced loans due to draws upon theoutstanding letters of credit) was terminated. Because the Company no longer has any right to borrow under the FinancingAgreement (other than forced loans due to draws upon the outstanding letters ofcredit), if the Company’s available cash is insufficient to satisfy the Company’sliquidity requirements and the Company is unable to find alternative sources ofcapital, the Company may be unable to continue its operations as a goingconcern.

 

These liquidity issues raise substantialdoubt about whether the Company will continue as a going concern. The Companyhas been in discussions with its lenders under the Financing Agreement as tothe steps it needs to take to resolve this situation, but there can be noassurance that the lenders will continue to forbear from exercising any oftheir default rights and remedies in response to the Company’s noncompliancewith any one or more of the loan covenants. The Company’s ability to continueas a going concern is dependent on the Company’s ability to comply with theloan covenants and the lenders’ willingness to waive any noncompliance withsuch covenants and/or forbear from exercising any of their default rights andremedies.

 

In response to the continued default, on August 25,2008, the Company secured a $3.0 million subordinated loan facility withDelStaff, LLC (“DelStaff”), which is the Company’s principal stockholder. As ofJanuary 24, 2009, loans in an aggregate principal amount of$2.7 million, including a $0.2 million facility fee, were outstandingunder this facility, the proceeds of which were used by the Company for workingcapital and general business purposes. On January 29, 2009, the Company was advanced an additional loan inan aggregate principal amount of $500,000 from DelStaff.  No additional borrowings are available to theCompany under this facility See Note 18.

 

On January 22, 2009, The TravelersIndemnity Company (“Travelers”), which is the Company’s workers’ compensationinsurance carrier, agreed to extend the coverage period of the Company’sworkers’ compensation insurance, which had been originally set to expire on February 1,2009, through April 1, 2009 which required $1.0 million in cashcollateral as of November 1, 2008 and $0.3 million as of February 28,2009. The collateral is included in other current assets.  The letter of credit supporting the workers’compensation insurance, which had been originally set to expire on February 28,2009, was extended to April 7, 2009 pursuant to the terms and conditionsof the Third Amended and Restated Forbearance Agreement.  There can be no assurance that the Companywill be able to renew or extend its current workers’ compensation policy ornegotiate a new policy with a new carrier on terms acceptable to the Company.

 

Among other things, the Company has respondedto these issues by reducing its headcount by approximately 60 positions in thecorporate and field offices during fiscal year 2008 and 66 positions in thefirst quarter of fiscal year 2009. This was accomplished by a combination ofattrition and a planned reduction in force. Total severance amounts related toheadcount reductions recorded in the first quarter of fiscal year 2009 were$0.3 million and are included as part of selling and administrative expenses.The Company continues to look and act on additional cost savings measureswithin the organization while it is exploring alternative financingarrangements and strategic partnering alternatives. See Note 18.

 

**2.    Restricted Cash**

 

During the 12 weeks ended January 24,2009, the $5.0 million in cash proceeds from the sale of the Company’s formerAustralia and New Zealand operations and the $5.0 million in cash proceeds fromthe sale of the Company’s former United Kingdom operations and relatedsubsidiary, totaling $10.0 million, as well as the interest thereon, were heldas collateral for U.S. Bank related to the Financing Agreement, as described inNote 8.

 

**3.    Adoption of Recent Pronouncement**

 

During the first quarter offiscal year 2008, the Company adopted the provisions of Financial AccountingStandards Board (“FASB”) Interpretation No. (“FIN”) 48, “Accounting forUncertainty in Income Taxes, an interpretation of FASB Statement No. 109”(“FIN 48”) effective November 4, 2007. FIN 48 clarifies the accounting for uncertainty in income taxesrecognized in an enterprise’s financial statements in accordance with FASBStatement No. 109, “Accounting for Income Taxes”, and prescribes arecognition threshold and measurement process for financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return.  FIN 48 also providesguidance on de-recognition, classification, interest and penalties, accountingin interim periods, disclosure and transition.

 

As a result of theimplementation of FIN 48, the Company made a comprehensive review of itsportfolio of uncertain tax positions in accordance with recognition standardsestablished by FIN 48.  The Companyperformed evaluations for the tax years ended 2008, 2007, 2006, 2005 and 2004,which were subject to examination by tax authorities, as well as the taxpositions presented in the current fiscal year financial statements.  During the current fiscal year the Companydetermined it had $0.9 million of uncertain tax positions.  Of this amount, $0.3 million was recorded asa liability in its financial statements as of January 24, 2009.

 

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Upon implementation of FIN 48,the Company adopted a methodology for recognition of interest and penaltiesaccruals related to unrecognized tax benefits and penalties within itsprovision for income taxes.  The Companyhad no such interest and penalties accrued at January 24, 2009 asany amounts are immaterial.

 

**4.****            ****Discontinued Operations**

 

In March 2008, the Company sold its former United Kingdomoperations and related subsidiary to Fortis Recruitment Group Limited, arecruiting and staffing company headquartered in England, for cash payments of$6.3 million, net of transaction costs of $0.2 million.  The Companyrecorded a pre-tax gain of $1.7 million ($0.4 million net of tax).  Inaccordance with FASB Statement No. 144, the Company has reflected theresults of its former United Kingdom operations as discontinued operations forall periods presented on the consolidated statement of operations.

 

On November 10, 2008, the Company sold its former Australia andNew Zealand subsidiaries to Humanis Blue Pty Ltd, an Australian staffingcompany (“Humanis”), for A$19 million (Australian dollars) (or $12.8 million USdollars).  Of this amount, A$3 million,(or $1.9 million US dollars) is payable in the form of a deferred payment dueone year after closing and is included in other current assets on the balancesheet.  As part of the agreement, thesale proceeds received were net of the amount outstanding on the formerAustralian GE Capital debt facility totaling A$7.8 million (or $5.2 million USdollars).  Cash payments received totaledA$7.6 million converted to approximately $5.0 million US dollars.  In connection with the final GE Capitalsettlement, the Company overpaid the debt by A$0.6 million (or $0.4 million USdollars) which has been recorded in other current assets and that amount was refunded to theCompany on February 10, 2009.  Thepurchase price is subject to a post-closing adjustment based on the netoperating assets of the subsidiaries at closing.   The parties are currently in discussionregarding the calculation of the adjustment. Management believes the Company will not incur a charge related to theworking capital adjustment and has not adjusted the gain on the sale for theresolution of the working capital adjustment. The gain on the sale is $1.7 million, net of fees of $0.5 million.  In accordance with FASB Statement No. 144,the Company has reflected the results of its former Australia and New Zealandoperations as discontinued operations for all periods presented on theconsolidated statements of operations.  Theincome taxes from this gain on sale were nil as a result of applying thebenefit of net operating loss carryforwards that had been fully reserved inearlier periods.  See Note 5.

 

Summarized financial data on discontinued operations is as follows:

 
| ** **                                              | ** ** | **12 Weeks Ended** | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|
| ** **                                              | ** ** | **January 24,  2009**   | ** ** | **January 26,  2008** | ** ** |
| ** **                                              | ** ** | **(In  thousands)**          | ** ** |
| ** **                                              | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Revenue                                                 |       | $                            | 2,086      |   | $ | 35,786 |   |
| Operating (loss) income from discontinued  operations   |       | (315                         | )          | 170 |   |
| Less: Income taxes and net interest expense             |       | 85                           |       | (1 | ) |
|                                                    |       |                         |       |   |   |
| Income (loss) from discontinued operations,  net of tax |       | (400                         | )          | 171 |   |
|                                                    |       |                         |       |   |   |
| Gain on sale, net of income taxes                       |       | 1,747                        |       | — |   |
|                                                    |       |                         |       |   |   |
| Total income from discontinued operations,  net of tax  |       | $                            | 1,347      |   | $ | 171 |   |

 
| ** **                             | ** ** | ** ** | ** ** | **November 1,  2008** | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------|------------|
|                                   |       |       |       |                       |       |
| Cash and cash equivalents              |       |       |       | $                          | 4,040      |   |
| Trade accounts receivable, net         |       |       |       | 9,176                      |       |
| Prepaid expenses                       |       |       |       | 291                        |       |
| Property and equipment, net            |       |       |       | 666                        |       |
| Other assets                           |       |       |       | 1,284                      |       |
| Assets of discontinued operations      |       |       |       | $                          | 15,457     |   |
|                                   |       |       |       |                       |       |
| Notes payable                          |       |       |       | $                          | 4,578      |   |
| Accounts payable                       |       |       |       | 208                        |       |
| Accrued payroll and expenses           |       |       |       | 2,873                      |       |
| Other liabilities                      |       |       |       | 1,422                      |       |
| Liabilities of discontinued operations |       |       |       | $                          | 9,081      |   |

 

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**5.****             ****Income Taxes and RelatedValuation Allowance**

 

For the 12 weeks ended January 24, 2009,the Company had a zero income tax provision from continuing operations on apre-tax loss from continuing operations of $5.6 million, which represents aneffective tax rate of zero.  The zero tax provision was primarily the resultof a full valuation allowance established against current period losses.  The Company had a gain on the sale ofdiscontinued operations of approximately $1.7 million, net of income tax.  The income taxes from this gain on sale werenil as a result of applying the benefit of net operating loss carryforwardsthat had been fully reserved in earlier periods.  The Company also had a loss from discontinuedoperations from its foreign operations of approximately $0.4 million, net of azero tax provision, which was also a result of the establishment of a currentperiod valuation allowance.

 

**6.****            ****Goodwill and Intangibles**

 

Following the sale of its foreignsubsidiaries, the Company operates as one reporting segment.  The Company performed the impairment testsrequired by Statement of Financial Accounting Standards (“SFAS”) No. 142, “Goodwilland Other Intangible Assets” due to the significant decline in revenue and thedecrease in market capitalization of the company to a level below the bookcarrying value of its equity during the third quarter of fiscal 2008.  As a result, the Company’s goodwill was fullyimpaired in the third quarter of fiscal year 2008 and the indefinite lifefranchise right intangible was impaired by $0.2 million.

 

Due to the continued decline in revenues inthe geographical markets that benefit from the franchise right intangibles,impairment tests were done in the fourth quarter of fiscal year 2008 and thefirst quarter of fiscal year 2009.  Noimpairment charges were made to the franchise rights as a result of theevaluation.

 

The following table shows the change tointangible assets during the first quarter of fiscal year 2009.

 
| ** **                                                                       | ** ** | **Gross goodwill and intangible assets** | ** ** | ** **                             | ** ** | ** **                                        | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------------------------|------------|----------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                       | ** ** | **Year End  November 1,  2008**                    | ** ** | **Effects of  Foreign  Currency** | ** ** | **Assets Sold**

**November 10,  2008** | ** ** | **Period End  January 24,  2009** | ** ** | **Accumulated  Amortization** | ** ** | **Net  Amount** | ** ** |
| ** **                                                                       | ** ** | ** **                                                   | ** ** | **(In thousands)**                | ** ** |
| ** **                                                                       | ** ** | ** **                                                   | ** ** |
| Domestic Business Services amortized  intangible assets - Non-compete agreements |       | $                                                            | 17         |                                   | $          | —                                            |       | $ | — |   | $ | 17 |   | $ | (4 | ) | $ | 13 |   |
| Domestic Business Services indefinite life  intangible assets - Franchise rights |       | 3,487                                                        |       | —                                 |       | —                                            |       | 3,487 |   | — |   | 3,487 |   |
| Total intangible assets                                                          |       | 3,504                                                        |       |                                   |       | —                                            |       | 3,504 |   | (4 | )  | 3,500 |   |
| ** **                                                                       | ** ** | ** **                                                   | ** ** | ** **                             | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Domestic Business Services goodwill                                              |       | —                                                       |       | —                                 |       | —                                            |       | — |   | — |   | — |   |
| Assets Held for Sale (Australia goodwill)                                        |       | 636                                                          |       | 33                                     |       | (669                                              | )          | — |   | — |   | — |   |
|                                                                             |       |                                                         |       |                                   |       |                                              |       |   |   |   |   |   |   |
| Total goodwill                                                                   |       | 636                                                          |       | 33                                     |       | (669                                              | )          | — |   | — |   | — |   |
| Total goodwill and intangible assets                                             |       | $                                                            | 4,140      |                                   | $          | 33                                                |       | $ | (669 | ) | $ | 3,504 |   | $ | (4 | ) | $ | 3,500 |   |

 

Total estimated amortization expense for theremaining 40 weeks of fiscal year 2009 is $13,000.

 

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**7.     Accrued Expenses**

** **
| ** **                                          | ** ** | **January 24,  2009** | ** ** | **November 1,  2008** | ** ** |
|-----------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                                          | ** ** | **(In  thousands)**        | ** ** |
|                                                |       |                       |       |                       |       |
| Accrued payroll and payroll taxes                   |       | $                          | 6,650      |                       | $          | 7,030 |   |
| Accrued insurance and general liability             |       | 1,775                      |       | 2,085                      |       |
| Accrued legal, audit and professional fees          |       | 1,529                      |       | 1,298                      |       |
| Deferred revenue on sale of building                |       | 655                        |       | 745                        |       |
| Franchise commisions payable                        |       | 519                        |       | 831                        |       |
| Checks outstanding in excess of book cash  balances |       | 345                        |       | 2,949                      |       |
| Taxes other than income taxes                       |       | 233                        |       | 242                        |       |
| Restructuring accrual (Note 14)                     |       | 294                        |       | 300                        |       |
| Other                                               |       | 1,057                      |       | 1,019                      |       |
|                                                |       | $                          | 13,057     |                       | $          | 16,499 |   |

 

**8.****             ****Credit Agreements**

 

On February 14, 2008, the Company’s wholly-owned subsidiaryWestaff (USA), Inc. (as borrower) and the Company (as parent guarantor)entered into the Financing Agreement with U.S. Bank and Wells Fargo, whichprovides for a five-year revolving credit facility that had originally providedfor aggregate revolving credit commitments of up to $50.0 million, including aletter of credit sub-limit of $35.0 million. Borrowings under the Financing Agreement bear interest, at the Company’selection, at either U.S. Bank’s prime rate or at LIBOR plus an applicable LIBORrate margin ranging from 1.25% to 2.00%. The Financing Agreement provides thata default rate would apply on all loan obligations in the event of defaultunder the Financing Agreement and related documents, at a rate per annum of2.0% above the applicable interest rate. Interest is payable on a monthly basis. The Company has $27.3 million of letters of credit supporting workers’compensation obligations outstanding under the U.S. Bank Credit facility at January 24,2009, but no cash borrowings.  The creditobligations under the Financing Agreement are secured by a first prioritysecurity interest in the assets of the Borrower, the Company and the otherGuarantors, with certain exceptions set forth in the Financing Agreement andthe other Credit Documents.

 

On May 23, 2008, Westaff (USA), Inc. received a notice ofdefault from U.S. Bank stating that (1) an Event of Default (as defined inthe Financing Agreement) had occurred due to its failure to achieve a minimumrequired Fixed Charge Coverage Ratio (as defined in the Financing Agreement)for the fiscal period ended April 19, 2008; and (2) as a result ofthe Event of Default, effective May 21, 2008, U.S. Bank increased the rateof interest to the default rate of interest on the borrowings outstanding underthe Financing Agreement.

 

Beginning on July 31, 2008, Westaff (USA), Inc. and theCompany entered into a series of Forbearance Agreements with U.S. Bank andWells Fargo, under which, among other things, U.S. Bank and Wells Fargo agreedto forbear from exercising any of their default rights and remedies in responseto the occurrence and continuance of the Event of Default commencing on thedate of the Forbearance Agreement and ending on December 19, 2008.  Among other things, the Company agreedto a reduction in the aggregate amount of the commitments under the FinancingAgreement from $50.0 million to $33.0 million effective as of June 23,2008 and agreed to maintain a reserve against the revolving credit availabilityto cover the Company’s payroll and payroll tax obligations.  The interest rates applicable to theloans made pursuant to the Financing Agreement continued at the default ratethroughDecember 19,2008.

 

FromDecember 20, 2008 to February 17, 2009, the Company did not enterinto any further forbearance agreements with U.S. Bank and Wells Fargo underwhich U.S. Bank and Wells Fargo would agree to continue to forbear fromexercising their default rights and remedies beyond December 19,2008.  Accordingly, the Company had operated without a continuedforbearance from U.S. Bank and Wells Fargo during this period.

 

On February 18, 2009, Westaff entered into a Third Amended andRestated Forbearance Agreement with U.S. Bank and Wells Fargo, under which,among other things, U.S. Bank and Wells Fargo agreed to continue to forbearfrom exercising any of their default rights and remedies during a forbearanceperiod ending on April 7, 2009.  TheCompany agreed to a further reduction in the aggregate amount of thecommitments under the Financing Agreement from $33.0 million to $28.0 millionand U.S. Bank agreed to amend certain letters of credit outstanding under theFinancing Agreement (including an outstanding letter of credit with a face amountof $27.0 million in favor of Travelers, which is the carrier under the Company’sexisting workers’ compensation insurance program) to extend the expiration dateof such letters of credit from February 28, 2009 to April 7, 2009. Inaddition, the Company’s ability to borrow under the Financing Agreement (otherthan forced loans due to draws upon the outstanding letters of credit) wasterminated.  The interest ratesapplicable to the loans made pursuant to the Financing Agreement will continueat the default rate through April 7, 2009.

 

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The Company has recorded $0.8 million of amortizable debt issuancecosts related to the U.S. Bank credit facility as a long term asset.  If the credit agreement was terminated forany reason, the amortization of these costs would be accelerated and the assetbalance would be fully expensed at the time of termination.

 

OnAugust 25, 2008, the Company secured a $3.0 million subordinated loanfacility with its principal stockholder, DelStaff.  This facility may be used by the Company forworking capital and general business purposes during the term of thefacility.  The outstanding loan balanceat January 24, 2009 was $2.7 million, which includes a $0.2 millionfacility fee that was added to the loan balance upon receipt of the initialadvance.  Accrued and unpaid interest onthis note at January 24, 2009 was $0.1 million.  See Note 9. Subsequent to quarter end on January 29, 2009, the Company wasadvanced an additional $500,000 from DelStaff. See Note 18.

 

The Company’s former Australian subsidiary had previously maintained anA$12 million Australian dollar facility agreement (the “A$ Facility Agreement”)with GE Capital, as primary agent, that had been set to expire in May 2009.  The outstanding balance on the AustraliaFacility Agreement was $4.6 million at 8.17% rate per annum and was classifiedas current liabilities held for sale in the consolidated balance sheet as of November 1,2008.  As of January 24, 2009, theGE Capital debt was paid in full in connection with the sale.

 

The Company has an unsecured subordinated promissory note in an amountof $2.0 million, dated May 17, 2002 and payable to the former Chairman ofthe Board of Directors.  Accrued andunpaid interest on this note at January 24, 2009 was $0.4 million and isincluded in accrued expenses in the Company’s consolidated balance sheets.

 

**9.****             ****Related Party Transactions**

 

The Company has an unsecured subordinated promissory note in an amountof $2.0 million, dated May 17, 2002 and payable to the former Chairman ofthe Board of Directors.  The note maturedon August 18, 2007, is now past due and has an interest rate equal to an indexedrate as calculated under the Company’s credit facilities plus seven percent,compounded monthly and payable 60 calendar days after the end of each of theCompany’s fiscal quarters.  The effectiveinterest rate on January 24, 2009 was 10.25%. Payment of interest iscontingent on the Company meeting minimum availability requirements under itscredit facilities.  Additionally,payments of principal or interest are prohibited in the event of any defaultunder the credit facilities.  U.S. Bank,which is the agent and a lender under our primary credit facility, hasexercised its right to prohibit repayment of the note.  There were no interest payments on this noteduring fiscal year 2008 and during the first quarter of fiscal year 2009.  Accrued and unpaid interest on this note at January 24,2009 was $0.4 million and is included in accrued expenses in the Company’sconsolidated balance sheets.

 

On August 25, 2008, the Company secured a $3.0 millionsubordinated loan facility with its principal stockholder, DelStaff.  This facility may be used by the Company forworking capital and general business purposes during the term of thefacility.  The unpaid principal balanceunder the Subordinated Loan bears interest at an annual rate of twenty percent(20%).  Interest is payable-in-kind andaccrues monthly in arrears on the first day of each month as an increase in theprincipal amount of the Subordinated Loan. A default rate applies on all obligations under the Subordinated LoanAgreement from and after the Maturity Date (August 15, 2009) and alsoduring the existence of an Event of Default (as defined in the SubordinatedLoan Agreement) at an annual rate of ten percent (10%) also payable-in-kindover the then-existing applicable interest rate.  If the principal is not repaid on theMaturity Date, an additional 5% of outstanding principal must be paid alongwith the default rate interest.  Theobligations under the Subordinated Loan Agreement are secured by a securityinterest in substantially all of the existing and future assets (the “SubordinatedCollateral”) of the Company.  The liengranted to the Subordinated Lender in the Subordinated Collateral issubordinated to the lien in that same collateral granted to U.S. Bank.  Borrowings in excess of $1.0 million requirethe Subordinated Lender approval.  TheSubordinated Loan may be prepaid without penalty, subject to approval by U.S.Bank and the terms of an Intercreditor Agreement.  Under certain circumstances, the Company mustprepay all or a portion of any amounts outstanding under the Subordinated LoanAgreement, subject to the terms of the Intercreditor Agreement.  The outstanding loan balance at January 24,2009 was $2.7 million, which includes a $0.2 million facility fee that wasadded to the loan balance upon receipt of the initial advance.  Accrued and unpaid interest on this note at January 24,2009 was $0.1 million.   There were nointerest payments on this note during fiscal year 2008.   Subsequentto quarter end on January 29, 2009, the Company was advanced an additional$500,000 from DelStaff.  See Note 18.

 

**10.****      ****Commitments and Contingencies**

 

In the ordinary course of its business, the Company is periodicallythreatened with or named as a defendant in various lawsuits, including, amongother, litigation brought by former franchisees or licensees, andadministrative claims and lawsuits brought by employees or formeremployees.  The Company insures itself tocover principal risks like workers’ compensation, general liability, automobileliability, property damage, alternative staffing errors and omissions,fiduciary liability and fidelity losses. Management believes there are nomatters that will have a material adverse effect on the Company’s consolidatedfinancial statements.

 

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During the fourth quarter of fiscal year 2005, we werenotified by the California Employment Development Department (“EDD”) that ourdomestic operating subsidiaries unemployment tax rates would be increasedretroactively for both calendar years 2005 and 2004.  The total assessment by the EDD of additionalunemployment taxes for both years, net of applied overpayments is approximately $1.5 millionincluding interest at applicable statutory rates.  Management believes that it has properlycalculated its unemployment insurance tax and is in compliance with allapplicable laws and regulations.  TheCompany has timely appealed the ruling by the EDD and is working with theoutside counsel to resolve this matter. Additionally, management contends thatthe notification by the EDD of the 2004 assessment was not timely and holds theposition that the assessment is procedurally invalid.  Consequently, at November 1, 2008 and atJanuary 24, 2009, the Company has no reserve for the 2004 assessment andhas accrued the assessment for 2005 of $0.3 million, including interest and netof an applied overpayment.  Although webelieve that we have properly calculated our unemployment insurance tax and arein compliance with all applicable laws and regulations, there can be noassurances this will be settled in our favor. Management believes the Company is well positioned to defend against theun-accrued portion and the ultimate resolution of this matter will not have amaterial adverse effect on the Company’s consolidated financial statements.

 

**11.****      ****Workers’ Compensation**

 

The Company is responsible for and pays workers’ compensation costs forits temporary and regular employees and is self-insured for the deductibleamount related to workers’ compensation claims. The Company accrues the estimated costs of workers’ compensation claimsbased upon the expected loss rates within the various temporary employmentcategories provided by the Company.  Atleast annually, the Company obtains an independent actuarial valuation of theestimated costs of claims reported but not settled, and claims incurred but notreported (IBNR), and adjusts the accruals based on the results of thevaluations.  The following summarizes theworkers’ compensation liability as of January 24, 2009 and November 1,2008:

 
| ** **                            | ** ** | **January 24, 2009** | ** ** | **November 1, 2008** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **(In millions)**         | ** ** |
| Current portion                  |       | $                              |  8.0  |                           | $          |  8.0 | ** ** |
| Long-term portion                     |       | $                              | 15.0       |                           | $          | 15.3 |   |
| Total Liabilities                     |       | $                              | 23.0       |                           | $          | 23.3 |   |
|                                  |       |                           |       |                           |       |
| Self-insurance deductible (per claim) |       | $                              | 0.75       |                           | $          | 0.75 |   |
| Letters of Credit (1)                 |       | $                              | 27.3       |                           | $          | 27.3 |   |

 

----

(1)The insurance carrier requires the Companyto collateralize its recorded obligations through the use of irrevocableletters of credit, surety bonds or cash. Per the Third Amended and RestatedForbearance Agreement, the letters of credit for Travelers in the amount of $27million expire on April 7, 2009. The Ohio workers’ compensation letter ofcredit expired on February 28 2009.

 

**12.  Stock-Based Compensation**

 

*Stock Incentive Plan and Employee Stock Purchase Plan*.  The Company has a stock incentiveplan and an Employee Stock Purchase Plan. Please refer to Note 12 of the Company’s audited consolidated financial statements included in the 2008 Form 10-Kfor additional information related to these stock-based compensation plans.

 

*Restricted Stock Units. *On May 30,2008, the Company granted 90,000 restricted stock units to certainemployees.  Each grant entitles the recipientto convert units to shares of common stock subject to terms of the awards.  The maximum units to be awarded, if allperformance conditions are met, are 135,000 units.  The restricted stock units will vest, if allconditions are met, 50% on October 30, 2010 and 50% on October 29,2011.  Besides the condition that therecipient must complete a period of continuous service to the Company throughand including the vest dates, there is a performance condition and a marketcondition, both of which must be met. First, for each of three fiscal years, beginning with fiscal year 2008, the company must meet anEBITDA target and second, the company’s stock price must meet certainrequirements as compared to a designated “peer” group’s average stockprice.  As of January 24, 2009, theachievement of performance based criteria is not probable; therefore nocompensation expense has been recognized.

 

*Stock-based compensation*.  Effective with the beginning of the first quarter of fiscalyear 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) Share-Based Payment (“SFAS123(R)”) using the modified prospective method of adoption.

 

Forthe 12-week period ended January 24, 2009 and January 26, 2008, theCompany recognized stock-based compensation expense as follows:

 
| ** **               | ** ** | **12 Weeks Ended**   | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **January 24, 2009** | ** ** | **January 26, 2008** | ** ** |
| ** **               | ** ** | **(In thousands)**        | ** ** |
| ** **               | ** ** | ** **                     | ** ** |
| Stock-based compensation |       | $                              | 42         |   | $ | 74 |   |
|                          |            |                                |            |  |  |  |  |

 

Stock-basedcompensation expense isincluded in selling and administrative expenses.

 

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The determination of the fair value of stock options, using theBlack-Scholes model, is affected by the Company’s stock price as well asassumptions as to the Company’s expected stock price volatility over the termof the awards, actual and projected employee stock option exercise behavior,the risk-free interest rate, and expected dividends.

 

TheCompany estimates the volatility of the common stock by using historicalvolatility over a period equal to the award’s expected term. The risk-freeinterest rates that are used in the valuation models are based upon yields ofthe U.S. Treasury constant maturities at the time of grant having a term thatapproximates the expected life of the options. Dividend yield is zero as theCompany did not declare or pay dividends during fiscal year 2009 or fiscal year 2008, and its current credit facilitiesprohibit payment of dividends.  TheCompany does not currently have plans to declare dividends in future years.

 

SFAS123(R) requires companies to estimate future expected forfeitures at thedate of grant and revise those estimates in subsequent periods if actualforfeitures differ from those estimates. In previous years, the Company had recognized the impact of forfeituresas they occurred.  Under SFAS 123(R), the Company useshistorical data to estimate pre-vesting forfeiture rates in determining theamount of stock-based compensation expense to recognize.  During the 12 weeks ended January 24,2009, the Company increased its forfeiture rate by analyzing historicforfeiture rates and reviewing outstanding unvested option grants whichresulted in a decrease to stock-based compensation expense.

 

The Company will accelerate the vesting ofall outstanding stock options per the Merger Agreement with KoosharemCorporation which was entered into on January 28, 2009.  Upon completion of the Merger eachoutstanding stock option to purchase shares of Company common stock, whether ornot then exercisable or vested, will be cancelled and converted into the rightto receive, within ten business days following the effective time of theMerger, an amount in cash (subject to applicable withholding taxes) equal to (a) theexcess, if any, of the Merger Consideration over the per share exercise priceof the stock option, multiplied by (b) the number of shares of Companycommon stock subject to the stock option. See Note 18.

 

Allstock-based compensationawards are amortized on a straight-line basis over the requisite serviceperiods of the awards.

 

**13.****      ****(Loss) Earnings per Share**

 

Basicloss per share of common stock is computed as loss divided by the weightedaverage number of common shares outstanding for the period.  Diluted loss per share of common stock iscomputed as loss divided by the weighted average number of common shares andpotentially dilutive common stock equivalents outstanding during theperiod.  Diluted loss per share reflectsthe potential dilution that could occur from common stock issuances as a resultof stock option exercises. The following table sets forth thecomputation of basic and diluted (loss) earnings per share:

 

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| ** **                                                                                             | ** ** | **12 Weeks Ended**                                          | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                             | ** ** | **January 24,  2009**                                            | ** ** | **January 26,  2008** | ** ** |
| ** **                                                                                             | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                                                                                   |       |                                                                  |       |   |   |
| Loss from continuing operations                                                                        |       | $                                                                     | (5,652     | ) | $ | (2,066 | ) |
| Income from  discontinued operations, net of income tax                                                |       | 1,347                                                                 |       | 171 |   |
| Net loss                                                                                               |       | $                                                                     | (4,305     | ) | $ | (1,895 | ) |
| Denominator for basic earnings per  share-weighted average shares                                      |       | 16,697                                                                |       | 16,697 |   |
|                                                                                                   |       |                                                                  |       |   |   |
| Effect of dilutive securities: stock  options and awards                                               |       | —                                                                |       | — |   |
| Denominator for diluted earnings per share  - adjusted weighted average shares and assumed conversions |       | 16,697                                                                |       | 16,697 |   |
|                                                                                                   |       |                                                                  |       |   |   |
| Loss per share from continuing operations                                                              |       |                                                                  |       |   |   |
| Basic                                                                                                  |       | $                                                                     | (0.34      | ) | $ | (0.12 | ) |
| Diluted                                                                                                |       | (0.34                                                                 | )          | (0.12 | ) |
|                                                                                                   |       |                                                                  |       |   |   |
| Earnings per share from discontinued  operations                                                       |       |                                                                  |       |   |   |
| Basic                                                                                                  |       | $                                                                     | 0.08       |   | $ | 0.01 |   |
| Diluted                                                                                                |       | 0.08                                                                  |       | 0.01 |   |
| Loss per share                                                                                         |       |                                                                  |       |   |   |
| Basic                                                                                                  |       | $                                                                     | (0.26      | ) | $ | (0.11 | ) |
| Diluted                                                                                                |       | $                                                                     | (0.26      | ) | $ | (0.11 | ) |
|                                                                                                   |       |                                                                  |       |   |   |
| Antidilutive weighted shares excluded from  diluted earnings per share                                 |       | 718                                                                   |       | 396 |   |

 

**14.  CompanyRestructuring**

 

In the third quarter of fiscal year 2007, the Company approved arestructuring plan to, among other things, reduce its workforce and consolidatefacilities.  Restructuring charges havebeen recorded to align the Company’s cost structure with changing marketconditions and to create a more efficient organization.  The Company’s restructuring charges have beencomprised primarily of: (i) severance and termination benefit costsrelated to the reduction of our workforce; and (ii) lease terminationcosts and costs associated with permanently vacating certain facilities.

 

The Company accounted for each of these costs in accordance withFASB 146, “Accounting for Costs Associated with Exit or DisposalActivities.”  The accrual represents theremaining costs related to leases associated with vacating certain facilitiesin the restructuring plan initiated in fiscal year 2007.

 

The detail is as follows:

 
|                                                                  |   | **12 Weeks Ended  January 24, 2009  (In thousands)** |   |
|-----------------------------------------------------------------------|--------|-------------------------------------------------------------------------------|--------|
|                                                                  |   | **Facilities**                                                                |   |
| Accrual balance at November 1, 2008                              |   | $                                                                             | 300    |   |
| Rent expense under non-cancellable leases  reduced by sublease income |   | (58                                                                           | )      |
| Restructuring expense                                                 |   | 52                                                                            |   |
| Accrual balance at January 24, 2009                              |   | $                                                                             | 294    |   |

 

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TheCompany is stillresponsible for lease payments on six locations and is actively negotiatingearly terminations, where possible.  Therestructuring accrual, representing rent payments due under non-cancellableleases has been reduced by any contractual subleases.  The Company has not reduced the January 24,2009 liability by any estimated future sublease income as the Company does notbelieve the remaining offices will be subleased.    The severance amounts related to headcountreductions in the first quarter of fiscal year 2009 were included as part ofselling and administrative expenses and the remaining accrual at January 24,2009 is $0.1 million.

 

**15.  Comprehensive Loss**

 

Comprehensive loss consists of the following:

 
| ** **                           | ** ** | **12 Weeks Ended** | ** ** |
|--------------------------------------|------------|------------------------------|------------|
| ** **                           | ** ** | **January 24,  2009**   | ** ** | **January 26,  2008** | ** ** |
| ** **                           | ** ** | **(In thousands)**      | ** ** |
|                                 |       |                         |       |   |   |
| Net loss                             |       | $                            | (4,305     | ) | $ | (1,895 | ) |
| Currency translation adjustments (1) |       | (668                         | )          | (571 | ) |
| Comprehensive loss                   |       | $                            | (4,973     | ) | $ | (2,466 | ) |

 

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(1)  The currency translation in thecurrent fiscal year relates to the recognition of cumulative translation amountsdue to the sale of the Australia and New Zealand operations.

 

**16.  OperatingSegments**

 

The Company had four reportable segments;however, only its domestic subsidiary is currently included in our results ofcontinuing operations. On March 31, 2008, the Company sold its formerUnited Kingdom operations and related subsidiary. On November 10, 2008,the Company sold its former Australia and New Zealand subsidiaries.  In accordance with SFAS 144, a component ofan entity that has been disposed of is considered a discontinued operation.Accordingly, the Company has reflected the results of these subsidiaries asdiscontinued operations in the consolidated statement of operations for allperiods presented. See Note 4.

 

Following the sale of the Company’s formerUnited Kingdom operations and related subsidiary and the sale of the Company’s former Australia and New Zealandsubsidiaries, the Company’s remaining segment consist of the DomesticBusiness Services. Domestic Business Services provides a variety of temporarystaffing and permanent placement services, primarily in clerical and lightindustrial positions, through a network of Company-owned and franchise agentoffices. The segment consists of four geographically diverse company regionsunder the direction of regional vice presidents and one combined franchiseregion, which together comprise a single reportable operating segment as suchterm is defined under SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information.” Revenue from the Domestic BusinessServices operating segment is derived wholly from the United States and itsterritories.

 

The following table summarizes reportingsegment data for Domestic Business Services and the Discontinued Operations:

 
| ** **                                | ** ** | **12 Weeks ended January 24, 2009** | ** ** |
|-------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                | ** ** | **Domestic  Business Svcs**                             | ** ** | **Discontinued  Operations** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **(In thousands)**                                      | ** ** |
|                                      |       |                                                         |       |   |   |   |   |
| Revenue                                   |       | $                                                            | 51,548     |   | $ | 2,086 |   | $ | 53,634 |   |
| Operating loss from continuing operations |       | $                                                            | (5,066     | ) | $ | (315 | ) | $ | (5,381 | ) |

 
|                                                |   | **12 Weeks ended January 26, 2008** |   |
|-----------------------------------------------------|--------|--------------------------------------------------------------|--------|
|                                                |   | **Domestic  Business Svcs**                             |   | **Discontinued  Operations** |   | **Total** |   |
|                                                |   | **(In thousands)**                                      |   |
|                                                |   |                                                         |   | ** ** |   |   |   |
| Revenue                                             |   | $                                                            | 81,048 |   | $ | 35,786 |   | $ | 116,834 |   |
| Operating income (loss) from continuing  operations |   | $                                                            | (1,964 | ) | $ | 170 |   | $ | (1,794 | ) |

 

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**17.****      ****Recent Accounting Pronouncements**

 

InDecember 2007, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) No. 141 (R), “BusinessCombinations.”  SFAS 141(R) requiresall business combinations completed after the effective date to be accountedfor by applying the acquisition method (previously referred to as the purchasemethod).  Companies applying this methodwill have to identify the acquirer, determine the acquisition date and purchaseprice and recognize at their acquisition-date fair values the identifiableassets acquired, liabilities assumed, and any non-controlling interests in theacquiree.  In the case of a bargainpurchase the acquirer is required to reevaluate the measurements of therecognized assets and liabilities at the acquisition date and recognize a gainon that date if an excess remains.  SFAS141(R) is effective for fiscal periods beginning on or after December 15,2008.  The Company is currentlyevaluating the impact of SFAS 141(R).

 

In September 2006, the FASB issued SFAS No. 157,“Fair Value Measurements.” SFAS No. 157 defines fair value, establishes aframework for measuring fair value in generally accepted accounting principlesand expands disclosures about fair value measurements. SFAS No. 157applies under other accounting pronouncements that require or permit fair valuemeasurements, the FASB having previously concluded in those accountingpronouncements that fair value is the relevant measurement attribute.Accordingly, SFAS No. 157 does not require any new fair valuemeasurements. SFAS No. 157 is effective for fiscal years beginning after November 15,2007. In February 2008, the FASB agreed to a one-year deferral for theimplementation of SFAS No. 157 for non-financial assets and liabilities tofiscal years beginning after November 15, 2008. The Company is currentlyevaluating the impact, if any, that the adoption of SFAS No. 157 will haveon its operating results and financial condition.

 

In February 2007, the FASB issued SFAS No. 159,“The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159permits companies to choose to measure many financial instruments and certainother items at fair value that are not currently required to be measured atfair value. The objective is to improve financial reporting by providingcompanies with the opportunity to mitigate volatility in reported earningscaused by measuring related assets and liabilities differently without havingto apply complex hedge accounting provisions. SFAS No. 159 is effectivefor fiscal years beginning after November 15, 2007. Companies are notallowed to adopt SFAS No. 159 on a retrospective basis unless they chooseearly adoption. The Company adopted the SFAS No. 159 in the first quarterof fiscal year 2009 and there was no impact to operating results and financialcondition.

 

In December 2007, the FASB issued SFAS No. 160,“Non-controlling Interests in Consolidated Financial Statements” (an Amendmentof ARB 51). SFAS 160 amends ARB 51 to establish accounting and reportingstandards for the non-controlling interest in a subsidiary and for thedeconsolidation of a subsidiary. The statement requires consolidated net incometo be reported at amounts that include the amounts attributable to both theparent and the non-controlling interest. It also requires disclosure on theface of the consolidated statement of operations, of the amounts ofconsolidated net income (loss) attributable to the parent and to thenon-controlling interest. In addition this statement establishes a singlemethod of accounting for changes in a parent’s ownership interest in asubsidiary that do not result in deconsolidation and requires that a parentrecognize a gain or loss in net income when a subsidiary is deconsolidated.SFAS 160 becomes effective for fiscal periods beginning after December 15,2008. The Company is currently evaluating the impact of SFAS 160.

 

InMarch 2008, the FASB issued SFAS No. 161, “Disclosures aboutDerivative Instruments and Hedging Activities.” SFAS 161 is intended to help investors better understand how derivativeinstruments and hedging activities affect an entity’s financial position,financial performance and cash flows through enhanced disclosurerequirements.  SFAS 161 is effective forfiscal years and interim periods beginning after November 15, 2008.  The Company does not expect the adoption ofSFAS 161 to have a material impact on the consolidated financial statements.

 

InMay 2008, the FASB issued SFAS No. 162, “The Hierarchy of GenerallyAccepted Accounting Principles.”  SFAS No. 162identifies the sources of accounting principles and the framework for selectingthe principles used in the preparation of financial statements which arepresented in conformity with generally accepted accounting principles (“GAAP”)in the United States.  SFAS No. 162became effective November 15, 2008. The adoption of SFAS 162 did not have a material impact on our financialposition or results of operations.

 

InNovember 2008 the Emerging Issues Task Force (“EITF”) issued Issue No. 08-7,“Accounting for Defensive Intangible Assets.” EITF 08-7 applies to all acquired intangible assets in which theacquirer does not intend to actively use the asset but intends to hold (lockup) the asset to prevent its competitors from obtaining access to the asset (adefensive asset), assets that the acquirer will never actually use, as well asassets that will be used by the acquirer during a transition period when theintention of the acquirer is to discontinue the use of those assets.  EITF 08-7 is effective for intangible assetsacquired on or after the beginning of the first annual reporting periodbeginning on or after December 15, 2008. The Company does not expect the adoption of EITF 08-7 to have a materialimpact on the consolidated financial statements.

 

**18.****      ****Subsequent Events**

 

On January 28, 2009, the Company enteredinto an Agreement and Plan of Merger (the “Merger Agreement”) with KoosharemCorporation, a California corporation doing business as Select Staffing (“Koosharem”)and Select Merger Sub Inc., a Delaware corporation and wholly-ownedsubsidiary of Koosharem (“Merger Sub”), pursuant to which Merger Sub will bemerged with and into the Company, with the Company continuing after the mergeras the surviving corporation and a wholly-owned subsidiary of Koosharem (the “Merger”),in accordance with and subject to the terms and conditions set forth in theMerger Agreement. Concurrently with the execution of the Merger Agreement, ourprincipal stockholder, DelStaff entered into a Stock & Note PurchaseAgreement with Koosharem (the “Purchase Agreement”), pursuant to whichKoosharem will purchase, immediately prior to the effective time of the

 

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Merger: (1) all of the Company common stock owned by DelStaff inexchange for first lien term loan debt to be issued by Koosharem underKoosharem’s first lien credit facility bearing a face amount of $40.0 millionand (2) all of the then outstanding subordinated notes (the “DelStaffSubordinated Notes”) issued by the Company to DelStaff under the SubordinatedLoan Agreement, dated as of August 25, 2008, by and among the Company,Westaff (USA), Inc., Westaff Support, Inc., MediaWorld International(as borrowers) and DelStaff, in exchange for first lien term loan debt to beissued by Koosharem under Koosharem’s first lien credit facility bearing a faceamount equal to the actual principal amount of the then outstanding DelStaffSubordinated Notes held by DelStaff, but which face amount shall not exceed$3.0 million.  In addition, subject to the terms andconditions of the Purchase Agreement, DelStaff has agreed (1) to vote allof its shares of Company common stock in favor of the proposed Merger andagainst any third-party proposal to acquire the Company and (2) not totransfer its shares of Company common stock other than in accordance with theMerger Agreement.

 

Pursuant to the terms and conditions of theMerger Agreement, at the effective time of the Merger: (1) eachoutstanding share of Company common stock (other than those owned by theCompany, Koosharem, Merger Sub or any subsidiary of the Company, Koosharem orMerger Sub, and other than those shares with respect to which dissenters rightsare properly exercised) will be cancelled and converted into the right toreceive $1.25 per share in cash (the “Merger Consideration”) and (2) eachoutstanding stock option to purchase shares of Company common stock, whether ornot then exercisable or vested, will be cancelled and converted into the rightto receive, within ten business days following the effective time of theMerger, an amount in cash (subject to applicable withholding taxes) equal to (a) theexcess, if any, of the Merger Consideration over the per share exercise priceof the stock option, multiplied by (b) the number of shares of Companycommon stock subject to the stock option.

 

Consummation of the Merger is subject to thesatisfaction of various conditions, including, among others, the receipt byKoosharem and Merger Sub of the financing pursuant to and on the termscontemplated by the applicable commitment letters, the consummation of thetransactions under the Purchase Agreement, the requisite approval by theCompany’s stockholders, a requirement for the Company to hold a minimum of$9.5 million in cash and equivalents immediately prior to the closingdate, the lack of any legal impediment to the Merger, and the lack of anyMaterial Adverse Effect as specified in the Merger Agreement. Upon therecommendation of a special committee of independent members of the Company’sboard of directors (the “Special Committee”), all of the members of the Company’sboard of directors not affiliated with DelStaff approved the Merger Agreementand the Purchase Agreement. Robert W. Baird & Co. Incorporatedprovided a fairness opinion to the Special Committee. The Merger Agreementcontains certain termination rights for both the Company, on the one hand, andKoosharem and Merger Sub, on the other hand. Upon any termination of the MergerAgreement, under specified circumstances, the Company may be required to payKoosharem and Merger Sub a $2.0 million termination fee, and under otherspecified circumstances, Koosharem and Merger Sub may be required to pay theCompany a $2.0 million termination fee.

 

For additional information regarding the Merger Agreement and theproposed Merger, please refer to the definitive proxy statement that theCompany filed with the SEC on February 23, 2009 and mailed to the Company’sstockholders in connection with the planned special meeting of stockholders tobe held on March 17, 2009 and at which the Company’s stockholders will beasked to consider and vote upon a proposal to adopt the Merger Agreement andthe transactions contemplated thereby.

 

On January 29, 2009, the Company wasadvanced a loan in an aggregate principal amount of $500,000 from DelStaffunder the previously-announced loan agreement, dated as of August 25, 2008(the “Subordinated Loan Agreement”), among DelStaff and the Borrowers.

 

In January 2009, Westaff USA, Inc.was notified that Australia received a ruling from the Tasmanian WorkplaceOmbudsmen stating that Westaff Australia owed $40,000 in back wages toemployees related to the fiscal year 2008. This amount was subsequently paid.Additionally, Westaff Australia has received a “Notice of Investigation” fromthe Workplace Ombudsmen (Melbourne) with respect to the Workplace RelationsAct. To date, there has been no assessment and no accrual. In February of2009, the Company was notified by the buyers of the Australian subsidiary thatthere are potential warranty claims under the Sale Agreement.  The issue will be reviewed as the Companycontinues to negotiate the calculation of the working capital adjustment.  However, based on our review of such claims,management believes this will not have a material adverse effect on the Company’sconsolidated financial statements.

 

In February 2009, Westaff was notifiedby NASDAQ Stock Market (“NASDAQ”) that the closing bid price of the Company’scommon stock has been at $1.00 per share or greater for at least 10 consecutivebusiness days. Accordingly, the Company has regained compliance withMarketplace Rule 4450(a)(5) and the matter of the common stockpossibly being delisted is now closed.

 

On February 18, 2009, Westaff (USA), Inc. and the Companyentered into a Third Amended and Restated Forbearance Agreement with U.S. Bankand Wells Fargo, under which, among other things, U.S. Bank and Wells Fargoagreed to continue to forbear from exercising any of their default rights andremedies during a forbearance period ending on April 7, 2009.  The Company agreed to a further reduction inthe aggregate amount of the commitments under the Financing Agreement from$33.0 million to $28.0 million and U.S. Bank agreed to amend certain letters ofcredit outstanding under the Financing Agreement (including an outstandingletter of credit with a face amount of $27.0 million in favor of Travelers,which is the carrier under the Company’s existing workers’ compensationinsurance program) to extend the expiration date of such letters of credit fromFebruary 28, 2009 to April 7, 2009. In addition, the Company’sability to borrow under the Financing Agreement (other than forced loans due todraws upon the outstanding letters of credit) was terminated. Theinterest rates applicable to the loans made pursuant to the Financing Agreementwill continue at the default rate through April 7, 2009.

 

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**Item2.  Management’s Discussion and Analysisof Financial Condition and Results of Operations**

 

The following discussion is intended to assist in the understanding andassessment of significant changes and trends related to the results ofoperations and financial condition of Westaff, Inc., together with itsconsolidated subsidiaries.  Thisdiscussion and analysis should be read in conjunction with the condensedconsolidated financial statements and notes thereto included elsewhere in this Quarterly Reporton Form 10-Q and the audited consolidated financial statements andnotes thereto included in the 2008 Form 10-K.

 

References in this Quarterly Report on Form 10-Q tothe “Company,” “Westaff,” “we,” “our,” and “us” refer to Westaff, Inc.,its predecessor and their respective subsidiaries, unless the context otherwiserequires.

 

### **Cautionary Statement Regarding Forward-LookingStatements**

###  

This Quarterly Report on Form 10-Q contains forward-lookingstatements within the “safe harbor” provisions of the Private SecuritiesLitigation Reform Act of 1995.  Exceptfor statements that are purely historical, all statements included in thisQuarterly Report on Form 10-Q are forward-looking statements, and readersare cautioned not to place undue reliance on those statements.  You can also identify these statements by thefact that they do not relate strictly to current facts and use words such as “will,”“anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “target,”“forecast,” and other words and terms of similar meaning in connection with anydiscussion of future operating or financial performance.  The forward-looking statements include,without limitation our ability to achieve better people and processefficiencies as a result of changes to our operational structure, our abilityto enhance the profitability of our accounts through hiring industry-provenplacement consultants, and our ability to reduce selling and administrativecosts.  These statements are onlypredictions, and actual events or results may differ materially.  The forward-looking statements provide ourcurrent expectations or forecasts of future events.  These forward-looking statements are madebased on information available as of the date of this report and are subject toa number of risks and uncertainties that could cause the Company’s actualresults and financial position to differ materially from those expressed orimplied in forward-looking statements and to be below the expectations ofpublic market analysts and investors. Investors should bear this in mind asthey consider forward-looking statements.

 

These risks and uncertainties include, but are not limited to, thosediscussed in Part II, Item 1A, “Risk Factors” and elsewhere in thisQuarterly Report on Form 10-Q.  Youshould understand that it is not possible to predict or identify all suchfactors.  Consequently, you should notconsider any such list to be a complete set of all potential risks oruncertainties faced by us.

 

The Company undertakes no obligation to publicly release the results ofany revisions to these forward-looking statements to reflect events orcircumstances after the date hereof or to reflect the occurrence of unanticipatedevents, except as required by applicable laws and regulations.

 

**Company Overview**

 

We provide staffing services primarily in suburban and rural markets (“secondarymarkets”), as well as in the downtown areas of certain major urban centers (“primarymarkets”) in the United States (“US”) through our network of Company-owned andfranchise agent offices. On March 31, 2008, the Company sold its former United Kingdom operations andrelated subsidiary.  On November 10,2008, the Company sold its former Australia and New Zealand subsidiaries asdescribed in Note 4 to the condensed consolidated financial statements included elsewhere in this Quarterly Reporton Form 10-Q.

 

We offer a wide range of staffing solutions, including permanentplacement, replacement, supplemental and on-site temporary programs tobusinesses and government agencies. Our primary focus is on recruiting andplacing clerical/administrative and light industrial personnel.  We have 60 years of experience in thestaffing industry and currently operate through a network of 152 offices in 41states.  60% of these offices areCompany-owned and operated and 40% are operated by franchise agents. Ourcorporate headquarters provides support services to the field offices, in areassuch as marketing, human resources, risk management, legal, strategic sales,accounting, and information technology.

 

To complement our service offerings, which include temporary staffing,permanent placement, temp-to-hire services, payroll services and on-locationprograms, we utilize a number of tools focused on increasing our pool ofqualified candidates.  Additionally, weemploy a robust, targeted marketing program as well as a consultative salesprocess, and both of these tools assist in our sales efforts to new andexisting customers.  Management believesall of these tools enhance our competitive edge and position us to effectivelypursue high growth market niches.

 

The staffing industry is highly competitive with generally few barriersto entry, which contributes to significant price competition as competitorsattempt to maintain or gain market share. On a prospective basis, we believe our focus on increasing clerical andadministrative sales, improving results from underperforming field offices andprudently managing costs will permit us to improve our operating margins.

 

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Our business tends to be seasonal, with sales for the first fiscalquarter typically lower than other fiscal quarters.  This decrease results from the traditionalholidays that are included within the first fiscal quarter, as well as othercustomer closures for the holiday season. These closures and post-holiday season declines in business activitynegatively impact orders received from customers, particularly in the lightindustrial sector. Demand for staffing services historically tends to growduring the second and third fiscal quarters and has historically been greatestduring the fourth fiscal quarter due largely to customers’ planning andbusiness cycles.  The recent economicdownturn in the fiscal year2008 and the first quarter offiscal year 2009 has negatively impacted this expected historical growth,reducing demand for temporary employees and adversely affecting our sales.  We anticipate that we may continue toexperience weaker demand for temporary employees through the remainder offiscal year 2009.

 

Payroll taxes and related benefits fluctuate with the level of payrollcosts, but tend to represent a smaller percentage of revenue and payroll costslater in our fiscal year as federal and state statutory wage limits forunemployment are exceeded on a per employee basis.  Workers’ compensation expense generallyvaries with both the frequency and severity of workplace injury claims reportedduring a quarter.  Adverse and positiveloss development of prior period claims during a subsequent quarter may also contributeto the volatility in our estimated workers’ compensation expense.

 

### **Critical Accounting Policies**

###  

The preparation of financial statements in conformity with generallyaccepted accounting principles in the United States of America requiresmanagement to make certain estimates and assumptions affecting the amounts anddisclosures reported within those financial statements.  These estimates are evaluated on an ongoingbasis by management and generally affect revenue recognition, workers’compensation costs, collectability of accounts receivable, impairment ofgoodwill and intangible assets, contingencies, litigation and incometaxes.  Management’s estimates andassumptions are based on historical experiences and other factors believed tobe reasonable under the circumstances. Actual results under circumstances and conditions different than thoseassumed could result in differences from the estimated amounts in the financialstatements.

 

Our critical accounting policies are described in the notes to theaudited consolidated financial statements included in the 2008 Form 10-K.  During the first quarter of fiscal year 2008,we adopted the provisions of FIN 48 effective November 4, 2007.  Please see Note 3 to the condensedconsolidated financial statements included elsewhere in this Quarterly Reporton Form 10-Q.  There were no changesto these policies during the 12-week period ended January 24, 2009.

 

**Executive Overview**

** **

Our gross revenues for the 12-week period ended January 24, 2009 were $51.5 million,which represents a decline of $29.5 million, or 36.4%, from the same periodlast year.  The decline in revenues wasprimarily due to the economic downturn that began in early fiscal year 2008 and the loss of two large customers which together made up 9.2% ofrevenues for the first quarter of the fiscal year 2008.

 

Our net loss for the first quarter of fiscal year 2009 was $4.3 millioncompared with a net loss of $1.9 million for the same period last year.  The loss for the first fiscal quarter of 2009 includes the gain on the sale of the Company’sformer Australia and New Zealand subsidiaries of $1.7 million and a loss of$0.4 million for the discontinued operations for the same period.  Additionally, the loss includes $0.3 millionof personnel expense related to a reduction in workforce and legal fees relatedto the potential merger of $0.2 million both which occurred in the firstquarter of fiscal year 2009.

 

We have made changes in our operationalstructure in an effort to achieve better people and process efficiencies. Weare committed to improving the profitability of our organization and increasingour market share. We have had success in reducing our selling andadministrative costs in total, including, among other things, reducing ourheadcount by approximately 66 positions in the first quarter of fiscal year2009, and we are evaluating and implementing additional opportunities forsavings. Further, we have divested our international subsidiaries in order toconcentrate on our core domestic business.

 

**Merger Agreement**

 

On January 28, 2009, we entered into theMerger Agreement with Koosharem and Merger Sub, pursuant to which Merger Subwill be merged with and into the Company, with the Company continuing after themerger as the surviving corporation and a wholly-owned subsidiary of Koosharem,in accordance with and subject to the terms and conditions set forth in theMerger Agreement.  For additionalinformation regarding the Merger Agreement and the proposed Merger, pleaserefer to the definitive proxy statement that the Company filed with the SEC on February 23,2009 and mailed to the Company’s stockholders in connection with the plannedspecial meeting of stockholders to be held on March 17, 2009 and at whichthe Company’s stockholders will be asked to consider and vote upon a proposalto adopt the Merger Agreement and the transactions contemplated thereby.

 

**Going Concern Considerations**

 

The Company has incurred operating lossessince the second quarter of fiscal year 2007, offset by slightoperating income in the fourth quarter of fiscal year 2007. The Company may incur additional losses in thefuture, particularly because of the current significant economic downturn andrecession.

 

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The Company’s operations, even if theyperform in accordance with management’s expectations, may not generatesufficient cash flow or accounts receivables to finance the Company’soperations at current levels, collateralize workers’ compensation liabilities,or permit the Company to expand its business. As a result, the Company expectsto continue to rely on operational cash flow to fund operations becausealternative sources of capital may be unavailable.

 

As discussed in Note 8 to theconsolidated financial statements included elsewhere in this Quarterly Reporton Form 10-Q, we are currently in default under certain covenants of theFinancing Agreement, which provides for our primary credit facility, and wehave entered into a Third Amended and Restated Forbearance Agreement, subjectto the terms and conditions of which, among other things: (1) U.S. Bankand Wells Fargo agreed to forbear from exercising their default rights andremedies under the Financing Agreement during a forbearance period ending on April 7,2009, (2) certain outstanding letters of credit expiring on February 28,2009 (including the outstanding letter of credit in favor of Travelers)previously issued by U.S. Bank under the Financing Agreement were extended to April 7,2009 and (3) the Company’s ability to borrow under the Financing Agreement(other than forced loans due to draws upon the outstanding letters of credit)was terminated.  Because the Company nolonger has any right to borrow under the Financing Agreement (other than forcedloans due to draws upon the outstanding letters of credit), if the Company’savailable cash is insufficient to satisfy the Company’s liquidity requirementsand the Company is unable to find alternative sources of capital, the Companymay be unable to continue its operations as a going concern.  Under these circumstances, unless theproposed Merger with Koosharem is completed, the Company may be required toseek alternative transactions and/or consider filing for bankruptcy protection.  There can be no assurance that anyalternative sources of capital and/or alternative transactions would beavailable to us on acceptable terms or at all in the current challengingeconomic environment.  While we were ableto obtain a forbearance under the Third Amended and Restated ForbearanceAgreement, there can be noassurances that we will be able to continue to satisfy the conditions requiredfor the forbearance or that waivers or additional forbearances can be obtainedby us on acceptable terms in the future. If we are unable to obtain waivers or additional forbearances from U.S.Bank and Wells Fargo on acceptable terms in the future, U.S. Bank and WellsFargo would be able to elect at any time to pursue further remedies availableto them under the Financing Agreement, including (1) electing not to renewor extend letters of credit issued under the Financing Agreement or (2) underspecified conditions and at certain times, limiting our ability to use our cashto pay ordinary course expenses and possibly disrupting our businessoperations.  In addition, while we wereable to obtain an extension of the letters of credit under the Third Amendedand Restated Forbearance Agreement, there can be no assurances that the Companywill be able to continue to satisfy the conditions required for the extensionand thereby obtain sufficient workers’ compensation coverage to support ouroperations.  Our workers’ compensationcarrier has the right to draw on the letter of credit supporting our workers’compensation insurance prior to its expiration. If our workers’ compensation carrier draws on this letter of credit,U.S. Bank may require us to fund the draw in cash which would force us toborrow under the Financing Agreement.  Ifno waiver or forbearance is then currently effective and U.S. Bank and WellsFargo elect to pursue remedies under the Financing Agreement, such as callingthe loan, there can be no assurance that we would be able to find alternativesources of capital to repay the loan, in which case we may be unable tocontinue our operations as a going concern.

 

In response to the continued default, theCompany secured a $3.0 million subordinated loan facility during thefourth quarter of fiscal year 2008. As of January 24, 2009,loans in an aggregate principal amount of $2.7 million, including a $0.2million facility fee, were outstanding under this facility, the proceeds ofwhich were used by the Company for working capital and general businesspurposes.  On January 29, 2009, theCompany was advanced an additional loan in an aggregate principal amount of$500,000 from DelStaff.  No additionalborrowings are available to the Company under this facility.  See Note 18.

 

The Company has extended its workers’compensation insurance through April 1, 2009 which required$1.0 million in cash collateral as of November 1, 2008 and$0.3 million paid by February 28, 2009.  The collateral is included in other currentassets. In addition, the letter of credit for the workers’ compensationinsurance expired on February 28, 2009. However on February 18, 2009, the Company entered into a ThirdAmended and Restated Forbearance Agreement which extended the letter of creditto April 7, 2009.  There can be noassurance that the Company will be able to renew or extend its current workers’compensation policy or negotiate a new policy with a new carrier on termsacceptable to the Company.

 

Among other things, the Company has respondedto these issues by selling its foreign operations in Australia and New Zealand,reducing operating costs, and reducing its headcount by approximately 60positions in the corporate and field offices during fiscal year 2008 and 66positions in the first quarter of fiscal year 2009. This was accomplished by acombination of attrition and a planned reduction in force.  Total severance amounts related to headcountreductions recorded in the first quarter of fiscal year 2009 were $0.3 millionand are included as part of selling and administrative expenses. The Companycontinues to look for and act on additional cost savings measures within theorganization while it is exploring alternative financing arrangements andstrategic partnering alternatives. See Note 18.

 

The audit report contained in the 2008 Form 10-Kincluded an explanatory paragraph from the Company’s independent registeredpublic accounting firm expressing substantial doubt about the Company’s abilityto continue as a going concern due to the fact that the Company has sufferedrecurring losses, is out of compliance with its bank covenants and may beunable to obtain an extension of its workers’ compensation policy.

 

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**Results of Operations —Fiscal Quarter ended January 24, 2009 and Fiscal Quarter ended January 26,2008**

 

***Revenue***

 

Gross revenue from continuing operations declined by $29.5 million or36.4% to $51.5 million for the 12 weeks ended January 24, 2009 as comparedto the same period in the prior year.

 

Revenue from franchise operations declined from $32.2 million or 42.4%to $18.5 million driven largely by a 45.6% decrease in billed hours due to theeconomic downturn. Revenue from company-owned operations declined from $48.7million or 32.0% to $33.1 million driven largely by a 34.8% decrease in billedhours due to the economic downturn. Total billings for the top 20 customers in the 12 weeks ended January 24,2009 declined by $8.7 million or 40.2% to $12.9 million compared to the sameperiod for fiscal year 2008.

 

The decrease was offset slightly by an increase in our average billrate.  Our average bill rate on a perhour basis for temporary services increased 4.9% in the first quarter of fiscalyear 2009 compared with the first quarter offiscal year 2008.

 

However, revenue from permanent placement and transition fees declinedby 56.3% or $0.4 million to $0.3 million for the 12 weeks ended January 24,2009 as compared to the same period in the prior year.

 

***Costs of services and grossmargin***

 

Costs of services include hourly wages of temporary employees, employerpayroll taxes, state unemployment and workers’ compensation costs and othertemporary employee-related costs. Costs of services from continuing operationsdecreased $23.7 million or 35.6% to $42.8 million for the 12 weeks ended January 24,2009 as compared to the same period in the prior year.

 

The major component in our costs of services is the pay rate of ourtemporary workers.  Our average pay rateon a per hour basis for temporary workers increased 2.5% in the first quarterof fiscal year 2009 compared with the first quarter offiscal year 2008. Additionally the Company adjusted its workers’ compensation reserveswith a charge of $0.6 million in the first quarter of fiscal year 2009.  The workers’ compensation insurance as apercentage of direct labor was 7.3% in the current fiscal quarter compared to5.5% in the first quarter of fiscal year 2008.

 

The gross margin percentage declined from 17.9% in the prior fiscalyear to 17.0% for the 12 weeks ended January 24, 2009.  The pay-bill spread on temporary services inthe first quarter has increased 10.8% in the 12 weeks ended January 24,2009 over the same period in the prior year. The change in the pay-bill spreadis a result of the continued focus of our sales efforts on opportunitiesyielding a higher gross margin.  Theincrease in the average pay-bill rate was offset by an increase in the averagepay rate and the charge to workers’ compensation to adjust the Company’sreserves in the first quarter of fiscal year 2009.  Additionally, the significant reduction inpermanent placement and transition fees negatively effected gross margin.

 

***Franchise agents’ share of grossprofit***

 

Franchise agents’ share of gross profit represents the net distributionpaid to franchise agents based either on a percentage of the sales or grossprofit generated by the franchise agents’ operations. Franchise agents’ shareof gross profit decreased $1.2 million or 35.2% to $2.2 million.  The decrease is a direct result of the 42.4%decrease in franchise operations revenue and the 37.9% decrease in gross marginfor the first quarter of fiscal year 2009 compared to same period in the priorfiscal year.  As a percentage of consolidatedrevenue, franchise agents’ share of gross profit increased slightly to 4.3% forthe first quarter of fiscal year 2009 quarter, from 4.2% for the first quarterof fiscal year 2008.

 

***Selling and administrativeexpenses***

 

Selling and administrative expenses decreased $1.7 million or 13.8% to$10.4 million for the 12 weeks ended January 24, 2009 as compared to thesame period in the prior year. This decrease is primarily attributable todecreased salary and related costs of $1.4 million as a result of the Company’sreductions in headcount in 2008 and the recent reduction in workforce in thefirst quarter of fiscal 2009, offset by severance and other non-recurringpersonnel costs related to the reduction in work force that incurred during thefirst quarter of fiscal year2009.

 

We achieved cost savings in the areas of advertising and promotion,travel, and professional fees totaling $0.6 million as we consciously looked atopportunities to reduce spending in light of the significant decline in grossrevenue.  In addition, we incurred lowercommunications and services costs of $0.2 million, largely due to improvementsmade in our information systems infrastructure.

 

Offsetting these savings, the Company expensed legal fees related tothe potential merger of $0.2 million in the first quarter of fiscal year 2009.

 

As a percentage of revenue, selling and administrative expenses were20.3% for the 12 weeks ended January 24, 2009, compared to 14.9% for sameperiod in the prior year. The increase as a percent of sales is primarily dueto the decreased level of sales as total selling and administrative costsdeclined at a slower rate for the 12 weeks ended January 24, 2009 ascompared to the same period in the prior year. In addition, there are certain fixed costs that do not correspond tofluctuations in revenue such as rent, utilities, and taxes and licenses.  We have also experienced a slight increase inbad debt expense due to the downturn of the economy.

 

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***Restructuring***

 

                We recordedcharges in the third and fourth quarter of fiscal year 2007 related toreduction in force and closure of several branch offices.  In connection with the closures we recordedan expense in the third and fourth quarter of fiscal 2007 for severancepayments and an estimate for lease termination costs calculated for theremainder of the lease term reduced by an estimate for sublease income.  During the first quarter of fiscal year 2009,we adjusted the accrual for the recalculation of the rent due on oneoffice.  As of January 24, 2009, theCompany is responsible for lease payments on six locations totaling $0.3million.  The restructuring accrual,representing rent payments under non-cancellable leases with lease terms thatextend through fiscal year 2012 has been reduced by the current estimatedfuture sublease income under contractual agreements.

 

***Depreciation and amortization***

 

Depreciation and amortization remained consistent at $1.1 million forthe first quarter of fiscal year2009, as compared to the firstquarter of fiscal year 2008. The Company has decreased its capital expenditures during fiscal year2008 and the first quarter of fiscal year 2009.

 

***Net interest expense***

 

Net interest expense for the 12 week periodended January 24, 2009 remained consistent at $0.6 million compared to thesame period for the prior fiscal year. Lower interest rates during the first quarter were offset by an increasein average borrowings.

 

***Income taxes***

 

For the 12-weeks ended January 24, 2009,we recorded an income tax provision of nil on a pre-tax loss from continuingoperations of $5.7 million.  The decreasefrom the prior year provision of $0.5 million is primarily the result of theestablishment of a full valuation allowance against deferred tax assetsrelating to current period losses.

 

***Net loss***

 

The result of the aforementioned items plus the gain on the sale of theAustralia and New Zealand subsidiaries of $1.7 million and the net loss fromdiscontinued operations of $0.4 million, was a total net loss of $4.3 million,or $0.26 per share, for the 12-week period ended January 24, 2009, ascompared with a net loss of $1.9 million, or $0.11 per share for the sameperiod in fiscal year 2008.

 

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**Liquidity and Capital Resources**

 

We require significant amounts of workingcapital to operate our business and to pay expenses relating to employment oftemporary employees. Our traditional use of cash is for financing of accountsreceivable, particularly during periods of economic upswings and growth whensales are seasonally high.  In periods ofeconomic contraction or recession, the Company builds cash collected fromaccounts receivable and uses this cash to fund operations as necessary.Temporary personnel are typically paid on a weekly basis while payments fromcustomers are generally received 30 to 60 days after billing.

 

We finance our operations primarily throughcash generated by our operating activities. Net cash provided by operations was$2.9 million for the first quarter of 2009, compared to cash used of$3.4 million for the first quarter of fiscal year 2008, an increase of$6.3 million. Changes in accounts receivable due to decreased sales andincreased cash collections was the largest significant source of cash providing$12.3 million during the first quarter of fiscal year 2009 as compared to$4.0 million for the first quarter of fiscal year 2008.  Cash provided by accounts receivable wasoffset by cash used to pay accounts payable and accrued expenses of $4.2million during the first quarter of fiscal year 2009.  The company used $5.5 million of cashfor accounts payable and accrued expenses in the first quarter of the prioryear.  For the first quarter of fiscalyear 2009, the net loss of $4.3 million includes $1.1 million innon-cash depreciation and amortization, compared with a net loss of$1.9 million and $1.4 million in non-cash depreciation andamortization for the same period of fiscal year 2008.  Additionally, included in the Company’s netloss for the first quarter of fiscal year 2009, is a recorded gain, net of tax,of $1.7 million resulting from the sale of our former Australia and NewZealand operations and related subsidiaries on November 10, 2008, asdescribed in Note 4.

 

Our domestic days sales outstanding (DSO) ismeasured by dividing our ending net accounts receivable balance by total salesmultiplied by the number of days in the fiscal quarter. DSO at January 24,2009 decreased to 37.8 days from 49.2 at January 26, 2008. Thisdecrease in DSO was a result of increased collection efforts in fiscal year2008 and the first quarter of fiscal year 2009.

 

Cash provided by investing activities was $7.0million for the first quarter of fiscal year 2009, as compared to cash used forinvesting activities of $0.6 million for the first quarter of fiscal year2008.  The cash generated by investingactivities was primarily due to the net proceeds of $7.6 million received fromthe sale of the company’s former Australia and New Zealand operations andrelated subsidiaries, offset by related fees and expenses of $0.5 million.  Capital spending in the first quarter of fiscalyear 2009 was only $10,000, as compared to $0.7 million of capital expendituresin the first quarter of fiscal year 2008. The decrease in capital expenditures for the first quarter of fiscalyear 2009 was primarily a result of less purchases of furniture and equipmentboth domestically and internationally.

 

Cash used in financing activities was $9.8million for the first quarter of fiscal year 2009 compared with cash providedby financing activities of $3.2 million for the first quarter of fiscalyear 2008. This increase in cash used for financing activities is primarilyattributable to $5.2 million in net payments under line of credit agreements ascompared to $3.4 million in net borrowings in the first quarter of fiscal year2008, and an increase in restricted cash of $5.0 million during the firstquarter of fiscal year 2009, related to the Company’s sale of its formerAustralia and New Zealand operations and related subsidiaries on November 10,2008 as described in Note 4. Additionally, in the first quarter of fiscalyear 2009 the Company made payments on capital lease obligations of $0.1million and also received $0.5 million in proceeds from its subordinated loanfacility with its principal stockholder, DelStaff.  See Note 9.

 

The Company’s wholly-owned subsidiary Westaff (USA), Inc. has afive-year revolving credit facility under the Financing Agreement with U.S.Bank and Wells Fargo.  As discussed inNote 8 to thecondensed consolidated financial statements included elsewhere in thisQuarterly Report on Form 10-Q, we are currently in default undercertain covenants of the Financing Agreement and on February 18, 2009, weentered into a Third Amended and Restated Forbearance Agreement with U.S. Bankand Wells Fargo, under which, among other things, U.S. Bank and Wells Fargoagreed to continue to forbear from exercising any of their default rights andremedies during a forbearance period ending on April 7, 2009.  Under the terms of the Third Amended andRestated Forbearance Agreement, the Company agreed to a further reduction inthe aggregate amount of the commitments under the Financing Agreement from$33.0 million to $28.0 million and U.S. Bank agreed to amend certain letters ofcredit outstanding under the Financing Agreement (including an outstandingletter of credit with a face amount of $27.0 million in favor of Travelers,which is the carrier under the Company’s existing workers’ compensationinsurance program) to extend the expiration date of such letters of credit fromFebruary 28, 2009 to April 7, 2009. In addition, the Company’sability to borrow under the Financing Agreement (other than forced loans due todraws upon the outstanding letters of credit) was terminated. Because the Company no longer has any rightto borrow under the Financing Agreement (other than forced loans due to drawsupon the outstanding letters of credit), if the Company’s available cash isinsufficient to satisfy the Company’s liquidity requirements and the Company isunable to find alternative sources of capital, the Company may be unable tocontinue its operations as a going concern. The interest rates applicable tothe loans made pursuant to the Financing Agreement will continue at the defaultrate through April 7,2009.  For additional informationregarding the Financing Agreement and the Third Amended and RestatedForbearance Agreement, please refer to Note 8 to the condensed consolidated financial statements included elsewherein this Quarterly Report on Form 10-Q.

 

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TheCompany has a $3.0 million subordinated loan facility with its principalstockholder, DelStaff, under a subordinated loan agreement, dated as of August 25,2008, by and among the Company, Westaff (USA), Inc., Westaff Support, Inc.,MediaWorld International (as borrowers) and DelStaff.  Foradditional information regarding the subordinated loan facility, please referto Note 9 to the condensed consolidatedfinancial statements included elsewhere in this Quarterly Report on Form 10-Q.  Theoutstanding loan balance at January 24, 2009 was $2.7 million, whichincludes a $0.2 million facility fee that was added to the loan balance uponreceipt of the initial advance.  Accruedand unpaid interest on this note at January 24, 2009 was $0.1million.  Subsequent to quarter end on January 29,2009, the Company was advanced an additional $500,000 from DelStaff.  No additional borrowings are available underthis facility.  See Note 18 to the condensed consolidated financialstatements included elsewhere in this Quarterly Report on Form 10-Q.

 

The Company’s former Australian subsidiary had previously maintained anA$12 million Australian dollar facility agreement (the “A$ Facility Agreement”)with GE Capital, as primary agent, that had been set to expire in May 2009.  The outstanding balance on the AustraliaFacility Agreement was $4.6 million at 8.17% rate per annum and was classifiedas current liabilities held for sale in the consolidated balance sheet as of November 1,2008.  As of January 24, 2009, theGE Capital debt was paid in full in connection with the sale.

 

The Company has an unsecured subordinatedpromissory note in an amount of $2.0 million, dated May 17, 2002 and payableto the former Chairman of the Board of Directors.  Accrued and unpaid interest on this note at January 24,2009 was $0.4 million and is included in accrued expenses in the Company’sconsolidated balance sheets.

 

We are responsible for and pay workers’compensation costs for our domestic temporary and regular employees and areself-insured for the deductible amount related to workers’ compensation claimsto a limit of $750,000 per claim for fiscal year 2009 and fiscalyear 2008. Typically, each policy year the terms of the agreement with theinsurance carrier are renegotiated. The insurance carrier requires us tocollateralize our obligations through the use of irrevocable standby letters ofcredit, surety bonds or cash.

 

For the policy term of November 1, 2008through April 1, 2009, we have paid cash premiums of $1.6 million for theworkers’ compensation insurance program. Cash payments for 2009 policy yearclaims will be paid directly by us up to our deductible of $750,000 per claim.As of January 24, 2009, we had outstanding $27.3 million of lettersof credit and paid an additional $1.3 million in cash to secure allestimated outstanding obligations under our workers’ compensation program forall years except 2003, which is fully funded although subject to annualretroactive premium adjustments based on actual claims activity. We willcontinue to make ongoing cash payments for claims for all other open policyyears (except for 2003 as noted above).

 

We calculate the estimated liabilitiesassociated with these programs based on our estimate of the ultimate costs tosettle known claims as well as claims incurred but not yet reported to us (“IBNRclaims”) as of the balance sheet date. Our estimated liabilities are notdiscounted and are based on information provided by our insurance brokers,insurers and actuary, combined with our judgment regarding a number ofassumptions and factors, including the frequency and severity of claims, claimsdevelopment history, case jurisdiction, applicable legislation and our claimssettlement practices. We maintain stop-loss coverage with third party insurersto limit our total exposure for each of these programs. Significant judgment isrequired to estimate IBNR amounts as parties have yet to assert such claims. Ifactual claims trends, including the severity or frequency of claims, differfrom our estimates, our financial results could be impacted.

 

We continue to evaluate other opportunitiesto further strengthen our financial position and improve our liquidity. For adiscussion regarding going concern considerations, please see “Going ConcernConsiderations” above elsewhere in this Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.

 

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

 

We are exposed to certain market risks fromtransactions that are entered into during the normal course of business.  Our primary market risk exposure relates tointerest rate risk.  At January 24,2009, our outstanding debt under variable-rate interest borrowings wasapproximately $4.8 million.  A change oftwo percentage points in the interest rates would cause a change in interestexpense of approximately $0.1 million on an annual basis.  Our exposure to market risk for changes ininterest rates is not significant with respect to interest income, as ourinvestment portfolio is not material to our consolidated balance sheet.  We currently have no plans to hold aninvestment portfolio that includes derivative financial instruments.

 

We do not currently hold any market risksensitive instruments entered into for hedging risks related to foreigncurrencies. In addition, we have not entered into any transactions withderivative financial instruments for trading purposes.

 

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### **Item 4.  Controls and Procedures**

###  

**Management’s Evaluation of DisclosureControls and Procedures.**

 

We carried out an evaluation required by theSecurities Exchange Act of 1934 (1934 Act), under the supervision and with theparticipation of our Chief Executive Officer and Chief Financial Officer, ofthe effectiveness of the design and operation of our disclosure controls andprocedures, as defined in Rule 13a-15(e) under the 1934 Act.Disclosure controls and procedures are designed to ensure that informationrequired to be disclosed in reports filed or submitted under the 1934 Act isrecorded, processed, summarized, and reported within the time periods specifiedin SEC rules and forms and that such information is accumulated andcommunicated to management, including the Principal Executive Officer andPrincipal Financial Officer, to allow timely decisions regarding requireddisclosures. Based on its evaluation, and in light of the previously identifiedmaterial weaknesses in internal control over financial reporting identified ineach of the first three quarters of fiscal year 2008, relating to a lack ofqualified resources within the accounting department which has since beenremediated, the Company’s Principal Executive Officer and Principal FinancialOfficer concluded that, as of January 24, 2009, the Company’s disclosurecontrols and procedures were effective.

 

Based on this evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that as of January 24, 2009(the end of the period covered by this report), our disclosure controls andprocedures were effective to provide reasonable assurance that informationrequired to be disclosed by us in the reports that we file or submit under the1934 Act is recorded, processed, summarized, and reported within the timeperiods specified in the Securities and Exchange Commission’s rules andforms and to provide reasonable assurance that such information is accumulatedand communicated to our management, including our Chief Executive Officer andChief Financial Officer, as appropriate to allow timely decisions regardingrequired disclosures.

 

**Changes in Internal Control over FinancialReporting.**

 

During thequarter ended January 24, 2009, there were no changes in our internalcontrol over financial reporting that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

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### **Part II.   Other Information**

###  

### **Item1.    Legal Proceedings**

###  

In the ordinary course of our business, weare periodically threatened with or named as a defendant in various lawsuits.The principal risks that we insure against, subject to and upon the terms andconditions of our various insurance policies, are workers’ compensation,general liability, automobile liability, property damage, alternative staffingerrors and omissions, fiduciary liability and fidelity losses.

 

During the fourth quarter of fiscal year2005, we were notified by the California Employment DevelopmentDepartment (“EDD”) that our domestic operating subsidiaries unemployment taxrates would be increased retroactively for both calendar years 2005 and 2004.The total assessment by the EDD of additional unemployment taxes for bothyears, net of applied overpayments, is approximately $1.5 millionincluding interest at applicable statutory rates. Management believes that ithas properly calculated its unemployment insurance tax and is in compliancewith all applicable laws and regulations. The Company has timely appealed theruling by the EDD and is working with the outside counsel to resolve this matter.Additionally, management contends that the notification by the EDD of the 2004assessment was not timely and holds the position that the assessment isprocedurally invalid. Consequently, at January 24, 2009, the Company hasno reserve for the 2004 assessment and has accrued the assessment for 2005 of$0.3 million, including interest and net of an applied overpayment.Although we believe that we have properly calculated our unemployment insurancetax and are in compliance with all applicable laws and regulations, there canbe no assurances this will be settled in our favor. Management believes theCompany is well positioned to defend against the un-accrued portion and theultimate resolution of this matter will not have a material adverse effect onthe Company’s consolidated financial statements.

 

Otherthan the action listed above, we are not currently a party to any materiallitigation.  However, from time to timewe have been threatened with, or named as a defendant in litigation brought byformer franchisees or licensees, and administrative claims and lawsuits broughtby employees or former employees. Management believes the resolution of these matters would not have amaterial adverse effect on our consolidated financial statements.

 

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### **Item1A.  Risk Factors**

###  

Investing in our commonstock involves a high degree of risk. The following risk factors, issues and uncertaintiesshould be carefully considered before deciding to buy, hold or sell our commonstock. Set forth below and elsewhere in this Quarterly Report on Form 10-Q,and in other documents that we file with the SEC, are risks and uncertainties that could cause the Company’s actual resultsand financial position to differ materially from those expressed or implied inforward-looking statements and to be below the expectations of public marketanalysts and investors. See “Cautionary Statement Regarding Forward-LookingStatements” in Part I, Item 2, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations.” Any one of the following risks couldharm our operating results or financial condition and could result in asignificant decline in the value of an investment in our common stock. Further,additional risks and uncertainties that have not yet been identified or whichwe currently believe are immaterial may also harm our operating results andfinancial condition.

 

*The recent economic downturn and recessionhas materially and adversely affected our business and a continuation ofcurrent economic conditions could cause further harm to our business, financialcondition, results of operations and cash flows.*

 

Demand for staffing services is significantlyaffected by the general level of economic activity. According to the NationalBureau of Economic Research, the United States economy has been in a recessionsince December 2007. We expect that the current significant economicdownturn and recession in the economy will continue to materially and adverselyimpact the demand for staffing services and the Company’s performance. Aseconomic activity slows, many customers reduce their utilization of temporaryemployees before undertaking layoffs of their regular full-time employees.Further, demand for permanent placement services also slows as the labor pooldirectly available to our customers’ increases, making it easier for them toidentify new employees directly. In addition, we have experienced and expect tocontinue to experience increased pricing pressures from other staffingcompanies adversely affecting our revenues and operating margins. These adverseimpacts may persist and worsen over the next several quarters if not longer,resulting in a material adverse effect on our financial condition.

 

*The process and uncertainties relating to theproposed Merger could adversely affect our business.*

 

We entered into the Merger Agreement withKoosharem Corporation, a California corporation doing business as SelectStaffing and Select Merger Sub Inc., a Delaware corporation andwholly-owned subsidiary of Koosharem, on January 28, 2009. The pendency ofthe Merger could adversely affect our ability to obtain and retain customers,to recruit temporary employees and to retain our existing employees. Further,the attention of our management will be directed at least in part toward thecompletion of a transaction and thus diverted in part from day-to-dayoperations. Our business and operating results could be adversely affected bythese factors.

 

Completion of the Merger is subject to anumber of conditions which are largely or partially outside of our control,including the ability of Koosharem to finalize the financing required in amanner satisfactory to our workers’ compensation carrier, our ability to avoiddeclines in our revenues, and our ability to maintain a specified cash and cashequivalent balance immediately prior to closing, all as set forth in the MergerAgreement. A failure to complete the Merger would require us to addressimmediate and substantial issues with our existing lenders and to raiseadditional capital at a time when our business may have declined substantiallyand our alternatives are limited. There can be no assurance that we would beable to successfully address issues with our lenders, raise additional capitalor address other problems we might face at the time if the Merger is notcompleted. Accordingly, if the Merger is not completed, we may be immediatelyunable to, among other things: (1) adequately collateralize our workers’compensation obligations and obtain sufficient workers’ compensation coverageto support our operations and (2) satisfy our liquidity requirements andcontinue our operations as a going concern. Under these circumstances, we maybe required to seek alternative transactions and/or consider filing forbankruptcy protection. There can be no assurance that any other alternativetransaction similar to the merger would be available to us. Further, whether ornot the proposed Merger is completed, we will have incurred substantial costsrelated to the Merger.

 

While the Merger Agreement is in effect, weare subject to significant restrictions on our business activities and mustgenerally operate our business in the ordinary course (subject to certainexceptions or the consent of Koosharem) as set forth in the Merger Agreement.These restrictions on our business activities could limit our ability torespond to changes in business conditions or other events, and therefore couldhave a material adverse effect on our future results of operations or financialcondition.

 

*We are currently in default under our primarycredit facility.  While we have recentlyobtained a forbearance through April 7, 2009 for this default, we nolonger have any right to borrow under this credit facility, except for forcedloans due to draws upon letters of credit outstanding under this creditfacility. Accordingly, if our available cash is insufficient to satisfy ourliquidity requirements and we are unable to find alternative sources ofcapital, which may not be available to us on acceptable terms or at all, we maybe unable to continue our operations as a going concern.*

 

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We are currently in default under the Financing Agreement, dated as of February 14,2008 (as amended, the “Financing Agreement”), among Westaff (USA), Inc.(as borrower), the Company (as parent guarantor), U.S. Bank NationalAssociation (as agent for the lenders, letter of credit issuer and a lender)and Wells Fargo Bank, National Association (as a lender), which provides forour primary credit facility. We have financed our operations primarily throughcash generated by our operating activities and through borrowings under ourrevolving line of credit under the Financing Agreement. On May 23, 2008,we received a notice of default from U.S. Bank (as agent for itself and WellsFargo Bank) stating that (1) an Event of Default (as defined in theFinancing Agreement) had occurred due to our failure to achieve a minimumrequired Fixed Charge Coverage Ratio (as defined in the Financing Agreement)for our fiscal period ended April 19, 2008; and (2) as a result ofthe Event of Default, effective May 21, 2008, U.S. Bank increased the rateof interest to the default rate of interest on the borrowings outstanding underour line of credit. We had no borrowings outstanding under the Financing Agreement,but do have $27.3 million of outstanding letters of credit supporting ourworkers’ compensation obligations. The Company previously entered into a seriesof forbearance agreements providing for the lenders to forbear from exercisingtheir default rights and remedies under the Financing Agreement through December 19,2008.  However, on January 28, 2009,Travelers, which is the carrier under the Company’s existing workers’compensation insurance program and the beneficiary of a letter of credit with aface amount of $27.0 million expiring on February 28, 2009 previouslyissued by U.S. Bank under the Financing Agreement, was notified by U.S. Bankthat such letter of credit will not be renewed. The Company recently entered into a Third Amended and RestatedForbearance Agreement, which became effective on February 18, 2009,subject to the terms and conditions of which, among other things: (1) thelenders agreed to forbear from exercising their default rights and remediesunder the Financing Agreement during the period from February 18, 2009 andending on April 7, 2009, (2) certain outstanding letters of creditexpiring on February 28, 2009 (including the outstanding letter of creditin favor of Travelers) previously issued by U.S. Bank under the Financing Agreementwere extended to April 7, 2009 and (3) the Company’s ability toborrow under the Financing Agreement (other than forced loans due to draws uponthe outstanding letters of credit) was terminated. Because the Company no longer has any right toborrow under the Financing Agreement (other than forced loans due to draws uponthe outstanding letters of credit), if the Company’s available cash isinsufficient to satisfy the Company’s liquidity requirements and the Company isunable to find alternative sources of capital, the Company may be unable tocontinue its operations as a going concern. Under these circumstances, unlessthe pending merger with Koosharem is completed, the Company may be required toseek alternative transactions and/or consider filing for bankruptcy protection. There can be no assurance that anyalternative sources of capital and/or alternative transactions would beavailable to us on acceptable terms or at all in the current challengingeconomic environment.  In addition, while the Company wasable to obtain a forbearance under the Third Amended and Restated ForbearanceAgreement, there can be no assurances that the Company will be able to continueto satisfy the conditions required for the forbearance or that waivers oradditional forbearances can be obtained by the Company on acceptable terms inthe future. If the Company is unable to obtain waivers or additionalforbearances from the lenders on acceptable terms in the future, the lenderswould be able to elect at any time to pursue further remedies available to themunder the Financing Agreement, including (1) electing not to renew orextend letters of credit issued under the Financing Agreement or (2) underspecified conditions and at certain times, limiting the Company’s ability touse its cash to pay ordinary course expenses and possibly disrupting theCompany’s business operations.

 

In response to our short term forbearance issues, on August 25,2008, the Company secured a $3.0 million Subordinated Loan facility withits principal stockholder, DelStaff. This facility may be used by the Companyfor working capital and general business purposes during the term of thefacility. The unpaid principal balance under the Subordinated Loan bearsinterest at an annual rate of twenty percent (20%). Interest is payable-in-kindand accrues monthly in arrears on the first day of each month as an increase inthe principal amount of the Subordinated Loan. A default rate applies on allobligations under the Subordinated Loan Agreement from and after the MaturityDate (August 15, 2009) and also during the existence of an Event ofDefault (as defined in the Subordinated Loan Agreement) at an annual rate often percent (10%) also payable-in-kind over the then-existing applicableinterest rate and if principal is not repaid on the Maturity Date, anadditional 5% of outstanding principal must be paid along with the default rateinterest. The obligations under the Subordinated Loan Agreement are secured bya security interest in substantially all of the existing and future assets (the“Subordinated Collateral”) of the Company. The lien granted to the SubordinatedLender in the Subordinated Collateral is subordinated to the lien in that samecollateral granted to U.S. Bank. Borrowings in excess of $1.0 million requirethe Subordinated Lender approval. The Subordinated Loan may be prepaid withoutpenalty, subject to approval by U.S. Bank and the terms of an IntercreditorAgreement. Under certain circumstances, the Company must prepay all or aportion of any amounts outstanding under the Subordinated Loan Agreement,subject to the terms of the Intercreditor Agreement. The outstanding loanbalance at January 24, 2009 was $2.7 million, which includes a$0.2 million facility fee that was added to the loan balance upon receiptof the initial advance. Accrued and unpaid interest on this note at January 24,2009 was $0.1 million. The Company borrowed an additional $500,000 on January 29,2009.

 

*We may be unable to adequately collateralizeour workers’ compensation obligations at their current levels or at all.*

 

We are contractually obligated to collateralize our workers’compensation obligations under our workers’ compensation program throughirrevocable letters of credit, surety bonds or cash. As of November 1,2008, our aggregate collateral requirements under these contracts have beensecured through $27.3 million of letters of credit obtained through theFinancing Agreement. Our workers’ compensation policy, which had beenoriginally set to expire on November 1, 2008, has been extended through April 1,2009. As part of the extension, the Company paid $1.0 million in cashcollateral on October 31, 2008 and an additional $0.3 million as of February 28,2009.  These amounts are included inother current assets. These collateral requirements are significant, placepressure on our liquidity and working capital capacity and are dependent on theCompany having sufficient accounts receivable and cash balances. If we are notable to obtain a renewal of our letters of credit at a level sufficient to meetour collateral requirements, we could be unable to obtain sufficient workers’compensation coverage to support our operations.

 

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On January 28, 2009, Travelers, which is the Company’s workers’compensation carrier, was notified by U.S. Bank that the letter of creditissued in favor of Travelers and expiring on February 28, 2009 would notbe renewed. The Company recently entered into the Third Amended and RestatedForbearance Agreement, which became effective on February 18, 2009,subject to the terms and conditions of which, among other things, U.S. Bankagreed to extend certain outstanding letters of credit expiring on February 28,2009 (including the outstanding letter of credit in favor of Travelers)previously issued by U.S. Bank under the Financing Agreement to April 7,2009. While the Company was able to obtain an extension of the letters ofcredit under the Third Amended and Restated Forbearance Agreement, there can beno assurances that the Company will be able to continue to satisfy theconditions required for the extension and thereby obtain sufficient workers’compensation coverage to support the Company’s operations. In addition, thecarrier has the right to draw on the letter of credit prior to the expiration.If the carrier draws on the Letter of Credit, U.S. Bank may require the Companyto fund the draw in cash which would force the Company to borrow under theFinancing Agreement. If no waiver or forbearance is then currently effectiveand the lenders elect to pursue remedies under the Financing Agreement, such ascalling the loan, there can be no assurance that the Company would be able tofind alternative sources of capital to repay the loan, in which case the Company may be unable to continue itsoperations as a going concern.

 

*We have significant working capitalrequirements and are heavily dependent upon our ability to borrow money to meetthese working capital requirements.*

 

We require significant amounts of workingcapital to operate our business and to pay expenses relating to employment oftemporary employees. Temporary personnel are generally paid on a weekly basiswhile payments from customers are generally received 30 to 60 days afterbilling. As a result, we must maintain sufficient cash availability to paytemporary personnel prior to receiving payment from customers. Any lack ofaccess to liquid working capital would have an immediate, material, and adverseimpact on our business. There can be no assurance that we will be able toaccess the funds necessary for our liquidity requirements, especially in lightof the recent downturn in the economy and dislocations in the credit andcapital markets.

 

We finance our operations primarily throughcash generated by our operating activities and through borrowings under ourrevolving credit facilities. Our primary credit facility is the FinancingAgreement with U.S. Bank and Wells Fargo, which provides for a five-yearrevolving credit facility with an aggregate commitment of up to$28.0 million. Additionally, the Company secured a $3.0 millionsubordinated loan facility with its principal stockholder, DelStaff, to be usedby the Company for working capital and general business purposes during theterm of the facility.

 

The Company recently entered into the ThirdAmended and Restated Forbearance Agreement, which became effective on February 18,2009, subject to the terms and conditions of which, among other things theCompany’s ability to borrow under the Financing Agreement (other than forcedloans due to draws upon the outstanding letters of credit) was terminated.   On January 29, 2009, the Company wasadvanced a loan in an aggregate principal amount of $500,000 from the DelStaffsubordinated loan facility which is now fully drawn.

 

Because the Company no longer has any right to borrow under the FinancingAgreement (other than forced loans due to draws upon the outstanding letters ofcredit) or the DelStaff loan, if the Company’s available cash is insufficientto satisfy the Company’s liquidity requirements and the Company is unable tofind alternative sources of capital, the Company may be unable to continue itsoperations as a going concern. Under these circumstances, unless the pendingmerger with Koosharem is completed, the Company may be required to seekalternative transactions and/or consider filing for bankruptcy protection. There can be no assurance that anyalternative sources of capital and/or alternative transactions would beavailable to us on acceptable terms or at all in the current challengingeconomic environment.  In addition, while the Company wasable to obtain a forbearance under the Third Amended and Restated ForbearanceAgreement, there can be no assurances that the Company will be able to continueto satisfy the conditions required for the forbearance or that waivers oradditional forbearances can be obtained by the Company on acceptable terms inthe future. If the Company is unable to obtain waivers or additionalforbearances from the lenders on acceptable terms in the future, the lenderswould be able to elect at any time to pursue further remedies available to themunder the Financing Agreement, including (1) electing not to renew orextend letters of credit issued under the Financing Agreement or (2) underspecified conditions and at certain times, limiting the Company’s ability touse its cash to pay ordinary course expenses and possibly disrupting theCompany’s business operations.

 

*We are exposed to credit risks on collectionsfrom our customers due to, among other things, our assumption of the obligationto make wage, tax, and regulatory payments to our temporary employees.*

 

We are exposed to the credit risk of some ofour customers. Temporary personnel are typically paid on a weekly basis whilepayments from customers are generally received 30 to 60 days afterbilling. We generally assume responsibility for and manage the risks associatedwith our payroll obligations, including liability for payment of salaries andwages, payroll taxes as well as group health insurance. These obligations arefixed and become a liability of ours, whether or not the associated client towhom these employees have been assigned makes payments required by our serviceagreement, which exposes us to credit risks. We attempt to mitigate these risksby billing on a frequent basis, which typically occurs daily or weekly. Inaddition, we establish an allowance for doubtful accounts for estimated lossesresulting from the inability of our customers to make required and timelypayments. Further, we carefully monitor the timeliness of our customers’payments and impose strict credit standards. However, there can be no assurancethat such steps will be effective in reducing these risks. Finally, themajority of our accounts receivable is used to secure our revolving creditfacilities, which we rely on for liquidity. If we fail to adequately manage ourcredit risks associated with accounts receivable, our financial position couldbe adversely impacted. Additionally, to the extent that recent turmoil in thecredit markets makes it more difficult for some customers to obtain financing,those customers’ ability to pay could be adversely impacted, which in turncould have a material adverse effect on our business, financial condition orresults of operations.

 

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*Price competition in the staffing industrycontinues to be intense, and pricing pressures from both competitors andcustomers could adversely impact our financial decisions.*

 

We expect the level of competition to remainhigh in the future, and competitive pricing pressures will continue to make itdifficult for us to raise our prices to immediately and fully offset increasedcosts of doing business, including increased labor costs, costs for workers’compensation and state unemployment insurance. If we are not able toeffectively compete in our targeted markets, our operating margins and otherfinancial results will be harmed and the price of our securities could decline.We also face the risk that our current or prospective customers may decide toprovide services internally.

 

*The market for our stock may be limited, andthe stock price may continue to be extremely volatile.*

 

The average daily trading volume for ourcommon stock on the NASDAQ Global Market was approximately 14,553 shares duringthe fiscal quarter ended January 24, 2009. Accordingly, the market priceof our common stock is subject to significant fluctuations that have been, andmay continue to be, exaggerated because an active trading market has notdeveloped for our common stock. We believe that the price of our common stockhas also been negatively affected by the fact that our common stock is thinlytraded and also due to the absence of analyst coverage. The lack of analystreports about our stock may make it difficult for potential investors to makedecisions about whether to purchase our stock and may make it less likely thatinvestors will purchase the stock, thus further depressing the stock price.These negative factors may make it difficult for stockholders to sell ourcommon stock, which may result in losses for investors.

 

*Recently our common shares traded at pricesbelow $1.00. If this continues in the future, our common shares could besubject to delisting by NASDAQ Stock Market.*

 

Our common stock currently trades on theNASDAQ Global Market. On September 10, 2008 we received a letter from theNASDAQ Stock Market (“NASDAQ”) indicating that for the last 30 consecutivebusiness days prior to the date of the letter, the bid price of Westaff’scommon stock had closed below the minimum $1.00 per share requirement forcontinued inclusion under NASDAQ Marketplace Rule 4450 (a)(5).  Since that time the common shares have tradedat prices above $1.00 per share and in February 2009, the Company wasnotified by NASDAQ that the closing bid price of Westaff’s common stock hasbeen at $1.00 per share or greater for at least 10 consecutive business days.Accordingly, the Company has regained compliance, however, the share price maydecrease in future and if our common shares are not listed on a nationalsecurities exchange or the NASDAQ, potential investors may be prohibited fromor be less likely to purchase our common shares, limiting the trading marketfor our stock.

 

*If we fail to maintain effective internalcontrol over our financial reporting, we may cause investors to lose confidencein our reported financial information, which could have an adverse effect onour stock price.*

 

Pursuant to Section 404 of theSarbanes-Oxley Act of 2002 and current SEC regulations and proposed rules, weare required to include in our annual report on Form 10-K a report thatassesses the effectiveness of our internal control over financial reporting. Inaddition, the SEC approved a one-year extension of the compliance date forsmaller public companies, therefore, beginning with our Form 10-K for the2010 fiscal year our external auditors will be required to audit our internalcontrol over financial reporting report and include their attestation on thatreport. The process of fully documenting and testing our internal controlprocedures in order to satisfy these requirements have resulted and are likelyto continue to result in increased general and administrative expenses and thediversion of management time and attention from profit-generating activities tocompliance activities. Furthermore, if our management identifies one or morematerial weaknesses in our internal control over financial reporting, we willbe unable to assert that our internal controls are effective and our businessmay be harmed. Market perception of our financial condition and the tradingprice of our stock may also be adversely affected and customer perception ofour business may suffer.

 

*Our principal stockholder, together with itsaffiliates, controls a significant amount of our outstanding common stock thusallowing them to exert significant influence on our management and affairs.*

 

As of January 24, 2009, our principalstockholder, DelStaff, together with its affiliates, controlled approximately49.5% of the total outstanding shares of our common stock. The members ofDelStaff are H.I.G. Staffing, 2007, Ltd., Alarian Associates, Inc.and Michael T. Willis. As our principal stockholder, DelStaff and itsaffiliates have the ability to significantly influence all matters submitted toour stockholders for approval, including the election of directors, and toexert significant influence over our management and affairs. On April 30,2007, we entered into a Governance Agreement with DelStaff, Mr. Willis andMr. Stover. On May 9, 2007, pursuant to the terms of the GovernanceAgreement, we expanded the size of our Board of Directors from five to ninedirectors and appointed the following DelStaff nominees to the Board: MichaelT. Willis, John R. Black, Michael R. Phillips, Gerald E. Wedren and John G.Ball. DelStaff also has the ability to strongly influence any merger,consolidation, sale of substantially all of our assets or other strategicdecisions affecting us or the market value of the stock. This concentration ofstock and voting power could be used by DelStaff to delay or prevent anacquisition of Westaff or other strategic action or result in strategicdecisions that could negatively impact the value and liquidity of ouroutstanding stock.

 

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*We derive a significant portion of ourrevenue from franchise agent operations.*

 

Franchise agent operations comprise asignificant portion of our revenue. As of January 24, 2009, franchiseesrepresented 36.0% of gross receipts. In addition, our ten largest franchiseagents (based on sales volume) accounted for 24.5% of our revenue. There can beno assurances that we will be able to attract new franchisees or that we willbe able to retain our existing franchisees. The loss of one or more of ourfranchise agents and any associated loss of customers and sales could have amaterial adverse effect on our results of operations.

 

*Our service agreements may be terminated onshort notice, leaving us vulnerable to loss of a significant amount ofcustomers in a short period of time.*

 

Our service agreements are generallycancellable with little or no notice by the customer to us. As a result, ourcustomers can terminate their agreement with us at any time, making usparticularly vulnerable to a significant decrease in revenue within a shortperiod of time that could be difficult to quickly replace.

 

*Our reserves for workers’ compensation claimsmay be inadequate to cover our ultimate liability, and we may incur additionalcharges if the actual amounts exceed the reserved amounts.*

 

We maintain reserves to cover our estimatedliabilities for workers’ compensation claims based upon actuarial estimates ofthe future cost of claims and related expenses which have been reported but notsettled, and that have been incurred but not yet reported. The determination ofthese reserves is based on a number of factors, including current andhistorical claims activity, medical cost trends and developments in existingclaims. Reserves do not represent an exact calculation of liability and areaffected by both internal and external events, such as adverse development onexisting claims, changes in medical costs, claims handling procedures,administrative costs, inflation, legal trends and legislative changes. Reservesare adjusted as necessary to reflect new claims and existing claimsdevelopment, and such adjustments are reflected in the results of the periodsin which the reserves are adjusted. While we believe our judgments andestimates are adequate, if our reserves are insufficient to cover our actuallosses, an adjustment could be charged to expense that may be material to ourearnings.

 

*Workers’ compensation costs for temporaryemployees may continue to rise and reduce margins and require more liquidity.*

 

In the United States, we are responsible forand pay workers’ compensation costs for our regular and temporary employees. Inrecent years, these costs have risen substantially as a result of increased claims,general economic conditions, increases in healthcare costs and governmentalregulations. The frequency of new claims decreased in fiscal year 2008as compared to prior years, yet the cost per claim continues to increase. Underour workers’ compensation insurance program, we maintain “per occurrence”insurance, which only covers claims for a particular event above a deductible.This deductible is currently $750,000 per claim for fiscal year 2008 and fiscal year 2009 claims.Our workers’ compensation insurance policy expired November 1, 2008 and wehave extended the policy through April 1, 2009. We have provided a cashpayment of $1 million which was recorded as a short term deposit in fiscalyear 2008 and we paid an additional $0.3 million in collateral as of February 28,2009. Should our workers’ compensation premium costs continue to increase inthe future, there can be no assurance that we will be able to increase the feescharged to our customers to keep pace with increased costs or if we were unableto obtain insurance on reasonable terms or forced to significantly increase ourdeductible per claim, our results of operations, financial condition andliquidity could be adversely affected.

 

*Our success is impacted by our ability toattract and retain qualified temporary and permanent candidates.*

 

We compete with other staffing services tomeet our customers’ needs, and we must continuously attract reliable candidatesto meet the staffing requirements of our customers. Consequently, we mustcontinuously evaluate and upgrade our base of available qualified personnel tokeep pace with changing customer needs and emerging technologies. Furthermore,a substantial number of our temporary employees during any given year willterminate their employment with us and accept regular staff employment with ourcustomers. Competition for individuals with proven skills remains intense, anddemand for these individuals is expected to remain strong for the foreseeablefuture. There can be no assurance that qualified candidates will continue to beavailable to us in sufficient numbers and on acceptable terms to us. Thefailure to identify, recruit, train and place candidates as well as retainqualified temporary employees over a long period of time could materiallyadversely affect our business.

 

*The staffing industry is highly competitivewith limited barriers to entry which could limit our ability to maintain orincrease market share.*

 

The staffing industry is highly competitivewith limited barriers to entry and continues to undergo consolidation. Wecompete in regional and local markets with large full service agencies,specialized temporary and permanent placement services agencies and small localcompanies. While some competitors are smaller than us, they may enjoy an advantagein discrete geographic markets because of a stronger local presence. Othercompetitors have greater marketing, financial and other resources than us that,among other things, could enable them to attempt to maintain or increase theirmarket share by reducing prices. Furthermore, in past years there has been anincrease in the number of customers consolidating their staffing servicespurchases with a single provider or with a small number of providers. The trendto consolidate staffing services purchases has in some cases made it moredifficult for us to obtain or retain business.

 

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*The cost of unemployment insurance fortemporary employees may rise and reduce our margins.*

 

In the United States, we are responsible forand pay unemployment insurance premiums for our temporary and regularemployees. At times, these costs have risen as a result of increased claims,general economic conditions and government regulations. Should these costscontinue to increase, there can be no assurance that we will be able toincrease the fees charged to our customers in the future to keep pace with theincreased costs, and if we do not, our results of operations and liquiditycould be adversely affected.

 

*Our information technology systems arecritical to the operations of our business.*

 

Our information management systems areessential for data exchange and operational communications with branches spreadacross large geographical distances. We have replaced key component hardwareand software including backup systems within recent years.  However, any future interruption, impairmentor loss of data integrity or malfunction of these systems could severely impactour business, especially our ability to timely and accurately pay employees andbill customers.

 

*Our business is subject to extensivegovernment regulation, which may restrict the types of employment services thatwe are permitted to offer or result in additional tax or other costs thatadversely affect our revenues and earnings.*

 

We are in the business of employing peopleand placing them in the workplace of other businesses on either a temporary orpermanent basis. As a result, we are subject to extensive laws and regulationsrelating to employment. Changes in laws or government regulations may result inprohibition or restriction of certain types of employment services we arepermitted to offer or the imposition of new or additional benefit, licensing ortax requirements that could reduce our revenues and earnings. There can be noassurance that we will be able to increase the fees charged to our customers ina timely manner and in a sufficient amount to cover increased costs as a resultof any changes in laws or government regulations. Any future changes in laws orgovernment regulations may make it more difficult or expensive for us toprovide staffing services and could have a material adverse effect on ourbusiness, financial condition or results of operations.

 

*We may be exposed to employment-relatedclaims and costs that could materially adversely affect our business.*

 

The risks related to engaging in our businessinclude but are not limited to:

 

·                  claimsby our placed personnel of discrimination and harassment directed at them,including claims arising from the actions of our customers;

 

·                  workers’compensation claims and other similar claims;

 

·                  violationsof wage and hour laws and requirements;

 

·                  claimsof misconduct, including criminal activity or negligence on the part of ourplaced personnel;

 

·                  claimsby our customers relating to actions by our placed personnel, includingproperty damage and personal injury, misuse of proprietary information andmisappropriation of assets or other similar claims; and

 

·                  immigrationrelated claims.

 

In addition, some or all of these claims maygive rise to litigation, which could be time-consuming to our management team,and therefore, could have a negative effect on our business, financialconditions and results of operations. In some instances, we have agreed toindemnify our customers against some or all of these types of liabilities. Wehave policies and guidelines in place to help reduce our exposure to theserisks and have purchased insurance policies against certain risks in amountsthat we currently believe to be adequate. However, there can be no assurancethat our insurance will be sufficient in amount or scope to cover these typesof liabilities or that we will be able to secure insurance coverage for suchrisks on affordable terms. Furthermore, there can be no assurance that we willnot experience these issues in the future or that they could have a materialadverse effect on our business.

 

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*We are involved in an action taken by theCalifornia Employment Development Department.*

 

During the fourth quarter of fiscal year 2005, we were notified by theCalifornia Employment Development Department (“EDD”) that our domesticoperating subsidiaries unemployment tax rates would be increased retroactivelyfor both calendar years 2005 and 2004. The total assessment by the EDD ofadditional unemployment taxes for both years, net of applied overpayments isapproximately $1.5 million including interest at applicable statutoryrates. Management believes that it has properly calculated its unemploymentinsurance tax and is in compliance with all applicable laws and regulations.The Company has timely appealed the ruling by the EDD and is working with theoutside counsel to resolve this matter. Additionally, management contends thatthe notification by the EDD of the 2004 assessment was not timely and holds theposition that the assessment is procedurally invalid. Consequently, at January 24,2009, the Company has no reserve for the 2004 assessment and has accrued theassessment for 2005 of $0.3 million, including interest and net of anapplied overpayment. Although we believe that we have properly calculated ourunemployment insurance tax and are in compliance with all applicable laws andregulations, there can be no assurances this will be settled in our favor.Management believes the Company is well positioned to defend against theun-accrued portion and the ultimate resolution of this matter will not have amaterial adverse effect on the Company’s consolidated financial statements.

 

*We are a defendant in a variety of litigationand other actions from time to time, which may have a material adverse effecton our business, financial condition and results of operations.*

 

We are regularly involved in a variety oflitigation arising out of our business and, in recent years, have paidsignificant amounts as a result of adverse arbitration awards. We do not haveinsurance for some of these claims, and there can be no assurance that theinsurance coverage we have will cover all claims that may be asserted againstus. Should the ultimate judgments or settlements not be covered by insurance orexceed our insurance coverage, they could have a material adverse effect on ourresults of operations, financial position and cash flows. There can also be noassurance that we will be able to obtain appropriate and sufficient types orlevels of insurance in the future or that adequate replacement policies will beavailable on acceptable terms, if at all.

 

*We have assets on our balance sheet for whichtheir realization is dependent on our future cash flows.*

 

As of January 24, 2009, we haveintangibles of $3.5 million. A majority of the remaining intangible assetbalance relates to an indefinite life franchise right relating to the Houstonmarket. If we are unable to maintain our projected levels of cash flows forthis market, we may need to write off a portion or all of these assets inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 142“Goodwill and Other Intangible Assets” which would result in a reduction of ourassets and stockholders equity. Furthermore, under SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets,” the Company is requiredto assess the recoverability of its long-lived assets (such as its property andequipment) whenever events and circumstances indicate the carrying value of anasset or asset group may not be recoverable from estimated cash flows expectedto result from its use and eventual disposition. If we are unable to generateadequate cash flows we may need to write off a portion of our long-livedassets.

 

*Improper disclosure of employee and customerdata could result in liability and harm to our reputation.*

 

Our business involves the use, storage andtransmission of information about our employees and their customers. It ispossible that our security controls over personal data and other practices weand our third party service providers follow may not prevent the improperaccess to or disclosure of personally identifiable information. Such disclosurecould harm our reputation and subject us to liability under our contracts andlaws that protect personal data, resulting in increased costs or loss ofrevenue. Further, data privacy is subject to frequently changing rules andregulations. Our failure to adhere to or successfully implement processes inresponse to changing regulatory requirements in this area could result in legalliability or impairment to our reputation in the marketplace.

 

**Item 2.    Unregistered Sales ofEquity Securities and Use of Proceeds**

 

Notapplicable.

 

**Item 3.    Defaults Upon SeniorSecurities**

 

Notapplicable.

 

**Item 4.    Submission of Mattersto a Vote of Security Holders**

 

None.

 

**Item 5.    Other Information**

 

No events.

 

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**Item 6.    Exhibits**

 

Set forthbelow is a list of the exhibits included as part of this QuarterlyReport:

 

| 31.1 |   | Certification of the Chief  Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                    |
|------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.2 |   | Certification of the Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                    |
| 32.1 |   | Certification of the Chief  Executive Officer pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002. |
| 32.2 |   | Certification of the 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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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                     |   | WESTAFF, INC.                                     |
|---------------------|--------|---------------------------------------------------|
|                |   |                                              |
| March 16, 2009 |   | /s/ Christa C. Leonard                            |
| Date                |   | Christa C. Leonard                                |
|                |   | Senior Vice President and Chief Financial Officer |

 

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