##### **UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C.  20549**

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

| **x**      | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934.**                                                                                                                                                     |
|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                                                                                                                                                                        |
| ** ** |       | **For the quarterly period ended January 20, 2007**                                                                                                                                                                                               |
| ** ** |       |                                                                                                                                                                                                                                              |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                     |
| ** ** |       |                                                                                                                                                                                                                                              |
| ** ** |       | **For the transition period  from                 to                 ** |

 

**Commissionfile number 0-24990**

**WESTAFF,INC.**(Exact name of registrant as specified in its charter)

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

 

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

##### **Walnut Creek, California  94598-2453**

##### (Address ofregistrant’s principal executive offices)

 

**(925) 930-5300**

(Registrant’s telephonenumber)

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 x    No o

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

Large accelerated file o   Acceleratedfiler o   Non-accelerated filer x

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).    Yes o    No x

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

| Class                          | ** ** | **Outstanding at March 2, 2007** |
|--------------------------------|------------|----------------------------------|
|                           |       |                             |
| Common Stock,  $0.01 par value |       | 16,609,603  shares               |

 

 

----

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

**INDEX**
|              | ** ** | ** **                                                                                               | ** ** | **PAGE** |
|--------------|------------|----------------------------------------------------------------------------------------------------------|------------|----------|
|         |       |                                                                                                     |       |     |
| **Part I.**  | ** ** | **Financial Information**                                                                                | ** ** |     |
|         |       |                                                                                                     |       |     |
| Item 1.      |       | Financial Statements  (Unaudited)                                                                        |       |     |
|         |       |                                                                                                     |       |     |
|         |       | Condensed  Consolidated Balance Sheets - January 20, 2007 and October 28, 2006                           |       | 3        |
|         |       |                                                                                                     |       |     |
|         |       | Condensed  Consolidated Statements of Operations - 12 weeks ended January 20, 2007 and  January 21, 2006 |       | 4        |
|         |       |                                                                                                     |       |     |
|         |       | Condensed  Consolidated Statements of Cash Flows - 12 weeks ended January 20, 2007 and  January 21, 2006 |       | 5        |
|         |       |                                                                                                     |       |     |
|         |       | Notes to  Condensed Consolidated Financial Statements                                                    |       | 6        |
|         |       |                                                                                                     |       |     |
| Item 2.      |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations              |       | 12       |
|         |       |                                                                                                     |       |     |
| Item 3.      |       | Quantitative  and Qualitative Disclosures About Market Risk                                              |       | 19       |
|         |       |                                                                                                     |       |     |
| Item 4.      |       | Controls and  Procedures                                                                                 |       | 19       |
|         |       |                                                                                                     |       |     |
| **Part II.** | ** ** | **Other Information**                                                                                    | ** ** |     |
|         |       |                                                                                                     |       |     |
| Item  1.     |       | Legal  Proceedings                                                                                       |       | 20       |
|         |       |                                                                                                     |       |     |
| Item  1A.    |       | Risk  Factors                                                                                            |       | 20       |
|         |       |                                                                                                     |       |     |
| Item 2.      |       | Unregistered  Sales of Equity Securities and Use of Proceeds                                             |       | 27       |
|         |       |                                                                                                     |       |     |
| Item 3.      |       | Defaults Upon  Senior Securities                                                                         |       | 27       |
|         |       |                                                                                                     |       |     |
| Item 4.      |       | Submission of  Matters to a Vote of Security Holders                                                     |       | 27       |
|         |       |                                                                                                     |       |     |
| Item  5.     |       | Other  Information                                                                                       |       | 27       |
|         |       |                                                                                                     |       |     |
| Item  6.     |       | Exhibits                                                                                                 |       | 27       |
|         |       |                                                                                                     |       |     |
|         |       | Signatures                                                                                               |       | 29       |

                                                

----

**Part l.  Financial Information**

**Item 1.  Financial Statements**

**Westaff, Inc.**

**Condensed Consolidated Balance Sheets (Unaudited)**
| ** **                                                                                                                                                       | ** ** | **January 20,**                | ** ** | **October 28,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|----------------------|------------|
| ** **                                                                                                                                                       | ** ** | **2007**                            | ** ** | **2006**             | ** ** |
| ** **                                                                                                                                                       | ** ** | **(In thousands, except** | ** ** |
| ** **                                                                                                                                                       | ** ** | **per share amounts)**    | ** ** |
| **ASSETS**                                                                                                                                                       | ** ** | ** **                          | ** ** | ** **           | ** ** |
| Current assets:                                                                                                                                                  |       |                                |       |                 |       |
| Cash and cash  equivalents                                                                                                                                       |       | $                                   | 4,843      |                 | $          | 3,545 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $765 and $811                                                                                |       | 72,899                              |       | 76,267               |       |
| Deferred income  taxes                                                                                                                                           |       | 6,083                               |       | 5,834                |       |
| Prepaid expenses                                                                                                                                                 |       | 4,541                               |       | 4,732                |       |
| Other current  assets                                                                                                                                            |       | 3,153                               |       | 4,694                |       |
| Total current  assets                                                                                                                                            |       | 91,519                              |       | 95,072               |       |
|                                                                                                                                                             |       |                                |       |                 |       |
| Property and equipment,  net                                                                                                                                     |       | 14,783                              |       | 15,046               |       |
| Deferred income taxes                                                                                                                                            |       | 12,420                              |       | 12,404               |       |
| Goodwill                                                                                                                                                         |       | 12,406                              |       | 12,367               |       |
| Intangible assets                                                                                                                                                |       | 3,420                               |       | 3,425                |       |
| Other long-term assets                                                                                                                                           |       | 1,116                               |       | 951                  |       |
| Total Assets                                                                                                                                                     |       | $                                   | 135,664    |                 | $          | 139,265 |   |
|                                                                                                                                                             |       |                                |       |                 |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                   | ** ** | ** **                          | ** ** | ** **           | ** ** |
| Current liabilities:                                                                                                                                             |       |                                |       |                 |       |
| Borrowing under  revolving credit facilities                                                                                                                     |       | $                                   | 4,890      |                 | $          | 4,790 |   |
| Current portion  of capital lease obligations                                                                                                                    |       | 358                                 |       | 345                  |       |
| Note payable to  related party                                                                                                                                   |       | 2,000                               |       | 2,000                |       |
| Accounts payable                                                                                                                                                 |       | 4,837                               |       | 5,245                |       |
| Accrued expenses                                                                                                                                                 |       | 35,346                              |       | 39,695               |       |
| Income taxes  payable                                                                                                                                            |       | 1,177                               |       | 1,105                |       |
| Total current  liabilities                                                                                                                                       |       | 48,608                              |       | 53,180               |       |
|                                                                                                                                                             |       |                                |       |                 |       |
| Long-term capital lease  obligations                                                                                                                             |       | 745                                 |       | 833                  |       |
| Other long-term  liabilities                                                                                                                                     |       | 19,293                              |       | 19,243               |       |
| Total  liabilities                                                                                                                                               |       | 68,646                              |       | 73,256               |       |
|                                                                                                                                                             |       |                                |       |                 |       |
| Commitments and  contingencies                                                                                                                                   |       |                                |       |                 |       |
|                                                                                                                                                             |       |                                |       |                 |       |
| Stockholders’ equity:                                                                                                                                       |       |                                |       |                 |       |
| Preferred stock,  $0.01 par value; authorized and unissued: 1,000,000 shares                                                                                     |       |                                |       |                 |       |
| Common stock,  $0.01 par value; authorized: 25,000,000 shares; issued and outstanding:  16,595,920 shares at January 20, 2007 and 16,561,520 at October 28, 2006 |       | 166                                 |       | 166                  |       |
| Additional  paid-in capital                                                                                                                                      |       | 38,776                              |       | 38,617               |       |
| Retained  earnings                                                                                                                                               |       | 27,674                              |       | 27,270               |       |
| Accumulated  other comprehensive income (loss)                                                                                                                   |       | 402                                 |       | (44                  | )          |
| Total stockholders’  equity                                                                                                                                 |       | 67,018                              |       | 66,009               |       |
| Total Liabilities and  Stockholders’ Equity                                                                                                                 |       | $                                   | 135,664    |                 | $          | 139,265 |   |

 

See accompanying notes tocondensed consolidated financial statements.

3

----

**Westaff, Inc.**

**Condensed Consolidated Statements of Operations(Unaudited)**
| ** **                                     | ** ** | **12 Weeks Ended**                                          | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                     | ** ** | **January 20,**                                                  | ** ** | **January 21,** | ** ** |
| ** **                                     | ** ** | **2007**                                                              | ** ** | **2006** | ** ** |
| ** **                                     | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                           |       |                                                                  |       |   |   |
| Revenue                                        |       | $                                                                     | 129,949    |   | $ | 138,600 |   |
|                                           |       |                                                                  |       |   |   |
| Costs of  services                             |       | 107,032                                                               |       | 115,363 |   |
|                                           |       |                                                                  |       |   |   |
| Gross profit                                   |       | 22,917                                                                |       | 23,237 |   |
|                                           |       |                                                                  |       |   |   |
| Franchise agents’  share of gross profit  |       | 3,539                                                                 |       | 4,333 |   |
| Selling and  administrative expenses           |       | 17,810                                                                |       | 17,957 |   |
| Depreciation and  amortization                 |       | 915                                                                   |       | 1,169 |   |
|                                           |       |                                                                  |       |   |   |
| Operating income  (loss)                       |       | 653                                                                   |       | (222 | ) |
|                                           |       |                                                                  |       |   |   |
| Interest expense                               |       | 319                                                                   |       | 309 |   |
| Interest income                                |       | (35                                                                   | )          | (18 | ) |
|                                           |       |                                                                  |       |   |   |
| Income (loss)  before income taxes             |       | 369                                                                   |       | (513 | ) |
| Income tax  benefit                            |       | (35                                                                   | )          | (117 | ) |
|                                           |       |                                                                  |       |   |   |
| Net income  (loss)                             |       | $                                                                     | 404        |   | $ | (396 | ) |
|                                           |       |                                                                  |       |   |   |
| Earnings (loss)  per share:                    |       |                                                                  |       |   |   |
| Basic and  diluted                             |       | $                                                                     | 0.02       |   | $ | (0.02 | ) |
|                                           |       |                                                                  |       |   |   |
| Weighted average  shares outstanding - basic   |       | 16,590                                                                |       | 16,378 |   |
| Weighted average shares  outstanding - diluted |       | 16,658                                                                |       | 16,378 |   |

 

See accompanying notes tocondensed consolidated financial statements.

4

----

**Westaff,Inc.**

**CondensedConsolidated Statements of Cash Flows (Unaudited)**
| ** **                                                                                | ** ** | **12 Weeks Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------------|------------|
| ** **                                                                                | ** ** | **January 20,**         | ** ** | **January 21,** | ** ** |
| ** **                                                                                | ** ** | **2007**                     | ** ** | **2006** | ** ** |
| ** **                                                                                | ** ** | **(In thousands)**      | ** ** |
| **Cash  flows from operating activities**                                                 | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                        |       | $                            | 404        |   | $ | (396 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |                         |       |   |   |
| Depreciation and  amortization                                                            |       | 915                          |       | 1,169 |   |
| Stock-based  compensation                                                                 |       | 41                           |       | 66 |   |
| Provision for  losses on doubtful accounts                                                |       | (28                          | )          | 207 |   |
| Amortization of  deferred gain on sale-leaseback                                          |       | (172                         | )          | (172 | ) |
| Amortization of  debt issuance costs                                                      |       | 75                           |       | 91 |   |
| Deferred income  taxes                                                                    |       | (244                         | )          | 1 |   |
| Amortization of  deferred gain from sales of affiliate operations                         |       | (42                          | )          | (48 | ) |
| Loss on sale or  disposal of assets                                                       |       | 2                            |       | 12 |   |
| Changes in  assets and liabilities:                                                       |       |                         |       |   |   |
| Trade accounts  receivable                                                                |       | 3,978                        |       | 8,132 |   |
| Other assets                                                                              |       | 1,630                        |       | 2,256 |   |
| Accounts payable  and accrued expenses                                                    |       | (4,624                       | )          | (4,427 | ) |
| Income taxes  payable                                                                     |       | 69                           |       | (264 | ) |
| Other  liabilities                                                                        |       | 258                          |       | (20 | ) |
|                                                                                      |       |                         |       |   |   |
| Net cash  provided by operating activities                                                |       | 2,262                        |       | 6,607 |   |
|                                                                                      |       |                         |       |   |   |
| **Cash  flows from investing activities**                                                 | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Capital  expenditures                                                                     |       | (906                         | )          | (1,787 | ) |
| Payments for the  purchase of affiliate operations                                        |       | (140                         | )          | — |   |
| Proceeds from  sales of affiliate operations                                              |       | 10                           |       | 10 |   |
| Other, net                                                                                |       | 17                           |       | (337 | ) |
|                                                                                      |       |                         |       |   |   |
| Net cash used in  investing activities                                                    |       | (1,019                       | )          | (2,114 | ) |
|                                                                                      |       |                         |       |   |   |
| **Cash  flows from financing activities**                                                 | ** ** | ** **                   | ** ** | ** ** | ** ** |
| Net repayments under  line of credit agreements                                           |       | (45                          | )          | (3,857 | ) |
| Principal  payments on capital lease obligations                                          |       | (75                          | )          | (66 | ) |
| Payment of debt  issuance costs                                                           |       | (61                          | )          | — |   |
| Proceeds from  the issuance of common stock                                               |       | 117                          |       | — |   |
|                                                                                      |       |                         |       |   |   |
| Net cash used in  financing activities                                                    |       | (64                          | )          | (3,923 | ) |
|                                                                                      |       |                         |       |   |   |
| Effect of  exchange rate changes on cash                                                  |       | 119                          |       | (8 | ) |
|                                                                                      |       |                         |       |   |   |
| Net change in  cash and cash equivalents                                                  |       | 1,298                        |       | 562 |   |
| Cash and cash  equivalents at beginning of period                                         |       | 3,545                        |       | 3,014 |   |
| Cash and cash  equivalents at end of period                                               |       | $                            | 4,843      |   | $ | 3,576 |   |

 

See accompanying notes tocondensed consolidated financial statements.

5

----

**Westaff, Inc.**

**Notes to Condensed Consolidated FinancialStatements (Unaudited)**

**1.****     Basis of Presentation**

The accompanying condensed consolidated financialstatements of Westaff, Inc. and its domestic and foreign subsidiaries(together, the Company), as of January 20, 2007 and for the 12-week periodsended January 20, 2007 and January 21, 2006 are unaudited.

The condensed consolidated financial statements, inthe opinion of management, reflect all adjustments, which are of a normalrecurring nature, necessary for a fair presentation of the financial position,results of operations and cash flows for the periods presented.  The condensed consolidated balance sheet asof October 28, 2006 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 28, 2006.

The Company’s critical accounting policies aredescribed in Item 7 “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and in the notes to the consolidatedfinancial statements in the Company’s previously filed Annual Report on Form10-K for the fiscal year ended October 28, 2006. There were no changes to thesepolicies during the 12-week period ended January 20, 2007. 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 28,2006.

The Company’s fiscal year is a 52 or 53-week periodending the Saturday nearest the end of October. For interim reporting purposes,the first three fiscal quarters comprise 12 weeks each, while the fourth fiscalquarter consists of 16 or 17 weeks. The results of operations for the 12-weekperiod ended January 20, 2007 are not necessarily indicative of the results tobe expected for the full fiscal year or for any future period.

**2.     Stock-Based Compensation**

**Stock options andrestricted stock**.  In April 2006, the Company’s stockholdersapproved the 2006 Stock Incentive Plan to replace the 1996 Stock Option/StockIssuance Plan, which terminated in April 2006. The 2006 Stock Incentive Planprovides for the granting of incentive and nonqualified stock options,restricted stock awards and stock appreciation rights. The 2006 Stock IncentivePlan also provides for the automatic grant of stock options to eachnon-employee director at pre-established times and at a predetermined value.Incentive stock options may be granted at a price not less than 100% of thefair market value of the Company’s common stock at the date of grant. Althoughnonqualified options may be granted at a price not less than 85% of the fairmarket value of the Company’s common stock at the date of grant, the Companyhas historically issued option grants with exercise prices equal to fair marketvalue on the date of grant. The options’ vesting schedules vary subject to theparticipant’s period of future service or to the Company’s or the optionholder’s attainment of designated performance goals, or otherwise at thediscretion of the Board of Directors. Standard vesting is over four years with25% of the options vesting upon completion of one year of service from thevesting commencement date, and the remaining options vesting in 36 equalmonthly installments. No option may have a term in excess of 10 years. As ofJanuary 20, 2007, 20,000 options were outstanding under the 2006 StockIncentive Plan. The Company may grant restricted shares to officers andemployees. The fair value of these shares at the date of grant is expensed on astraight-line basis over the vesting period. No restricted shares have beengranted under the 2006 Stock Incentive Plan.

6

----

**Employee Stock Purchase Plan**.  In July 2006, the Board ofDirectors adopted and approved an amendment and restatement of the Company’s1996 Employee Stock Purchase Plan. The Purchase Plan was bifurcated into theCompany’s Employee Stock Purchase Plan and the Company’s International EmployeeStock Purchase Plan, (together the “Purchase Plans”). Under the Purchase Plans,eligible employees 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 for shares purchased under the PurchasePlans is equal to 90% of the lower of the fair market value at the beginning ofthe purchase period or the fair market value on the last day of the purchaseperiod. The Purchase Plans provide for the issuance of up to 750,000 shares ofthe Company’s common stock. As of January 20, 2007, shares issued under thePurchase Plans totaled 663,457.

 

**Stock-based compensation**.  Effective with the beginningof the first quarter of fiscal 2006, the Company adopted Statement of FinancialAccounting Standards No. 123 (revised 2004) "Share-Based Payment"(SFAS 123(R)) using the modified prospective method of adoption, which does notrequire restatement of prior periods. SFAS 123(R) requires the Company torecognize compensation expense for its stock options, restricted stock awardsand employee stock purchase shares outstanding, but not yet vested, as of thedate of adoption and for future stock option and award grants and employeestock purchase shares.

 

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

 

TheCompany estimates the expected term of options granted taking into accounthistorical and expected future exercise, cancellations and forfeiture behavior.The Company estimates the volatility of the common stock by using historicalvolatility over a period equal to the award’s expected term. The risk-freeinterest rates that are used in the valuation models are based upon yields ofthe U.S. Treasury constant maturities at the time of grant having a term thatapproximates the expected life of the options. Dividend yield is zero as we didnot declare or pay dividends during fiscal 2007 or fiscal 2006, and our currentcredit facilities prohibit payment of dividends.

 

SFASNo. 123(R) requires companies to estimate future expected forfeitures at thedate of grant and revise those estimates in subsequent periods if actualforfeitures differ from those estimates. In previous years, the Company hadrecognized the impact of forfeitures as they occurred. Now, the Company useshistorical data to estimate pre-vesting forfeiture rates in determining theamount of stock-based compensation expense to recognize. All stock-basedcompensation awards are amortized on a straight-line basis over the requisiteservice periods of the awards.

 

Thefair value of stock options granted during the 12 weeks ended January 20, 2007were estimated using the Black-Scholes option pricing model and the followingweighted average assumptions:

 

|                                        | ** ** | **12 Weeks Ended**   | ** ** |
|----------------------------------------|------------|--------------------------------|------------|
| **Stock Options**                 | ** ** | **January 20,**

**2007** | ** ** |
|                                   |       |                           |       |
| Expected life  from grant date (years) |       | 4.8                            |       |
| Expected  volatility                   |       | 70                             | %          |
| Risk-free  interest rate               |       | 4.6                            | %          |
| Dividend Yield                         |       | —                         |       |

7

----

The Company did not grantany stock options for the 12-week period ending January 21, 2006, and had nostock issuances from the employee stock purchase plan for the 12-week periodsended January 20, 2007 and January 21, 2006.

 

The Company recordedstock-based compensation of $41,000 ($30,000 net of related income tax benefit)for the quarter ended January 20, 2007 and $66,000 ($49,000 net of relatedincome tax benefit) for the quarter ended January 21, 2006, which is includedin selling and administrative expenses. The total compensation cost related tononvested stock options and awards not yet recognized is currently expected tobe a combined total of approximately $0.2 million over the next 3.1 years.

 

The weighted average fairvalue per share of stock options granted for the 12-week period ended January20, 2007 was $2.63.

 

**Stockoption activity**.The following table summaries stock option activity for the 12-weeks endedJanuary 20, 2007:

|                                               | ** ** | **Shares**  | ** ** | **Weighted average**

**exercise price** | ** ** |
|-----------------------------------------------|------------|-------------|------------|----------------------------------------------------|------------|
|                                          |       | (In  000's) |       |                                               |       |
| Options outstanding  at October 28, 2006 |       | 417         |       | $                                                  | 3.39       |   |
| Granted                                       |       | 20          |       | 4.35                                               |       |
| Exercised                                     |       | (35         | )          | 3.30                                               |       |
| Cancelled                                     |       | (2          | )          | 9.50                                               |       |
| Options outstanding at  January 20, 2007 |       | 400         |       | $                                                  | 3.41       |   |

 

The followingtable summarizes information about the weighted average remaining contractuallife (in years) and the weighted average exercise prices for stock options bothoutstanding and exercisable as of January 20, 2007:

 
|                                                                    | ** ** | **Options Outstanding**   | ** ** | **Options Exercisable** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------|------------|------------------------------|------------|
| **Exercise price range**                                 | ** ** | **Number of**

**Shares** | ** ** | **Remaiming**

**Life**      | ** ** | **Exercise**

**Price** | ** ** | **Number of**

**Shares** | ** ** | **Exercise**

**Shares** | ** ** |
|                                                               |       | (In  000's)                    |       |                         |       |   |   | (In  000's) |   |   |   |
| $  2.20  to  $   2.56 |       | 37                             |       | 5.74                         |       | $ | 2.39 |   | 37 |   | $ | 2.39 |   |
| $  3.15  to  $   3.15 |       | 97                             |       | 5.56                         |       | 3.15 |   | 97 |   | 3.15 |   |
| $  3.20  to  $   3.20 |       | 3                              |       | 4.34                         |       | 3.20 |   | 3 |   | 3.20 |   |
| $  3.22  to  $   3.22 |       | 200                            |       | 8.21                         |       | 3.22 |   | 40 |   | 3.22 |   |
| $  3.50  to  $ 16.17            |       | 63                             |       | 6.25                         |       | 5.00 |   | 29 |   | 5.64 |   |
| Totals                                                             |       | 400                            |       | 7.00                         |       | $ | 3.41 |   | 206 |   | $ | 3.38 |   |

 

The aggregateintrinsic value (the difference between the market price and the option’sexercise price) of options outstanding and options exercisable as of January20, 2007 was $0.7 million and $0.4 million, respectively.

 

**Restrictedstock activity**.  AtJanuary 20, 2007, the Company had 20,000 restricted stock shares outstandingwith an intrinsic value of $35,000. The unamortized compensation expense atJanuary 20, 2007 was $14,000.

 

**Employeestock purchase plan activity**. At January 20, 2007, the Company had recorded liabilities forwithholdings of $53,000 under its employee stock purchase plan representing33,000 shares at a weighted average exercise price of $3.10 with an estimatedaggregate intrinsic value of $61,000.

 

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

The following summarizesthe change in goodwill during the fiscal quarter ended January 20, 2007:

|                                         | ** ** | **Domestic**               | ** ** | ** **    | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|----------------------------|------------|---------------|------------|------------|------------|
| ** **                              | ** ** | **Business Services** | ** ** | **Australia** | ** ** | **Total**  | ** ** |
| ** **                              | ** ** | **(In thousands)**    | ** ** |
| Balance at  October 28, 2006            |       | $                          | 11,369     |          | $          | 998        |       | $ | 12,367 |   |
| Effect of  foreign currency translation |       | —                     |       | 39            |       | 39         |       |
|                                    |       |                       |       |          |       |       |       |
| Balance at January 20,  2007            |       | $                          | 11,369     |          | $          | 1,037      |       | $ | 12,406 |   |

 

The Company performs itsannual impairment evaluation in the fourth quarter of each fiscal year.

8

----

**4.****              DiscontinuedOperations**

In June 2005, the Company sold its Norway and Denmark operations toPersonalhuset AS, a recruitment and staffing company headquartered in Norway,for approximately $2.7 million. Of the total proceeds, approximately $0.2million is being held in an interest bearing escrow account as security forpotential Westaff Norway pension claims, which the Company currently estimatesto be zero. The escrowed funds, net of any claim payments, are scheduled to beremitted to the Company in June 2007.

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

The Company is responsible for and pays workers’ compensation costs forits temporary and regular employees and is self-insured for the deductibleamount related to workers’ compensation claims ($500,000 per claim for fiscal2007 and fiscal 2006.) The Company accrues the estimated costs of workers’compensation claims based upon the expected loss rates within the varioustemporary employment categories provided by the Company. At least annually, theCompany obtains an independent actuarial valuation of the estimated costs ofclaims reported but not settled, and claims incurred but not reported, andadjusts the accruals based on the results of the valuations. As of January 20,2007 and October 28, 2006, workers’ compensation liabilities were approximately$22.4 million and $24.3 million respectively, of which $16.4 million is includedin other long-term liabilities on each of the respective balance sheets forobligations that are not expected to be paid within one year of the balancesheet date.

Periodically, the termsof the agreement with the insurance carrier are renegotiated.  The insurance carrier requires the Company tocollateralize its recorded obligations through the use of irrevocable lettersof credit, surety bonds or cash.  AtJanuary 20, 2007, the Company had $35.3 million of letters of credit securingits domestic workers’ compensation obligations.

**6.****              Earnings Per Share**

The following table sets forth the computation ofbasic and diluted earnings per share:
|                                                                                                         | ** ** | **12 Weeks Ended**                                          | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                                                                                              | ** ** | **January 20,**                                                  | ** ** | **January 21,** | ** ** |
| ** **                                                                                              | ** ** | **2007**                                                              | ** ** | **2006** | ** ** |
| ** **                                                                                              | ** ** | **(In thousands, except per share amounts)** | ** ** |
|                                                                                                    |       |                                                                  |       |   |   |
| Net income  (loss)                                                                                      |       | $                                                                     | 404        |   | $ | (396 | ) |
|                                                                                                    |       |                                                                  |       |   |   |
| Denominator for  basic earnings per share - weighted average shares                                     |       | 16,590                                                                |       | 16,378 |   |
|                                                                                                    |       |                                                                  |       |   |   |
| Effect of  dilutive securities: stock options and awards                                                |       | 68                                                                    |       | — |   |
|                                                                                                    |       |                                                                  |       |   |   |
| Denominator for  diluted earnings per share - adjusted weighted average shares and assumed  conversions |       | 16,658                                                                |       | 16,378 |   |
|                                                                                                    |       |                                                                  |       |   |   |
| Earnings (loss)  per share                                                                              |       |                                                                  |       |   |   |
| Basic                                                                                                   |       | $                                                                     | 0.02       |   | $ | (0.02 | ) |
| Diluted                                                                                                 |       | $                                                                     | 0.02       |   | $ | (0.02 | ) |
|                                                                                                    |       |                                                                  |       |   |   |
| Anti-dilutive weighted  shares excluded from diluted earnings per share                                 |       | 182                                                                   |       | 359 |   |

 

9

----

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

Comprehensive income consists of the following:
|                                  | ** ** | **12 Weeks Ended** | ** ** |
|----------------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **January 20,**         | ** ** | **January 21,** | ** ** |
| ** **                       | ** ** | **2007**                     | ** ** | **2006** | ** ** |
| ** **                       | ** ** | **(In thousands)**      | ** ** |
|                             |       |                         |       |   |   |   |
| Net income (loss)                |       | $                            | 404        |   | $ | (396 | ) |   |
| Currency translation adjustments |       | 446                          |       | (60 | ) |   |
|                             |       |                         |       |   |   |   |
| Comprehensive income (loss)      |       | $                            | 850        |   | $ | (456 | ) |   |

 

**8.****              Credit Agreement**

The Company has creditfacilities with GE Capital, as primary agent, expiring in May 2009. Thefacilities comprise a five-year syndicated Multicurrency Credit Agreementconsisting of a $55 million U.S. Revolving Loan Commitment and a £2.74 millionU.K. Revolving Loan Commitment.  Inaddition, the Company’s Australian subsidiary maintains a $12 millionAustralian dollar facility agreement (the “A$ Facility Agreement”) that expiresin May 2009. Each agreement includes a letter of credit sub-facility. Lettersof credit under the agreements expire one year from date of issuance, but areautomatically renewed for one additional year unless written notice is given toor from the holder.

On January 2, 2007, the Company and its lendersexecuted a Tenth Amendment to its Multicurrency Credit Agreement. Thisamendment reduced the interest rates within the first level of the pricing gridimplemented with the Eighth Amendment, resets future minimum earnings beforeinterest, taxes, depreciation and amortization (“EBITDA”) covenants and reducedsome of the reporting requirements provided minimum borrowing requirements aremet. Further, the amendment extended the credit facility for one additionalyear to May 2009. Finally, the Company was not in compliance with its minimumEBITDA covenant as of the end of the fiscal year 2006, and the amendmentincluded a waiver of this covenant violation.

On January 25, 2007, the Company and its lenderexecuted an amendment to the A$ Facility Agreement, which extended theAgreement for two additional years to May 2009.

**9.****              Related PartyTransactions**

The Company has anunsecured subordinated promissory note payable to its Chairman of the Board ofDirectors dated May 17, 2002 in the amount of $2.0 million. The note has amaturity date of August 18, 2007 and an interest rate equal to an indexed rateas calculated under the Company’s credit facilities plus seven percent,compounded monthly and payable 60 calendar days after the end of each of theCompany’s fiscal quarters. The interest rate in effect on January 20, 2007 was15.25%. The Company recorded $71,000 of interest expense for the 12 weeksended January 20, 2007. Payment of interest is contingent on the Companymeeting minimum availability requirements under its credit facilities.Additionally, payments of principal or interest are prohibited in the event ofany default under the credit facilities.

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

The following tablesummarizes reporting segment data:

10

----

 
| ** **                       | ** ** | ** **              | ** ** | ** **  | ** ** | ** **    | ** ** | ** **  | ** ** | ** ** | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------|------------|---------------|------------|-------------|------------|------------|------------|
| ** **                       | ** ** | **Domestic**            | ** ** | **United**  | ** ** | ** **    | ** ** | **New**     | ** ** | ** ** | ** ** |
| ** **                       | ** ** | **Business Svcs.** | ** ** | **Kingdom** | ** ** | **Australia** | ** ** | **Zealand** | ** ** | **Total**  | ** ** |
| ** **                       | ** ** | **(In thousands)** | ** ** |
| 12 Weeks Ended  January 20, 2007 |       |                    |       |        |       |          |       |        |       |       |       |
|                             |       |                    |       |        |       |          |       |        |       |       |       |
| Revenue                          |       | $                       | 97,202     |        | $          | 9,262         |       | $           | 21,712     |       | $          | 1,773 |   | $ | 129,949 |   |
| Operating income  (loss)         |       | $                       | 598        |        | $          | (166          | )          | $           | 147        |       | $          | 74 |   | $ | 653 |   |
|                             |       |                    |       |        |       |          |       |        |       |       |       |
| 12 Weeks Ended  January 21, 2006 |       |                    |       |        |       |          |       |        |       |       |       |
|                             |       |                    |       |        |       |          |       |        |       |       |       |
| Revenue                          |       | $                       | 107,784    |        | $          | 8,915         |       | $           | 20,566     |       | $          | 1,335 |   | $ | 138,600 |   |
| Operating income (loss)          |       | $                       | (587       | )           | $          | 305           |       | $           | 44         |       | $          | 16 |   | $ | (222 | ) |

 

**11.****       Commitments andContingencies**

In the ordinary course ofits business, the Company is periodically threatened with or named as adefendant in various lawsuits. The principal risks that the Company insuresagainst are workers’ compensation, general liability, automobile liability,property damage, alternative staffing errors and omissions, fiduciary liabilityand fidelity losses.

During the fourth quarter offiscal 2005, the Company was notified by the California Employment DevelopmentDepartment (“EDD”) that Westaff’s domestic operating subsidiaries unemploymenttax rates would be increased retroactively for both calendar years 2005 and2004, which would result in additional unemployment taxes of approximately $0.9million. The Company believes that it has properly calculated its unemploymentinsurance tax and is in compliance with all applicable laws and regulations.The Company has timely appealed the ruling by the EDD and is working with 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 January20, 2007.

Other than the action listedabove, the Company is not a party to any material litigation. However, fromtime to time the Company has been threatened with, or named as a defendant in,litigation brought by former franchisees or licensees, and administrativeclaims and lawsuits brought by employees or former employees. Managementbelieves the resolution of these matters will not have a material adverseeffect on the Company’s financial statements.

**12.****       Recent AccountingPronouncements**

In June 2006, theFinancial Accounting Standards Board (“FASB’) issued FASB Interpretation No.48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASBStatement No. 109” (“FIN 48’). FIN 48 prescribes a recognition threshold andmeasurement process for recording in the financial statements uncertain taxpositions taken or expected to be taken in a tax return in accordance with SFASNo. 109, “Accounting for Income Taxes.” Tax positions must meet amore-likely-than-not recognition threshold at the effective date to berecognized upon the adoption of FIN 48 and in subsequent periods. Theaccounting provisions of FIN 48 will be effective for the Company beginning infiscal year 2008. The Company has not yet completed its evaluation of theimpact of adoption on the Company’s financial position or results ofoperations.

11

----

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

### **Cautionary Statement**

This Form 10-Q containsforward-looking statements within the meaning of the Private SecuritiesLitigation Reform Act of 1995. Except for the historical information containedherein, the matters discussed should be considered forward-looking statementsand readers are cautioned not to place undue reliance on those statements.These statements are only predictions, and actual events or results may differmaterially. The forward-looking statements give our current expectations orforecasts of future events. You can identify these statements by the fact thatthey do not relate strictly to current facts. They use words such as “will,” “anticipate,”“estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “target,” “forecast,”and other words and terms of similar meaning in connection with any discussionof future operating or financial performance. These forward-looking statementsare made based on information available as of the date of this report and aresubject to a number of risks and uncertainties that could cause the Company’sactual results and financial position to differ materially from those expressedor implied in the forward-looking statements and to be below the expectationsof public market analysts and investors. Investors should bear this in mind asthey consider forward-looking statements.

These risks and uncertaintiesinclude, but are not limited to, those discussed in Part II Item 1A “RiskFactors” and elsewhere in this Form 10-Q. You should understand that it is notpossible to predict or identify all such factors. Consequently, you should notconsider any such list to be a complete set of all potential risks oruncertainties faced by us.

The Company undertakes noobligation to publicly release the results of any revisions to theseforward-looking statements to reflect events or circumstances after the datehereof or to reflect the occurrence of unanticipated events, except as requiredby applicable laws and regulations.

The following discussion isintended to assist in the understanding and assessment of significant changesand trends related to the results of operations and financial condition ofWestaff, Inc., together with its consolidated subsidiaries. Thisdiscussion and analysis should be read in conjunction with the Company’sConsolidated Financial Statements and Notes included elsewhere in this Form10-Q and in the Company’s Annual Report on Form 10-K for the fiscal year endedOctober 28, 2006.

**CompanyOverview**

We provide staffing servicesprimarily in suburban and rural markets through a network of Company-owned,franchise agent and licensed offices in the United States, United Kingdom,Australia and New Zealand. We offer a wide range of staffing solutions,including permanent placement, replacement and temporary staffing, primarilyfocused on recruiting and placing clerical/administrative and light industrialpersonnel. We have over 58 years of experience in the staffing industry andannually put more than 125,000 people to work through more than 230 fieldoffices in 45 states and three foreign countries. Our corporate headquartersprovides support services to the field offices in areas such as marketing,human resources, risk management, legal, strategic sales, accounting, andinformation technology.

To complement our serviceofferings, which include temporary staffing, permanent placement, temp-to-hireservices, payroll services and on-location programs; we utilize a number oftools focused on increasing our pool of qualified candidates. Additionally, weemploy a robust, targeted marketing program as well as a consultative salesprocess, and both of these tools assist in our sales efforts to new andexisting customers.

12

----

Management believes all of these tools enhance ourcompetitive edge and position us to effectively pursue high growth marketniches.

 

The staffing industry is highly competitive withgenerally few barriers to entry, which contributes to significant price competitionas competitors attempt to maintain or gain market share. While the pricecompetition continues in 2007, we have noted consolidated margin improvementsas compared to the prior year. On a prospective basis, we believe our focus onincreasing permanent placement services, increasing clerical/administrativesales, improving results from underperforming field offices and prudentlymanaging costs will permit us to improve our operating margins.

 

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 itcontaining traditional holidays as well as customer shutdowns during theholiday season. These shutdowns and post-holiday season declines in businessactivity negatively impacts orders received from customers, particularly in thelight industrial sector. Demand for staffing services has historically tendedto grow during the second and third fiscal quarters and has been greatestduring the fourth fiscal quarter due largely to customers’ planning cycles.Furthermore, our fourth fiscal quarter consists of 16 or 17 weeks, while thefirst, second and third 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, which isincurred domestically and in Australia, generally varies with both thefrequency and severity of workplace injury claims reported during a quarter andthe estimated future costs of such claims. Adverse and positive loss developmentof prior period claims during a subsequent quarter may also contribute to thevolatility in our estimated workers’ compensation expense.

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

·                  seasonality, especially in our light industrialbusiness,

·                  wage limits on statutory payroll taxes,

·                  claims experience for workers’ compensation,

·                  demand and competition for our services, and

·                  theeffects 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 second fiscal quarter in order to benefit from these investmentsduring the third and fourth quarters of the fiscal year.

We were advised at ourFebruary 28, 2007 Board Meeting by W. Robert Stover, our Chairman of the Boardof Directors, that all of our common stock held by Mr. Stover and his childrenwere sold in a private transaction to H.I.G. Capital LLC and its affiliates(collectively, the “Investors”). According to the Form 4 filed by Mr. Stover onMarch 5, 2007, these shares were sold at a price of $4.10 per share.Representatives of the Investors have further advised our Board of Directorsthat H.I.G. Capital LLC, with its affiliates, have acquired additional sharesof our common stock on the open market and the total shares of our common stockacquired by the Investors is 8,263,196 shares as of March 1, 2007, whichconstitutes approximately 49.7% of our outstanding common stock. At this time,we are not aware of the total consideration for all of the shares purchased bythe Investors or their source of funds. Mr. Stover has indicated to us that hewas asked to remain on the Board by the Investors. We are beginning discussionswith the Investors regarding prospective, mutual goals and are not aware of anyother arrangements or understandings between Mr. Stover and the Investorsregarding election of directors or other matters.

### **Critical Accounting Policies**

Thepreparation of our financial statements in conformity with generally acceptedaccounting principles in the United States of America requires management tomake estimates and assumptions affecting the amounts and disclosures reportedwithin those financial statements. These estimates are evaluated on an ongoingbasis by management and generally affect revenue recognition, workers’compensation costs, collectibility of accounts receivable, impairment ofgoodwill and intangible assets, contingencies, litigation and income taxes.Management’s estimates and assumptions are based on historical experiences

13

----

and other factors believed to be reasonableunder the circumstances. Actual results under circumstances and conditionsdifferent than those assumed could result in differences from the estimatedamounts in the financial statements.

 

Our critical accounting policies aredescribed in Item 7 “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and in the notes to the consolidatedfinancial statements in the Company’s previously filed Annual Report on Form10-K for the fiscal year ended October 28, 2006. There were no changes to thesepolicies during the 12-week period ended January 20, 2007.

**Executive Overview**

Weare pleased to report net income for the first quarter of fiscal 2007.  Historically, it has been challenging for usto generate a profit in our first quarter, which is traditionally our slowestquarter. We are also pleased to report our gross margin has increased from16.8% to 17.6%, which is consistent with one of our initiatives. We weresuccessful with another initiative, to prudently manage costs, as our operatingcosts have decreased from the first quarter of last year. Additionally,permanent placement revenue increased from the first quarter of last year andall of these achievements caused our operating income to improve $875,000 fromthe first quarter of the prior year. Further, our working capital and cashbalance both increased as compared to our most recent fiscal year end, which isalso an achievement in light of the first quarter being our slowest quarter.

Whereaswe are delighted to report all of these items, the fact remains that we haveother issues to improve upon going forward. Whereas we expected our totalrevenue to be less than the prior year’s first quarter, we did expect them tobe higher than they actually were. This shortfall was largely isolated to theUnited States with the bulk of it occurring towards the latter part of thequarter. Much of this shortfall can be attributable to the holiday seasonhaving a larger effect than expected. Therefore, we believe a portion of thisshortfall can be isolated to the holiday season and, therefore, should not beongoing into the remainder of fiscal 2007. We also have implemented otherinitiatives designed to increase domestic sales prospectively, which should assistin growing domestic revenue over the first quarter’s results.

Inaddition to this, we are not satisfied with the operating results of our UnitedKingdom operations, which generated an operating loss in the first quarter. Ascompared to the prior year, our gross margins in the United Kingdom havedeteriorated, partially due to a shift in revenue volume away from commercialaccounts, coupled with growth in two large, national accounts, which generatelower margins for us. We have implemented plans to improve these operatingresults on a prospective basis and are optimistic that future quarters willshow an improvement over the first quarter results.

Notwithstandingthese issues, we continue to believe we are well positioned to report improvedoperating results as compared to the prior year in future quarters of fiscal2007.

**Results of Operations - Fiscal Quarter ended January 20, 2007 andFiscal Quarter ended January 21, 2006**

Revenue decreased $8.7 millionor 6.2% for the first fiscal quarter of 2007 as compared to the first fiscalquarter of 2006. Domestic revenue decreased $10.6 million, or 9.8%, drivenlargely by a 13.5% decrease in billed hours. This decrease was experienced inmost geographical areas and is largely attributable to a decrease in lower margin,high-volume, light industrial accounts. The effect of the billable hoursdecrease was partially offset by an increase of 4.2% in average, domestic billrates. In addition, domestic permanent

14

----

placement revenue increased 23%as compared to the first quarter of the prior year, also offsetting a portionof the billable hours decrease.

International revenue increasedby 6.3%, due to a 3.9% increase in the United Kingdom, a 5.6% increase inAustralia and a 32.8% increase in New Zealand. The United Kingdom and NewZealand increases are primarily attributable to increased sales volumes atlarge national accounts, whereas the increase in Australia is largely due toincreases in commercial sales to retail customers.

Costs of services includehourly wages of temporary employees, employer payroll taxes, state unemploymentand workers’ compensation costs and other temporary employee-relatedcosts. Costs of services decreased $8.3 million or 7.2% for the fiscal 2007quarter as compared to the fiscal 2006 quarter. Because this percentage decrease was higher than the percentage decreasein revenue, consolidated gross margin increased from 16.8% in the first quarterof fiscal 2006 to 17.6% in the first quarter of fiscal 2007.  Domestic gross margin increased from 16.4% inthe fiscal 2006 quarter to 17.7% in fiscal 2007, due largely to a shift inbusiness away from lower margin, light industrial business towards highermargin, clerical/administrative business. In addition, the 23% increase inpermanent placement revenue aided the gross margin increase. Internationally,the gross margin in Australia increased from 12.9% to 13.2%, primarily due to ashift away from large, national accounts to higher margin, commercialaccounts.  Gross margins for the UnitedKingdom and New Zealand decreased, as a higher portion of their revenue weregenerated at large, national accounts.

Franchise agents’ share ofgross profit represents the net distribution paid to franchise agents basedeither on a percentage of the sales or gross profit generated by the franchiseagents’ operations. Franchise agents’ share of gross profit decreased $0.8million or 18.3% primarily as a result of the Company having acquired twofranchisees during the last fiscal year. Both of these franchisees received ashare of gross profits in the first quarter of fiscal 2006 but not in the firstquarter of fiscal 2007 as these offices were operated as Company-ownedoffices.  As a percentage of consolidatedrevenue, franchise agents’ share of gross profit decreased from 3.1% for thefiscal 2006 quarter to 2.7% for the fiscal 2007 quarter.

Selling and administrativeexpenses decreased $0.1 million, or 0.8%, for the 2007 quarter as compared to the 2006quarter. This decrease is primarily attributable to decreased salary and relatedcosts, as a result of decreased headcount. In addition, we incurred lowercommunications and services costs, largely due to improvements made in ourinformation systems infrastructure. Offsetting a portion of the overalldecreases were increases in incentive compensation, employee benefits andrecruiting expenses. As a percentage of revenue, selling and administrativeexpenses were 13.7% for the fiscal 2007 quarter, compared to 13.0% for thefiscal 2006 quarter. The increase is primarily due to the decreased level ofsales. In addition, the Company operated two markets in the first quarter offiscal 2007 that were franchised operations in the first quarter of fiscal2006. Therefore, the operating expenses associated with these operations areincluded in selling and administrative expenses this quarter, but were not inthe prior quarter.

Depreciationand amortization decreased $0.3 million or 21.7% primarily as a result ofcertain fixed assets becoming fully depreciated by the end of fiscal 2006 andremaining in service. Therefore, no new depreciation expenses were incurred forthese assets in the first quarter of fiscal 2007. Further, no new businessprocess management system modules were placed into service, although we arecurrently anticipating implementing some new modules in the fourth quarter offiscal 2007. Upon implementation, we anticipate depreciation expense willincrease.

15

----

Forthe fiscal quarter ended January 20, 2007, we recorded a consolidated incometax benefit of $35,000 on pre-tax income of $0.4 million. This benefit waslargely driven by domestic workers’ opportunity tax benefits of $0.4 millionrelated to 2006, largely offset by income taxes from various domestic andinternational jurisdictions. The prior year quarter’s tax benefit was $82,000higher than this year’s, primarily because of the pre-tax loss generated in thefirst quarter of the prior year.

Dueto the aforementioned items, net income was $0.4 million for the first quarterof fiscal 2007 as compared to a net loss of $0.4 million in the first quarterof fiscal 2006. This caused basic and diluted earnings per share to be $0.02 inthe first quarter of 2007 as compared to a basic and diluted loss per share of$0.02 in the first quarter of the prior year.

**Liquidityand Capital Resources**

Werequire significant amounts of working capital to operate our business and topay expenses relating to employment of temporary employees. Our traditional useof cash is for financing of accounts receivable, particularly during periods ofeconomic upswings and growth, when sales are seasonally high. Temporarypersonnel are typically paid on a weekly basis while payments from customersare generally received 30 to 60 days after billing.

Wefinance our operations primarily through cash generated by our operatingactivities and borrowings under our revolving credit facilities. Net cashprovided by operating activities was $2.3 million for the first quarter of2007, compared to $6.6 million for the first quarter of fiscal 2006. This $4.3million decrease is primarily attributable to a decrease in cash provided frommanaging our accounts receivables, which provided $4.0 million of the operatingcash flow in this quarter as compared to $8.1 million in the prior quarter.During fiscal 2006, we consciously managed receivables to improve cash flow andas a result of those efforts, $7.5 million of operating cash flow was generatedduring fiscal 2006. Although we will continue to manage these going forward, webelieve the opportunities for increasing operating cash flow going forward willnot be as dramatic as they were during the prior year.

Cashused for investing activities was $1.0 million in the first quarter of fiscal2007, as compared to $2.1 million in the first quarter of fiscal 2006. Capitalexpenditures, which are primarily for information system initiatives bothdomestically and internationally, represented the majority of this in bothquarters. We continue to invest in enhancements and upgrades to ourcomputer-based technologies. During fiscal 2004, we entered into a licenseagreement for a domestic business process management, or BPM, system which isbeing implemented in three phases. The initial phase, which consisted of thehuman resources system for regular Westaff employees, was successfully implementedin July 2005. The second phase, which includes the core financial systemsand the accounts receivable module, went live in the beginning of fiscal year2006. The final phase, which will include fully integrated front officefunctionality along with payroll and billing for temporary associates, iscurrently scheduled to go live in the fourth quarter of fiscal 2007. Our creditagreement currently allows up to a maximum of $6.0 million in capitalexpenditures for fiscal 2007.

Cashused for financing activities was $64,000 in the first quarter of fiscal 2007as compared to $3.9 million in the first quarter of fiscal 2006. In the prioryear quarter, the primary cause behind this usage was repayments under ourlines of credit. As of the beginning and the end of the first quarter 2007, theonly borrowing under our lines of credit was in Australia, and those borrowingsremained relatively constant at the beginning and end of the quarter.

InMay 2002, we entered into agreements with GE Capital, as primary agent, toprovide senior secured credit facilities that originally expired inMay 2007. The credit facility comprised a five-year syndicatedMulticurrency Credit Agreement (the ‘Multicurrency Credit Agreement”)consisting of a $50.0 million

16

----

U.S.Revolving Loan Commitment, a £2.74 million U.K. Revolving Loan Commitment (U.S.dollar equivalent of approximately $4.0 million at the date of the agreement),and a $5.0 million term loan, which was repaid during fiscal 2003. Inaddition, a five-year Australian dollar facility agreement (the “A$ FacilityAgreement”) was executed in May 2002, consisting of an A$12.0 millionrevolving credit facility (U.S. dollar equivalent of approximately $6.0 millionat the date of the A$ Facility Agreement).

InAugust 2005, the Multicurrency Credit Agreement was amended to allow anadd-back of approximately $1.0 million to the earnings before income taxes,depreciation and amortization, or EBITDA, covenant relating to separation andrestructuring costs incurred or to be incurred during fiscal 2005. Theamendment also allowed the gain from the sale of the Registrant’s Norway andDenmark operations of $1.1 million to be included in determining compliancewith the EBITDA and fixed charge covenants. Additionally, the amendmentincreased the maximum capital expenditures allowed for fiscal 2005 from $6.0million to $8.5 million and also increased the letter of credit sub-limit from$35.0 million to $40.0 million.

InMarch 2006, we and our lenders executed an Eighth Amendment to the MulticurrencyCredit Agreement. Among other things, the amendment reset minimum EBITDAcovenants for fiscal 2006 and beyond, adjusted the fixed charge coverage ratiofor our second quarter of fiscal 2006, extended the credit facility for oneadditional year to May 2008 and added an additional pricing grid that willallow us to benefit from reduced interest rates and letter of credit fees uponachieving certain minimum EBITDA targets. Additionally, the amendment increasedthe maximum amount of the U.S. Revolving Loan Commitment by $5.0 million to$55.0 million and increased the letter of credit sub-limit from $40.0 millionto $45.0 million.

InJuly 2006, we and our lenders executed a Ninth Amendment to the MulticurrencyCredit Agreement solely for the purpose of determining the financial covenants.The amendment allows for a one-time add-back adjustment of approximately $0.5million to EBITDA commencing the fiscal quarter ending April 15, 2006, for theseparation and transition charges related to the termination of employment fortwo of our former executives.

OnJanuary 2, 2007, we and our lenders executed a Tenth Amendment to ourMulticurrency Credit Agreement. Among other things, this amendment reduces theinterest rates if certain financial benchmarks are achieved and resets thefuture minimum EBITDA covenants. The amendment extended the credit facility forone additional year to May 2009. We were not in compliance with its minimumEBITDA covenant as of the end of fiscal 2006, and the amendment included awaiver of this covenant violation.

OnJanuary 25, 2007, we and our lenders executed an amendment to the A$ FacilityAgreement, which extended the agreement for two additional years to May 2009.

Asof January 20, 2007, we had $4.9 million outstanding under our credit facilitiesall of which was outstanding under the A$ Facility Agreement. We have combinedavailable borrowing capacity under our credit facilities of $14.9 millionconsisting of $6.0 million for the U.S., $4.2 million for the U.K. and $4.7million for Australia.

InFebruary 2004, we completed the sale of our former corporate headquarters’building for cash proceeds of $1.9 million. The proceeds were used to pay downoutstanding borrowings under our revolving credit facilities. We have anoutstanding $0.7 million irrevocable standby letter of credit as a securitydeposit for the December 2002 sale leaseback of the land and buildingshousing our administrative offices.

Wehave an unsecured subordinated promissory note payable to our Chairman of theBoard of Directors in the amount of $2.0 million with a maturity date ofAugust 18, 2007, and an

17

----

interestrate equal to an indexed rate as calculated under the Company’s creditfacilities plus seven percent (15.25% at January 20, 2007), compounded monthlyand payable 60 calendar days after the end of each of our fiscal quarters.Payment of interest is contingent on us meeting minimum availabilityrequirements under our credit facilities. Additionally, payments of principalor interest are prohibited in the event of any default under the creditfacilities. The Sixth Amendment to our Multicurrency Credit Agreement providesfor optional prepayment of the note subject to certain borrowing availabilitylimits on the U.S. revolving loan commitment portion of the credit facilities.

Wework to balance our worldwide cash needs through dividends from and loans toour international subsidiaries. These loans and dividends are limited by thecash availability and needs of each respective subsidiary, restrictions imposedby our senior secured debt facilities and, in some cases, statutory regulationsof the subsidiary. The U.S. operations cannot directly draw on the excessborrowing availability of the U.K. or Australian operations; however, we mayrequest dividends from the U.K. The U.S. can also request repayments on itsintercompany loan to Australia, along with intercompany interest and royalties,although remittances from Australia may be limited by certain covenants underthe terms of the Australia credit facility. Outstanding principal on theintercompany loan to Australia was $4.3 million as of January 20, 2007.

Weare responsible for and pay workers’ compensation costs for our domestictemporary and regular employees and are self-insured for the $500,000deductible amount related to workers’ compensation claims. Typically, eachpolicy year the terms of the agreement with the insurance carrier arerenegotiated. The insurance carrier requires us to collateralize ourobligations through the use of irrevocable standby letters of credit, suretybonds or cash. In April 2005, our insurance carrier reduced our collateralrequirements through the cancellation of a $3.8 million surety bond therebyeliminating any remaining outstanding surety bond. Currently, we do not believethat surety bonds will be available or required in the foreseeable future tosecure workers’ compensation obligations.

Duringthe fourth quarter of fiscal 2005, we and our insurance carrier negotiated thereturn of $11.0 million of the fiscal 2005 cash collateral and we issued $11.0million of letters of credit in its place. During the first quarter of fiscal2006, we issued an additional $1.9 million of letters of credit in exchange for$1.2 million in cash, which represented all of the cash remaining in the 2005collateral fund.

Forour 2007 policy year insurance program, we anticipate total cash payments of$4.8 million will be paid during fiscal 2007 in equal monthly installments,which commenced on November 1, 2006. Cash payments for 2007 policy yearclaims will be paid directly by us. Through January 20, 2007, we have madepayments of $1.2 million on the 2007 policy year. As of January 2007, we hadoutstanding $35.3 million of letters of credit to secure all outstandingobligations under our workers’ compensation program for all years except 2003,which is fully funded although subject to annual retroactive premiumadjustments based on actual claims activity. Under certain circumstancesincluding a change of ownership and or senior management, we may be required toincrease our letters of credit to $40 million. We will also make ongoing cashpayments for claims for all other open policy years (except for 2003 as notedabove).

Wecontinue to evaluate other opportunities to further strengthen our financialposition. However, we believe that the borrowing capacity provided under theamended credit agreement, together with cash generated through our operatingperformance, will be sufficient to meet our working capital needs for theforeseeable future.

18

----

**Item3.  Quantitative and QualitativeDisclosures 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. AtJanuary 20, 2007, our outstanding debt under variable-rate interest borrowingswas approximately $6.9 million. A change of two percentage points in theinterest rates would cause a change in interest expense of approximately$0.1million on an annual basis. Our exposure to market risk for changes ininterest rates is not significant with respect to interest income, as ourinvestment portfolio is not material to our consolidated balance sheet. Wecurrently have no plans to hold an investment portfolio that includesderivative financial instruments.

For the 12 weeksended January 20, 2007, our international operations comprised 25.2% of ourrevenue and, as of the end of that period, 20.7% of our total assets. We areexposed to foreign currency risk primarily due to our investments in foreignsubsidiaries. Our multicurrency credit facility, which allows our Australianand United Kingdom subsidiaries to borrow in local currencies, partiallymitigates the exchange rate risk resulting from fluctuations in foreigncurrency denominated net investments in these subsidiaries in relation to theU.S. dollar. We do not currently hold any market risk sensitive instrumentsentered into for hedging risks related to foreign currencies. In addition, wehave not entered into any transactions with derivative financial instrumentsfor trading purposes.

### **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 January 20, 2007 (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 January 20, 2007, thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal controls over financial reporting.

19

----

### **PartII.   Other Information**

### **Item1.    Legal Proceedings**

In the ordinary course ofour business, we are periodically threatened with or named as a defendant invarious lawsuits.  The principal risksthat we insure against are workers’ compensation, general liability, automobileliability, property damage, alternative staffing errors and omissions,fiduciary liability and fidelity losses.

During the fourth quarter offiscal 2005, we were notified by the California Employment DevelopmentDepartment (“EDD”) that Westaff’s domestic operating subsidiaries unemploymenttax rates would be increased retroactively for both calendar years 2005 and2004, which would result in additional unemployment taxes of approximately $0.9 million.Management believes that it has properly calculated its unemployment insurancetax and is in compliance with all applicable laws and regulations. We havetimely appealed the ruling by the EDD and are working with our outside counselto resolve this matter. Management believes that it has strong defenses andlegal arguments with respect to the unaccrued assessment and, accordingly, hasnot accrued for that portion of the assessment as of January 20, 2007.

Other than the action listedabove, we are not currently a party to any material litigation. However, fromtime to time we have been threatened with, or named as a defendant inlitigation brought by former franchisees or licensees, and administrativeclaims and lawsuits brought by employees or former employees. Managementbelieves the resolution of these matters will not have a material adverseeffect on our financial statements.

### **Item1A.  Risk Factors**

This Form 10-Q containsforward-looking statements concerning our future programs, products, expenses, revenue,liquidity and cash needs as well as our plans and strategies. Theseforward-looking statements are based on current expectations and we assume noobligation to update this information, except as required by applicable lawsand regulations. Any one of the following risks could harm our operatingresults or financial condition and could result in a significant decline invalue of an investment in us. Further, additional risks and uncertainties thathave not yet been identified or which we currently believe are immaterial mayalso harm our operating results and financial condition. Numerous factors couldcause actual results to differ significantly from the results described inthese forward-looking statements, including the following updated risk factors.

 

**One largeshareholder with its affiliates controls a significant amount of ouroutstanding stock thus allowing them to exert significantinfluence on our management and affairs.**

 

We wereadvised on February 28, 2007, that H.I.G. Capital LLC and its affiliates hadacquired and beneficially own, directly or indirectly, orhas voting power over, in excess of 49% of ouroutstanding common stock. As the principal stockholder ofWestaff, H.I.G. Capital and its affiliates will have the ability to materially influence all matters submittedto the stockholders for approval and to exert significant influence on ourmanagement and affairs. For example, H.I.G. Capital has the ability to sell its sharesindependently and to strongly influence the election of the Board of Directorsand the appointment of executive management. It also hasthe ability to strongly influence any merger, consolidation, sale ofsubstantially all of our assets or other strategic decisions affecting us orthe market value of the stock. This concentration of stock and voting powercould be used by H.I.G. Capital to delay or prevent anacquisition of Westaff or other strategic action or result in strategicdecisions that could negatively impact the value and liquidity of ouroutstanding stock.

** **

**Price competition in thestaffing industry continues to be intense, and pricing pressures from bothcompetitors and customers could adversely impact our financial results.**

 

The staffing industry ishighly competitive with limited barriers to entry and continues to undergoconsolidation. We compete in regional and local markets with large full serviceagencies, specialized temporary and permanent placement services agencies andsmall local companies. While some competitors are smaller than us, they may enjoyan advantage in discrete geographic markets because of a stronger localpresence. Other competitors have greater marketing, financial and otherresources than us that, among other things, could enable them to attempt tomaintain or increase their market share by reducing prices. Furthermore, inpast years there has been an increase in the number of customers consolidatingtheir staffing services purchases with a single provider or with a small numberof providers. The trend to consolidate staffing services purchases has in somecases made it more difficult for us to obtain or retain business.

 

We expect thelevel of competition to remain high in the future, and competitive pricingpressures will continue to make it difficult for us to raise our prices to immediatelyand fully offset increased costs of doing business, including increased laborcosts, costs for workers’ 

20

----

compensation and, domestically, 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.

 

**We havesignificant working capital requirements and are heavily dependent upon ourability to borrow money to meet these working capital requirements.**

** **

We require significant amounts of working capital to operate ourbusiness and to pay expenses relating to employment of temporary employees.Temporary personnel are generally paid on a weekly basis while payments fromcustomers are generally received 30 to 60 days after billing. As a result, wemust maintain sufficient cash availability to pay temporary personnel prior toreceiving payment from customers.

 

We financeour operations primarily through borrowings under our revolving creditfacilities and also through cash generated by our operating activities. As of January 20, 2007, our total borrowing capacity was $14.9 million consisting of $6.0million for the domestic operations, $4.2 million for theUnited Kingdom operations and $4.7 million for the Australianoperations.

 

The amount we are entitled to borrow under our revolving creditfacilities is calculated daily and is dependent on eligible trade accountsreceivable generated from operations, which are affected by financial,business, economic and other factors, as well as by the daily timing of cashcollections and cash outflows. If we experience a significant and sustaineddrop in operating profits, or if there are unanticipated reductions in cashinflows or increases in cash outlays, we may be subject to cash shortfalls. Ifsuch a shortfall were to occur for even a brief period of time, it may have asignificant adverse effect on our business. Furthermore, our receivables maynot be adequate to allow for borrowings for other corporate purposes, such ascapital expenditures or growth opportunities, and we would be less able toreact to changes in the market or industry conditions.

 

The creditfacilities contain covenants which, among other things, require us to maintaina minimum fixed charge coverage ratio and minimum earnings before interest,taxes, depreciation and amortization, or EBITDA. At the end of fiscal 2006, theminimum EBITDA covenant increased to $13.0 million on a trailing thirteenperiod basis. We failed to comply with that covenant and were required toobtain a waiver from our lenders, which we did in conjunction with our TenthAmendment executed January 2, 2007. Any future failure to comply with thecovenants under our credit facilities could result in an event of defaultwhich, if not cured or waived, could trigger prepayment obligations. Inaddition, a change of control is defined as an event of default and also couldtrigger prepayment obligations. If we were forced to refinance borrowings underthe current facilities, there can be no assurance that such financing would beavailable or that such financing would not have a material adverse effect onour business and financial condition. Even if such refinancing were available,the terms could be less favorable and our results of operations and financialcondition could be adversely affected by increased costs and rates.

 

We typicallyexperience significant seasonal and other fluctuations in our borrowings andborrowing availability, particularly in the United States, and have, in thepast, been required to 

21

----

aggressively manage our cash to ensureadequate funds to meet working capital requirements. Such steps includedworking to improve collections and adjusting the timing of cash expenditures,reducing operating expenses where feasible and working to generate cash from avariety of other sources.

 

We havehistorically experienced periods of negative cash flow from operations andinvestment activities, especially during seasonal peaks in revenue experiencedin the third and fourth fiscal quarters of the year. In addition, we arerequired to pledge amounts to secure letters of credit that collateralizecertain workers’ compensation obligations, and these amounts may increase infuture periods. Any such increase in pledged amounts or sustained negative cashflows would decrease amounts available for working capital purposes and couldhave an adverse effect on our liquidity and financial condition.

** **

**The amount of collateralthat we are required to maintain to support our workers’ compensation obligationscould increase, reducing the amount of capital that we have available tosupport and grow our field operations.**

 

We are contractuallyobligated to collateralize our workers’ compensation obligations under ourworkers’ compensation program through irrevocable letters of credit, suretybonds or cash. As of January 20, 2007 our aggregate collateral requirements under thesecontracts have been secured through $35.3 million ofletters of credit; however, under certain circumstances, such as an inabilityto maintain minimum borrowing availability or a change in ownership and orsenior management, we could be required to increase our letters of credit by $5million. Further, our workers’ compensation program expires November 1, 2008,and as part of the renewal, could be subject to an increase in collateral.These collateral requirements are significant and place pressure on ourliquidity and working capital capacity. We believe that our current sources ofliquidity are adequate to satisfy our immediate needs for these obligations;however, our available sources of capital are limited. Depending on futurechanges in collateral requirements, we could be required to seek additionalsources of capital in the future, which may not be available on commercially reasonableterms.

** **

**Our reserves for workers’compensation claims may be inadequate to cover our ultimate liability, and wemay incur additional charges if the actual amounts exceed the reserved amounts.**

 

We maintainreserves to cover our estimated liabilities for workers’ compensation claimsbased upon actuarial estimates of the future cost of claims and relatedexpenses which have been reported but not settled, and that have been incurredbut not yet reported. The determination of these reserves is based on a numberof factors, including current and historical claims activity, medical costtrends and developments in existing claims. Reserves do not represent an exactcalculation of liability and are affected by both internal and external events,such as adverse development on existing claims, changes in medical costs,claims handling procedures, administrative costs, inflation, legal trends andlegislative changes. Reserves are adjusted as necessary to reflect new claimsand existing claims development, and such adjustments are reflected in theresults of the periods in which the reserves are adjusted. While we believe ourjudgments and estimates are adequate, if our reserves are insufficient to coverour actual losses, an adjustment could be charged to expense that may bematerial to our earnings.

** **

22

----

**Workers’ compensationcosts for temporary employees may continue to rise and reduce margins andrequire more liquidity.**

 

In the UnitedStates, we are responsible for and pay workers’ compensation costs for ourregular and temporary employees. In recent years, these costs have risensubstantially as a result of increased claims, general economic conditions,increases in healthcare costs and governmental regulations. In fiscal 2006, theincrease in the volume of claims has fallen despite an increase in our domesticrevenue, yet the increases in cost per claim have continued. Under our workers’compensation insurance program, we maintain “per occurrence” insurance, whichonly covers claims for a particular event above a $500,000 deductible. Ourworkers’ compensation insurance policy expires November 1, 2008 and we cannotguarantee that we will be able to successfully renew such policy. Further,there are covenants associated with the continuation of the policy and there canbe no guarantee that we will continue to meet those covenants going forward.Should our workers’ compensation premium costs continue to increase in thefuture, 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.

** **

**Any significant economicdownturn could result in our customers using fewer staffing services, whichcould materially adversely affect our business.**

 

Demand forstaffing services is significantly affected by the general level of economicactivity. As economic activity slows, many customers reduce their utilizationof temporary employees before undertaking layoffs of their regular full-timeemployees. Further, demand for permanent placement services also slows as thelabor pool directly available to our customers increases, making it easier forthem to identify new employees directly. Typically, we may experience increasedpricing pressures from other staffing companies during periods of economicdownturn, which could have a material adverse effect on our financial condition.The domestic economic recession of 2001 and 2002 did have a material adverseeffect on our business. Additionally, in geographic areas where we derive asignificant amount of business, a regional or localized economic downturn couldadversely affect our operating results and financial position.

** **

**We assume the obligationto make wage, tax, and regulatory payments to our temporary employees and arethen exposed to accounts receivable risks from our customers.**

 

We generallyassume responsibility for and manage the risks associated with our payrollobligations, including liability for payment of salaries and wages, payrolltaxes as well as group health insurance. These obligations are fixed and becomea liability of ours, whether or not the associated client where these employeeshave been assigned makes payments required by our service agreement, whichexposes us to credit risks. We attempt to mitigate this risk by billing on afrequent basis, which typically occurs daily or weekly. In addition, we establishan allowance for doubtful accounts for estimated losses resulting from theinability of our customers to make required and timely payments. Further, wecarefully monitor the timeliness of our customers’ payments and impose strictcredit standards. Finally, the majority of our accounts receivable is used tosecure our revolving credit facilities, which we rely on for liquidity. If wefail to 

23

----

adequately manage our credit risksassociated with accounts receivable, our financial position could be adverselyimpacted.

** **

**We derive a significantportion of our revenue from franchise agent operations.**

 

Franchiseagent operations comprise a significant portion of our revenue. For the firstfiscal quarter of 2007, 25.0% of our total revenue was derived from franchiseagent operations. In addition, our ten largest franchise agents for fiscal 2006(based on sales volume) accounted for 17.3% of our revenue. There can be noassurances that we will be able to attract new franchisees or that we will beable to retain our existing franchisees. The loss of one or more of ourfranchise agents and any associated loss of customers and sales could have amaterial adverse effect on our results of operations.

** **

**We are subject tobusiness risks associated with international operations and fluctuatingexchange rates.**

 

We presentlyhave operations in the United Kingdom, Australia and New Zealand, whichcomprised 25.2% of our revenue during the first fiscal quarter of 2007.Operations in foreign markets are inherently subject to certain risks,including in particular:

 

·      different cultures and business practices,

·      overlapping or differing tax structures,

·      economic and political uncertainties,

·      compliance issues associated withaccounting and reporting requirements, and

·      changing, complexor ambiguous foreign laws and regulations, particularly as they relate toemployment.

 

All of our sales outside of the United States are denominated inlocal currencies and, accordingly, we are subject to risks associated withfluctuations in exchange rates, which could cause a reduction in our profits.There can be no assurance that any of these factors will not have a materialadverse effect on our business, results of operations, cash flows or financialcondition.

** **

**The loss of any of ourkey personnel could harm our business.**

 

Our futurefinancial performance is significantly impacted by our ability to attract,motivate and retain key management personnel including our Chief ExecutiveOfficer and other members of the senior management team. Competition forqualified management personnel is very competitive and in the event that weexperience turnover in senior management positions, we cannot assure you thatwe will be able to recruit suitable replacements on a timely basis. We mustalso successfully integrate all new management and other key positions withinour 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.

** **

24

----

**Our success is impactedby our ability to attract and retain qualified temporary and permanentcandidates.**

 

We competewith other staffing services to meet our customers’ needs, and we must continuouslyattract reliable candidates to meet the staffing requirements of our customers.Consequently, we must continuously evaluate and upgrade our base of availablequalified personnel to keep pace with changing customer needs and emergingtechnologies. 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 candidates 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.

** **

**Our service agreementsmay be terminated on short notice, leaving us vulnerable to loss of asignificant amount of customers in a short period of time.**

 

Our serviceagreements are generally cancellable with little or no notice by the customerto us. 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.

** **

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

 

In the UnitedStates, we are responsible for and pay unemployment insurance premiums for ourtemporary and regular employees. At times, these costs have risen as a resultof increased claims, general economic conditions and government regulations.Should these costs continue to increase, there can be no assurance that we willbe able to increase the fees charged to our customers in the future to keeppace with the increased costs, and if we do not, our results of operations andliquidity could be adversely affected.

** **

**Our informationtechnology systems are critical to the operations of our business.**

 

Ourinformation management systems are essential for data exchange and operationalcommunications with branches spread across large geographical distances. Wehave replaced key component hardware and software including backup systemswithin the past twelve months and are currently working towards replacingfurther key components over the next twelve to eighteen months. Anyinterruption, impairment or loss of data integrity or malfunction of thesesystems could severely impact our business, especially our ability to timelyand accurately pay employees and bill customers. Further, any significant delayin our plans to replace the remaining key components could adversely affect thebusiness. Issues with either would require that we commit significantadditional capital as well as management resources in order to resolve theinterruption or delay.

** **

25

----

**We may be exposed toemployment-related claims and costs that could materially adversely affect ourbusiness.**

 

We are in thebusiness of employing people and placing them in the workplace of otherbusinesses 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:

 

·      claims of discrimination and harassment,

·      violations of wage and hour laws,

·      criminal activity,

·      claims relating to actions by customersincluding property damage and personal injury, misuse of proprietary informationand misappropriation of assets, and

·      immigrationrelated claims.

 

In addition, some or all of these claims may give rise tolitigation, which could be time-consuming to our management team, andtherefore, could have a negative effect on our business. In some instances, wehave agreed to indemnify our customers against some or all of these types ofliabilities. We have policies and guidelines in place to help reduce ourexposure to these risks and have purchased insurance policies against certain risksin amounts that we currently believe to be adequate. However, there can be noassurance that our insurance will be sufficient in amount or scope to coverthese types of liabilities or that we will be able to secure insurance coveragefor such risks on affordable terms. Furthermore, there can be no assurance thatwe will not experience these issues in the future or that they could have amaterial adverse effect on our business.

** **

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

 

The averagedaily trading volume for our common stock on the NASDAQ Global Market wasapproximately 33,000 shares from January 1, 2006, through December 31, 2006.Accordingly, the market price of our common stock is subject to significantfluctuations that have been, and may continue to be, exaggerated because anactive trading market has not developed for the stock. We believe that thecommon stock price has also been negatively affected by the fact that our stockis thinly traded and also due to the absence of analyst coverage. The lack ofanalyst reports about our stock may make it difficult for potential investorsto make decisions about whether to purchase our stock and may make it lesslikely that investors will purchase the stock, thus further depressing thestock price. These negative factors may make it difficult for stockholders tosell our common stock, which may result in losses for investors.

** **

**The compliance costsassociated with Section 404 of the Sarbanes-Oxley Act regarding internalcontrol over financial reporting could be substantial, while failure to achieveand maintain compliance could have an adverse effect on our stock price.**

 

Pursuant toSection 404 of the Sarbanes-Oxley Act of 2002 and current Securities and ExchangeCommission (“SEC”) regulations and proposed rules, beginning with our Annual 

26

----

Report for the fiscal year ended November1, 2008, we expect to be required to furnish a report by our management on ourinternal control over financial reporting. Further, we expect that our externalauditors will be required to audit our internal control over financialreporting report and include their attestation on that report in our annualreport on Form 10-K starting from our annual report for the 2009 fiscal year.The process of fully documenting and testing our internal control procedures inorder to satisfy these requirements will result in increased general andadministrative expenses and may shift management time and attention fromprofit-generating activities to compliance activities. Furthermore, during thecourse of our internal control testing, we may identify deficiencies which wemay not be able to remediate in time to meet the reporting deadline underSection 404. Failure to achieve and maintain an effective internal controlenvironment or complete our Section 404 certifications could have a materialadverse effect on our stock price.

** **

**We are involved in anaction taken by the California Employment Development Department.**

 

During thefourth quarter of fiscal 2005, we were notified by the California EmploymentDevelopment Department, or EDD, that our domestic operating subsidiariesunemployment tax rates would be increased retroactively for both calendar years2005 and 2004, which would result in additional unemployment taxes ofapproximately $0.9 million. We have timely appealed the ruling by the EDD andare working with our outside counsel to resolve this matter. Although webelieve that we have properly calculated our unemployment insurance tax and arein compliance with all applicable laws and regulations, there can be noassurances this will be settled in our favor.

** **

**We are a defendant in avariety of litigation and other actions from time to time, which may have amaterial adverse effect on our business, financial condition and results ofoperations.**

 

We are regularly involvedin a variety of litigation arising out of our business and, in recent years,have paid significant amounts as a result of adverse arbitration awards. We donot have insurance for some of these claims, and there can be no assurance thatthe insurance coverage we have will cover all claims that may be assertedagainst us. Should the ultimate judgments or settlements not be covered byinsurance or exceed our insurance coverage, they could have a material adverseeffect on our results of operations, financial position and cash flows. Therecan also be no assurance that we will be able to obtain appropriate andsufficient types or levels of insurance in the future or that adequate replacementpolicies will be available on acceptable terms, if at all.

 

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

 

Not applicable.

 

### **Item3.    Defaults Upon Senior Securities**

Not applicable.

### **Item4.    Submission of Matters to a Vote of SecurityHolders**

None.

### **Item5.    OtherInformation**

No events.

**Item 6.    Exhibits**

Set forth below is a list of the exhibits included aspart of this Quarterly Report:
| 10.3.13.1 |   | Employment Agreement by and between Westaff Support,  Inc. and Jeffrey A. Elias dated November 28, 2006.             |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------|
| 10.3.14.1 |   | Employment Contract by and between Westaff (USA),  Inc./Westaff Support, Inc. and Eric Person dated August 14, 2006. |
| 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.             |

 

27

----

 
| 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. |

 

28

----

**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.        |   |   |
|---------------|---------------------------------------------------------------|----------------------|--------|--------|
|          |                                                          |                 |   |   |
|          |                                                          |                 |   |   |
| March 6, 2007 |                                                          | /s/ John P.  Sanders |   |   |
| Date          |                                                          | John P. Sanders      |   |   |
|          | Senior Vice President, Chief Financial Officer and  Treasurer |                 |
|               |                                                               |                      |        |        |  |  |

 

29

----

**EXHIBIT INDEX**
| Exhibit No. | ** ** | **Description of Document**                                                                                                                             |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                    |
| 10.3.13.1   |       | Employment Agreement by and between Westaff Support,  Inc. and Jeffrey A. Elias dated November 28, 2006.                                                |
|        |       |                                                                                                                                                    |
| 10.3.14.1   |       | Employment Contract by and between Westaff (USA),  Inc./Westaff Support, Inc. and Eric Person dated August 14, 2006.                                    |
|        |       |                                                                                                                                                    |
| 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. |

 

----