##### **UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C.  20549**

 

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

 

##### **(MARK ONE)**

 
| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934.**                                                                                                                                           |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                     |
|       |       | **For the quarterly period ended****July 10, 2004**                                                                                                                                                                                      |
|       |       |                                                                                                                                                                                                                                     |
| **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 registrantas specified in its charter)

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

 

##### **298 North WigetLane**

**Walnut Creek, California  94598-2453**

(Address of registrant’sprincipal executive offices)

 

**(925)  930-5300**

(Registrant’s telephone number)

 

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

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).     Yes   o    No   ý

 

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

 

| **Class**                     | ** ** | **Outstanding at August 23, 2004** |
|-------------------------------|------------|------------------------------------|
|                          |       |                               |
| Common Stock, $.01 par  value |       | 16,047,167 shares                  |

 

 

----

 

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

 

**INDEX**

 

 
| ** **   | ** **                                                                                                | **Page**   |
|--------------|-----------------------------------------------------------------------------------------------------------|------------|
| ** **   | ** **                                                                                                | ** ** |
| **Part I.**  | **Financial Information**                                                                                 | ** ** |
| ** **   |                                                                                                      |       |
| Item  1.     | Financial  Statements (Unaudited)                                                                         |       |
|         |                                                                                                      |       |
|         | Condensed Consolidated  Balance Sheets -  July 10, 2004 and November 1, 2003                              | 3          |
|         |                                                                                                      |       |
|         | Condensed  Consolidated Statements of Operations -  12 and 36 weeks ended July 10, 2004 and July 12, 2003 | 4          |
|         |                                                                                                      |       |
|         | Condensed  Consolidated Statements of Cash Flows -  36 weeks ended July 10, 2004 and July 12, 2003        | 5          |
|         |                                                                                                      |       |
|         | Notes  to Condensed Consolidated Financial Statements                                                     | 6          |
|         |                                                                                                      |       |
| Item  2.     | Management’s Discussion and Analysis of  Financial Condition and Results of Operations               | 13         |
|         |                                                                                                      |       |
| Item  3.     | Quantitative  and Qualitative Disclosures About Market Risk                                               | 19         |
|         |                                                                                                      |       |
| Item  4.     | Controls  and Procedures                                                                                  | 19         |
|         | ** **                                                                                                | ** ** |
| **Part II.** | **Other Information**                                                                                     | ** ** |
| ** **   | ** **                                                                                                | ** ** |
| Item 1.      | Legal Proceedings                                                                                         | 21         |
|         |                                                                                                      |       |
| Item 2.      | Changes in Securities, Use of  Proceeds and Issuer Purchases of Equity Securities                         | 21         |
|         |                                                                                                      |       |
| Item 3.      | Defaults Upon Senior  Securities                                                                          | 21         |
|         |                                                                                                      |       |
| Item  4.     | Submission  of Matters to a Vote of Security Holders                                                      | 21         |
|         |                                                                                                      |       |
| Item 5.      | Other Information                                                                                         | 21         |
|         |                                                                                                      |       |
| Item 6.      | Exhibits and Reports  on Form 8-K                                                                         | 21         |
|         |                                                                                                      |       |
| Signatures   | 23                                                                                                        |

 

----

 

**Partl**.     FinancialInformation

 

**Item1.**    FinancialStatements

 

**Westaff,Inc.**

 

**CondensedConsolidated Balance Sheets**(Unaudited)

**(Inthousands except per share amounts)**

 
| ** **                                                                                                                                               | ** ** | **July 10,  2004** | ** ** | **November 1,  2003** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                               | ** ** | ** **         | ** ** | ** **            | ** ** |
| **ASSETS**                                                                                                                                               |       |               |       |                  |       |
| Current assets:                                                                                                                                          |       |               |       |                  |       |
| Cash and cash  equivalents                                                                                                                               |       | $                  | 3,445      |                  | $          | 4,759 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $1,051 and $1,067                                                                    |       | 77,329             |       | 74,564                |       |
| Income taxes  receivable                                                                                                                                 |       | 528                |       | 536                   |       |
| Prepaid expenses                                                                                                                                         |       | 2,893              |       | 2,833                 |       |
| Other current  assets                                                                                                                                    |       | 1,221              |       | 1,741                 |       |
| Total current  assets                                                                                                                                    |       | 85,416             |       | 84,433                |       |
|                                                                                                                                                     |       |               |       |                  |       |
| Property and  equipment, net                                                                                                                             |       | 9,464              |       | 12,569                |       |
| Goodwill, net                                                                                                                                            |       | 11,716             |       | 11,687                |       |
| Other long-term  assets                                                                                                                                  |       | 12,439             |       | 4,458                 |       |
| Total Assets                                                                                                                                             |       | $                  | 119,035    |                  | $          | 113,147 |   |
|                                                                                                                                                     |       |               |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                           |       |               |       |                  |       |
| Current  liabilities:                                                                                                                                    |       |               |       |                  |       |
| Borrowing under  revolving credit facilities                                                                                                             |       | $                  | 23,012     |                  | $          | 25,410 |   |
| Current portion  of capital lease obligations                                                                                                            |       | 455                |       | 432                   |       |
| Note payable to  related party                                                                                                                           |       | 1,000              |       |                  |       |
| Accounts payable                                                                                                                                         |       | 2,278              |       | 2,013                 |       |
| Accrued expenses                                                                                                                                         |       | 40,478             |       | 34,086                |       |
| Income taxes  payable                                                                                                                                    |       | 567                |       | 626                   |       |
| Net liabilities  of discontinued operations                                                                                                              |       | 248                |       | 629                   |       |
| Total current  liabilities                                                                                                                               |       | 68,038             |       | 63,196                |       |
|                                                                                                                                                     |       |               |       |                  |       |
| Note payable to  related party                                                                                                                           |       | 2,000              |       | 2,000                 |       |
| Long-term capital  lease obligations                                                                                                                     |       | 270                |       | 590                   |       |
| Other long-term  liabilities                                                                                                                             |       | 11,598             |       | 11,905                |       |
| Total  liabilities                                                                                                                                       |       | 81,906             |       | 77,691                |       |
|                                                                                                                                                     |       |               |       |                  |       |
| Commitments and  contingencies                                                                                                                           |       |               |       |                  |       |
|                                                                                                                                                     |       |               |       |                  |       |
| Stockholders’  equity:                                                                                                                              |       |               |       |                  |       |
| Preferred stock,  $.01 par value; authorized and unissued: 1,000 shares                                                                                  |       |               |       |                  |       |
| Common stock,  $.01 par value; authorized: 25,000 shares; issued and outstanding: 16,033  shares at July 10, 2004 and 16, 015 shares at November 1, 2003 |       | 160                |       | 160                   |       |
| Additional  paid-in capital                                                                                                                              |       | 36,737             |       | 36,706                |       |
| Retained earnings  (accumulated retained deficit)                                                                                                        |       | 570                |       | (448                  | )          |
| Accumulated  other comprehensive loss                                                                                                                    |       | (338               | )          | (962                  | )          |
| Total  stockholders’ equity                                                                                                                         |       | 37,129             |       | 35,456                |       |
| Total  Liabilities and Stockholders’ Equity                                                                                                         |       | $                  | 119,035    |                  | $          | 113,147 |   |

 

See accompanying notes tocondensed consolidated financial statements.

 

3

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**Westaff, Inc.**

 

**Condensed Consolidated Statements ofOperations****(Unaudited)**

**(In thousands except per shareamounts)**

 
| ** **                                                                                                             | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                                             | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Revenue                                                                                                                |       | $                  | 142,266    |               | $          | 117,149 |   | $ | 395,922 |   | $ | 351,424 |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Costs of  services                                                                                                     |       | 117,639            |       | 96,479             |       | 328,663 |   | 290,573 |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Gross profit                                                                                                           |       | 24,627             |       | 20,670             |       | 67,259 |   | 60,851 |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Franchise  agents’ share of gross profit                                                                          |       | 4,313              |       | 3,699              |       | 12,099 |   | 10,673 |   |
| Selling and  administrative expenses                                                                                   |       | 16,890             |       | 16,043             |       | 49,211 |   | 49,157 |   |
| Depreciation and  amortization                                                                                         |       | 1,026              |       | 1,317              |       | 3,199 |   | 3,907 |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Operating income  (loss) from continuing operations                                                                    |       | 2,398              |       | (389               | )          | 2,750 |   | (2,886 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Interest expense                                                                                                       |       | 510                |       | 374                |       | 1,425 |   | 1,196 |   |
| Interest income                                                                                                        |       | (24                | )          | (39                | )          | (58 | ) | (140 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Income (loss)  from continuing operations before income taxes and cumulative effect of  change in accounting principle |       | 1,912              |       | (724               | )          | 1,383 |   | (3,942 | ) |
| Provision for  income taxes                                                                                            |       | 307                |       | 123                |       | 515 |   | 232 |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Income (loss)  from continuing operations before cumulative effect of change in accounting  principle                  |       | 1,605              |       | (847               | )          | 868 |   | (4,174 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Income from  discontinued operations                                                                                   |       | 150                |       |               |       | 150 |   | 316 |   |
| Cumulative  effect of change in accounting principle                                                                   |       |               |       |               |       |   |   | (670 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Net income  (loss)                                                                                                     |       | $                  | 1,755      |               | $          | (847 | ) | $ | 1,018 |   | $ | (4,528 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Earnings (loss)  per share - basic and diluted:                                                                        |       |               |       |               |       |   |   |   |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Continuing  operations before cumulative effect of change in accounting principle                                      |       | $                  | 0.10       |               | $          | (0.05 | ) | $ | 0.05 |   | $ | (0.26 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Discontinued  operations                                                                                               |       | $                  | 0.01       |               | $          | — |   | $ | 0.01 |   | $ | 0.02 |   |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Cumulative  effect of change in accounting principle                                                                   |       | $                  | —     |               | $          | — |   | $ | — |   | $ | (0.04 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Net income  (loss)                                                                                                     |       | $                  | 0.11       |               | $          | (0.05 | ) | $ | 0.06 |   | $ | (0.28 | ) |
|                                                                                                                   |       |               |       |               |       |   |   |   |   |
| Weighted average  shares outstanding - basic                                                                           |       | 16,033             |       | 15,995             |       | 16,027 |   | 15,987 |   |
| Weigthed average  shares outstanding - diluted                                                                         |       | 16,068             |       | 15,995             |       | 16,033 |   | 15,987 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**Westaff, Inc.**

 

**Condensed Consolidated Statements ofCash Flows****(Unaudited)**

**(In thousands)**

 
| ** **                                                                                | ** ** | **36 Weeks Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** |
| **Cash  flows from operating activities**                                                 |       |               |       |   |   |
| Net income  (loss)                                                                        |       | $                  | 1,018      |   | $ | (4,528 | ) |
| Adjustments to  reconcile net income (loss) to net cash provided by operating activities: |       |               |       |   |   |
| Income from  discontinued operations                                                      |       | (150               | )          | (316 | ) |
| Loss from  cumulative effect of change in accounting principle                            |       |               |       | 670 |   |
| Depreciation and  amortization                                                            |       | 3,199              |       | 3,907 |   |
| Provision for losses  on doubtful accounts                                                |       | 782                |       | 375 |   |
| (Gain) loss on  sale or disposal of assets                                                |       | (677               | )          | 9 |   |
| Income from sale  of affiliate operations                                                 |       | (16                | )          |   |   |
| Other                                                                                     |       | (148               | )          | (109 | ) |
| Changes in  assets and liabilities:                                                       |       |               |       |   |   |
| Trade accounts  receivable                                                                |       | (2,545             | )          | 10,860 |   |
| Other assets                                                                              |       | (7,750             | )          | (1,731 | ) |
| Accounts payable  and accrued expenses                                                    |       | 5,977              |       | 688 |   |
| Income taxes  payable                                                                     |       | (77                | )          | (244 | ) |
| Other  liabilities                                                                        |       | 282                |       | (4,491 | ) |
|                                                                                      |       |               |       |   |   |
| Net cash (used)  provided by continuing operations                                        |       | (105               | )          | 5,090 |   |
| Net cash (used)  provided by discontinued operations                                      |       | (231               | )          | 393 |   |
|                                                                                      |       |               |       |   |   |
| Net cash (used)  provided by operating activities                                         |       | (336               | )          | 5,483 |   |
|                                                                                      |       |               |       |   |   |
| **Cash  flows from investing activities**                                                 |       |               |       |   |   |
| Capital  expenditures                                                                     |       | (1,291             | )          | (2,245 | ) |
| Proceeds from  sales of affiliate operations                                              |       | 26                 |       | 272 |   |
| Proceeds from  sales of assets                                                            |       | 1,938              |       | 7,386 |   |
| Other                                                                                     |       | 26                 |       | 38 |   |
|                                                                                      |       |               |       |   |   |
| Net cash  provided by investing activities                                                |       | 699                |       | 5,451 |   |
|                                                                                      |       |               |       |   |   |
| **Cash  flows from financing activities**                                                 |       |               |       |   |   |
| Net repayments  under line of credit agreements                                           |       | (2,560             | )          | (5,799 | ) |
| Principal  payments on long-term debt and capital lease obligations                       |       | (296               | )          | (4,722 | ) |
| Proceeds from  notes payable to related parties                                           |       | 1,000              |       |   |   |
| Payment of note  payable to related party                                                 |       |               |       | (1,000 | ) |
| Payment of debt  issuance costs                                                           |       | (121               | )          | (357 | ) |
| Proceeds from  issuance of common stock                                                   |       | 32                 |       | 43 |   |
|                                                                                      |       |               |       |   |   |
| Net cash used by  financing activities                                                    |       | (1,945             | )          | (11,835 | ) |
|                                                                                      |       |               |       |   |   |
| Effect of  exchange rate changes on cash                                                  |       | 268                |       | 64 |   |
|                                                                                      |       |               |       |   |   |
| Net change in  cash and cash equivalents                                                  |       | (1,314             | )          | (837 | ) |
| Cash and cash  equivalents at beginning of period                                         |       | 4,759              |       | 5,484 |   |
| Cash and cash  equivalents at end of period                                               |       | $                  | 3,445      |   | $ | 4,647 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

5

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**Westaff, Inc.**

 

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

**(In thousands except per shareamounts)**

 

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

 

The accompanyingcondensed consolidated financial statements of Westaff, Inc. and its domesticand foreign subsidiaries (together, the Company), as of July 10, 2004 and forthe 12 and 36 week periods ended July 10, 2004 and July 12, 2003 are unaudited.

 

The condensedconsolidated financial statements, in the opinion of management, reflect alladjustments, which are of a normal recurring nature, necessary for a fairpresentation of the financial position, results of operations and cash flowsfor the periods presented.  The condensedconsolidated balance sheet as of November 1, 2003 presented herein, has beenderived from the audited balance sheet included in the Company’s Annual Reporton Form 10-K for the fiscal year ended November 1, 2003.

 

Certain financialinformation which is normally included in annual financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates, but which is not required for interim reporting purposes, has beencondensed or omitted.  The accompanyingcondensed consolidated financial statements should be read in conjunction withthe financial statements and notes thereto included in the Company’s AnnualReport on Form 10-K for the fiscal year ended November 1, 2003.

 

The Company’s fiscal yearis a 52 or 53 week period ending the Saturday nearest the end of October.  For interim reporting purposes, the firstthree fiscal quarters comprise 12 weeks each, while the fourth fiscal quarterconsists of 16 or 17 weeks.  The resultsof operations for the 12 and 36 week periods ended July 10, 2004 are notnecessarily indicative of the results to be expected for the full fiscal yearor for any future period.

 

During fiscal year1999, the Company sold its medical business, primarily operated through WesternMedical Services, Inc. (Western Medical), a wholly owned subsidiary of theCompany (see Note 4).  As a result, theCompany has classified its medical operations as discontinued operations inthese condensed consolidated financial statements and notes thereto.

 

**2.**     Stock-basedCompensation

 

TheCompany measures compensation cost for employee stock options and similarequity instruments using the intrinsic value-based method of accountingprescribed by Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees”(APB 25), and follows the disclosure-only provisions ofSFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No.148, “Accounting for Stock-Based Compensation – Transition andDisclosure”.  As all options have beengranted at fair value, no compensation cost has been recognized in thefinancial statements.  The followingtable represents pro forma net income (loss) and pro forma income (loss) pershare had compensation cost been determined using the fair value method:

 

6

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| ** **                                                       | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                       | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** |
|                                                             |       |               |       |               |       |   |   |   |   |
| Net income  (loss) as reported                                   |       | $                  | 1,755      |               | $          | (847 | ) | $ | 1,018 |   | $ | (4,528 | ) |
| Stock based  compensation determined under the fair value method |       | (102               | )          | (128               | )          | (310 | ) | (382 | ) |
|                                                             |       |               |       |               |       |   |   |   |   |
| Pro forma net  income (loss)                                     |       | $                  | 1,653      |               | $          | (975 | ) | $ | 708 |   | $ | (4,910 | ) |
|                                                             |       |               |       |               |       |   |   |   |   |
| Income (loss)  per common share:                                 |       |               |       |               |       |   |   |   |   |
| Basic and  diluted - as reported                                 |       | $                  | 0.11       |               | $          | (0.05 | ) | $ | 0.06 |   | $ | (0.28 | ) |
| Basic and  diluted - pro forma                                   |       | $                  | 0.10       |               | $          | (0.06 | ) | $ | 0.04 |   | $ | (0.31 | ) |

 

Becausestock options generally become exercisable over several years and additionalgrants are likely to be made in future periods, the pro forma amounts forcompensation cost may not be indicative of the effects on net income andearnings per share for future periods.

 

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

 

Effective November 3,2002, the Company adopted Statement of Financial Accounting Standards (SFAS)No. 142 “Goodwill and Other Intangible Assets”. SFAS No. 142 provides that goodwill and other intangible assets withindefinite lives are no longer amortized, but rather are evaluated forimpairment by applying a fair-value based test. The impairment test iscomprised of two parts.  The first stepcompares the fair value of a reporting unit with its carrying value, includinggoodwill.  If the carrying value of areporting unit exceeds its fair value, the second step of the goodwillimpairment test must be performed.  Thesecond step compares the implied fair value of the reporting units’ goodwillwith the respective carrying value in order to determine the amount ofimpairment loss, if any.

 

During fiscal 2003, theCompany performed tests for impairment in accordance with the newstandard.  In the initial test under thetransitional provisions of SFAS No. 142, the Company determined that animpairment of $670 existed in its Australia reporting unit. In accordance withSFAS No. 142, the impairment was classified as a cumulative effect of a changein accounting principle and resulted in a restatement of the Company’s net lossfor the fiscal quarter ended January 25, 2003.

 

The Company performs itsannual impairment evaluation in the fourth quarter of each fiscal year. Noadditional impairment was identified in the Company’s annual impairmentevaluation for fiscal 2003.

 

7

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**The change in the carrying amount of goodwill for the 36weeks ended July 10, 2004 is due to the effect of changes in foreign currencytranslation rates.**

 

**In accordance with SFAS No. 142, no amortization of goodwillwas recorded in the 12 and 36 week periods ended July 10, 2004 and July 12,2003.**

 

**4.**     DiscontinuedOperations

 

Duringfiscal 1999, the Company sold certain of its franchise agent and Company-ownedmedical offices and entered into a termination agreement with one of itsmedical licensees. During the fourth quarter of fiscal 1999, the Companycompleted the sale of the remaining medical business to Intrepid U.S.A. Inc.under an asset purchase agreement. Under the terms of the sale, the Companyretained the majority of accounts receivable, including trade and Medicareaccounts receivable balances.

 

Priorto fiscal 2003, the Company appealed Western Medical’s 1996 Medicare costreport settlement.  During the firstquarter of fiscal 2003, the appeal was settled and Western Medical receivedadditional cost reimbursements.  As aresult of the favorable appeal settlement, the Company recognized $316 ofincome from discontinued operations in the fiscal quarter ended January 25,2003.

 

Duringthe third quarter of 2004, the Company resolved certain significant legal andliability claims and evaluated future risks associated with remaining pendingclaims.  As a result, income fromdiscontinued operations of $150 was recognized and is reflected on theStatements of Operations for the 12 and 36 weeks ended July 10, 2004.

 

As of July 10, 2004, theremaining current liabilities of the discontinued medical operations are forsettled but unpaid legal claims of $175, malpractice/liability claims of $70and other costs of $3.

 
| ** **                                  | ** ** | **July 10,  2004** | ** ** | **November 1,  2003** | ** ** |
|---------------------------------------------|------------|--------------------|------------|-----------------------|------------|
|                                        |       |               |       |                  |       |
| Current assets                              |       | $                  |       |                  | 15         |   |
| Current  liabilities                        |       | (248               | )          | (644                  | )          |
| Net liabilities  of discontinued operations |       | $                  | (248       | )                     | $          | (629 | ) |
|                                             |            |                    |            |                       |            |  |  |

 

**5.****     Workers’ Compensation**

 

The Company isresponsible for and pays workers’ compensation costs for its temporary andregular employees and is self-insured for the deductible amount related toworkers’

 

8

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compensation claims ($500per claim for fiscal year 2003 and increasing to $750 per claim for fiscal2004.)  Each policy year the terms of theagreement 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. In addition to premium and claim payments, theCompany is cash collateralizing its fiscal 2004 policy year through paymentstotaling $13,800.  As of July 10, 2004,$10,300 had been paid and is included in long term assets on the Company’sConsolidated Balance Sheet at July 10, 2004.

 

**6.**     Earnings(Loss) Per Share

 

The followingtable sets forth the computation of basic and diluted earnings (loss) pershare:

 
| ** **                                                                                                                          | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                                                          | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** |
|                                                                                                                                |       |               |       |               |       |   |   |   |   |
| Income (loss)  from continuing operations before cumulative effect of change in accounting  principle                               |       | $                  | 1,605      |               | $          | (847 | ) | $ | 868 |   | $ | (4,174 | ) |
|                                                                                                                                |       |               |       |               |       |   |   |   |   |
| Denominator for  basic earnings per share - weighted average shares                                                                 |       | 16,033             |       | 15,995             |       | 16,027 |   | 15,987 |   |
|                                                                                                                                |       |               |       |               |       |   |   |   |   |
| Effect of  dilutive securities - stock options                                                                                      |       | 35                 |       | —             |       | 6 |   | — |   |
| Denominator for  diluted earngs per share - adjusted weighted average shares and assumed  conversions                               |       | 16,068             |       | 15,995             |       | 16,033 |   | 15,987 |   |
|                                                                                                                                |       |               |       |               |       |   |   |   |   |
| Basic and  diluted earnings (loss) per share from continuing operations before  cumulative effect of change in accounting principle |       | $                  | 0.10       |               | $          | (0.05 | ) | $ | 0.05 |   | $ | (0.26 | ) |
|                                                                                                                                |       |               |       |               |       |   |   |   |   |
| Anti-dilutive  weighted shares excluded from diluted earnings (loss) per share                                                      |       | 422                |       | 1,075              |       | 999 |   | 1,083 |   |

 

**7.****     Comprehensive Income (Loss)**

 

Comprehensiveincome (loss) consists of the following

 
| ** **                        | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                        | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** | **July 10,  2004** | ** ** | **July 12,  2003** | ** ** |
|                              |       |               |       |               |       |   |   |   |   |
| Net income  (loss)                |       | $                  | 1,755      |               | $          | (847 | ) | $ | 1,018 |   | $ | (4,528 | ) |
| Currency  translation adjustments |       | (17                | )          | 474                |       | 624 |   | 1,007 |   |
| Comprehensive  income (loss)      |       | $                  | 1,738      |               | $          | (373 | ) | $ | 1,642 |   | $ | (3,521 | ) |

 

9

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**8.****     CreditAgreement**

 

At fiscal year end November 1, 2003 and through the first fiscalquarter of 2004, the Company was out of compliance with certain financialcovenants under its Multicurrency Credit Agreement, including a minimumearnings before interest, taxes, depreciation and amortization (EBITDA)covenant.  On February 20, 2004, theCompany and its lending agents executed a fourth amendment to thatagreement.  The amendment allowed certainone-time add-backs to EBITDA for the fiscal period ended November 1, 2003,which corrected the covenant defaults and reset the EBITDA and certain othercovenants going forward.  The amendmentalso required a separate EBITDA covenant calculation for the Company’s domesticoperations on a stand-alone basis.  Inaddition, the amendment reset the reserves which affect the Company’s borrowingcapacity, redefined eligible trade accounts receivable for purposes ofcalculating the US and UK borrowing base, increased the applicable margins onoutstanding irrevocable letters of credit by 1.0% and reduced maximum capitalexpenditures allowed for fiscal 2004 by $1,000.

 

At July 10, 2004 the Company was in compliance with all covenants underthe credit agreement.

 

Effective July 31, 2004 the Company and its lenders executed a fifthamendment to the Multicurrency Credit Agreement. The amendment increased theeligible collateral that may be used for the Company’s borrowing base andeliminated certain reserves against the borrowing availability.  Additionally, the amendment resetconsolidated minimum EBITDA covenants, eliminated the requirement for aseparate EBITDA covenant calculation for domestic operations, reduced the rangeof margins on bank borrowings and outstanding letters of credit and increasedallowable capital expenditures for fiscal 2004 to $5,000.

 

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

 

On September 25, 2003 theCompany executed a one-year unsecured subordinated draw down note with itsprincipal stockholder and Chairman of the Board of Directors.  The note provides for the Chairman to makeadvances to the Company upon request, at his sole discretion and with noobligation to do so, in an aggregate principal amount not to exceed $1,000outstanding at any one time.  Principaland interest on advances are due and payable on the earlier of twenty-two businessdays from the date of the advance or the final maturity date of the draw downnote (September 25, 2004), subject to certain restrictions regarding borrowingcapacity and compliance with certain covenants in the Company’s senior securedcredit facilities.  The interest rate onoutstanding advances is equal to an indexed rate as calculated under theCompany’s credit facilities plus seven percent, compounded monthly. On December23, 2003 the Chairman made a $1,000 advance to the Company under the terms ofthe note.  The advance plus accruedinterest was repaid on August 3, 2004.

 

The Company also has anunsecured subordinated promissory note payable to its principal stockholder andChairman of the Board of Directors dated May 17, 2002 in the amount of

 

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$2,000.  The note has a maturity date of August 18,2007 and an interest rate equal to an indexed rate as calculated under theCompany’s credit facilities plus seven percent, compounded monthly and payable60 calendar days after the end of each of the Company’s fiscal quarters.  The interest rate in effect on July 10, 2004was 11.25%.  Payment of interest iscontingent on the Company meeting minimum availability requirements under itscredit facilities. Additionally, payments of principal or interest areprohibited in the event of any default under the credit facilities.

 

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

 

The following tablesummarizes reporting segment data:

 
| ** **                                                                                                      | ** ** | **Domestic  Business Svcs.** | ** ** | **United Kingdom  Operations** | ** ** | **Other  International** | ** ** | **Total  Continuing  Operations** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------------|------------|--------------------------|------------|-----------------------------------|------------|
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| **12  Weeks Ended July 10, 2004**                                                                               |       |                         |       |                           |       |                     |       |                              |       |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| Revenue                                                                                                         |       | $                            | 111,852    |                           | $          | 10,726                   |       | $                                 | 19,688     |   | $ | 142,266 |   |
| Operating income  (loss) from continuing operations before cumulative effect of change in  accounting principle |       | $                            | 1,277      |                           | $          | 829                      |       | $                                 | 292        |   | $ | 2,398 |   |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| **12  Weeks Ended July 12, 2003**                                                                               |       |                         |       |                           |       |                     |       |                              |       |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| Revenue                                                                                                         |       | $                            | 92,940     |                           | $          | 8,111                    |       | $                                 | 16,098     |   | $ | 117,149 |   |
| Operating income  (loss) from continuing operations before cumulative effect of change in  accounting principle |       | $                            | (659       | )                              | $          | 368                      |       | $                                 | (98        | ) | $ | (389 | ) |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| **36  Weeks Ended July 10, 2004**                                                                               |       |                         |       |                           |       |                     |       |                              |       |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| Revenue                                                                                                         |       | $                            | 308,405    |                           | $          | 29,013                   |       | $                                 | 58,504     |   | $ | 395,922 |   |
| Operating income  (loss) from continuing operations before cumulative effect of change in  accounting principle |       | $                            | 939        |                           | $          | 1,424                    |       | $                                 | 387        |   | $ | 2,750 |   |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| **36  Weeks Ended July 12, 2003**                                                                               |       |                         |       |                           |       |                     |       |                              |       |
|                                                                                                            |       |                         |       |                           |       |                     |       |                              |       |
| Revenue                                                                                                         |       | $                            | 283,806    |                           | $          | 21,757                   |       | $                                 | 45,861     |   | $ | 351,424 |   |
| Operating income  (loss) from continuing operations before cumulative effect of change in  accounting principle |       | $                            | (2,926     | )                              | $          | 664                      |       | $                                 | (624       | ) | $ | (2,886 | ) |

 

**11.  Commitments and Contingencies**

 

In the ordinary course of its business, the Company is periodicallythreatened with or named as a defendant in various lawsuits.  The principal risks that the Company insuresagainst are workers’ compensation, general liability, automobile liability,property damage, alternative staffing errors

 

11

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and omissions, fiduciary liability and fidelity losses.  From time to time the Company has beenthreatened with, or named as a defendant in, lawsuits, including countersuitsbrought by former franchise agents or licensees, and administrative claims andlawsuits brought by employees or former employees.  The Company does not believe the outcome ofany proceedings on these actions would have a material adverse effect on itsfinancial position, results of operations or cash flows.

 

**12.****  RecentAccounting Pronouncements**

 

In January 2003, theFinancial Accounting Standards Board (FASB) issued FASB Interpretation No. 46,“Consolidation of Variable Interest Entities, an Interpretation of AccountingResearch Bulletin No. 51” (FIN 46).  FIN46 provides guidance on identifying variable interest entities and assessingwhether or not they should be consolidated. The Company was required to adopt the Interpretation effective with itsfiscal quarter ended April 17, 2004.  Theadoption did not have a material impact on the Company’s consolidated resultsof operations or financial position.

 

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

 

### **Cautionary Statement**

 

This notice is intendedto take advantage of the “safe harbor” provided by the Private SecuritiesLitigation Reform Act of 1995 with respect to forward-looking statements.Except for the historical information contained herein, the matters discussedshould be considered forward-looking statements and readers are cautioned notto place undue reliance on those statements. The forward-looking statements inthis discussion are made based on information available as of the date hereofand are subject to a number of risks and uncertainties that could cause theCompany’s actual results and financial position to differ materially from thoseexpressed or implied in the forward-looking statements. These risks anduncertainties include, but are not limited to, those discussed in Item 1.“Factors Affecting Future Operating Results” and elsewhere in the Company’sAnnual Report on Form 10-K for the fiscal year ended November 1, 2003.  The Company undertakes no obligation topublicly release the results of any revisions to these forward-lookingstatements to reflect events or circumstances after the date hereof or toreflect the occurrence of unanticipated events, except as required byapplicable laws and regulations.

 

The following discussionis intended to assist in the understanding and assessment of significantchanges and trends related to the results of operations and financial conditionof Westaff, Inc., together with its consolidated subsidiaries. Thisdiscussion and analysis should be read in conjunction with the Company’s ConsolidatedFinancial Statements and Notes thereto included elsewhere in this Form 10-Q andin the Company’s Annual Report on Form 10-K for the fiscal year ended November1, 2003.

 

### **Critical Accounting Policies**

 

Thepreparation of the Company’s financial statements in conformity with generallyaccepted accounting principles in the United States of America requiresmanagement to make estimates and assumptions affecting the amounts anddisclosures reported within those financial statements.  These estimates are evaluated on an ongoingbasis by management and generally affect revenue recognition, collectibility ofaccounts receivable, workers’ compensation costs, income taxes andcontingencies and litigation. Management’s estimates and assumptions are based on historicalexperiences and other factors believed to be reasonable under thecircumstances.  However, actual resultsunder circumstances and conditions different than those assumed could result indifferences from the estimated amounts in the financial statements.

 

TheCompany’s critical accounting policies are described in Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andin the notes to the consolidated financial statements in the Company’spreviously filed Annual Report on Form 10-K for the fiscal year ended November1, 2003.  There were no changes to thesepolicies during the 36 week period ended July 10, 2004.

 

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### **Executive Overview**

 

With a better than 21%increase in revenue this quarter compared to the third quarter of fiscal 2003,this fiscal quarter’s results have exceeded our expectations. The quarter’srevenue is the highest for a third quarter since fiscal 2000.  Domestic revenue is up over 20% from the prioryear quarter with double-digit growth in each of our three geographic zones. Weare encouraged by recent domestic economic data that suggests a moderate, butperhaps sustainable recovery in the temporary staffing industry.  Our weekly domestic revenue has shown asteadily increasing trend since March, though the increases for the first fourweeks of our fourth quarter are trending slightly downward to about 15% aheadof last year.  Our internationaloperations are continuing their strong sales growth, and on a constant currencybasis have reported a solid 15.8% revenue increase over the fiscal 2003 thirdquarter.  We currently expect that theyear over year revenue increase for the fourth quarter will be in the range of11% to 14%.

 

Gross margins for thedomestic staffing industry in general remain undermined by higher relativeworkers’ compensation and state unemployment costs and continued competitivepricing pressures.  While our domesticmargins have been affected by these issues as well, our consolidated marginshave increased from 16.8% and 16.7% in the first and second quarters of thisyear to 17.3% in the third quarter.  Weare maintaining our focus on growing our direct hire business, particularly inthe U.S., as one approach to increase margins. We are enjoying our highestoperating income for a 12-week quarter since the second quarter of fiscal2000.  This is primarily because weremain very prudent with our selling and administrative expenditures to drivebottom line profitability.

 

In addition to ourpositive news regarding sales and profitability, we are pleased to report theexecution of a fifth amendment to our credit agreement.  Largely made possible because of ourfavorable operating results in recent months, the amendment reduces and/or eliminatescertain restrictions on our borrowing capacity. As of the July 31, 2004 effective date, we immediately increased ourborrowing availability by $7.6 million dollars. While we continue to evaluate additional opportunities to improve ourfinancial condition, the increased borrowing capacity alleviates many of theliquidity concerns we reported in our first and second quarterly reports thisyear and in our fiscal 2003 annual report. We currently believe that we will be able to meet our working capitalneeds for the foreseeable future.

 

**Results of Operations**

 

**Fiscal Quarter Ended July 10,2004 compared to Fiscal Quarter Ended July 12, 2003**

 

Total revenue increased$25.1 million or 21.4% for the fiscal quarter of 2004 as compared to the fiscal2003 quarter.  Domestic revenue increased20.3%, while international revenue increased 25.6%, assisted by the effect offavorable exchange rates.

 

The domestic revenueincrease is the result of an increase in billed hours of 18.5% coupled with amodest increase in average bill rates of 1.2%. The growth in domestic billed hours reflects new business as well asincreases in volume with various existing customers.  Combined revenue from

 

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the top five domestic customersfor the current quarter increased over 50% when compared to revenue for thesesame customers for the third quarter of fiscal 2003.

 

Excluding the effect ofexchange rate fluctuations, international revenue increased 15.8%, with anincrease of 12.6% in billed hours and, on a constant currency basis, anincrease in average bill rates of 2.5%.

 

Costs of services includehourly wages of temporary employees, employer payroll taxes, state unemploymentand workers’ compensation insurance and other employee-related costs.  Costs of services increased $21.2 million, or21.9%, in the 2004 fiscal quarter as compared to 2003.  Gross margin declined from 17.6% for thethird quarter of fiscal 2003 to 17.3% for the current quarter, althoughimproved from the fiscal 2004 first and second quarter margins of 16.8% and16.7%, respectively.  The margin declinewhen compared to the fiscal 2003 quarter, reflects a continuing industry-widestrain on domestic margins due to competitive pressures and higher relativestate unemployment and workers’ compensation costs.  As a percent of direct labor, domestic stateunemployment rates increased 0.6 percentage points and workers’ compensationrates increased 0.2 percentage points, over the fiscal 2003 quarter rates.

 

The Company’s workers’compensation costs tend to vary depending upon the mix of business betweenclerical/administrative and light industrial staffing. Unexpected adversedevelopment of open claims and increases in the Company’s incurred but notreported claims can also significantly affect the level of accruals needed tocover workers’ compensation costs.  TheCompany reviews interim and annual actuarial estimates and monitors claimactivity to ensure that accruals remain appropriate in light of losstrends.  Based on current projections,the Company estimates that accrual rates for workers’ compensation costs forthe remainder of fiscal 2004 will be in the range of 5.2% to 5.6% of directlabor for its domestic operations. However, unanticipated adverse loss development trends could result in aneed for additional charges to be recorded before the end of the fiscal yearresulting in higher accrual rates than those currently estimated.

 

Franchise agents’ shareof gross profit represents the net distribution paid to franchise agents basedeither on a percentage of the sales or gross profit generated by the franchiseagents’ operations. As a percentage of consolidated revenue, franchise agents’share of gross profit was 3.0% for the fiscal 2004 quarter and 3.2% for the fiscal2003 quarter.

 

* *Selling and administrativeexpenses increased $0.8 million, or 5.3% for the 2004 quarter as compared tothe 2003 quarter primarily due to higher exchange rates used to translateinternational local currency expenses into U.S. dollars.  As a percentage of revenue these expensesdecreased from 13.7% to 11.9% as a result of the Company’s generating higherrevenue in the current quarter while maintaining approximately the same sellingand administrative expenditure level as in the prior year quarter.

 

Depreciation andamortization decreased $0.3 million or 22.1%, primarily due to reduced capitalexpenditures and assets becoming fully depreciated.

 

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During the third quarterof 2004, the Company resolved certain significant legal and liability claimsrelated to its discontinued medical operations and evaluated future risksassociated with remaining pending claims. As a result, income from discontinued operations of $150,000 wasrecognized and is reflected on the Statements of Operations for the 12 and 36weeks ended July 10, 2004.

 

**36 Weeks Ended July 10, 2004 compared to 36 WeeksEnded July 12, 2003**

 

On a constant currency basis, fiscal year-to-daterevenue growth for 2004 was 9.3% over the same 36-week period in 2003. * *Gross margin for the36 weeks ended July 10, 2004 was 17.0% as compared to 17.3% for the 2003period. The Company’s gross margin can be appreciably affected by its highvolume national account agreements that tend to carry lower gross margins thanother accounts.  The Company iscontinuing its focus on improving margins through adjusting bill rates wherefeasible, and by marketing its direct hire programs.

 

As a percent of revenue,selling and administrative expenses decreased from 14.0% in fiscal 2003 to12.4% in fiscal 2004.  Included in thefiscal 2004 selling and administrative expenses is a $0.7 million gain on thesale of the Company’s remaining corporate building.

 

During fiscal 1999, theCompany discontinued its medical operations (Western Medical). In the firstquarter of fiscal 2003, an appeal of Western Medical’s 1996 Medicare costreport was settled and Western Medical received additional costreimbursements.  As a result of the favorablesettlement, the Company recognized $0.3 million of income from discontinuedoperations in the first quarter of fiscal 2003. As noted in the above fiscal quarter discussion, the Company alsorecognized $150,000 of income from these discontinued operations in the thirdquarter of fiscal 2004 primarily as a result of favorable progress with respectto legal and liability claims settlements. Currently, the Company believes it has adequate reserves for remainingestimated liabilities related to the medical business of $0.2 million; however,if actual resolution costs differ from those estimated by management, theCompany would record additional losses or gains in future periods.

 

Effective November 3, 2002, the Company adoptedStatement of Financial Accounting Standards (SFAS) No. 142 “Goodwill and OtherIntangible Assets”.  SFAS No. 142provides that goodwill and other intangible assets with indefinite lives are nolonger amortized, but rather are evaluated for impairment by applying afair-value based test.  During fiscal2003, the Company performed tests for impairment in accordance with the newstandard.  In the initial test under thetransitional provisions of SFAS No. 142, the Company determined that animpairment of $670,000 existed in its Australia reporting unit.  In accordance with SFAS No. 142, theimpairment was classified as a cumulative effect of a change in accountingprinciple and resulted in a restatement of the Company’s net loss for the firstfiscal quarter of 2003.

 

**Liquidity and Capital Resources**

 

The Company requiressignificant amounts of working capital to operate its business and to payexpenses relating to employment of temporary employees. The Company’straditional use of cash

 

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is for financing ofaccounts receivable, particularly during periods of economic upswings andgrowth and during periods where sales are seasonally high. Temporary personnelare generally paid on a weekly basis while payments from customers aregenerally received 30 to 60 days after billing.

 

The Company finances itsoperations primarily through cash generated by its operating activities andborrowings under its revolving credit facilities. Net cash used by operatingactivities was $0.3 million for the 36 weeks ended July 10, 2004 compared tonet cash provided by operating activities of $5.5 million for the 36 weeksended July 12, 2003.  In the currentyear, cash payments of $10.7 million , primarily for collateral for theCompany’s workers’ compensation obligations, along with higher trade receivablebalances generated by current sales, more than offset non-cash charges andincreases in accounts payable and accrued expenses.

 

At November 1, 2003 andthrough the first quarter of fiscal 2004, the Company was out of compliancewith certain financial covenants under its Multicurrency Credit Agreement,including a minimum earnings before interest, taxes, depreciation andamortization (EBITDA) covenant.  InFebruary 2004 a fourth amendment to the agreement was executed which, amongother things, allowed certain one-time addbacks to EBITDA for the fiscal periodended November 1, 2003.  During thesecond and third quarters of fiscal 2004, the Company was in compliance withall covenants in the amended agreement. However, as discussed in the Company’ssecond quarter Form 10-Q for the period ended April 17, 2004, the Company’sU.S. operations were experiencing periods of low cash availability.

 

 Effective July 31, 2004, the Company and thelenders executed a fifth amendment to the Multicurrency Credit Agreement.  The amendment increased the eligible tradeaccounts receivable the Company uses in calculating the amount it is allowed toborrow, and eliminated previously in-place reserves that had reduced theavailable borrowings.  As of August 7,2004 the Company had $24.7 million outstanding under its credit facilities withavailable borrowing capacity of $17.6 million consisting of $10.1 million forthe U.S. operations, $4.2 million for the U.K. operations and $3.3 million forthe Australia operations.  This representsa significant increase in availability compared to prior 2004 periods.  In addition, the amendment lowered the rangeof margins on bank borrowings and outstanding irrevocable letters of credit,reset the consolidated EBITDA covenant going forward and increased allowablecapital expenditures for the fiscal 2004 year to $5.0 million.

 

The Company has anunsecured subordinated promissory note payable to its principal stockholder andChairman of the Board of Directors in the amount of $2.0 million with a maturitydate of August 18, 2007, and an interest rate equal to an indexed rate ascalculated under the Company’s credit facilities plus seven percent, compoundedmonthly and payable 60 calendar days after the end of each of the Company’sfiscal quarters.  The interest rate ineffect on July 10, 2004 was 11.25%. Payment of interest is contingent on the Company meeting minimumavailability requirements under its credit facilities.  Additionally, payments of principal orinterest are prohibited in the event of any default under the creditfacilities.

 

On September 25,2003 the Company executed a one-year unsecured subordinated draw down note withits principal stockholder and Chairman of the Board of Directors.  The note provides for the Chairman to makeadvances to the Company upon request, at his sole discretion and with

 

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no obligation todo so, in an aggregate principal amount not to exceed $1.0 million outstandingat any one time.  Principal and interest onadvances are due and payable on the earlier of twenty-two business days fromthe date of the advance or the final maturity date of the draw down note,September 25, 2004.  On December 23, 2003the Chairman made a $1.0 million advance to the Company under the terms of thenote. The advance plus accrued interest was repaid on August 3, 2004.  The Company currently does not anticipaterequesting any further advances before the note’s maturity date.

 

The Company works to balance its worldwide cash needs through dividendsfrom and loans to its international subsidiaries.  These loans and dividends are limited by theimmediate future cash availability and needs of each respective subsidiary,restrictions imposed by the Company’s senior secured debt facilities and, insome cases, statutory regulations of the subsidiary.  The US operations cannot directly draw on theexcess borrowing availability of the UK or Australian operations; however, theCompany may request dividends from the UK. During the first 36 weeks of fiscal 2004, the UK utilized cash fromoperations and excess borrowing capacity to pay dividends to the US totaling$2.7 million.  The US can also requestrepayments on its intercompany loan to Australia, although any significantremittances from Australia are currently restricted under the terms of theAustralia credit facility.  However, as aresult of positive operating performance in Australia in recent months, theCompany currently believes these restrictions may be reduced or eliminatedduring the fourth quarter of fiscal 2004.

 

The Company has generatedcash in the past through sales of Company-owned offices to franchise owners orsales of franchise agent and license offices back to the franchise agent orlicense owner, and through sales and sale/leasebacks of property and equipment.On February 12, 2004 the Company completed the sale of its remaining unoccupiedcorporate headquarters’ building for cash proceeds of $1.9 million.  The proceeds were used to pay downoutstanding borrowings under the Company’s revolving credit facilities.

 

Cash used for capitalexpenditures, which are primarily for management information systemsinitiatives, other software, computers and peripherals, and office furnitureand equipment, totaled $1.3 million for the 36 weeks ended July 10, 2004.  The Company continues to invest inenhancements and upgrades to its computer-based technologies.  On August 19, 2004 the Company entered into alicense agreement for new back-office systems. Capital expenditures for this system are expected to be in the range of$2 million to $3 million during the fourth quarter of fiscal 2004.  The Company’s credit agreement currentlyallows up to a maximum of $6 million in capital expenditures for fiscal 2005.

 

The Company isresponsible for and pays workers’ compensation costs for its temporary andregular employees and is self-insured for the deductible amount related toworkers’ compensation claims ($500,000 per claim for fiscal year 2003 andincreasing to $750,000 per claim for fiscal 2004.)  Each policy year the terms of the agreementwith the insurance carrier are renegotiated. The insurance carrier requires the Company to collateralize itsobligations through the use of irrevocable letters of credit, surety bonds orcash.  At July 10, 2004 the Company had$12.3 million of outstanding letters of credit and $5.8 million in surety bondsto secure workers compensation obligations for policy years 1992 through2003.  The Company is cashcollateralizing its fiscal 2004

 

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policy year throughpayments totaling $13.8 million, with additional payments of $4.1 million forinsurance premiums and expenses.  As ofAugust 16, 2004 the Company has made payments of $15.5 million.  Two additional monthly payments of $1.2million each are due through the end of fiscal 2004.  The Company will also make ongoing cashpayments for claims for all open policy years except 2003, which is fullyfunded although subject to annual retroactive premium adjustments based on actualclaims activity.  The Company anticipatesreducing its outstanding surety bonds by $2.0 million in the fourth quarter offiscal 2004.

 

The Company continues toevaluate other opportunities to further strengthen its financial position,including a potential restructuring of its workers’ compensation collateralarrangements. However, the Company believes that the additional borrowingcapacity provided under the amended credit agreement, together with cashgenerated through its improving operating performance, will be sufficient tomeet the Company’s working capital needs for the foreseeable future.

 

**Item 3****.****    Quantitative and QualitativeDisclosures About Market Risk**

 

The Company is exposed tocertain market risks from transactions that are entered into during the normalcourse of business.  The Company’sprimary market risk exposure relates to interest rate risk.  At July 10, 2004, the Company’s outstandingdebt under variable-rate interest borrowings was approximately $26.0million.  A change of 2% in the interestrates would cause a change in interest expense of approximately $0.4 million onan annual basis.  The Company’s exposureto market risk for changes in interest rates is not significant with respect tointerest income, as its investment portfolio is not material to itsconsolidated balance sheet.  The Companycurrently has no plans to hold an investment portfolio that includes derivativefinancial instruments.

 

For the 36 weeks endedJuly 10, 2004, the Company’s international operations comprised 22.1% of itsrevenue and, as of the end of that period, 21.1% of its total assets.  The Company is exposed to foreign currencyrisk primarily due to its investments in foreign subsidiaries.  The Company’s multicurrency credit facility,which allows the Company’s Australia and United Kingdom subsidiaries to borrowin local currencies, partially mitigates the exchange rate risk resulting fromfluctuations in foreign currency denominated net investments in thesesubsidiaries in relation to the U.S. dollar. The Company does not currently hold any market risk sensitiveinstruments entered into for hedging transaction risks related to foreigncurrencies.  In addition, the Company hasnot entered into any transactions with derivative financial instruments fortrading purposes.

 

### **Item 4**.    Controlsand 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 Company’s“disclosure controls and procedures” (which are defined under SEC rules ascontrols and other procedures of a company that are designed to ensure thatinformation required to be disclosed by a company in the reports it files underthe Securities Exchange Act of 1934 is recorded, processed, summarized andreported within required time

 

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periods).  Based on this evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of July 10, 2004 (theend of the period covered by this report) the Company’s disclosure controls andprocedures are effective.  There was nochange in the Company’s internal control over financial reporting that occurredduring the fiscal period ended July 10, 2004, that has materially affected, oris reasonably likely to materially affect, the Company’s internal controls overfinancial reporting.

 

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### **Item 1.**           LegalProceedings

 

The Company is not currentlya party to any material litigation. However, from time to time the Company hasbeen threatened with or named as a defendant in lawsuits, includingcountersuits brought by former franchise agents or licensees, andadministrative claims and lawsuits brought by employees or former employees.

 

### **Item 2.**           Changes in Securities, Use of Proceeds and Issuer Purchases of EquitySecurities

 

None.

 

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

 

Not applicable.

 

### **Item 4.**           Submission of Matters to a Vote of Security Holders

 

At the Annual Meeting ofStockholders held on May 19, 2004, Dwight S. Pedersen was elected as Class IIdirector to serve for a three-year term until his successor is elected andqualified.  The voting was as follows:

 

| Votes For:      |   | 14,625,680 |   |
|-----------------|--------|------------|--------|
| Votes Withheld: |   | 742,441    |   |

 

The terms of W. RobertStover and Janet M. Brady as Class III directors will continue until theCompany’s 2005 annual meeting of stockholders. The terms of Jack D. Samuelson and Ronald D. Stevens as Class I directorswill continue until the Company’s 2006 annual meeting of stockholders.

 

### **Item 5.**           OtherInformation

 

Not applicable.

 

**Item 6.****           Exhibits and Reports on Form 8-K**

 
|   | (a)    | Exhibits  |   |                                                                                                                 |
|--------|--------|-----------|--------|----------------------------------------------------------------------------------------------------------------------|
|   |   |      |   |                                                                                                                 |
|   |   | 10.3.5.2  |   | Second Amendment to  Employment Contract By and Between Westaff Support, Inc. and Dirk A.  Sodestrom                 |
|   |   | 10.3.8.4  |   | Second Amendment to  Employment Agreement By and Among Westaff Support, Inc., Westaff, Inc., and  Dwight S. Pedersen |
|   |   | 10.8.20.5 |   | Fifth Amendment to  Multicurrency Credit Agreement and Consent of Guarantors                                         |
|   |   | 31.1      |   | Certification of the  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.            |

 

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|   |   | 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. |
|   |   |                |   |                                                                                                                                                    |
|   | (b)    | Reports on Form 8-K |

 

Current Report on Form8-K (Items 7 and 12) dated May 26, 2004 filed with the Securities and ExchangeCommission on May 27, 2004.

 

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**SIGNATURES**

 

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

 

 
|            |   | WESTAFF, INC.                                      |
|-----------------|--------|----------------------------------------------------|
|            |   |                                               |
|            |   |                                               |
| August 24, 2004 |   |                                               |   | /s/ Dirk A.  Sodestrom |   |
| Date            |   | Dirk A.  Sodestrom                                 |
|            |   | Senior Vice  President and Chief Financial Officer |
|                 |        |                                                    |  |  |  |

 

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