##### **UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

 

##### **FORM10-Q**

##### ** **

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

 

**For thequarterly period ended****April 15, 2006**

 

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

 

**For thetransition period from                     to                   **

 

**Commissionfile number 0-24990**

 

**WESTAFF,INC.**

(Exact name ofregistrant as specified in its charter)

 

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

 

##### **298North Wiget Lane**

**WalnutCreek, California  94598-2453**

(Address ofregistrant’s principal executive offices)

 

**(925) 930-5300**

(Registrant’s telephone number)

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. Yes ý    No        o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of accelerated filer and largeaccelerated filer in Rule 12b-2 of the Exchange Act. (Check One):

 

Large accelerated file   o  Accelerated filer  o  Non-accelerated filer  ý

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date:

 

| **Class**                      | ** ** | **Outstanding at May 26, 2006** |
|--------------------------------|------------|-----------------------------------------------------|
| Common Stock,  $0.01 par value |       | 16,489,212  shares                                  |

 

 

----

 

##### **WESTAFF,INC. AND SUBSIDIARIES**

##### ** **

**INDEX**

 
| **Part I.**  | **Financial Information**                                                                   | ** ** |
|--------------|---------------------------------------------------------------------------------------------|------------|
| ** **   | ** **                                                                                  | ** ** |
| Item 1.      | Financial Statements (Unaudited)                                                            |       |
|         |                                                                                        |       |
|         | Condensed Consolidated  Balance Sheets -                                                    |       |
|         | April 15, 2006 and October  29, 2005                                                        |       |
|         |                                                                                        |       |
|         | Condensed Consolidated  Statements of Operations -                                          |       |
|         | 12 and 24 weeks ended April  15, 2006 and April 16, 2005                                    |       |
|         |                                                                                        |       |
|         | Condensed Consolidated  Statements of Cash Flows -                                          |       |
|         | 24 weeks ended April 15,  2006 and April 16, 2005                                           |       |
|         |                                                                                        |       |
|         | Notes to Condensed  Consolidated Financial Statements                                       |       |
|         |                                                                                        |       |
| Item  2.     | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |       |
|         |                                                                                        |       |
| Item 3.      | Quantitative  and Qualitative Disclosures About Market Risk                                 |       |
|         |                                                                                        |       |
| Item 4.      | Controls and Procedures                                                                     |       |
|         |                                                                                        |       |
| **Part II.** | **Other Information**                                                                       | ** ** |
| ** **   | ** **                                                                                  | ** ** |
| Item 1.      | Legal Proceedings                                                                           |       |
|         |                                                                                        |       |
| Item  1A.    | Risk  Factors                                                                               |       |
|         |                                                                                        |       |
| Item 2.      | Unregistered  Sales of Equity Securities and Use of Proceeds                                |       |
|         |                                                                                        |       |
| Item 3.      | Defaults  Upon Senior Securities                                                            |       |
|         |                                                                                        |       |
| Item 4.      | Submission  of Matters to a Vote of Security Holders                                        |       |
|         |                                                                                        |       |
| Item 5.      | Other Information                                                                           |       |
|         |                                                                                        |       |
| Item  6.     | Exhibits                                                                                    |       |
|         |                                                                                        |       |
| Signatures   |                                                                                        |

 

----

 

**Part l.  Financial Information**

** **

**Item 1.  Financial Statements**

** **

**Westaff, Inc.**

** **

**Condensed Consolidated BalanceSheets (Unaudited)**

**(In thousands except per share amounts)**

 
| ** **                                                                                                                                        | ** ** | **April 15,** | ** ** | **October 29,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|------------|-----------------|------------|
| ** **                                                                                                                                        | ** ** | **2006**      | ** ** | **2005**        | ** ** |
| **ASSETS**                                                                                                                                        | ** ** | ** **    | ** ** | ** **      | ** ** |
| Current assets:                                                                                                                                   |       |          |       |            |       |
| Cash and cash  equivalents                                                                                                                        |       | $             | 6,682      |            | $          | 3,014 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $1,019 and $997                                                               |       | 69,765        |       | 83,416          |       |
| Income taxes  receivable                                                                                                                          |       | 59            |       | 82              |       |
| Deferred income  taxes                                                                                                                            |       | 5,096         |       | 5,097           |       |
| Prepaid expenses                                                                                                                                  |       | 3,538         |       | 3,847           |       |
| Other current  assets                                                                                                                             |       | 2,043         |       | 1,337           |       |
| Total current  assets                                                                                                                             |       | 87,183        |       | 96,793          |       |
|                                                                                                                                              |       |          |       |            |       |
| Property and equipment, net                                                                                                                       |       | 14,959        |       | 15,184          |       |
| Deferred income taxes                                                                                                                             |       | 11,944        |       | 11,951          |       |
| Goodwill                                                                                                                                          |       | 13,154        |       | 11,770          |       |
| Other long-term assets                                                                                                                            |       | 1,406         |       | 3,084           |       |
| Total Assets                                                                                                                                      |       | $             | 128,646    |            | $          | 138,782 |   |
|                                                                                                                                              |       |          |       |            |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                     | ** ** | ** **    | ** ** | ** **      | ** ** |
| Current liabilities:                                                                                                                              |       |          |       |            |       |
| Borrowing under  revolving credit facilities                                                                                                      |       | $             | 3,879      |            | $          | 8,568 |   |
| Current portion  of capital lease obligations                                                                                                     |       | 317           |       | 343             |       |
| Accounts payable                                                                                                                                  |       | 2,354         |       | 3,755           |       |
| Accrued expenses                                                                                                                                  |       | 40,343        |       | 42,609          |       |
| Income taxes  payable                                                                                                                             |       | 340           |       | 817             |       |
| Liabilities of  discontinued operations                                                                                                           |       | 24            |       | 75              |       |
| Total current  liabilities                                                                                                                        |       | 47,257        |       | 56,167          |       |
|                                                                                                                                              |       |          |       |            |       |
| Note payable to related party                                                                                                                     |       | 2,000         |       | 2,000           |       |
| Long-term capital lease obligations                                                                                                               |       | 1,053         |       | 1,174           |       |
| Other long-term liabilities                                                                                                                       |       | 17,436        |       | 17,820          |       |
| Total  liabilities                                                                                                                                |       | 67,746        |       | 77,161          |       |
|                                                                                                                                              |       |          |       |            |       |
| Commitments and contingencies                                                                                                                     |       |          |       |            |       |
|                                                                                                                                              |       |          |       |            |       |
| Stockholders’ equity:                                                                                                                        |       |          |       |            |       |
| Preferred stock,  $0.01 par value; authorized and unissued: 1,000 shares                                                                          |       |          |       |            |       |
| Common stock,  $0.01 par value; authorized: 25,000 shares; issued and outstanding:  16,406 shares at April 15, 2006 and 16,378 at October 29,2005 |       | 164           |       | 164             |       |
| Additional  paid-in capital                                                                                                                       |       | 37,972        |       | 37,803          |       |
| Deferred stock  compensation                                                                                                                      |       | —        |       | (54             | )          |
| Retained  earnings                                                                                                                                |       | 23,489        |       | 24,151          |       |
| Accumulated  other comprehensive loss                                                                                                             |       | (725          | )          | (443            | )          |
| Total  stockholders’ equity                                                                                                                  |       | 60,900        |       | 61,621          |       |
| Total  Liabilities and Stockholders’ Equity                                                                                                  |       | $             | 128,646    |            | $          | 138,782 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**Westaff, Inc.**

 

**Condensed Consolidated Statementsof Operations (Unaudited)**

**(In thousands except per share amounts)**

 
| ** **                                                    | ** ** | **12 Weeks Ended** | ** ** | **24 Weeks Ended** | ** ** |
|---------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                    | ** ** | **April 15,**           | ** ** | **April 16,**           | ** ** | **April 15,** | ** ** | **April 16,** | ** ** |
| ** **                                                    | ** ** | **2006**                     | ** ** | **2005**                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Revenue                                                       |       | $                            | 138,635    |                         | $          | 135,521 |   | $ | 277,236 |   | $ | 270,826 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Costs of services                                             |       | 114,559                      |       | 112,368                      |       | 229,922 |   | 224,816 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Gross profit                                                  |       | 24,076                       |       | 23,153                       |       | 47,314 |   | 46,010 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Franchise agents’ share of gross profit                  |       | 4,006                        |       | 4,056                        |       | 8,339 |   | 8,030 |   |
| Selling and administrative expenses                           |       | 19,043                       |       | 18,190                       |       | 37,000 |   | 34,975 |   |
| Depreciation and amortization                                 |       | 1,174                        |       | 956                          |       | 2,344 |   | 1,915 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Operating income (loss) from continuing operations            |       | (147                         | )          | (49                          | )          | (369 | ) | 1,090 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Interest expense                                              |       | 248                          |       | 282                          |       | 557 |   | 677 |   |
| Interest income                                               |       | (31                          | )          | (23                          | )          | (49 | ) | (43 | ) |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Income (loss) from continuing operations before  income taxes |       | (364                         | )          | (308                         | )          | (877 | ) | 456 |   |
| Income tax provision (benefit)                                |       | (98                          | )          | 20                           |       | (215 | ) | 216 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Income (loss) from continuing operations                      |       | (266                         | )          | (328                         | )          | (662 | ) | 240 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Loss from discontinued operations                             |       | —                       |       | (43                          | )          | — |   | (105 | ) |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Net income (loss)                                             |       | $                            | (266       | )                            | $          | (371 | ) | $ | (662 | ) | $ | 135 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Earnings (loss) per share:                                    |       |                         |       |                         |       |   |   |   |   |
| Continuing  operations                                        |       |                         |       |                         |       |   |   |   |   |
| Basic                                                         |       | $                            | (0.02      | )                            | $          | (0.02 | ) | $ | (0.04 | ) | $ | 0.01 |   |
| Diluted                                                       |       | $                            | (0.02      | )                            | $          | (0.02 | ) | $ | (0.04 | ) | $ | 0.01 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Discontinued  operations - basic and diluted                  |       | $                            | —     |                         | $          | — |   | $ | — |   | $ | — |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Net income  (loss) - basic and diluted                        |       | $                            | (0.02      | )                            | $          | (0.02 | ) | $ | (0.04 | ) | $ | 0.01 |   |
|                                                          |       |                         |       |                         |       |   |   |   |   |
| Weighted average shares outstanding - basic                   |       | 16,394                       |       | 16,302                       |       | 16,386 |   | 16,175 |   |
| Weighted average shares outstanding - diluted                 |       | 16,394                       |       | 16,302                       |       | 16,386 |   | 16,378 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

4

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**Westaff, Inc.**

** **

**Condensed Consolidated Statementsof Cash Flows (Unaudited)**

**(In thousands)**

 
| ** **                                                                                | ** ** | **24 Weeks Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                | ** ** | **April 15,**      | ** ** | **April 16,** | ** ** |
| ** **                                                                                | ** ** | **2006**           | ** ** | **2005** | ** ** |
| **Cash flows from operating activities**                                                  | ** ** | ** **         | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                        |       | $                  | (662       | ) | $ | 135 |   |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |               |       |   |   |
| Stock-based  compensation                                                                 |       | 136                |       | — |   |
| Depreciation and  amortization                                                            |       | 2,344              |       | 1,937 |   |
| Provision for  losses on doubtful accounts                                                |       | 262                |       | 269 |   |
| (Gain) loss on  sale or disposal of assets                                                |       | 12                 |       | (35 | ) |
| Income from  sales of affiliate operations                                                |       | (95                | )          | (12 | ) |
| Other                                                                                     |       | (167               | )          | (72 | ) |
| Changes in  assets and liabilities:                                                       |       |               |       |   |   |
| Trade accounts  receivable                                                                |       | 12,919             |       | 10,973 |   |
| Other assets                                                                              |       | 1,563              |       | (8,629 | ) |
| Accounts payable  and accrued expenses                                                    |       | (2,930             | )          | (789 | ) |
| Income taxes  payable                                                                     |       | (474               | )          | (232 | ) |
| Other  liabilities                                                                        |       | 37                 |       | (73 | ) |
|                                                                                      |       |               |       |   |   |
| Net cash provided by operating activities                                                 |       | 12,945             |       | 3,472 |   |
|                                                                                      |       |               |       |   |   |
| **Cash flows from investing activities**                                                  |       |               |       |   |   |
| Capital  expenditures                                                                     |       | (2,859             | )          | (2,682 | ) |
| Proceeds from  sales of affiliate operations                                              |       | 22                 |       | 1,054 |   |
| Payment for  purchase of affiliate operations                                             |       | (1,484             | )          | (7 | ) |
| Other, net                                                                                |       | (292               | )          | 194 |   |
|                                                                                      |       |               |       |   |   |
| Net cash used by investing activities                                                     |       | (4,613             | )          | (1,441 | ) |
|                                                                                      |       |               |       |   |   |
| **Cash flows from financing activities**                                                  |       |               |       |   |   |
| Net repayments  under line of credit agreements                                           |       | (4,545             | )          | (5,498 | ) |
| Principal  payments on capital lease obligations                                          |       | (148               | )          | (232 | ) |
| Issuance of  common stock                                                                 |       | 88                 |       | 646 |   |
| Other                                                                                     |       | —             |       | (8 | ) |
|                                                                                      |       |               |       |   |   |
| Net cash used by financing activities                                                     |       | (4,605             | )          | (5,092 | ) |
|                                                                                      |       |               |       |   |   |
| Effect of exchange rate changes on cash                                                   |       | (59                | )          | 110 |   |
|                                                                                      |       |               |       |   |   |
| Net change in cash and cash equivalents                                                   |       | 3,668              |       | (2,951 | ) |
| Cash and cash equivalents at beginning of period                                          |       | 3,014              |       | 6,993 |   |
| Cash and cash equivalents at end of period                                                |       | $                  | 6,682      |   | $ | 4,042 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

5

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**Westaff, Inc.**

 

**Notes to Condensed ConsolidatedFinancial Statements (Unaudited)**

**(In thousands except per share amounts)**

 

**1.****              Basis ofPresentation**

 

The accompanyingcondensed consolidated financial statements of Westaff, Inc. and its domesticand foreign subsidiaries (together, the Company), as of April 15, 2006 and forthe 12 and 24-week periods ended April 15, 2006 and April 16, 2005 areunaudited.

 

The condensedconsolidated financial statements, in the opinion of management, reflect alladjustments, which are of a normal recurring nature, necessary for a fairpresentation of the financial position, results of operations and cash flowsfor the periods presented. The condensed consolidated balance sheet as ofOctober 29, 2005 presented herein, has been derived from the audited balancesheet included in the Company’s Annual Report on Form 10-K for the fiscal yearended October 29, 2005.

 

Certain financialinformation normally included in annual financial statements prepared inaccordance with accounting principles generally accepted in the United Statesthat is not required for interim reporting purposes, has been condensed oromitted. The accompanying condensed consolidated financial statements should beread in conjunction with the financial statements and notes thereto included inthe Company’s Annual Report on Form 10-K for the fiscal year ended October 29,2005.

 

The Company’sfiscal year is a 52 or 53-week period ending the Saturday nearest the end ofOctober. For interim reporting purposes, the first three fiscal quarterscomprise 12 weeks each, while the fourth fiscal quarter consists of 16 or 17weeks. The results of operations for the 12 and 24 week period ended April 15,2006 are not necessarily indicative of the results to be expected for the fullfiscal year or for any future period.

 

In June 2005, theCompany sold its subsidiary operations in Norway and Denmark. As a result, theCompany has classified these operations as discontinued operations and,accordingly has segregated the assets, liabilities, revenue and expenses ofthese discontinued operations in the accompanying condensed consolidated financialstatements and notes thereto. Cash flows pertaining to discontinued operationsare not disclosed separately in the condensed consolidated statements of cashflows.

 

**2.**              Stock-BasedCompensation

** **

The Company’s 1996 Stock Option/StockIssuance Plan provides for the granting of incentive and nonqualified stockoptions, restricted stock awards and stock appreciation rights. Incentive stockoptions may be granted at a price not less than 100% of the fair market valueof the Company’s common stock at the date of grant. Although nonqualifiedoptions may be granted at a price not less than 85% of the fair market value ofthe Company’s common stock at the date of grant, the Company has historicallyissued option grants with exercise prices equal to fair market value on thedate of grant. The options’ vesting schedules vary subject to the participant’speriod of future service or to the Company’s or the option holder’s attainmentof designated performance goals, or otherwise at the discretion of the Board ofDirectors. Standard vesting is over four years with 25% of the options vestingupon completion of one year of service from the vesting commencement date, andthe 

 

6

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remaining options vesting in thirty-six equalmonthly installments. No option may have a term in excess of 10 years.

 

Under the Company’s 1996 Employee Stock Purchase Plan, eligibleemployees may authorize payroll deductions of up to 10% of eligiblecompensation for the purchase of the Company’s common stock during each semiannualpurchase period. The purchase price will equal the lower of 85% of the fairmarket value at the beginning of the purchase period or on the last day of thepurchase period. The plan provides for the issuance of up to 750 shares of theCompany’s common stock. As of April 15, 2006, shares issued under the plantotaled 641.

 

Effective October 30, 2005, the Company adoptedStatement of Financial Accounting Standards No. 123 (revised 2004) “Share-BasedPayment” (SFAS 123(R)) using the modified prospective method of adoption, whichdoes not require restatement of prior periods. SFAS 123(R) requires the Companyto recognize compensation expense for its stock options, restricted stockawards and employee stock purchase shares outstanding, but not yet vested, asof the date of adoption and for future stock option and awards grants andemployee stock purchase shares.

 

Activity in the Company’s stock option plan for the 24weeks ended April 15, 2006 was as follows:

 
| ** **                              | ** ** | ** ** | ** ** | ** **                | ** ** | **Weighted average**      | ** ** | **Aggregate** | ** ** |
|-----------------------------------------|------------|------------|------------|---------------------------|------------|--------------------------------|------------|---------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **Weighted average** | ** ** | **remaining contractual** | ** ** | **intrinsic** | ** ** |
| ** **                              | ** ** | **Shares** | ** ** | **exercise price**   | ** ** | **term (years)**          | ** ** | **value**     | ** ** |
|                                    |       |       |       |                      |       |                           |       |          |       |
| Options outstanding at October 29, 2005 |       | 640        |       | $                         | 3.69       |                           |       |          |       |   |
| Granted                                 |       | —     |       |                      |       |                           |       |          |       |
| Exercised                               |       | (10        | )          | 2.78                      |       |                           |       |          |       |
| Cancelled                               |       | (34        | )          | 2.99                      |       |                           |       |          |       |
| Options outstanding at April 15, 2006   |       | 596        |       | $                         | 3.74       |                           | 6.65       |          | $          | 435 |   |
| Exercisable at April 15, 2006           |       | 406        |       | $                         | 3.94       |                           | 5.64       |          | $          | 303 |   |

 

Intrinsic value is defined as the difference betweenthe current market value and the grant price. At April 15, 2006, the Companyhad 20 restricted stock shares outstanding with an intrinsic value of $15 andrecorded liabilities for withholdings under its employee stock purchase planrepresenting 39 shares at a weighted average exercise price of $3.39 with anestimated aggregate intrinsic value of $22.

 

For the 12 weeks ended April 15, 2006, the Companyrecorded stock-based compensation of $70 ($54 net of related income tax benefit),and for the 24 weeks ended April 15, 2006, the Company recorded stock-basedcompensation of $136 ($105 net of related income tax benefit). Stock-basedcompensation expense is included in selling and administrative expenses. Thetotal compensation cost related to nonvested stock options and awards not yetrecognized is currently expected to be a combined total of approximately $328over the next two fiscal years.

 

Prior to the adoption of SFAS 123(R), the Company measuredcompensation cost for employee stock options and similar equity instrumentsusing the intrinsic value-based method of accounting 

 

7

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prescribed by Accounting Principles Board OpinionNo. 25, “Accounting for Stock Issued to Employees” (APB 25), and followed thedisclosure-only provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation,” as amended by SFAS No. 148, “Accounting for Stock-BasedCompensation - Transition and Disclosure.” Accordingly, compensation cost wasnot recognized for options granted at fair market value. The following tablerepresents pro forma net income and pro forma earnings per share for the fiscalquarter ended April 16, 2005 as if compensation cost had been determined usingthe fair value method:

 
| ** **                                                       | ** ** | **12 Weeks Ended** | ** ** | **24 Weeks Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                       | ** ** | **April 16,**      | ** ** | **April 16,**      | ** ** |
| ** **                                                       | ** ** | **2005**           | ** ** | **2005**           | ** ** |
|                                                             |       |               |       |               |       |
| Net income (loss) as reported                                    |       | $                  | (371       | )                  | $          | 135 |   |
| Stock-based compensation determined under the fair  value method |       | 65                 |       | (33                | )          |
| Pro forma net income (loss)                                      |       | $                  | (306       | )                  | $          | 102 |   |
|                                                             |       |               |       |               |       |
| Income (loss) per common share:                                  |       |               |       |               |       |
| Basic and  diluted - as reported                                 |       | $                  | (0.02      | )                  | $          | 0.01 |   |
| Basic and  diluted - pro forma                                   |       | $                  | (0.02      | )                  | $          | 0.01 |   |

 

The fair value of eachoption grant was estimated on the date of grant using the Black-Scholesvaluation model, with a six year expected life and the assumption of a zerodividend rate. Volatility is based on the Company’s historical volatilitythrough the date of grant. The risk-free interest rate used is based on theU.S. Treasury constant maturities at the time of grant having a term thatapproximates the expected life of the option.

 

**3.****             ****Goodwill**

 

**The following summarizes the change in goodwill during the 24weeks ended April 15, 2006:**

 
| ** **                                        | ** ** | **Domestic**               | ** ** | ** **    | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|----------------------------|------------|---------------|------------|------------|------------|
| ** **                                        | ** ** | **Business Services** | ** ** | **Australia** | ** ** | **Total**  | ** ** |
|                                              |       |                       |       |          |       |       |       |
| Balance at October 29, 2005                       |       | $                          | 10,797     |          | $          | 973        |       | $ | 11,770 |   |
| Effect of foreign currency translation            |       | —                     |       | (35           | )          | (35        | )          |
| Acquisition of affiliate operations (See Note 12) |       | 1,419                      |       | —        |       | 1,419      |       |
| Balance at April 15, 2006                         |       | $                          | 12,216     |          | $          | 938        |       | $ | 13,154 |   |

 

**The Company performs its annual impairment evaluation inthe fourth quarter of each fiscal year.**

** **

**4.**              DiscontinuedOperations

 

8

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InJune 2005, the Company sold its Norway and Denmark subsidiary operations toPersonalhuset AS, a recruitment and staffing company headquartered in Norway,for approximately $2,700. Additionally, as a part of the sale transaction,Westaff Norway repaid approximately $610 of intercompany debt to Westaff USA.Of the total proceeds, approximately $220 is being held in an interest bearingescrow account as security for potential Westaff Norway pension claims, whichthe Company currently estimates to be zero. The escrowed funds, net of anyclaim payments, are scheduled to be remitted to the Company in June 2007. TheCompany recorded a net gain on the sale of $1,163.

 

As requiredby the terms of the Company’s Multicurrency Credit Agreement, the net proceedson the sale of the Norway and Denmark operations, including the intercompanydebt repayment, were used to pay down borrowings on the Company’s revolvingcredit facility. In accordance with EITF 87-24, the Company has allocatedinterest expense to the discontinued operations of $31 and $58 for the 12 weeksand 24 weeks ended April 16, 2005, respectively.

 

Summarizedinformation on the Norway and Denmark discontinued operations is as follows:

 
| ** **                        | ** ** | **12 Weeks Ended** | ** ** | **24 Weeks Ended** | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                        | ** ** | **April 16,**      | ** ** | **April 16,**      | ** ** |
| ** **                        | ** ** | **2005**           | ** ** | **2005**           | ** ** |
|                              |       |               |       |               |       |
| Revenue                           |       | $                  | 2,803      |               | $          | 5,741 |   |
|                              |       |               |       |               |       |
| Costs and expenses                |       | 2,846              |       | 5,846              |       |
|                              |       |               |       |               |       |
| Loss from discontinued operations |       | $                  | (43        | )                  | $          | (105 | ) |

 

**5.****              Workers’ Compensation**

 

The Company isresponsible for and pays workers’ compensation costs for its temporary andregular employees and is self-insured for the deductible amount related toworkers’ compensation claims ($500 per claim for fiscal 2006 and fiscal 2005). TheCompany accrues the estimated costs of workers’ compensation claims based uponthe expected loss rates within the various temporary employment categoriesprovided by the Company. At least annually, the Company obtains an independentactuarial valuation of the estimated costs of claims reported but not settled,and claims incurred but not reported, and adjusts the accruals based on theresults of the valuations. As of April 15, 2006 and October 29, 2005, workers’compensation liabilities were approximately $21,000 and $19,600 respectively,of which $14,200 is included in other long-term liabilities on each of therespective balance sheets for obligations that are not expected to be paid withinone year of the balance sheet date.

 

Eachpolicy year the terms of the agreement with the insurance carrier arerenegotiated. The insurance carrier requires the Company to collateralize itsrecorded obligations through the use of irrevocable letters of credit, suretybonds or cash. At April 15, 2006, the Company had $35,253 of letters of creditsecuring its domestic workers’ compensation obligations.

 

**6.**              EarningsPer Share

 

9

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The followingtable sets forth the computation of basic and diluted earnings per share fromcontinuing operations:

 
| ** **                                                                                              | ** ** | **12 Weeks Ended** | ** ** | **24 Weeks Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                                                                                              | ** ** | **April 15,**           | ** ** | **April 16,**           | ** ** | **April 15,** | ** ** | **April 16,** | ** ** |
| ** **                                                                                              | ** ** | **2006**                     | ** ** | **2005**                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                    |       |                         |       |                         |       |   |   |   |   |
| Income (loss) from continuing operations                                                                |       | $                            | (266       | )                            | $          | (328 | ) | $ | (662 | ) | $ | 240 |   |
|                                                                                                    |       |                         |       |                         |       |   |   |   |   |
| Denominator for  basic earnings per share - weighted average shares                                     |       | 16,394                       |       | 16,302                       |       | 16,386 |   | 16,175 |   |
|                                                                                                    |       |                         |       |                         |       |   |   |   |   |
| Effect of dilutive securities: stock options and  awards                                                |       | —                       |       | —                       |       | — |   | 203 |   |
| Denominator for  diluted earnings per share - adjusted weighted average shares and assumed  conversions |       | 16,394                       |       | 16,302                       |       | 16,386 |   | 16,378 |   |
|                                                                                                    |       |                         |       |                         |       |   |   |   |   |
| Earnings (loss) per share from continuing operations                                                    |       |                         |       |                         |       |   |   |   |   |
| Basic                                                                                                   |       | $                            | (0.02      | )                            | $          | (0.02 | ) | $ | (0.04 | ) | $ | 0.01 |   |
| Diluted                                                                                                 |       | $                            | (0.02      | )                            | $          | (0.02 | ) | $ | (0.04 | ) | $ | 0.01 |   |
|                                                                                                    |       |                         |       |                         |       |   |   |   |   |
| Anti-dilutive  weighted shares excluded from diluted earnings (loss) per share                          |       | 354                          |       | 252                          |       | 348 |   | 79 |   |

 

**7.****              Comprehensive Income**

 

Comprehensiveincome consists of the following:

 
| ** **                       | ** ** | **12 Weeks Ended** | ** ** | **24 Weeks Ended** | ** ** |
|----------------------------------|------------|------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **April 15,**           | ** ** | **April 16,**           | ** ** | **April 15,** | ** ** | **April 16,** | ** ** |
| ** **                       | ** ** | **2006**                     | ** ** | **2005**                     | ** ** | **2006** | ** ** | **2005** | ** ** |
|                             |       |                         |       |                         |       |   |   |   |   |
| Net income (loss)                |       | $                            | (266       | )                            | $          | (371 | ) | $ | (662 | ) | $ | 135 |   |
| Currency translation adjustments |       | (222                         | )          | (5                           | )          | (282 | ) | 262 |   |
| Comprehensive income (loss)      |       | $                            | (488       | )                            | $          | (376 | ) | $ | (944 | ) | $ | 397 |   |

 

**8.****              CreditAgreement**

 

On May 17, 2002, theCompany entered into agreements with GE Capital, as primary agent, to providesenior secured credit facilities totaling $65,000, expiring in May 2007. Thefacilities comprise a five-year syndicated Multicurrency Credit Agreementconsisting of a $50,000 U.S. Revolving Loan Commitment, a £2,740 U.K. RevolvingLoan Commitment (U.S. dollar equivalent of approximately $4,000 at the date ofthe agreement), and a $5,000 term loan (the Term Loan), which was repaid duringfiscal 2003. In addition, a five-year Australian dollar facility agreement (theA$ Facility Agreement) was executed on May 16, 2002, consisting of an A$12,000revolving credit facility (U.S. dollar equivalent of approximately $6,000 atthe date of the agreement). Each agreement includes a letter of creditsub-facility. Letters of credit under the agreements expire one 

 

10

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year from date ofissuance, but are automatically renewed for one additional year unless writtennotice is given to or from the holder.

 

Effective March 1, 2006, the Company and itslenders executed an eighth amendment to the Multicurrency Credit Agreement. Amongother things, the amendment reset minimum earnings before interest, taxes,depreciation and amortization (“EBITDA”) covenants for fiscal 2006 and beyond,adjusted the fixed charge coverage ratio for the Company’s second quarter offiscal 2006, extended the credit facility for one additional year to May 2008and added an additional pricing grid that will allow the Company to benefitfrom reduced interest rates and letter of credit fees upon achieving certainminimum EBITDA targets. Additionally, the amendment increased the maximum amountof the U.S. Revolving Loan Commitment by $5,000 to $55,000 and increased theletter of credit sublimit from $40,000 to $45,000. The Company was not incompliance with its minimum EBITDA covenant as of the end of the first quarterof fiscal 2006 and the amendment included a waiver of this covenant violation.

 

**9.****              RelatedParty Transactions**

 

The Company also has anunsecured subordinated promissory note payable to its principal stockholder andChairman of the Board of Directors dated May 17, 2002 in the amount of $2,000. Thenote has a maturity date of August 18, 2007 and an interest rate equal to anindexed rate as calculated under the Company’s credit facilities plus sevenpercent, compounded monthly and payable 60 calendar days after the end of eachof the Company’s fiscal quarters. The interest rate in effect on April 15, 2006was 14.75%. Payment of interest is contingent on the Company meeting minimumavailability requirements under its credit facilities. Additionally, paymentsof principal or interest are prohibited in the event of any default under thecredit facilities.

 

**10.****       Operating Segments**

 

As discussed in Note 4above, the Company sold its Norway and Denmark operations in June 2005, and hasclassified these as discontinued operations. Prior to the sale, theseoperations were included in the Other International reportable segmentdisclosures.

 

The following tablesummarizes reporting segment data with the 12 and 24 weeks ended April 16, 2005restated to exclude the Norway and Denmark operations:

 

11

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| ** **                                          | ** ** | **Domestic**            | ** ** | **United**  | ** ** | ** **    | ** ** | **New**     | ** ** | **Continuing** | ** ** |
|-----------------------------------------------------|------------|-------------------------|------------|-------------|------------|---------------|------------|-------------|------------|----------------|------------|
| ** **                                          | ** ** | **Business Svcs.** | ** ** | **Kingdom** | ** ** | **Australia** | ** ** | **Zealand** | ** ** | **Operations** | ** ** |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| 12 Weeks Ended  April 15, 2006                      |       |                    |       |        |       |          |       |        |       |           |       |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| Revenue                                             |       | $                       | 108,885    |        | $          | 9,004         |       | $           | 19,303     |           | $          | 1,443 |   | $ | 138,635 |   |
| Operating income  (loss) from continuing operations |       | $                       | (38        | )           | $          | 21            |       | $           | (200       | )              | $          | 70 |   | $ | (147 | ) |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| 12 Weeks Ended  April 16, 2005                      |       |                    |       |        |       |          |       |        |       |           |       |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| Revenue                                             |       | $                       | 102,687    |        | $          | 9,951         |       | $           | 21,088     |           | $          | 1,795 |   | $ | 135,521 |   |
| Operating income  (loss) from continuing operations |       | $                       | (606       | )           | $          | 124           |       | $           | 336        |           | $          | 97 |   | $ | (49 | ) |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| 24 Weeks Ended  April 15, 2006                      |       |                    |       |        |       |          |       |        |       |           |       |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| Revenue                                             |       | $                       | 216,669    |        | $          | 17,920        |       | $           | 39,869     |           | $          | 2,778 |   | $ | 277,236 |   |
| Operating income  (loss) from continuing operations |       | $                       | (625       | )           | $          | 326           |       | $           | (157       | )              | $          | 87 |   | $ | (369 | ) |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| 24 Weeks Ended  April 16, 2005                      |       |                    |       |        |       |          |       |        |       |           |       |
|                                                |       |                    |       |        |       |          |       |        |       |           |       |
| Revenue                                             |       | $                       | 205,749    |        | $          | 19,771        |       | $           | 41,469     |           | $          | 3,837 |   | $ | 270,826 |   |
| Operating income  (loss) from continuing operations |       | $                       | (49        | )           | $          | 470           |       | $           | 492        |           | $          | 177 |   | $ | 1,090 |   |

 

**11.**       Commitmentsand Contingencies

 

In the ordinary course of its business, theCompany is periodically threatened with or named as a defendant in variouslawsuits. The principal risks that the Company insures against are workers’compensation, general liability, automobile liability, property damage,alternative staffing errors and omissions, fiduciary liability, and fidelitylosses.

 

The Company previouslyreported a claim for contribution asserted against Westaff’s Australiansubsidiary and several other entities by ADI Ltd. The litigation originated inMay 1998, when a fire occurred at sea on board an Australian Navy ship. Thefire resulted in the death of four crewmen and extensive damage to the ship.ADI alleged that the negligence of a supervisor placed by Westaff with ADIcontributed to the accident. In May 2006, ADI and Westaff agreed to settle ADI’sclaim for approximately $37, and the Company believes its insurance coveragewill be sufficient to cover this amount.

 

Duringthe fourth quarter of fiscal 2005, the Company was notified by the CaliforniaEmployment Development Department (“EDD”) that Westaff’s domestic operatingsubsidiaries unemployment tax rates would be increased retroactively for bothcalendar 2005 and 2004, which would result in additional unemployment taxes ofapproximately $900. The Company believes that it has properly calculated itsunemployment insurance tax and is in compliance with all applicable laws and 

 

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regulations.The Company has timely appealed the ruling by the EDD and is working with itsoutside counsel to resolve this matter. The Company believes that it has strongdefenses and legal arguments with respect to the unaccrued assessment and,accordingly, has not accrued for that portion of the assessment as of April 15,2006.

 

Other than the actions listed above, theCompany is not currently a party to any material litigation. However, from timeto time the Company has been threatened with, or named as a defendant in, litigation,brought by former franchisees or licensees, and administrative claims andlawsuits brought by employees or former employees. Management believes theresolution of these matters will not have a material adverse effect on theCompany’s financial statements.

 

**12.**       Acquisition

** **

Effective January 23, 2006, the Companyacquired certain assets of Peggy Fruhwirth Enterprises, Inc., previously aWestaff franchise located in Houston, Texas. The Company paid $1,500 in cashfor the assets and the selling shareholders’ noncompete agreements.Furthermore, the Company agreed to pay a contingent earn-out based on the levelof financial performance achieved by the business through September 30, 2006. TheCompany believes the terms and conditions of the preexisting relationship wereconsistent with other relationships the Company has with other franchisees, andaccordingly has not recorded a settlement gain or loss. The transactionresulted in the Company recording $1,414 of goodwill, $65 of intangible assetsand $21 of fixed assets. The contingent earn-out is expected to be paid in thefourth quarter of fiscal 2006. The Company has not completed its valuation ofthe acquired assets and has preliminarily recorded the excess purchase price asgoodwill. The Company anticipates that the final purchase price allocation willbe completed in the third quarter of fiscal 2006.

 

**13.**       SubsequentEvent

** **

On May 1, 2006, the Company announced that ithas implemented a reduction in selling, general and administrative costs,principally by reducing headcount in support functions, primarily at ourcorporate headquarters. As a result, the Company expects to incur severancecosts associated with the restructuring of approximately $314 in the thirdquarter of fiscal 2006.

 

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**Item 2. Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

### **CautionaryStatement**

### ** **

ThisForm 10-Q contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. Except for the historical informationcontained herein, the matters discussed should be considered forward-lookingstatements and readers are cautioned not to place undue reliance on thosestatements. These statements are only predictions, and actual events or resultsmay differ materially. The forward-looking statements give our currentexpectations or forecasts of future events. You can identify these statementsby the fact that they do not relate strictly to current facts. They use wordssuch as “will,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,”“believe,” “target,” “forecast,” and other words and terms of similar meaningin connection with any discussion of future operating or financial performance.These forward-looking statements are made based on information available as ofthe date of this report and are subject to a number of risks and uncertaintiesthat could cause the Company’s actual results and financial position to differmaterially from those expressed or implied in the forward-looking statementsand to be below the expectations of public market analysts and investors.Investors should bear this in mind as they consider forward-looking statements.

 

Theserisks and uncertainties include, but are not limited to, those discussed in thesection titled “Risk Factors” included below and in the Company’s Annual Reporton Form 10-K for the fiscal year ended October 29, 2005. You should understandthat it is not possible to predict or identify all such factors. Consequently,you should not consider any such list to be a complete set of all potentialrisks or uncertainties faced by us.

 

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

 

Thefollowing discussion is intended to assist in the understanding and assessment ofsignificant changes and trends related to the results of operations andfinancial condition of Westaff, Inc., together with its consolidatedsubsidiaries. This discussion and analysis should be read in conjunction withthe Company’s Consolidated Financial Statements and Notes included elsewhere inthis Form 10-Q and in the Company’s Annual Report on Form 10-K for the fiscalyear ended October 29, 2005.

 

**Company Overview**

 

Weprovide staffing services primarily in suburban and rural markets through anetwork of Company-owned, franchise agent and licensed offices in the UnitedStates, United Kingdom, Australia and New Zealand. We offer a wide range ofstaffing solutions, including permanent placement, replacement and temporary staffing,primarily focused on recruiting and placing light industrial andclerical/administrative personnel. The Company has over 55 years of experiencein the staffing industry and annually puts more than 125,000 people to workthrough 240 field offices. Our corporate headquarters provides support servicesto the field offices in areas such as marketing, human resources, riskmanagement, legal, national sales, accounting, and information technology.

 

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Tocomplement our service offerings, which include temporary staffing, permanentplacement, temp-to-hire services, payroll services and on-location programs, weutilize a number of tools focused on increasing our pool of qualifiedcandidates. Additionally, we employ a robust, targeted marketing program aswell as a consultative sales process, and both of these tools assist in oursales efforts to new and existing customers. Management believes all of thesetools enhance our competitive edge and position us to effectively pursue highgrowth market niches.

 

Thestaffing industry is highly competitive with generally few barriers to entry,which contributes to significant price competition and lower margins ascompetitors attempt to maintain or gain market share. While the pressure ongross margins continues in 2006, particularly in the United Kingdom andAustralian marketplaces, we have noted margin improvements in the United Statesand New Zealand. On a prospective basis, we believe our focus on increasingpermanent placement services, improving results from underperforming fieldoffices and prudently managing costs will allow us to improve our operatingmargins.

 

Itis important to note that our business tends to be seasonal with sales for thefirst fiscal quarter typically lower than other fiscal quarters due to nationalholidays as well as plant shutdowns during and after the holiday season. Theseshutdowns and post-holiday season declines negatively impact customer ordersreceived by us, particularly in the light industrial sector. Demand forstaffing services has historically tended to grow during the second and thirdfiscal quarters and has been greatest during the fourth fiscal quarter duelargely to the planning cycles of many of our customers. Furthermore, ourfourth fiscal quarter consists of 16 or 17 weeks, while the first, second andthird fiscal quarters consist of 12 weeks each.

 

Domestically,payroll taxes and related benefits fluctuate with the level of payroll costs,but tend to represent a smaller percentage of revenue and payroll costs laterin our fiscal year as federal and state statutory wage limits for unemploymentand social security taxes are exceeded on a per employee basis. Workers’compensation expense varies with both the frequency and severity of workplaceinjury claims reported during a quarter and the estimated future costs of suchclaims. Adverse and positive loss development of prior period claims during asubsequent quarter may also contribute to the volatility in our estimatedworkers’ compensation expense.

 

Ouroperating results may fluctuate due to a number of factors such as:

 

•                  seasonality, especially in our lightindustrial business,

•                  wage limits on statutory payroll taxes,

•                  claims experience for workers’ compensation,

•                  demand and competition for our services, and

•                  the effects of acquisitions.

 

Inaddition, our operating results have also historically tended to followseasonal sales trends with the bulk of annual operating profits falling withinthe third and fourth fiscal quarters.

 

Managementbelieves that, as a result of the typical sales cycle within the staffingindustry, it is critical to invest in field office staff and growth initiativesduring the first and second fiscal quarters in order to benefit from theseinvestments during the third and fourth quarters of the fiscal year.

 

15

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### **Summary of CriticalAccounting Policies**

### ** **

Management’sDiscussion and Analysis of Financial Condition and Results of Operationsdiscusses our consolidated financial statements, which have been prepared inconformity with generally accepted accounting principles in the United Statesof America. The preparation of these financial statements requires managementto make estimates and assumptions that affect the amounts and disclosuresreported within those financial statements. On an on-going basis, management evaluatesits estimates, including those related to revenue recognition, workers’compensation costs, collectibility of accounts receivable, bad debts, goodwilland intangible assets, contingencies, litigation and income taxes. Managementbases its estimates and judgments on historical experiences and on variousother factors that are believed to be reasonable under the circumstances.Actual results under circumstances and conditions different than those assumedcould result in differences from the estimated amounts in the financialstatements.

 

Managementbelieves the following critical accounting policies reflect the moresignificant judgments and estimates used in the preparation of our consolidatedfinancial statements. There have been no material changes to these policiesduring fiscal year 2006 to date.

 

Formore information on these policies, please see Note 1 of Notes to ConsolidatedFinancial Statements, located in Item 8 of Part II of our Form 10-K for thefiscal year ended October 29, 2005.

 

*RevenueRecognition* - Werecord revenue from the sale of temporary staffing, permanent placement fees,and temp-to-hire fees by our Company-owned and franchised operations. Temporarystaffing revenue and the related labor costs and payroll taxes are recorded in theperiod in which the services are performed. Temp-to-hire fees are generallyrecorded when the temporary employee is hired on directly by the customer.Permanent placement fees are recognized when the candidate commences full-timeemployment and, if necessary, sales allowances are established to estimatelosses due to placed candidates not remaining employed for the permanentplacement guarantee period, which is typically four weeks.

 

Weaccount for our revenue and the related direct costs of our franchisearrangements in accordance with Emerging Issues Task Force (“EITF”) 99-19, *Recording Revenue Gross as a Principal versus Net as an Agent*.We first assess whether we act as a principal in our transactions or as anagent acting on the behalf of others. When we are the principal in atransaction and have the risks and rewards of ownership, we record thetransaction gross in our income statement. Where we act merely as an agent,only the net fees earned are recorded in the income statement. Under our traditionalfranchise agreement, we have the direct contractual arrangements with ourcustomers and the contracts are binding on us. We are also the employer of alltemporary employees in the franchise agents operations and, as such, areobligated for the temporary employee payroll, related payroll taxes and therisk of loss for accounts receivable collection. As we retain the risks andrewards of ownership, the revenue and direct expenses of our franchise agentsare included in our Results of Operations. Each accounting period, we remit toeach franchisee either a portion of the gross margin or a portion of the salesgenerated by its office(s), based on what the relevant franchise agreementdictates.

 

*Workers’Compensation Reserves*- We self-insure the deductible amount related to workers’ compensation claims,which was $500,000 per claim for policy years 2006 and 2005 and $750,000 perclaim for policy year 2004. We maintain reserves for workers’ compensationcosts based upon actuarial 

 

16

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methodsutilized to estimate the remaining undiscounted liability for the deductibleportion of all claims, including those incurred but not reported. This processincludes establishing loss development factors, based on the historical claimsexperience of the Company and the staffing industry, and applying those factorsto current claims information to derive an estimate of our ultimate claimsliability. The calculated ultimate liability is calculated for each policy yearand is then reduced by the cumulative claims payments to determine the requiredreserves. We evaluate the reserve and the underlying assumptions regularlythroughout the year and make adjustments accordingly. If the actual cost ofsuch claims and related expenses exceeds the amounts estimated, additionalreserves may be required. While we believe that the recorded reserves areadequate, there can be no assurances that future, unfavorable changes toestimates relied upon in the determination of these reserves will not occur.

 

*Collectibilityof Accounts Receivable*- We provide an allowance for doubtful accounts on accounts receivable based onan estimation of losses, which could occur if customers are unable to makerequired payments. We evaluate this allowance on a regular basis throughout theyear and make adjustments as the evaluation warrants. If the financialcondition of our customers were to deteriorate, resulting in an impairment oftheir ability to make payments, additional allowances could be required. Ourestimates are influenced by numerous factors including our large, diversecustomer base, which is disbursed across a wide geographical area. For the 24weeks ended April 15, 2006, no single customer accounted for more than 10% ofrevenue or 10% of accounts receivable at April 15, 2006.

 

*Goodwilland Intangible Assets*- Statement of Financial Accounting Standards (“SFAS”) No. 142, *Goodwill and Other Intangible Assets*(“SFAS No. 142”)requires that goodwill no longer be amortized but instead be subject to animpairment test performed on an annual basis or whenever events orcircumstances indicate that impairment may have occurred. Intangible assetswith finite lives continue to be amortized over their estimated useful lives.

 

*IncomeTaxes* - We accountfor income taxes by utilizing an asset and liability approach that requiresrecording deferred tax assets and liabilities for the future year consequencesof events that have been recognized in our financial statements or tax returns.As required under SFAS No. 109, *Accounting for IncomeTaxes*, we measure these expected future tax consequences based uponprovisions of tax law as currently enacted. The effects of future changes intax laws are not anticipated. Variations in the actual outcome of these futuretax consequences could materially impact our financial position or our resultsof operations. We also provide a reserve for tax contingencies when we believea probable and estimatable exposure exists.

 

*Reservesfor Contingent Legal and Regulatory Liabilities* - There are various claims,lawsuits and pending actions against Westaff incident to its operations forwhich we have recorded liabilities that we believe are appropriate. We evaluatethis reserve regularly throughout the year and make adjustments as needed. Ifthe actual outcome of these matters is different than expected, an adjustmentis charged or credited to expense in the period the outcome occurs or theperiod in which the estimatechanges.

 

**Accounting Changes**

 

EffectiveOctober 30, 2005, we adopted SFAS No. 123(R)(revised 2004)*Share-Based Payment*using the modified prospective transition method of adoption, which does notrequire restatement of prior periods. This requires us to recognizecompensation expense for stock options granted, restricted stock 

 

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awardsand employee stock purchase shares outstanding, but not yet vested on the dateof adoption and for future stock option and award grants and employee stockpurchase shares. See Note 2, Stock-basedCompensation, in the accompanying notes to the condensed consolidated financialstatements for further information.

 

Forthe 12 weeks ended April 15, 2006, we recorded stock-based compensation expenseof $70,000 ($54,000 net of related incometax benefit), and for the 24 weeks ended April 15, 2006 we recorded $136,000($105,000 net of related income tax benefit). The total compensation costrelated to non-vested stock options and awards not yet recognized is currentlyestimated at $0.3 million over the next two fiscal years.

 

### **Results of Operations - 12weeks ended April 15, 2006 and April 16, 2005**

### ** **

Totalrevenue for the 12 weeks ended April 15, 2006 was $138.6 million, an increaseof 2.3% or $3.1 million over the same period in the prior year. Domestic revenueincreased by 6.0% or $6.2 million driven largely by a 3.9% increase intemporary billed hours, a 1.2% increase in average temporary billing rates anda 151% increase in permanent placement revenue. Our domestic revenue growth isattributable to the investments we continue to make in our field operations,including an increase in our staff assigned to our field offices. Some of theseindividuals are permanent placement consultants, which accounts for thesignificant growth in our permanent placement revenue. Offsetting a portion ofthe domestic revenue growth was a decrease in international revenue of 9.4% or$3.1 million. This decrease was caused by a 6.7% decrease in temporary billedhours partially offset by a 10.9% increase in permanent placement revenue. Thedecrease in billable hours is primarily due to the competitive pressures facedin all three international countries. The increase in permanent placementrevenue is primarily due to a 20.2% increase noted in Australia, attributableto an increase in staff focused on the permanent placement business.

 

Costsof services include hourly wages of temporary employees, employer payrolltaxes, state unemployment, workers’ compensation insurance and other employee-relatedcosts. Costs of services as a percentage of revenue decreased slightly from82.9% in the second quarter of fiscal 2005 to 82.6% in fiscal 2006, primarily asa result of increased permanent placement revenues, which result in few directcosts. Gross profit increased by 4.0% or $0.9 million over the second quarterof fiscal 2005, while the gross profit margin increased from 17.1% in 2005 to17.4% over the same period. Domestic gross profit increased $2.1 million, withgross margin increasing from 16.5% in the fiscal 2005 quarter to 17.4% in fiscal2006, due largely to revenue increases noted above without a correspondingincrease in average pay rates, state unemployment rates and workers’compensation costs, which compose the bulk of costs of services. Further, a $0.7million increase in domestic permanent placement revenue also increased thegross margin, as there are only a small percentage of direct costs associatedwith this revenue. Offsetting a portion of this increase was a $1.2 milliondecrease in international gross profit, due primarily to a $0.5 milliondecrease in the United Kingdom gross profit and a $0.6 million decrease inAustralian gross profit. Competitive pressures noted in both countries causedrevenue declines, and the revenue that was maintained generally produced lowermargins. We have initiatives in place within all our markets to improve thegross margins, which include increasing permanent placement revenue, improvingthe results of underperforming offices and more closely managing direct costs.

 

Franchiseagents’ share of gross profit represents the net distribution paid to franchiseagents based either on a percentage of revenue or gross profit generated by thefranchise agents’ operations. As a percentage of 

 

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consolidatedrevenue, franchise agents’ share of gross profit decreased slightly, from 3.0%of revenue in the 2005 fiscal quarter to 2.9% in the 2006 fiscal quarter.During the second fiscal quarter of 2006, we acquired our Houston, Texasfranchised operations, which is a primary cause of the decrease as a percentageof revenue.

 

Sellingand administrative expenses increased $0.9 million, or 4.7% for the 2006 fiscalquarter as compared to the 2005 quarter. As a percentage of revenue, sellingand administrative expenses were 13.7% for the fiscal 2006 quarter and 13.4%for the fiscal 2005 quarter. The increase is primarily due to increaseddomestic salaries and related expenses resulting from additional staff in ourfield offices. We deliberately increased these personnel as a means to drivemore sales and improve service, and this investment has resulted in theincreased domestic revenue previously noted. As of the end of the secondquarter of fiscal 2006 compared to the end of the second quarter of fiscal2005, we had increased the domestic field staff by 9%. Over half of these fieldstaff additions were in support of our permanent placement service line ofbusiness with the remainder focused on developing the temporary staffingbusiness line. We believe these staff additions represent importantinvestments, which will benefit the seasonally strongest third and fourth fiscalquarters. Following the end of the second fiscal quarter, we implemented areduction in our selling, general and administrative costs, principally byreducing our headcount in support functions, primarily at our corporateheadquarters. These reductions in costs are expected to yield in excess of $1.2million of costs savings on an annualized basis.

 

Depreciationand amortization increased $0.2 million primarily as a result of depreciationand amortization related to the new, domestic business process managementsystem, some modules of which have been placed into service. This new systemhas replaced our former systems for regular staff payroll, human resources,general ledger, purchasing, accounts receivable, and accounts payable. We arestill developing the portion of the system that will replace our existingbilling, temporary payroll and front office systems.

 

Interestexpense decreased $34,000 or 12.1% primarily as a result of decreased averageborrowings during the fiscal 2006 quarter, partially offset by higher averageinterest rates. We had no domestic borrowings under our line of credit at April15, 2006, compared to $6.9 million of short-term borrowings at the close of the2005 second fiscal quarter. Internationally, Australia had $3.9 million ofshort-term borrowings at April 15, 2006 compared to $2.6 million of borrowingsat April 16, 2005, and the United Kingdom had minimal borrowings at April 15,2006 versus $0.8 million outstanding at April 16, 2005.

 

Netloss for the fiscal quarter decreased to $0.3 million from a $0.4 million lossin the same quarter of fiscal 2005, due to decreased interest expense and a taxbenefit in 2006 versus a tax provision in 2005. The tax benefit in the quarteris the result of income tax benefits on pre-tax losses both domestically and inAustralia partially offset by estimated income taxes on income in the UnitedKingdom and New Zealand. Diluted loss per share was $(0.02) in both fiscal yearquarters.

 

### **Results of Operations - 24weeks ended April 15, 2006 and April 16, 2005**

### ** **

Totalrevenue was $277.2 million during the first 24 weeks of fiscal 2006, anincrease of 2.4% or $6.4 million from the same period in 2005. Domestic revenueincreased by 5.3% or $10.9 million driven largely by a 3.7% increase in billedhours, a 0.4% increase in average temporary billing rates and a 125.6% increasein permanent placement revenue. Our domestic revenue growth is attributable toan increase in our staff assigned to our field offices. Some of theseindividuals are permanent placement 

 

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consultants,which account for the significant growth in our permanent placement revenue.Offsetting a portion of the domestic revenue growth was a decrease ininternational revenue of 6.9% or $4.5 million. This decrease was caused by a 6.7%decrease in temporary billed hours partially offset by a 9.6% increase inpermanent placement revenue. The decrease in billable hours is primarily due tothe competitive pressures faced in all three international countries. Theincrease in permanent placement revenue is primarily due to a 43.6% increasenoted in Australia, attributable to an increase in staff focused on thepermanent placement business.

 

Costsof services include hourly wages of temporary employees, employer payrolltaxes, state unemployment and workers’ compensation insurance and otheremployee-related costs. Costs of services as a percentage of revenue decreased marginallyto 82.9% during the first 24 weeks of fiscal 2006 from 83.0% from the sameperiod in 2005. Gross profit increased marginally to 17.1% during the first 24weeks of fiscal 2006 from 17.0% from the same period in 2005. Domestic grossprofit increased by 9.3% or $3.1 million over the first 24 weeks of fiscal2005, while the gross profit margin increased from 16.3% in fiscal 2005 to 16.9%in fiscal 2006, due largely to revenue increases noted above without acorresponding increase in average pay rates, state unemployment rates andworkers’ compensation costs, which comprise the bulk of costs of services.Further, a $1.1 million increase in domestic permanent placement revenue alsoincreased the gross margin, as there are only a small percentage of directcosts associated with this revenue. Offsetting a portion of the domestic grossprofit increase was a $1.8 million decrease in international gross profit, dueprimarily to a $0.8 million decrease in the United Kingdom gross profit as wellas a $0.8 million decrease in Australian gross profit. Competitive pressures inboth countries caused revenue declines, and the revenue that was maintainedgenerally produced lower margins. We have initiatives in place within all ourmarkets to improve gross margins, which include increasing permanent placementrevenue, improving the results of underperforming offices and more closelymanaging direct costs.

 

Franchiseagents’ share of gross profit represents the net distribution paid to franchiseagents based either on a percentage of the sales or gross profit generated bythe franchise agents’ operations. As a percentage of consolidated revenue,franchise agents’ share of gross profit remained stable at 3.0% of revenue for thefirst 24 weeks of fiscal 2006 compared to fiscal 2006 year-to-date.

 

Sellingand administrative expenses increased $2.0 million, or 5.8% for the first 24weeks of fiscal 2006 as compared to the same period in 2005. As a percentage ofrevenue, selling and administrative expenses were 13.3% for the first 24 weeksof fiscal 2006 and 12.9% for the corresponding period in fiscal 2005. Theincrease is primarily due to increased domestic salaries and related expensesresulting from additional staff in our field offices. We deliberately increasedthese personnel as a means to drive more sales and improve service, and thisinvestment has resulted in the increased domestic revenue previously noted. Webelieve these staff additions represent important investments, which willbenefit the seasonally strongest third and fourth fiscal quarters. Followingthe end of the second fiscal quarter, we implemented a reduction in ourselling, general and administrative costs, principally by reducing ourheadcount in support functions, the majority of which are at our corporateheadquarters. These reductions in costs are expected to yield in excess of $1.2million of costs savings on an annualized basis.

 

Depreciationand amortization increased $0.4 million or 22.4% primarily as a result ofdepreciation and amortization related to the new, domestic business processmanagement system, some modules of which have been placed in service. This newsystem has replaced our former systems for regular staff payroll, humanresources, general ledger, purchasing, accounts receivable and accountspayable. We are still 

 

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developingthe portion of the system that will replace our existing billing, temporarypayroll and front office systems.

 

Interestexpense decreased $0.1 million or 17.7% primarily as a result of decreasedaverage borrowings during fiscal 2006 partially offset by higher averageinterest rates. We had no domestic borrowings under our line of credit at April15, 2006, compared to $6.9 million of short-term borrowings at the close of the2005 second fiscal quarter. Internationally, Australia had $3.9 million ofshort-term borrowing at the close of the second fiscal quarter of 2006 comparedto $2.6 million at the close of the 2005 second fiscal quarter, and the UnitedKingdom had minimal short-term borrowings compared to $0.8 million outstandingat April 15, 2005.

 

Netloss was $0.7 million for the first 24 weeks of fiscal 2006 compared to netincome of $0.1 million for the first 24 weeks of fiscal 2005, due to the decreasesin operating income discussed previously, partially offset by decreasedinterest expense and a tax benefit in 2006 versus a tax provision in 2005. Thetax benefit for the 24 weeks ended April 15, 2006, is the result of income taxbenefits on pre-tax losses both domestically and in Australia partially offsetby estimated income taxes on income in the United Kingdom and New Zealand. Forthe first 24 weeks of fiscal 2006, there was a diluted loss per share of $(0.04)compared to diluted earnings of $0.01 for the same fiscal period of 2005.

 

**Liquidityand Capital Resources**

 

**CashFlows from Operating Activities**

 

Werequire significant amounts of working capital to operate our business and topay expenses relating to employment of our temporary associates. Ourtraditional use of cash is for financing our accounts receivable, particularlyduring periods where sales are seasonally high. Our temporary associates aregenerally paid on a weekly basis; we bill our customers on a daily basis whilepayments from customers are generally received between 30 and 60 days afterbilling. Consequently, from time to time we may experience negative cash flowfrom operations.

 

Ourcash position of $6.7 million at April 15, 2006, increased by $3.7 million overOctober 29, 2005. The increase in cash is due primarily to net cash provided byoperating activities of $12.9 million, partially offset by capitalexpenditures, repayments under our line of credit agreements and payments forthe purchase of affiliate operations.

 

Netcash provided by operating activities was $12.9 million for the 24 weeks endedApril 15, 2006. Reduced cash outflows for the fiscal 2006 workers’ compensationprogram combined with significantly higher accounts receivable collections morethan offset the net loss for the 24 weeks.

 

Duringthe 24 weeks ended April 15, 2006, cash used for capital expenditures wasprimarily for the business process management system implementation, additionalcomputer software and hardware and office furniture and equipment. Theseexpenditures aggregated to $2.9 million during that period. Currently, weanticipate total capital expenditures to be $6.0 million to $7.0 million forfiscal year 2006.

 

OnJanuary 23, 2006, we acquired our Houston franchise operation, consisting of twobranch offices. The purchase price was $1.5 million in cash plus a contingentearn-out payment based on the gross profit of 

 

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theoperations. The earn-out period concludes on September 30, 2006, and theestimated contingent payment is expected to be between $1.7 million and $2.3million.

 

**CapitalResources**

 

In May 2002, we entered into agreements with GE Capital, as primaryagent, to provide senior secured credit facilities totaling $65.0 million,expiring in May 2007. The facilities comprise a five-year syndicatedMulticurrency Credit Agreement consisting of a $50.0 million U.S. RevolvingLoan Commitment, a £2.7 million U.K. Revolving Loan Commitment (U.S. dollarequivalent of approximately $4.0 million at the date of the agreement), and a$5.0 million term loan (the “Term Loan”), which was repaid during fiscal 2003.In addition, a five-year Australian dollar facility agreement (the “A$ FacilityAgreement”) was executed on May 16, 2002, consisting of an A$12.0 millionrevolving credit facility (U.S. dollar equivalent of approximately $6.0 millionat the date of the agreement). Each agreement includes a letter of creditsub-facility. Letters of credit under the agreements expire one year from dateof issuance, but are automatically renewed for one additional year unlesswritten notice is given to or from the holder.

 

The credit facilities are secured by substantially all of the assets ofthe Company. GE Capital, in its role as primary agent under the credit facilities,has sole dominion and control over our primary domestic, United Kingdom andAustralian cash receipts accounts. Cash receipts into these accounts areapplied against our respective outstanding obligations under the facilities,with additional borrowings under the revolving facilities directed into ourdisbursement accounts.

 

Effective March 1, 2006, we executed aneighth amendment to the Multicurrency Credit Agreement. Among other things, theamendment reset minimum EBITDA covenants for fiscal 2006 and beyond, adjustedthe fixed charge coverage ratio for the second quarter of fiscal 2006, extendedthe credit facility for one additional year and added an additional pricinggrid that will allow us to benefit from reduced interest rates and letter ofcredit fees upon achieving certain minimum EBITDA targets. Additionally, theamendment increased the maximum amount of the facility by $5.0 million to $55.0million and increased the letter of credit sub-facility limit from $40.0million to $45.0 million. We had not been in compliance with the minimum EBITDAcovenant as of the end of the first quarter of fiscal 2006, and this amendmentincluded a waiver of this covenant violation. We are currently in compliancewith all covenants related to the Multicurrency Credit Agreement.

 

Asof April 15, 2006, we had $3.9 million outstanding under our Multicurrency CreditAgreement, substantially all of which was attributable to borrowings under theAustralian revolving credit facility. We had consolidated available borrowingcapacity of $15.2 million consisting of $6.4 million for the domesticoperations, $4.0 million for the United Kingdom operations and $4.8 million forthe Australian operations.

 

Wehave an unsecured subordinated promissory note payable to our principalstockholder and Chairman of the Board of Directors in the amount of $2.0million with a maturity date of August 18, 2007, and an interest rate equal toan indexed rate as calculated under our credit agreement plus seven percent,compounded monthly and payable 60 calendar days after the end of each of thefiscal quarters. The interest rate in effect on April 15, 2006 was 14.75%.Payment of interest is contingent on our meeting minimum availabilityrequirements as stated in the credit agreement. Additionally, payments ofprincipal or interest are prohibited in the event of any default under thecredit agreement.

 

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Ourcurrent ratio increased to 1.8 from 1.7 when comparing the April 15, 2006 balancesheet to the October 29, 2005 balance sheet, a reflection of higher cash andcash equivalents coupled with lower short-term borrowings.

 

We work to balance our worldwide cash needsthrough dividends from and loans to our international subsidiaries. These loansand dividends are limited by the immediate future cash availability and needsof each respective subsidiary, restrictions imposed by the senior secured debtfacilities and, in some cases, statutory regulations of the subsidiary. The domesticoperations cannot directly draw on the excess borrowing availability of the UnitedKingdom or Australian operations, however, we may request dividends from our UnitedKingdom subsidiary. We can also request repayments on intercompany balances duefrom our international subsidiaries, subject to their cash flow needs andregulatory restrictions. During the second fiscal quarter, $0.5 million waspaid to us by our international operations in the form of intercompany interestand royalties.

 

Weare responsible for paying workers’ compensation costs for our temporary andregular employees and are self-insured for the deductible amount related toworkers’ compensation claims ($500,000 per claim for fiscal years 2005 and2006). We are required by our insurance carriers to collateralize our potentialworkers’ compensation liabilities through the use of irrevocable standbyletters of credit, surety bonds or cash.

 

Asof April 15, 2006, we had outstanding $35.3 million of letters of credit tosecure all outstanding obligations under our workers’ compensation program forall years except 2003, which has been fully funded subject to annualretroactive premium adjustments based on actual claims activity. Under certaincircumstances, we may be required to increase our letters of credit to $40.0million. We will also have to make ongoing cash payments for claims for allother open policy years.

 

Underthe terms of our fiscal 2006 policy year insurance program, we are required tomake total cash payments of $4.9 million during fiscal 2006 in equal monthlyinstallments, which commenced on November 1, 2005. Cash payments for 2006policy year claims will be paid directly by us.

 

Fromtime to time, we have generated cash through the sales of Company-owned officesto franchise owners or sales of territorial rights to a franchisee.

 

Wehave no material, unrecorded commitments, losses, contingencies or guaranteesassociated with any related parties or unconsolidated entities.

 

Managementbelieves that current liquid assets, the funds anticipated to be generated fromoperations and borrowing capacity available under our credit agreement will besufficient to meet our working capital needs for the foreseeable future.

 

**Operating Activities**

 

Ourworking capital position was $39.9 million at the end of the second fiscalquarter of 2006, compared to $40.6 million at October 29, 2005.

 

DaysSales Outstanding (“DSO,” a measure of how quickly accounts receivable arecollected) decreased domestically to 41.6 days as compared to 44.7 days as ofOctober 29, 2005. Internationally, DSO 

 

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decreasedto 44.9 days as compared to 55.0 days as of October 29, 2005. Consolidatedaccounts receivable decreased by $13.7 million or 16.4% net of the allowancefor doubtful accounts, reflecting the seasonality of our business coupled withthe impact of lower DSO.

 

**Discontinued Operations**

 

OnJune 15, 2005, we sold our Norway and Denmark subsidiary operations toPersonalhuset AS, a recruitment and staffing company headquartered in Norway.Net proceeds from the sale were approximately $2.7 million. Additionally, as apart of the sale transaction, Westaff Norway repaid approximately $0.6 millionof intercompany debt to Westaff US. Of the total proceeds, approximately $0.2million is being held in an interest bearing escrow account as security forpotential Westaff Norway pension claims. The escrowed funds, net of any claimpayments, will be remitted in June 2007. We recorded a net gain on the sale of$1.2 million. We have classified the operations as discontinued operations and,accordingly, have segregated the assets, liabilities, revenue and expenses ofthese discontinued operations in the accompanying financial statements andnotes thereto. Cash flows pertaining to discontinued operations are notdisclosed separately in the condensed consolidated statements of cash flows.

 

Asrequired under the terms of the Multicurrency Credit Agreement, the netproceeds from the sale of the Norway and Denmark operations were used to paydown borrowings on our revolving credit facility. Interest expense has beenallocated to these discontinued operations in accordance with EITF 87-24.

 

**Risk Factors**

 

Investingin our securities involves risk. The following risk factors, issues anduncertainties should be considered when evaluating our future prospects. Inparticular, please consider these risk factors when reading “forward-looking”statements which appear throughout this report. Forward-looking statementsrelate to our expectations for future events and time periods. Generally, wordssuch as “expect,” “intend,” “anticipate” and similar expressions identifyforward-looking statements. Each of these forward-looking statements involvesrisks and uncertainties, and future events and circumstances could differsignificantly from those anticipated in the forward-looking statements. Any oneof the following risks could harm our operating results or financial conditionand could result in a significant decline in value of an investment in us.Further, additional risks and uncertainties that have not yet been identifiedor which we currently believe are immaterial may also harm our operatingresults and financial condition.

 

**Pricecompetition in the staffing industry continues to be intense, and pricingpressures from both competitors and customers could adversely impact ourfinancial results.**

 

Thestaffing industry is highly competitive with limited barriers to entry andcontinues to undergo consolidation. We compete in regional and local marketswith large full service agencies, specialized temporary and permanent placementservices agencies and small local companies. While some competitors are smallerthan us, they may enjoy an advantage in discrete geographic markets because ofa stronger local presence. Other competitors have greater marketing, financialand other resources than us that, among other things, could enable them toattempt to maintain or increase their market share by reducing prices.Furthermore, in past years there has been an increase in the number ofcustomers consolidating their staffing services purchases with a singleprovider or with a small number of 

 

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providers.The trend to consolidate staffing services purchases has in some cases made itmore difficult for us to obtain or retain business.

 

Weexpect the level of competition to remain high in the future, and competitivepricing pressures will continue to make it difficult for us to raise our pricesto immediately and fully offset increased costs of doing business, includingincreased labor costs, costs for workers’ compensation and state unemploymentinsurance. If we are not able to effectively compete in our targeted markets,our operating margins and other financial results will be harmed and the priceof our securities could decline.

 

**Workers’compensation costs for temporary employees may continue to rise and reducemargins and require more liquidity.**

 

In the United States, we are responsible for and payworkers’ compensation costs for our regular and temporary employees. In recentyears, these costs have risen substantially as a result of increased claims,general economic conditions and governmental regulations. To date in fiscal2006, the increase in the volume of claims has fallen despite an increase inour domestic revenue, yet the increases in cost per claim have continued. Underour workers’ compensation insurance program, we maintain “per occurrence”insurance, which only covers claims for a particular event above a $500,000deductible. Our workers’ compensation insurance expires November 1, 2007, andwe cannot guarantee that we will be able to successfully renew such policy.Further, there are covenants associated with the continuation of the policy andthere can be no guarantee that we will continue to meet those covenants goingforward. 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.

 

**The amount of collateral that we are required to maintain to supportour workers’ compensation obligations could increase, reducing the amount ofcapital that we have available to support and grow our field operations.**

 

We are contractually obligated to collateralize ourworkers’ compensation obligations under our workers’ compensation programthrough irrevocable letters of credit, surety bonds or cash. As of April 15,2006, our aggregate collateral requirements under these contracts have beensecured through $35.3 million of letters of credit; however under certaincircumstances, such as an inability to maintain minimum borrowing availability,we could be required to increase our letters of credit to $40 million. Further,our workers’ compensation program expires November 1, 2007, and as part of therenewal could be subject to an increase in collateral. These collateralrequirements are significant and place pressure on our liquidity and workingcapital capacity. We believe that our current sources of liquidity are adequateto satisfy our immediate needs for these obligations; however, our availablesources of capital are limited. Depending on future changes in collateralrequirements, we could be required to seek additional sources of capital in thefuture, which may not be available on commercially reasonable terms.

 

**Our reserves for workers’ compensation claims may be inadequate tocover our ultimate liability, and we may incur additional charges if the actualamounts 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 

 

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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.

 

**We have significant workingcapital requirements and are heavily dependent upon our ability to borrow moneyto meet these working capital requirements.**

 

We require significant amounts of working capital tooperate our business and to pay expenses relating to employment of temporaryemployees. Temporary personnel are generally paid on a weekly basis whilepayments from customers are generally received 30 to 60 days after billing. Asa result, we must maintain sufficient cash availability to pay temporarypersonnel prior to receiving payment from customers.

 

We finance our operations primarily throughborrowings under our revolving credit facilities and also through cashgenerated by our operating activities. As of April 15, 2006, our totalborrowing capacity was $15.2 million consisting of $6.4 million for thedomestic operations, $4.0 million for the United Kingdom operations and $4.8million for the Australian operations.

 

The amount we are entitled to borrow under ourrevolving credit facilities is calculated daily and is dependent on eligibletrade accounts receivable generated from operations, which are affected byfinancial, business, economic and other factors, as well as by the daily timingof cash collections and cash outflows. If we experience a significant andsustained drop in operating profits, or if there are unanticipated reductionsin cash inflows or increases in cash outlays, we may be subject to cashshortfalls. If such a shortfall were to occur for even a brief period of time,it may have a significant adverse effect on our business. Furthermore, ourreceivables may not be adequate to allow for borrowings for other corporatepurposes, such as capital expenditures or growth opportunities, and we would beless able to react to changes in the market or industry conditions.

 

The credit facilities contain covenants which, amongother things, require us to maintain a minimum fixed charge coverage ratio andminimum earnings before interest, taxes, depreciation and amortization (“EBITDA”).We have, in the past, failed to comply with certain of these covenants and havebeen required to obtain a waiver or an amendment to the credit agreement fromour lenders. Any future failure to comply with the covenants under our creditfacilities could result in an event of default which, if not cured or waived,could trigger prepayment obligations. If we were forced to refinance borrowingsunder the current facilities, there can be no assurance that such financingwould be available or that such financing would not have a material adverseeffect on our business and financial condition. Even if such refinancing wereavailable, the terms could be less favorable and our results of operations andfinancial condition could be adversely affected by increased costs and rates.

 

We typically experience significant seasonal andother fluctuations in our borrowings and borrowing availability, particularlyin the United States, and have, in the past, been required to aggressivelymanage our cash to ensure adequate funds to meet working capital requirements.Such steps included working to improve collections and adjusting the timing ofcash expenditures, reducing operating expenses where feasible and working togenerate cash from a variety of other sources.

 

We have historically experienced periods of negativecash flow from operations and investment activities, especially during seasonalpeaks in revenue experienced in the third and fourth fiscal quarters of theyear. In addition, we are required to pledge amounts to secure letters ofcredit that collateralize 

 

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certain workers’ compensation obligations, and theseamounts may increase in future periods. Any such increase in pledged amounts orsustained negative cash flows would decrease amounts available for workingcapital purposes and could have an adverse effect on our liquidity andfinancial condition.

 

**We assume the obligation to make wage, tax, and regulatory payments toour temporary employees and are then exposed to accounts receivable risks fromour customers.**

 

Wegenerally assume responsibility for and manage the risks associated with ourpayroll obligations, including liability for payment of salaries and wages,payroll taxes as well as group health insurance. These obligations are fixedand become a liability of ours, whether or not the associated client wherethese employees have been assigned makes payments required by our serviceagreement, which exposes us to credit risks. We attempt to mitigate this riskby 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. Finally, the majority of ouraccounts receivable is used to secure our revolving credit facilities, which werely on for liquidity. If we fail to adequately manage our credit risksassociated with accounts receivable, our financial position could be adverselyimpacted.

 

**Any significant economic downturn could result in our customers usingfewer staffing services, which could materially adversely affect our business.**

 

Demand for staffing services is significantlyaffected by the general level of economic activity. As economic activity slows,many customers reduce their utilization of temporary employees beforeundertaking layoffs of their regular full-time employees. Further, demand forpermanent placement services also slows as the labor pool directly available toour customers increases, making it easier for them to identify new employeesdirectly. Typically, we may experience increased pricing pressures from otherstaffing companies during periods of economic downturn, which could have amaterial adverse effect on our financial condition. The domestic economicrecession of 2001 and 2002 did have a material adverse effect on our business.Additionally, in geographic areas where we derive a significant amount ofbusiness, a regional or localized economic downturn could adversely affect ouroperating results and financial position.

 

**The cost of unemploymentinsurance for temporary employees may rise and reduce our margins.**

 

In the United States, we are responsible for and payunemployment insurance premiums for our temporary and regular employees. Inrecent years, these costs have risen as a result of increased claims, generaleconomic conditions and government regulations. Should these costs continue toincrease, there can be no assurance that we will be able to increase the feescharged to our customers in the future to keep pace with the increased costs,and if we do not, our results of operations and liquidity could be adverselyaffected.

 

**We derive a significant portion of our revenue from franchise agentoperations.**

 

Franchise agent operations comprise a significantportion of our revenue. For the first twenty-four weeks of 2006, 28.9% of ourtotal revenue was derived from franchise agent operations. In addition, our tenlargest franchise agents for the first twenty-four weeks of fiscal 2006 (basedon sales volume) accounted for 18.0% of our revenue. There can be no assurancesthat we will be able to attract new franchisees or that we will be able toretain our existing franchisees. The loss of one or more of our franchiseagents and 

 

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any associated loss of customers and sales couldhave a material adverse effect on our results of operations.

 

**We aresubject to business risks associated with international operations andfluctuating exchange rates.**

 

We presently have operations in the United Kingdom,Australia and New Zealand, which comprised 21.8% of our revenue during thefirst twenty-four weeks of fiscal 2006. Operations in foreign markets areinherently subject to certain risks, including in particular:

 

•                  differentcultures and business practices,

•                  overlapping ordiffering tax structures,

•                  economic andpolitical uncertainties,

•                  complianceissues associated with accounting and reporting requirements, and

•                  changing,complex or ambiguous foreign laws and regulations, particularly as they relateto employment.

 

All of our sales outside of the United States aredenominated in local currencies and, accordingly, we are subject to risksassociated with fluctuations in exchange rates, which could cause a reductionin our profits. There can be no assurance that any of these factors will nothave a material adverse effect on our business, results of operations, cashflows or financial condition.

 

**The loss ofany of our key personnel could harm our business.**

 

Ourfuture financial performance is significantly impacted by our ability toattract, motivate and retain key management personnel including our ChiefExecutive Officer and other members of the senior management team. Competitionfor qualified management personnel is very competitive and in the event that weexperience further turnover in senior management positions, we cannot assureyou that we will be able to recruit suitable replacements on a timely basis. Wemust also successfully integrate all new management and other key positionswithin our organization to achieve our operating objectives. Even if we aresuccessful, turnover in key management positions could temporarily harm ourfinancial performance and results of operations until the new managementbecomes familiar with our business.

 

**Oursuccess is impacted by our ability to attract and retain qualified temporaryand permanent personnel.**

 

Wecompete with other staffing services to meet our customers’ needs, and we mustcontinuously attract reliable candidates to meet the staffing requirements ofour customers. Consequently, we must continuously evaluate and upgrade our baseof available qualified personnel to keep pace with changing customer needs andemerging technologies. Furthermore, a substantial number of our temporary employeesduring any given year will terminate their employment with us and acceptregular staff employment with our customers. Competition for individuals withproven skills remains intense, and demand for these individuals is expected toremain strong for the foreseeable future. There can be no assurance thatqualified personnel will continue to be available to us in sufficient numbersand on acceptable terms to us. The failure to identify, recruit, train andplace candidates as well as retain qualified temporary employees over a longperiod of time could materially adversely affect our business.

 

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**Our service agreements may be terminated on short notice,leaving us vulnerable to loss of a significant amount of customers in a shortperiod of time.**

 

Ourservice agreements are generally cancellable on 30-days notice by the customer tous. As a result, our customers can terminate their agreement with us at anytime, making us particularly vulnerable to a significant decrease in revenuewithin a short period of time that could be difficult to quickly replace.

 

**Our information technology systemsare critical to the operations of our business.**

 

Our domestic information management systems areessential for data exchange and operational communications with branches spreadthroughout the United States. We have replaced key component hardware andsoftware including backup systems within the past twelve months and arecurrently working towards replacing further key components over the next twelveto eighteen months. Any interruption, impairment or loss of data integrity ormalfunction of these systems could severely impact our business; especially ourability to timely and accurately pay employees and bill customers. Further, anysignificant delay in our plans to replace the remaining key components couldadversely affect the business. Issues with either require that we commitsignificant additional capital as well as management resources in order toresolve the interruption or delay.

 

**We may beexposed to employment-related claims and costs that could materially adverselyaffect our business.**

 

Weare in the business of employing people and placing them in the workplace ofother businesses on either a temporary or permanent basis. As a result, we aresubject to a large number of laws and regulations relating to employment. Therisks related to engaging in such business include but are not limited to:

 

•                  potential claims of discrimination andharassment,

•                  violations of health and safety, wage andhour laws,

•                  immigration related claims,

•                  criminal activity, and

•                  claims relating to actions by customersincluding misuse of proprietary information and misappropriation of assets.

 

Inaddition, some or all of these claims may give rise to litigation, which couldbe time-consuming to our management team, and therefore, could have a negativeeffect on our business. In some instances, we have agreed to indemnify ourcustomers against some or all of these types of liabilities. We have policiesand guidelines in place to help reduce our exposure to these risks and havepurchased insurance policies against certain risks in amounts that we currentlybelieve to be adequate. However, there can be no assurance that our insurancewill be sufficient in amount or scope to cover these types of liabilities orthat we will be able to secure insurance coverage for such risks on affordableterms. Furthermore, there can be no assurance that we will not experience theseissues in the future or that they could have a material adverse effect on ourbusiness.

 

**Our Founder and Chairman controls a significant amount of ouroutstanding stock thus allowing him to exert significant influence on ourmanagement and affairs.**

 

Our Chairman and Founder, W. Robert Stover,beneficially owns directly or indirectly, or has voting power over, in excessof 38% of our outstanding stock. As the principal stockholder of Westaff, 

 

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Mr. Stover has the ability to materiallyinfluence all matters submitted to the stockholders for approval and to exertsignificant influence on our management and affairs. For example,Mr. Stover has the ability to sell his shares independently and tostrongly influence the election of the Board of Directors and the appointmentof executive management. He also has the ability to strongly influence anymerger, consolidation, sale of substantially all of our assets or otherstrategic decisions affecting us or the market value of the stock. Thisconcentration of stock and voting power could be used by Mr. Stover todelay or prevent an acquisition of Westaff or other strategic action or resultin strategic decisions that could negatively impact the value and liquidity ofthe outstanding stock.

 

**The market for our stock may be limited, and the stock price maycontinue to be extremely volatile.**

 

The average daily trading volume for our commonstock on the Nasdaq National Market was approximately 33,000 shares fromJanuary 1, 2006, through April 15, 2006. Accordingly, the marketprice of our common stock is subject to significant fluctuations that havebeen, and may continue to be, exaggerated because an active trading market hasnot developed for the stock. We believe that the common stock price has alsobeen negatively affected by the fact that our stock is thinly traded and alsodue to the absence of analyst coverage. The lack of analyst reports about ourstock may make it difficult for potential investors to make decisions aboutwhether to purchase our stock and may make it less likely that investors willpurchase the stock, thus further depressing the stock price. These negativefactors may make it difficult for stockholders to sell our common stock, whichmay result in losses for investors.

 

**Thecompliance costs associated with Section 404 of the Sarbanes-Oxley Actregarding internal control over financial reporting could be substantial, whilefailure to achieve and maintain compliance could have an adverse effect on ourstock price.**

 

Pursuantto Section 404 of the Sarbanes-Oxley Act of 2002 and current Securities andExchange Commission (“SEC”) regulations, beginning with our Annual Report forthe fiscal year ended November 1, 2008, we expect to be required to furnish areport by our management on our internal control over financial reporting.Further, our external auditors will be required to audit that report andinclude their audit report within the fiscal 2008 Form 10-K. The process offully documenting and testing our internal control procedures in order tosatisfy these requirements will result in increased general and administrativeexpenses and may shift management time and attention from profit-generatingactivities to compliance activities. Furthermore, during the course of ourinternal control testing, we may identify deficiencies which we may not be ableto remediate in time to meet the reporting deadline under Section 404. Failureto achieve and maintain an effective internal control environment or completeour Section 404 certifications could have a material adverse effect on ourstock price.

 

**We area defendant in a variety of litigation and other actions from time to time,which may have a material adverse effect on our business, financial conditionand results of operations.**

 

We are regularly involved in a variety of litigationarising out of our business and, in recent years, have paid significant amountsas a result of adverse arbitration awards. We do not have insurance for some ofthese claims, and there can be no assurance that the insurance coverage we havewill cover all claims that may be asserted against us. Should the ultimatejudgments or settlements not be covered by insurance or exceed our insurancecoverage, they could have a material adverse effect on our results ofoperations, financial position and cash flows. There can also be no assurancethat we will be able to obtain 

 

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appropriate and sufficient types or levels ofinsurance in the future or that adequate replacement policies will be availableon acceptable terms, if at all.

 

**Item 3. Quantitativeand Qualitative Disclosures About Market Risk**

 

We are exposed to certainmarket risks from transactions that are entered into during the normal courseof business. Our primary market risk exposure relates to interest rate risk. AtApril 15, 2006, our outstanding debt under variable-rate interest borrowingswas approximately $5.9 million. A change of two percentage points in theinterest rates would cause a change in interest expense of approximately $0.1 millionon an annual basis. Our exposure to market risk for changes in interest ratesis not significant with respect to interest income, as our investment portfoliois not material to our consolidated balance sheet. We currently have no plansto hold an investment portfolio that includes derivative financial instruments.

 

For the 24 weeks ended April15, 2006, our international operations comprised 21.8% of our revenue and, asof the end of that period, 19.9% of our total assets. We are exposed to foreigncurrency risk primarily due to our investments in foreign subsidiaries. Ourmulticurrency credit facility, which allows our Australian and United Kingdomsubsidiaries to borrow in local currencies, partially mitigates the exchangerate risk resulting from fluctuations in foreign currency denominated netinvestments in these subsidiaries in relation to the U.S. dollar. We do notcurrently hold any market risk sensitive instruments entered into for hedgingtransaction risks related to foreign currencies. In addition, we have notentered into any transactions with derivative financial instruments for tradingpurposes.

 

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

### ** **

TheCompany carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperations of the Company’s “disclosure controls and procedures” (as definedunder Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934,as amended). Based on this evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that, as of April 15, 2006 (the end of the periodcovered by this report) the Company’s disclosure controls and procedures areeffective in timely alerting them to material information required to be publiclyreported. There was no change in the Company’s internal control over financialreporting that occurred during the fiscal period ended April 15, 2006, that hasmaterially affected, or is reasonably likely to materially affect, the Company’sinternal controls over financial reporting.

 

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

 

### **Item 1.**   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 are workers’ compensation, generalliability, automobile liability, property damage, alternative staffing errorsand omissions, fiduciary liability, and fidelity losses.

 

We previously reported aclaim for contribution asserted against Westaff’s Australian subsidiary andseveral other entities by ADI Ltd. The litigation originated in May 1998, whena fire occurred at sea on board an Australian Navy ship. The fire resulted inthe death of four crewmen and extensive damage to the ship. ADI alleged thatthe negligence of a supervisor placed by us with ADI contributed to theaccident. In May 2006, ADI and we agreed to settle ADI’s claim for approximately$37,000, and we believe our insurance coverage will be sufficient to cover thisamount.

 

Otherthan the action listed above, we are not currently a party to any materiallitigation. However, from time to time we have been threatened with, or namedas a defendant in litigation brought by former franchisees or licensees, andadministrative claims and lawsuits brought by former employees. Managementbelieves the resolution of these matters will not have a material adverseeffect on our financial statements.

 

**Item 1A. Risk Factors**

 

The disclosure in thesection above titled “Risk Factors” in Part I Item 2 “Management’s Discussionand Analysis of Financial Condition and Results of Operations” is herebyincorporated by reference.

 

### **Item 2. Unregistered Sales of Equity Securities andUse of Proceeds**

### ** **

Not applicable.

 

### **Item 3. Defaults Upon Senior Securities**

### ** **

Not applicable.

 

### **Item 4. Submission of Matters to a Vote of SecurityHolders**

### ** **

Not applicable.

 

### **Item 5. Other Information**

### ** **

Not applicable.

 

**Item 6. Exhibits**

 

Set forth below is a listof the exhibits included as part of this Quarterly Report:

 
| 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. |

 

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| 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 therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|         | WESTAFF, INC.                                            |
|--------------|----------------------------------------------------------|
|         |                                                     |
|         |                                                     |
| May 30, 2006 |                                                     |   /s/ John P.  Sanders |   |
| Date         |                                                     |    John P.  Sanders |
|         |  Senior Vice President and Chief Financial  Officer |
|              |                                                          |  |  |  |

 

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**EXHIBIT INDEX**

 
| **Exhibit No.** | ** ** | **Description of Document**                                                                                                                   |
|----------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|                 |       |                                                                                                                                                    |
| 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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