##### **UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

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

##### ** **

| **ý** | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934.**                                                                                                                                                                                                                                                                                 |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                                                                                                                                                                                                                                                                                                     |
|       |       | **For the  quarterly period ended January 21, 2006**                                                                                                                                                                                                                                                                                                                                |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                     |
| **o**      | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE  ACT OF 1934**                                                                                                                                                                                                                                                                                 |
|       |       |                                                                                                                                                                                                                                                                                                                                                                                     |
|       |       | **For the  transition period from                             to                              ** |

 

**Commission file 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 LaneWalnut Creek, California  94598-2453**

(Address of registrant’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 by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes  ý    No  o

 

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

 

Large acceleratedfile  o  Acceleratedfiler  o  Non-acceleratedfiler  ý

 

Indicate by check markwhether the registrant is a shell company (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 March 6, 2006** |
|------------------------------|------------|---------------------------------------|
|                         |       |                                  |
| Common Stock, $.01 par value |       | 16,395,568 shares                     |

 

 

----

 

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

##### ** **

**INDEX**

 
| **Part I.**  | **Financial Information**                                                                                          | ** ** |
|-------------------|--------------------------------------------------------------------------------------------------------------------|------------|
| ** **        | ** **                                                                                                         | ** ** |
| Item 1.           | Financial Statements (Unaudited)                                                                                   |       |
|              |                                                                                                               |       |
|              | Condensed  Consolidated Balance Sheets - January 21, 2006 and October 29, 2005                           | 3          |
|              |                                                                                                               |       |
|              | Condensed  Consolidated Statements of Operations - 12 weeks ended January 21, 2006  and January 22, 2005 | 4          |
|              |                                                                                                               |       |
|              | Condensed  Consolidated Statements of Cash Flows - 12 weeks ended January 21, 2006  and January 22, 2005 | 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                                                                                            | 20         |
|              |                                                                                                               |       |
| **Part II.** | **Other Information**                                                                                              | ** ** |
| ** **        | ** **                                                                                                         | ** ** |
| Item 1.           | Legal Proceedings                                                                                                  | 21         |
|              |                                                                                                               |       |
| Item 2.           | Unregistered Sales of Equity  Securities and Use of Proceeds                                                       | 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                                                                                                           | 22         |
|              |                                                                                                               |       |
| Signatures        | 23                                                                                                                 |

 

2

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**Part l.  Financial Information**

 

**Item 1. Financial Statements**

 

**Westaff, Inc.**

 

**Condensed ConsolidatedBalance Sheets (Unaudited)**

**(Inthousands except per share amounts)**

 
| ** **                                                                                                                                        | ** ** | **January 21,  2006** | ** ** | **October 29,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| **ASSETS**                                                                                                                                        |       |                       |       |                       |       |
| Current assets:                                                                                                                                   |       |                       |       |                       |       |
| Cash and cash equivalents                                                                                                                         |       | $                          | 3,576      |                       | $          | 3,014 |   |
| Trade accounts receivable, less allowance for doubtful  accounts of $1,074 and $997                                                               |       | 74,949                     |       | 83,416                     |       |
| Income taxes receivable                                                                                                                           |       | 77                         |       | 82                         |       |
| Deferred income taxes                                                                                                                             |       | 5,096                      |       | 5,097                      |       |
| Prepaid expenses                                                                                                                                  |       | 3,348                      |       | 3,847                      |       |
| Other current assets                                                                                                                              |       | 1,493                      |       | 1,337                      |       |
| Total current assets                                                                                                                              |       | 88,539                     |       | 96,793                     |       |
|                                                                                                                                              |       |                       |       |                       |       |
| Property and equipment, net                                                                                                                       |       | 15,190                     |       | 15,184                     |       |
| Deferred income taxes                                                                                                                             |       | 11,949                     |       | 11,951                     |       |
| Goodwill                                                                                                                                          |       | 11,772                     |       | 11,770                     |       |
| Other long-term assets                                                                                                                            |       | 1,515                      |       | 3,084                      |       |
| Total Assets                                                                                                                                      |       | $                          | 128,965    |                       | $          | 138,782 |   |
|                                                                                                                                              |       |                       |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                     |       |                       |       |                       |       |
| Current liabilities:                                                                                                                              |       |                       |       |                       |       |
| Borrowing under revolving credit facilities                                                                                                       |       | $                          | 4,686      |                       | $          | 8,568 |   |
| Current portion of capital lease obligations                                                                                                      |       | 280                        |       | 343                        |       |
| Accounts payable                                                                                                                                  |       | 5,766                      |       | 3,755                      |       |
| Accrued expenses                                                                                                                                  |       | 35,744                     |       | 42,609                     |       |
| Income taxes payable                                                                                                                              |       | 552                        |       | 817                        |       |
| Liabilities of discontinued operations                                                                                                            |       | 49                         |       | 75                         |       |
| Total current liabilities                                                                                                                         |       | 47,077                     |       | 56,167                     |       |
|                                                                                                                                              |       |                       |       |                       |       |
| Note payable to related party                                                                                                                     |       | 2,000                      |       | 2,000                      |       |
| Long-term capital lease obligations                                                                                                               |       | 1,171                      |       | 1,174                      |       |
| Other long-term liabilities                                                                                                                       |       | 17,488                     |       | 17,820                     |       |
| Total liabilities                                                                                                                                 |       | 67,736                     |       | 77,161                     |       |
|                                                                                                                                              |       |                       |       |                       |       |
| 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: 16,378 shares at January 21, 2006 and October 29,2005 |       | 164                        |       | 164                        |       |
| Additional paid-in capital                                                                                                                        |       | 37,814                     |       | 37,803                     |       |
| Deferred stock compensation                                                                                                                       |       |                       |       | (54                        | )          |
| Retained earnings                                                                                                                                 |       | 23,755                     |       | 24,151                     |       |
| Accumulated other comprehensive loss                                                                                                              |       | (504                       | )          | (443                       | )          |
| Total stockholders’ equity                                                                                                                   |       | 61,229                     |       | 61,621                     |       |
| Total Liabilities and Stockholders’ Equity                                                                                                   |       | $                          | 128,965    |                       | $          | 138,782 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

3

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**Westaff, Inc.**

 

**CondensedConsolidated Statements of Operations (Unaudited)**

**(Inthousands except per share amounts)**

 
| ** **                                                    | ** ** | **12 Weeks Ended**         | ** ** |
|---------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                    | ** ** | **January 21,  2006** | ** ** | **January 22,  2005** | ** ** |
|                                                          |       |                       |       |   |   |
| Revenue                                                       |       | $                          | 138,600    |   | $ | 135,305 |   |
|                                                          |       |                       |       |   |   |
| Costs of services                                             |       | 115,363                    |       | 112,448 |   |
|                                                          |       |                       |       |   |   |
| Gross profit                                                  |       | 23,237                     |       | 22,857 |   |
|                                                          |       |                       |       |   |   |
| Franchise agents’ share of gross profit                  |       | 4,333                      |       | 3,974 |   |
| Selling and administrative expenses                           |       | 17,957                     |       | 16,785 |   |
| Depreciation and amortization                                 |       | 1,169                      |       | 959 |   |
|                                                          |       |                       |       |   |   |
| Operating income (loss) from continuing operations            |       | (222                       | )          | 1,139 |   |
|                                                          |       |                       |       |   |   |
| Interest expense                                              |       | 309                        |       | 396 |   |
| Interest income                                               |       | (18                        | )          | (21 | ) |
|                                                          |       |                       |       |   |   |
| Income (loss) from continuing operations before  income taxes |       | (513                       | )          | 764 |   |
| Income tax provision (benefit)                                |       | (117                       | )          | 196 |   |
| Income (loss) from continuing operations                      |       | (396                       | )          | 568 |   |
|                                                          |       |                       |       |   |   |
| Loss from discontinued operations                             |       |                       |       | (62 | ) |
|                                                          |       |                       |       |   |   |
| Net income (loss)                                             |       | $                          | (396       | ) | $ | 506 |   |
|                                                          |       |                       |       |   |   |
| Earnings (loss) per share:                                    |       |                       |       |   |   |
| Continuing operations                                         |       |                       |       |   |   |
| Basic                                                         |       | $                          | (0.02      | ) | $ | 0.04 |   |
| Diluted                                                       |       | $                          | (0.02      | ) | $ | 0.03 |   |
|                                                          |       |                       |       |   |   |
| Discontinued operations - basic and diluted                   |       | $                          | —     |   | $ | — |   |
|                                                          |       |                       |       |   |   |
| Net income (loss) - basic and diluted                         |       | $                          | (0.02      | ) | $ | 0.03 |   |
|                                                          |       |                       |       |   |   |
| Weighted average shares outstanding - basic                   |       | 16,378                     |       | 16,048 |   |
| Weigthed average shares outstanding - diluted                 |       | 16,480                     |       | 16,262 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

4

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**Westaff, Inc.**

 

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

**(In thousands)**

 
| ** **                                                                                | ** ** | **12 Weeks Ended**         | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                | ** ** | **January 21,  2006** | ** ** | **January 22,  2005** | ** ** |
| **Cash flows from operating activities**                                                  |       |                       |       |   |   |
| Net income (loss)                                                                         |       | $                          | (396       | ) | $ | 506 |   |
| Adjustments to reconcile net income (loss) to net  cash provided by operating activities: |       |                       |       |   |   |
| Stock based compensation                                                                  |       | 66                         |       |   |   |
| Depreciation and amortization                                                             |       | 1,169                      |       | 970 |   |
| Provision for losses on doubtful accounts                                                 |       | 207                        |       | 183 |   |
| Deferred income taxes                                                                     |       | 1                          |       |   |   |
| (Gain) loss on sale or disposal of assets                                                 |       | 12                         |       | (5 | ) |
| Income from sales of affiliate operations                                                 |       | (48                        | )          | (18 | ) |
| Other                                                                                     |       | (81                        | )          | (81 | ) |
| Changes in assets and liabilities:                                                        |       |                       |       |   |   |
| Trade accounts receivable                                                                 |       | 8,132                      |       | 10,346 |   |
| Other assets                                                                              |       | 2,256                      |       | (4,859 | ) |
| Accounts payable and accrued expenses                                                     |       | (4,427                     | )          | (6,125 | ) |
| Income taxes payable                                                                      |       | (264                       | )          | (9 | ) |
| Other liabilities                                                                         |       | (20                        | )          | (13 | ) |
| Net cash provided by operating activities                                                 |       | 6,607                      |       | 895 |   |
|                                                                                      |       |                       |       |   |   |
| **Cash flows from investing activities**                                                  |       |                       |       |   |   |
| Capital expenditures                                                                      |       | (1,787                     | )          | (1,182 | ) |
| Proceeds from sales of affiliate operations                                               |       | 10                         |       | 1,045 |   |
| Other, net                                                                                |       | (337                       | )          | 193 |   |
|                                                                                      |       |                       |       |   |   |
| Net cash (used) provided by investing activities                                          |       | (2,114                     | )          | 56 |   |
|                                                                                      |       |                       |       |   |   |
| **Cash flows from financing activities**                                                  |       |                       |       |   |   |
| Net repayments under line of credit agreements                                            |       | (3,857                     | )          | (3,542 | ) |
| Principal payments on capital lease obligations                                           |       | (66                        | )          | (115 | ) |
| Issuance of common stock                                                                  |       |                       |       | 11 |   |
| Other                                                                                     |       |                       |       | (6 | ) |
|                                                                                      |       |                       |       |   |   |
| Net cash used by financing activities                                                     |       | (3,923                     | )          | (3,652 | ) |
|                                                                                      |       |                       |       |   |   |
| Effect of exchange rate changes on cash                                                   |       | (8                         | )          | 114 |   |
|                                                                                      |       |                       |       |   |   |
| Net change in cash and cash equivalents                                                   |       | 562                        |       | (2,587 | ) |
| Cash and cash equivalents at beginning of period                                          |       | 3,014                      |       | 6,993 |   |
| Cash and cash equivalents at end of period                                                |       | $                          | 3,576      |   | $ | 4,406 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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**Westaff, Inc.**

 

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

**(Inthousands except per share amounts)**

 

**1.****              Basisof Presentation**

 

The accompanying condensed consolidated financial statements of Westaff, Inc.and its domestic and foreign subsidiaries (together, the Company), as of January 21,2006 and for the 12  week periods ended January 21,2006 and January 22, 2005 are unaudited.

 

The condensed consolidated financial statements, in the opinion ofmanagement, reflect all adjustments, which are of a normal recurring nature,necessary for a fair presentation of the financial position, results ofoperations and cash flows for the periods presented. The condensed consolidatedbalance sheet as of October 29, 2005 presented herein, has been derivedfrom the audited balance sheet included in the Company’s Annual Report on Form 10-Kfor the fiscal year ended October 29, 2005.

 

Certain financial information normally included in annual financialstatements prepared in accordance with accounting principles generally acceptedin the United States, that is not required for interim reporting purposes, hasbeen condensed or omitted. The accompanying condensed consolidated financialstatements should be read in conjunction with the financial statements andnotes thereto included in the Company’s Annual Report on Form 10-K for thefiscal year ended October 29, 2005.

 

The Company’s fiscal year is a 52 or 53 week period ending the Saturdaynearest the end of October. For interim reporting purposes, the first threefiscal quarters comprise 12 weeks each, while the fourth fiscal quarterconsists of 16 or 17 weeks. The results of operations for the 12 week periodended January 21, 2006 are not necessarily indicative of the results to beexpected for the full fiscal year or for any future period.

 

In June 2005, the Company sold its subsidiary operations in Norwayand Denmark, and during fiscal year 1999, the Company sold its medicalbusiness, primarily operated through Western Medical Services, Inc., awholly owned subsidiary of the Company. As a result, the Company has classifiedthese operations as discontinued operations and, accordingly has segregated theassets, liabilities, revenue and expenses of these discontinued operations inthe accompanying condensed consolidated financial statements and notes thereto.Cash flows pertaining to discontinued operations are not disclosed separatelyin the condensed consolidated statements of cash flows.

 

**2.**              Stock-basedCompensation

** **

The Company’s 1996 Stock Option/StockIssuance Plan provides for the granting of incentive and nonqualified stockoptions, restricted stock awards and stock appreciation rights. Incentive stockoptions may be granted at a price not less than 100% of the fair marketvalue of the Company’s common stock at the date of grant. Although nonqualifiedoptions may be granted at a price not less than 85% of the fair marketvalue of the Company’s common stock at the date of grant, the Company hashistorically issued option grants at fair market value. The options’ vestingschedules vary subject to the participant’s period of future service or to theCompany’s or the option holder’s attainment of designated performance goals, orotherwise at the discretion of the Board of Directors. Standard vesting is overfour years with 25% of the options vesting upon completion of one year ofservice from the vesting commencement date, and the remaining options vestingin thirty-six equal monthly installments. No option may have a term inexcess of 10 years.

 

6

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Under the Company’s 1996 Employee StockPurchase Plan, eligible employees may authorize payroll deductions of upto 10% of eligible compensation for the purchase of the Company’s common stockduring each semi-annual purchase period. The purchase price will equal thelower of 85% of the fair market value at the beginning of the purchase periodor on the last day of the purchase period. The plan provides for the issuanceof up to 750 shares of the Company’s common stock. As of January 21, 2006,shares issued under the plan totaled 623.

 

Effective with the beginningof the first quarter of fiscal 2006, the Company adopted Statement of FinancialAccounting Standards No. 123 (revised 2004) “Share-Based Payment” (SFAS123(R)) using the modified prospective method of adoption, which does not requirerestatement of prior periods. SFAS 123(R) requires the Company to recognizecompensation expense for its stock options, restricted stock awards andemployee stock purchase shares outstanding, but not yet vested, as of the dateof adoption and for future stock option and award grants and employee stockpurchase shares.

 

Activity in the Company’sstock option plan for the fiscal quarter ended January 21, 2006 was asfollows:

 
| ** **                                   | ** ** | **Shares** | ** ** | **Weighted average  exercise price** | ** ** | **Weighted average  remaining contractual  term (years)** | ** ** | **Aggregate  intrinsic value** | ** ** |
|----------------------------------------------|------------|------------|------------|--------------------------------------|------------|-----------------------------------------------------------|------------|--------------------------------|------------|
|                                         |       |       |       |                                 |       |                                                      |       |                           |       |
| Options outstanding at October 29, 2005 |       | 640        |       | $                                    | 3.69       |                                                      |       |                           |       |   |
| Granted                                      |       | —     |       |                                 |       |                                                      |       |                           |       |
| Exercised                                    |       | —     |       |                                 |       |                                                      |       |                           |       |
| Cancelled                                    |       | (11        | )          | $                                    | 3.15       |                                                      |       |                           |       |   |
| Options outstanding at January 21, 2006 |       | 629        |       | $                                    | 3.70       |                                                      | 6.93       |                           | $          | 750 |   |
|                                         |       |       |       |                                 |       |                                                      |       |                           |       |
| Exercisable at January 21, 2006         |       | 359        |       | $                                    | 4.01       |                                                      | 5.52       |                           | $          | 425 |   |

 

Intrinsic value is definedas the difference between the current market value and the grant price. At January 21,2006, the Company had 20 restricted stock shares outstanding with an intrinsicvalue of $25 and recorded liabilities for withholdings under its employee stockpurchase plan representing 35 shares at a weighted average exercise price of$3.07 with an estimated aggregate intrinsic value of $48.

 

For the fiscal quarter endedJanuary 21, 2006, the Company recorded stock-based compensation of $66($49 net of related income tax benefit), which is included in selling andadministrative expenses. The total compensation cost related to nonvested stockoptions and awards not yet recognized is currently expected to be a combinedtotal of approximately $380 over the next two fiscal years.

 

Prior to the adoption ofSFAS 123(R), the Company measured compensation cost for employee stock optionsand similar equity instruments using the intrinsic value-based method ofaccounting prescribed by Accounting Principles Board Opinion No. 25, “Accountingfor Stock Issued to Employees” (APB 25), and followed the disclosure-onlyprovisions of SFAS No. 123, “Accounting for Stock-Based Compensation”, asamended by SFAS No. 148, “Accounting for Stock-Based Compensation -Transition and Disclosure.”  Accordingly,compensation cost was not recognized for options granted at fair market value. Thefollowing table represents pro forma net income and pro

 

7

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forma earnings per share forthe fiscal quarter ended January 22, 2005 as if compensation cost had beendetermined using the fair value method:

 
| ** **                                                       | ** ** | **12 Weeks Ended  January 22,  2005** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------------------|------------|
|                                                             |       |                                       |       |
| Net income as reported                                           |       | $                                          | 506        |   |
| Stock based compensation determined under the fair  value method |       | (99                                        | )          |
| Pro forma net income                                             |       | $                                          | 407        |   |
|                                                             |       |                                       |       |
| Income per common share:                                         |       |                                       |       |
| Basic and diluted - as reported                                  |       | $                                          | 0.03       |   |
| Basic and diluted - pro forma                                    |       | $                                          | 0.03       |   |

 

Thefair value of each option grant was estimated on the date of grant using theBlack-Scholes valuation model, with a six year expected life and the assumptionof a zero dividend rate. Volatility is based on the Company’s historicalvolatility through the date of grant. The risk-free interest rate used is basedon the U.S. Treasury constant maturities at the time of grant having a termthat approximates the expected life of the option.

 

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

 

**The following summarizes thechange in goodwill during the fiscal quarter ended January 21, 2006.**

** **
| ** **                             | ** ** | **Domestic  Business Services** | ** ** | **Australia** | ** ** | **Total** | ** ** |
|----------------------------------------|------------|---------------------------------|------------|---------------|------------|-----------|------------|
|                                   |       |                            |       |          |       |      |       |
| Balance at October 29, 2005       |       | $                               | 10,797     |          | $          | 973       |       | $ | 11,770 |   |
| Effect of foreign currency translation |       |                            |       | 2             |       | 2         |       |
|                                   |       |                            |       |          |       |      |       |
| Balance at January 21, 2006       |       | $                               | 10,797     |          | $          | 975       |       | $ | 11,772 |   |

 

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

** **

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

** **

In June 2005, the Company sold its Norway and Denmark subsidiaryoperations to Personalhuset AS, a recruitment and staffing companyheadquartered in Norway, for approximately $2,700. Additionally, as a part ofthe sale transaction, Westaff Norway repaid approximately $610 of intercompanydebt to Westaff USA. Of the total proceeds, approximately $220 is being held inan interest bearing escrow account as security for potential Westaff Norwaypension claims, which the Company currently estimates to be zero. The escrowedfunds, net of any claim payments, will be remitted to the Company in June 2007.The Company recorded a net gain on the sale of $1,163.

 

As required by the terms of the Company’s Multicurrency CreditAgreement, the net proceeds on the sale of the Norway and Denmark operations,including the intercompany debt repayment, were used to pay down borrowings onthe Company’s revolving credit facility. In accordance with EITF 87-24,

 

8

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the Company has allocated interest expense to the discontinuedoperations of $27 for the 12 weeks ended January 22, 2005.

 

Summarized information on the Norway and Denmark discontinuedoperations is as follows:

 
| ** **                        | ** ** | **12 Weeks Ended  January 22,  2005** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|
|                              |       |                                       |       |
| Revenue                           |       | $                                          | 2,938      |   |
|                              |       |                                       |       |   |
| Costs and expenses                |       | 3,000                                      |       |
|                              |       |                                       |       |
| Loss from discontinued operations |       | $                                          | (62        | ) |

 

During fiscal 1999, the Company sold certain of its franchise agent andCompany-owned medical offices and entered into a termination agreement with oneof its medical 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. As of January 21, 2006, there areremaining current liabilities of the discontinued medical operations of $49 forsettled but unpaid claims.

 

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

 

The Company is responsiblefor and pays workers’ compensation costs for its temporary and regularemployees and is self-insured for the deductible amount related to workers’compensation claims ($500 per claim for fiscal 2006 and fiscal 2005.)  The Company accrues the estimated costs ofworkers’ compensation claims based upon the expected loss rates within thevarious temporary employment categories provided by the Company. At leastannually, the Company obtains an independent actuarial valuation of theestimated costs of claims reported but not settled, and claims incurred but notreported, and adjusts the accruals based on the results of the valuation. As ofJanuary 21, 2006 and October 29, 2005, workers’ compensation liabilitieswere approximately $22,500 and $19,600 respectively, of which $14,200 isincluded in other long-term liabilities on each of the respective balancesheets for obligations which are not expected to be paid in the followingfiscal year.

 

Eachpolicy year the terms of the agreement with the insurance carrier arerenegotiated. The insurance carrier requires the Company to collateralize itsrecorded obligations through the use of irrevocable letters of credit, suretybonds or cash. At January 21, 2006, the Company had $35,253 of letters ofcredit securing its domestic workers’ compensation obligations.

 

**6.****              EarningsPer Share**

 

The following table sets forth the computation of basic and dilutedearnings per share from continuing operations:

 

9

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| ** **                                                                                             | ** ** | **12 Weeks Ended**         | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                             | ** ** | **January 21,  2006** | ** ** | **January 22,  2005** | ** ** |
| Income (loss) from continuing operations                                                               |       | $                          | (396       | ) | $ | 568 |   |
|                                                                                                   |       |                       |       |   |   |
| Denominator for basic earnings per share - weighted  average shares                                    |       | 16,378                     |       | 16,048 |   |
|                                                                                                   |       |                       |       |   |   |
| Effect of dilutive securities: stock options and  awards                                               |       | 102                        |       | 214 |   |
|                                                                                                   |       |                       |       |   |   |
| Denominator for diluted earnings per share -  adjusted weighted average shares and assumed conversions |       | 16,480                     |       | 16,262 |   |
|                                                                                                   |       |                       |       |   |   |
| Earnings (loss) per share from continuing operations                                                   |       |                       |       |   |   |
| Basic                                                                                                  |       | $                          | (0.02      | ) | $ | 0.04 |   |
| Diluted                                                                                                |       | $                          | (0.02      | ) | $ | 0.03 |   |
|                                                                                                   |       |                       |       |   |   |
| Anti-dilutive weighted shares excluded from diluted  earnings per share                                |       | 263                        |       | 94 |   |

 

**7.****              ComprehensiveIncome**

 

Comprehensive income consists of the following:

 
| ** **                       | ** ** | **12 Weeks Ended**         | ** ** |
|----------------------------------|------------|----------------------------|------------|
| ** **                       | ** ** | **January 21,  2006** | ** ** | **January 22,  2005** | ** ** |
|                             |       |                       |       |   |   |
| Net income (loss)                |       | $                          | (396       | ) | $ | 506 |   |
| Currency translation adjustments |       | (60                        | )          | 268 |   |
|                             |       |                       |       |   |   |
| Comprehensive income (loss)      |       | $                          | (456       | ) | $ | 774 |   |

 

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

 

On May 17,2002, the Company entered into agreements with GE Capital, as primary agent, toprovide senior secured credit facilities totaling $65,000, expiring in May 2007.The facilities comprise a five-year syndicated Multicurrency Credit Agreementconsisting of a $50,000 US Revolving Loan Commitment, a £2,740 UK RevolvingLoan Commitment (US dollar equivalent of approximately $4,000 at the date ofthe agreement), and a $5,000 term loan (the Term Loan), which was repaid duringfiscal 2003. In addition, a five-year Australian dollar facility agreement (theA$ Facility Agreement) was executed on May 16, 2002, consisting of anA$12,000 revolving credit facility (US dollar equivalent of approximately$6,000 at the date of the agreement). Each agreement includes a letter ofcredit sub-facility. Letters of credit under the agreements expire one yearfrom date of issuance but are automatically renewed for one additional yearunless written notice is given to or from the holder.

 

Effective March 1,2006, the Company and its lenders executed an eighth amendment to theMulticurrency Credit Agreement. Among other things, the amendment reset minimumearnings before interest, taxes, depreciation and amortization (EBITDA)covenants for fiscal 2006 and beyond, adjusted the fixed charge coverage ratiofor the Company’s second quarter of fiscal 2006,

 

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extended the credit facilityfor one additional year to May 2008 and added an additional pricing gridthat will allow the Company to benefit from reduced interest rates and letterof credit fees upon achieving certain minimum EBITDA targets. Additionally, theamendment increased the maximum amount of the US Revolving Loan Commitment by$5,000 to $55,000 and increased the letter of credit sublimit from $40,000 to$45,000. The Company was not in compliance with its minimum EBITDA covenant asof the end of the first quarter of fiscal 2006 and the amendment included awaiver of this covenant violation.

 

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

 

The Company alsohas an unsecured subordinated promissory note payable to its principalstockholder and Chairman of the Board of Directors dated May 17, 2002 inthe amount of $2,000. The note has a maturity date of August 18, 2007 andan interest rate equal to an indexed rate as calculated under the Company’scredit facilities plus seven percent, compounded monthly and payable 60calendar days after the end of each of the Company’s fiscal quarters. Theinterest rate in effect on January 21, 2006 was 14.25%. Payment ofinterest is contingent on the Company meeting minimum availability requirementsunder its credit facilities. Additionally, payments of principal or interestare prohibited in the event of any default under the credit facilities.

 

**10.****       OperatingSegments**

 

Asdiscussed in Note 4 above, the Company sold its Norway and Denmark operationsin June 2005, and has classified these as discontinued operations. Priorto the sale, these operations were included in the Other Internationalreportable segment disclosures.

 

Thefollowing table summarizes reporting segment data with the 12 weeks ended January 22,2005 restated to exclude the Norway and Denmark operations:

 
| ** **                                         | ** ** | **Domestic  Business Svcs.** | ** ** | **United  Kingdom** | ** ** | **Australia** | ** ** | **Other  International** | ** ** | **Continuing  Operations** | ** ** |
|----------------------------------------------------|------------|------------------------------|------------|---------------------|------------|---------------|------------|--------------------------|------------|----------------------------|------------|
| 12 Weeks Ended January 21, 2006               |       |                         |       |                |       |          |       |                     |       |                       |       |
|                                               |       |                         |       |                |       |          |       |                     |       |                       |       |
| Revenue                                            |       | $                            | 107,784    |                | $          | 8,915         |       | $                        | 20,566     |                       | $          | 1,335 |   | $ | 138,600 |   |
| Operating income (loss) from continuing operations |       | $                            | (587       | )                   | $          | 305           |       | $                        | 44         |                       | $          | 16 |   | $ | (222 | ) |
|                                               |       |                         |       |                |       |          |       |                     |       |                       |       |
| 12 Weeks Ended January 22, 2005               |       |                         |       |                |       |          |       |                     |       |                       |       |
|                                               |       |                         |       |                |       |          |       |                     |       |                       |       |
| Revenue                                            |       | $                            | 103,062    |                | $          | 9,820         |       | $                        | 20,381     |                       | $          | 2,042 |   | $ | 135,305 |   |
| Operating income from continuing operations        |       | $                            | 557        |                | $          | 346           |       | $                        | 156        |                       | $          | 80 |   | $ | 1,139 |   |

 

**11.****       Commitmentsand Contingencies**

 

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’

 

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compensation, generalliability, automobile liability, property damage, alternative staffing errorsand omissions, fiduciary liability and fidelity losses.

 

In September 2005, Westaff’s Australiansubsidiary, together with several other entities, was named in a claim forcontributions asserted by ADI Ltd. The litigation originated in May 1998,when a fire occurred at sea on board an Australian Navy ship. The fire resultedin the death of four crewmen, and extensive damage to the ship. Aninvestigation determined that the fire was caused by the failure of fuel hosesinstalled by ADI in the ship’s engine room. The Commonwealth of Australia fileda claim against ADI which is estimated to have a value of approximatelyA$31,000. The investigation further found that mistakes were made in theinstallation process, including those of a technical supervisor placed byWestaff with ADI. ADI alleges that if it is liable to the Commonwealth, thenWestaff is vicariously liable for the supervisor’s negligence. A defense to theclaim has been filed on behalf of Westaff. Trial is scheduled for September 2006.

 

During the first quarter of fiscal 2006, the Companywas notified by its primary insurance carrier that coverage would be provided,pending confirmation of certain factual information. The Company is continuingto work with its excess carrier to evaluate the extent of potential additionalcoverage available, if necessary.

 

At this stage of the litigation, it is premature togauge the extent of potential liability of ADI and the other defendants,including Westaff, in the event of an unfavorable outcome.

 

During the fourth quarter of fiscal 2005, theCompany was notified by the California Employment Development Department (EDD)that Westaff’s domestic operating subsidiaries unemployment tax rates would beincreased retroactively for both calendar 2005 and 2004, which would result inadditional unemployment taxes of approximately $900. The Company believes thatit has properly calculated its unemployment insurance tax and is in compliancewith all applicable laws and regulations. The Company has timely appealed theruling by the EDD and is working with its outside counsel to resolve thismatter. The Company believes that it has strong defenses and legal argumentswith respect to the unaccrued assessment and, accordingly, has not accrued forthat portion of the assessment as of January 21, 2006.

 

From time to time theCompany has been threatened with, or named as a defendant in, lawsuits,including countersuits brought by former franchise agents or licensees, andadministrative claims and lawsuits brought by employees or former employees. TheCompany does not believe the outcome of any proceedings on these actions wouldhave a material adverse effect on its financial position, results of operationsor cash flows. The Company is not currently a party to any material litigation,except as disclosed above.

 

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**Item 2.Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

### **CautionaryStatement**

 

Thisnotice is intended to take advantage of the “safe harbor” provided by thePrivate Securities Litigation Reform Act of 1995 with respect toforward-looking statements. 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. Theforward-looking statements in this discussion are made based on informationavailable as of the date hereof and are subject to a number of risks anduncertainties that could cause the Company’s actual results and financialposition to differ materially from those expressed or implied in theforward-looking statements and to be below the expectations of public marketanalysts and investors. These risks and uncertainties include, but are notlimited to, those discussed in Item 1A “Risk Factors” and elsewhere in theCompany’s Annual Report on Form 10-K for the fiscal year ended October 29,2005. The Company undertakes no obligation to publicly release the results ofany revisions to these forward-looking statements to reflect events orcircumstances after the date hereof or to reflect the occurrence ofunanticipated events, except as required by applicable laws and regulations.

 

Thefollowing discussion is intended to assist in the understanding and assessmentof significant changes and trends related to the results of operations andfinancial condition of Westaff, Inc., together with its consolidatedsubsidiaries. This discussion and analysis should be read in conjunction withthe Company’s Consolidated Financial Statements and Notes thereto includedelsewhere in this Form 10-Q and in the Company’s Annual Report on Form 10-Kfor the fiscal year ended October 29, 2005.

 

### **CriticalAccounting 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 areevaluated on an ongoing basis by management and generally affect revenuerecognition, collectibility of accounts receivable, workers’ compensationcosts, impairment of goodwill, income taxes, including the realizability ofdeferred tax assets, and contingencies and litigation. Management’s estimatesand assumptions are based on historical experiences and other factors believedto be reasonable under the circumstances. However, actual results undercircumstances and conditions different than those assumed could result indifferences from the estimated amounts in the financial statements.

 

The Company’s critical accountingpolicies are described in Item 7 “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations” and in the notes to theconsolidated financial statements in the Company’s previously filed AnnualReport on Form 10-K for the fiscal year ended October 29, 2005. Exceptas noted below, there were no changes to these policies during the 12 weekperiod ended January 21, 2006.

 

Effective with the beginning of the first quarter offiscal 2006, the Company adopted Statement of Financial Accounting Standards No. 123(revised 2004) “Share-Based Payment” (SFAS 123(R)) using the modifiedprospective method of adoption, which does not require restatement of priorperiods. SFAS 123(R) requires the Company to recognize compensation expense forits stock options, restricted stock awards and employee stock purchase sharesoutstanding, but not yet vested, as of the date of adoption and for futurestock option and award grants and employee stock purchase shares.

 

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The Company estimates the fair value of its stockoptions and employee share purchases using a Black-Scholes option valuationmodel. This model requires the input of subjective assumptions, including stockprice volatility, estimated life and estimated forfeitures of each option andemployee share purchase. Prior to the adoption of SFAS 123(R), the Companymeasured compensation cost for employee stock options and similar equityinstruments using the intrinsic value-based method of accounting prescribed byAccounting Principles Board Opinion No. 25, “Accounting for Stock Issuedto Employees” (APB 25), and followed the disclosure-only provisions of SFAS No. 123,“Accounting for Stock-Based Compensation”, as amended by SFAS No. 148, “Accountingfor Stock-Based Compensation - Transition and Disclosure.”   Accordingly, compensation cost was notrecognized for options granted at fair market value.

 

For the fiscal quarter ended January 21, 2006,the Company recorded stock-based compensation of $66,000 ($49,000 net ofrelated income tax benefit). The total compensation cost related to nonvestedstock options and awards not yet recognized is currently expected to be acombined total of approximately $0.4 million over the next two fiscal years.

 

### **ExecutiveOverview**

 

Theresults of operations for the first quarter of fiscal 2006 reflect thesignificant investments made by the Company in its field and corporateoperations in an effort to foster improved growth and sustained profitability. TheCompany reported an operating loss of $0.2 million for the fiscal quarter endedJanuary 21, 2006 as compared to operating income of $1.1 million for thefiscal quarter ended January 22, 2005. This decline in operating income islargely attributable to increases in costs associated with strategic staffadditions the Company has made in its domestic operations in an effort tosupport longer term growth trends and profitability. As of the end of the firstquarter of fiscal 2006, the Company had increased its domestic field staff by12% as compared to the end of the first quarter of fiscal 2005. Over half ofthese field staff additions were in support of the Company’s permanentplacement service line of business with the remainder focused on developing thetemporary staffing business line.

 

Itis important to note that the Company’s business tends to be seasonal, withsales for the first fiscal quarter typically lower than other fiscal quartersdue to national holidays as well as plant shutdowns during and after theholiday season. These shutdowns and post-holiday season declines negativelyimpact job orders received by the Company, particularly in the light industrialsector. Demand for temporary staffing has historically tended to grow duringthe second and third fiscal quarters and has been greatest during the Company’sfourth fiscal quarter due largely to the planning cycles of many of itscustomers. Furthermore, the Company’s fourth fiscal quarter consists of 16 or17 weeks, while the first, second and third fiscal quarters consist of 12 weekseach. The Company’s operating profits have historically also tended to followthe seasonal sales trends with the bulk of the Company’s annual operatingprofits falling within the third and fourth fiscal quarters.  As a result of the typical sales cycle withinthe staffing industry, it is critical to invest in field office staff andgrowth initiatives during the first and second quarters in order to benefitfrom these investments during the third and fourth quarters of the fiscal year.

 

TheCompany believes that its investments in domestic field office staff arebeginning to show initial results. Domestic revenue increased 4.6% during thefirst quarter of fiscal 2006 as compared to the first quarter of fiscal 2005and domestic revenue from permanent placements increased 98% from $0.4 millionfor the fiscal 2005 first quarter to $0.8 million for the first quarter offiscal 2006. Management currently expects domestic revenue to increase at arate of 3% to 5% for the second quarter of fiscal 2006 as compared to the sameperiod in fiscal 2005. The Company does not currently intend to add additional

 

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fieldoffice or corporate staff during the second quarter of fiscal 2006 unlesswarranted by specific growth opportunities and to enhance permanent placementbusiness.

 

Thefirst quarter operating results are also affected by the investments theCompany is making in the development and implementation of a new, fullyintegrated, domestic business process management software platform. The systemimplementation is moving forward as planned with the human resources and corefinancials modules fully in place as of the end of the first quarter of fiscal2006. Subsequent to the end of the quarter the Company also successfullyimplemented the accounts receivable modules. The final phase, which willinclude fully integrated front office functionality along with payroll andbilling for temporary associates, is currently scheduled to begin rolloutstarting late in the fourth quarter of fiscal 2006.

 

Theoverall results of operations for the first fiscal quarter of 2006 were in linewith management’s plans and expectations. In spite of the decline in operatingresults during the first quarter of fiscal 2006 as compared to the fiscal 2005first quarter, the Company’s fiscal 2006 goals call for improved revenue andprofits as compared to fiscal 2005 and through the first quarter of fiscal 2006the Company was on target with its goals.

 

The Company continues to enjoy a strong liquidityposition at January 21, 2006 with no revolver debt in the US and aggregateavailable borrowing capacity of $16.2 million.

 

**Discontinued Operations**

 

Effective June 15, 2005, the Company sold its Norway and Denmarksubsidiary operations to Personalhuset AS, a recruitment and staffing companyheadquartered in Norway. Net proceeds from the sale were approximately $2.7million. Additionally, as a part of the sale transaction, Westaff Norwayrepaid approximately $0.6 million of intercompany debt to Westaff US. Of thetotal proceeds, approximately $0.2 million is being held in an interest bearingescrow account as security for potential Westaff Norway pension claims. The escrowedfunds, net of any claim payments, will be remitted to the Company in June 2007.The Company recorded a net gain on the sale of $1.2 million. The Company hasclassified the operations as discontinued operations and, accordingly, hassegregated the assets, liabilities, revenue and expenses of these discontinuedoperations in the accompanying financial statements and notes thereto. Cashflows pertaining to discontinued operations are not disclosed separately in thecondensed consolidated statements of cash flows.

 

As required under the terms of the Company’s Multicurrency CreditAgreement, the net proceeds from the sale of the Norway and Denmark operationswere used to pay down borrowings on the Company’s revolving credit facility.Interest expense has been allocated to these discontinued operations inaccordance with EITF 87-24.

 

During fiscal 1999, the Company discontinued its medical business(Western Medical) principally through a sale to Intrepid U.S.A. Under the termsof the sale, the Company retained the majority of accounts receivable,including trade and Medicare accounts receivable balances.

 

As of January 21, 2006, there are remaining current liabilities ofthe discontinued medical operations of $0.1 million, primarily for settled butunpaid claims.

 

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**Results of Continuing Operations**

 

**Fiscal Quarter Ended January 21, 2006 compared to Fiscal QuarterEnded January 22, 2005**

 

Revenueincreased $3.3 million or 2.4% for the first fiscal quarter of 2006 as comparedto the fiscal 2005 quarter. Domestic revenue increased 4.6% driven largely by a3.6% increase in billed hours coupled with a slight increase in average billrates. International revenue decreased by 4.4% primarily as a result of a 9.2%decrease in revenue in the United Kingdom as a result of “offshoring” ofcertain staffing functions by a number of Westaff’s UK customers, partiallyoffset by a 1% increase in sales in Australia. During the four quarters offiscal 2005, Australia reported local currency double digit growth over thecomparative prior year quarters. For the first quarter of fiscal 2006, thatgrowth has slowed as a result of sales declines for some national accountprojects which have been completed.

 

Domesticrevenue was negatively impacted by the August 2005 divestiture of one ofthe Company’s franchise operations. The Company currently expects domesticrevenue to increase from 3% to 5% during the second quarter of fiscal 2006 ascompared to the second quarter of fiscal 2005.

 

Costsof services include hourly wages of temporary employees, employer payrolltaxes, state unemployment and workers’ compensation insurance and otheremployee-related costs. Costs of services increased $2.9 million or 2.6% forthe fiscal 2006 quarter as compared to the fiscal 2005 quarter. Consolidatedgross margin declined from 16.9% in the first quarter of fiscal 2005 to 16.8%in the first quarter of fiscal 2006. Domestic gross margin increased from 16.2%in the fiscal 2005 quarter to 16.4% in fiscal 2006, due largely to bill rateincreases and a 98% increase in permanent placement fees from $0.4 million inthe fiscal 2005 quarter to $0.8 million in 2006. Domestic state unemploymenttaxes as a percentage of direct labor increased 12.3% for the fiscal 2006 quarteras compared to the fiscal 2005 quarter, while domestic workers’ compensationrates were relatively flat. International margins declined due primarily to achange in the geographic mix of business, with a larger relative proportion ofbusiness coming from Westaff’s Australia operations which tend to have lowermargins associated with its national account program.

 

Franchiseagents’ share of gross profit represents the net distribution paid to franchiseagents based either on a percentage of the sales or gross profit generated bythe franchise agents’ operations. Franchise agents’ share of gross profitincreased $0.4 million or 9.0 % primarily reflecting revenue growth forfranchise offices of 6.3% coupled with slightly higher margins. As a percentageof consolidated revenue, franchise agents’ share of gross profit increased from2.9% for the fiscal 2005 quarter to 3.1% for the fiscal 2006 quarter. Effectivewith the beginning of the second quarter of fiscal 2006, the Company acquiredthe operations of its two Houston franchise offices. As a result of thistransaction, the Company has assumed the operating expenses associated withthese offices but will no longer be incurring franchise agents’ share of grossprofit for the Houston operation.

 

Sellingand administrative expenses increased $1.2 million, or 7.0% for the 2006quarter as compared to the 2005 quarter. As a percentage of revenue, sellingand administrative expenses were 13.0% for the fiscal 2006 quarter and 12.4%for the fiscal 2005 quarter. The increase is primarily due to increaseddomestic salaries and related expenses associated with staff additions tosupport the Company’s goals of driving both temporary and permanent sales inthe US. As of the end of the first quarter of fiscal 2006 compared to the endof the first quarter of fiscal 2005, the Company had increased its domesticfield staff by 12%. Over half of these field staff additions were in support ofthe Company’s permanent placement service line of business with the remainderfocused on developing the temporary staffing business line. The Companybelieves that these staff additions represent important investments in itsfield operations in an effort to foster stronger growth and profitabilityduring the Company’s seasonally strongest third and fourth quarters. Excludingthe effect of the acquisition of the Houston franchise offices noted above, the

 

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Companydoes not currently intend to add additional field office or corporate staffduring the second quarter of fiscal 2006 unless warranted by specific growthopportunities and to enhance permanent placement business.

 

Depreciationand amortization increased $0.2 million or 21.9% primarily as a result of thedepreciation of the new business process management system modules placed intoservice to date.

 

Interestexpense decreased $0.1 million or 22.0% primarily as a result of decreasedaverage borrowings during the fiscal 2006 quarter somewhat offset by higheraverage interest rates.

 

Forthe fiscal quarter ended January 21, 2006, the Company recorded an incometax benefit of $0.1 million on pre-tax loss of $0.5 million, representingestimated domestic tax benefits partially offset by estimated taxes on incomein the United Kingdom. The fiscal quarter ended January 22, 2005 includesa charge for income taxes of $0.2 million on pre-tax income of $0.8 million.

 

**Liquidity and Capital Resources**

 

TheCompany requires significant amounts of working capital to operate its businessand to pay expenses relating to employment of temporary employees. The Company’straditional use of cash is for financing of accounts receivable, particularlyduring periods of economic upswings and growth and during periods where salesare seasonally high. Temporary personnel are generally paid on a weekly basiswhile payments from customers are generally received 30 to 60 days afterbilling.

 

TheCompany finances its operations primarily through cash generated by itsoperating activities and borrowings under its revolving credit facilities. Netcash provided by operating activities from continuing operations was $6.6million for the 12 weeks ended January 21, 2006 and $0.9 million for the12 weeks ended January 22, 2005. Reduced cash outflows for the fiscal 2006workers’ compensation program coupled with $1.2 million in cash inflowsrelating to the conversion of cash collateral to letters of credit more thanoffset the decline in net income and slightly lower collections of accountsreceivable as compared to the fiscal 2005 quarter.

 

Cashused for capital expenditures, which are primarily for business processmanagement (BPM) system initiatives, other software, computers and peripherals,and office furniture and equipment, totaled $1.8 million for the 12 weeks endedJanuary 21, 2006 as compared to $1.2 million for the same period in fiscal2005. The increase in capital expenditures during fiscal 2006 is primarily dueto continued work in process on the implementation of a new BPM system that theCompany began in late fiscal 2004. The Company currently anticipates capitalexpenditures will be approximately $6.0 million for the fiscal 2006 year.

 

Fromtime to time, the Company has generated cash through sales of Company-ownedoffices to franchise owners or sales of franchise agent and license officesback to the franchise agent or license owner. During the first quarter offiscal 2005, the Company sold one of its franchise operations back to thefranchise agent for cash proceeds of $1.0 million. The Company secured thefranchise agents’ note payable obligation to the bank that funded the purchasethrough a $1.0 million letter of credit that is declining as the noteobligation is paid by the franchise agent. The $1.0 million gain on the sale ofthe franchise operations has been deferred, and is being recognized as the noteobligation payments are made. As of January 21, 2006, the balance on theletter of credit was $0.9 million.

 

In May 2002, the Company entered intoagreements with GE Capital, as primary agent, to provide senior secured creditfacilities totaling $65.0 million, expiring in May 2007. The facilitiescomprise a five-year

 

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syndicated Multicurrency Credit Agreementconsisting of a $50.0 million US Revolving Loan Commitment, a £2.7 million UKRevolving Loan Commitment (US dollar equivalent of approximately $4.0 millionat the date of the agreement), and a $5.0 million term loan (the Term Loan),which was repaid during fiscal 2003. In addition, a five-year Australian dollarfacility agreement (the A$ Facility Agreement) was executed on May 16,2002, consisting of an A$12.0 million revolving credit facility (US dollarequivalent of approximately $6.0 million at the date of the agreement). Eachagreement includes a letter of credit sub-facility. Letters of credit under theagreements expire one year from date of issuance but are automatically renewedfor one additional year unless written notice is given to or from the holder.

 

Effective March 1,2006, the Company and its lenders executed an eighth amendment to theMulticurrency Credit Agreement. Among other things, the amendment reset minimumEBITDA covenants for fiscal 2006 and beyond, adjusted the fixed charge coverageratio for the Company’s second quarter of fiscal 2006, extended the creditfacility for one additional year and added an additional pricing grid that willallow the Company to benefit from reduced interest rates and letter of creditfees upon achieving certain minimum EBITDA targets. Additionally, the amendmentincreased the maximum amount of the US Revolving Loan Commitment by $5 million to$55 million and increased the letter of credit sublimit from $40 million to $45million. The Company was not in compliance with its minimum EBITDA covenant asof the end of the first quarter of fiscal 2006 and the amendment included awaiver of this covenant violation.

 

Asof January 21, 2006, the Company had $4.7 million outstanding under itsrevolving credit facilities, virtually all of which was attributable to theCompany’s Australia revolving credit facility. As of January 21, 2006, theCompany had consolidated available borrowing capacity of $16.2 millionconsisting of $7.5 million for the U.S. operations, $3.9 million for the U.K.operations and $4.8 million for the Australia operations.

 

TheCompany has an unsecured subordinated promissory note payable to its principalstockholder and Chairman of the Board of Directors in the amount of$2.0 million with a maturity date of August 18, 2007, and an interestrate equal to an indexed rate as calculated under the Company’s creditfacilities plus seven percent, compounded monthly and payable 60 calendar daysafter the end of each of the Company’s fiscal quarters. The interest rate ineffect on January 21, 2006 was 14.25%. Payment of interest is contingenton the Company meeting minimum availability requirements under its creditfacilities. Additionally, payments of principal or interest are prohibited inthe event of any default under the credit facilities.

 

The Company works to balanceits worldwide cash needs through dividends from and loans to its internationalsubsidiaries. These loans and dividends are limited by the immediate futurecash availability and needs of each respective subsidiary, restrictions imposedby the Company’s senior secured debt facilities and, in some cases, statutoryregulations 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. The US can also requestrepayments on intercompany balances due from its international subsidiaries,subject to their cash flow needs and regulatory

 

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restrictions. During thefirst quarter of fiscal 2006, Westaff’s Australia subsidiary repaidapproximately $0.7 million of intercompany interest and royalties.

 

TheCompany is responsible for and pays workers’ compensation costs for itstemporary and regular employees and is self-insured for the deductible amountrelated to workers’ compensation claims ($500,000 per claim for fiscal years2006 and 2005). Each policy year the terms of the agreement with the insurancecarrier are renegotiated. The insurance carrier requires the Company tocollateralize its obligations through the use of irrevocable standby letters ofcredit, surety bonds or cash.

 

Duringthe fourth quarter of fiscal 2005, the Company and its insurance carriernegotiated the return of $11.0 million of the fiscal 2005 cash collateral andthe Company issued $11.0 million of letters of credit in its place. During thefirst quarter of fiscal 2006, the Company issued an additional $1.9 million ofletters of credit in exchange for $1.2 million in cash which represented all ofthe cash remaining in the 2005 collateral fund.

 

Asof January 21, 2006, the Company had outstanding $35.3 million of lettersof credit to secure all outstanding obligations under its workers’ compensationprogram for all years except 2003, which is fully funded although subject toannual retroactive premium adjustments based on actual claims activity. Undercertain circumstances, the Company may be required to increase its lettersof credit to $40 million. The Company will also make ongoing cash payments forclaims for all other open policy years (except for 2003 as noted above).

 

Underthe terms of the Company’s fiscal 2006 policy year insurance program, theCompany is required to make total cash payments of $4.9 million during fiscal2006 in equal monthly installments, which commenced on November 1, 2005.Cash payments for 2006 policy year claims will be paid directly by the Company.

 

TheCompany believes that the current borrowing capacity provided under its creditfacilities, together with cash generated through operations, will be sufficientto meet the Company’s working capital needs for the foreseeable future.

 

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

 

TheCompany is exposed to certain market risks from transactions that are enteredinto during the normal course of business. The Company’s primary market riskexposure relates to interest rate risk. At January 21, 2006, the Company’soutstanding debt under variable-rate interest borrowings was approximately $6.7million. A change of two percentage points in the interest rates would cause achange in interest expense of approximately $0.1million on an annual basis. TheCompany’s exposure to market risk for changes in interest rates is notsignificant with respect to interest income, as its investment portfolio is notmaterial to its consolidated balance sheet. The Company currently has no plansto hold an investment portfolio that includes derivative financial instruments.

 

For the 12 weeks ended January 21,2006, the Company’s international operations comprised 22.3% of its revenueand, as of the end of that period, 23.3% of its total assets. The Company isexposed to foreign currency risk primarily due to its investments in foreignsubsidiaries. The Company’s multicurrency credit facility, which allows theCompany’s Australia and United Kingdom subsidiaries to

 

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borrow in localcurrencies, 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 currentlyhold any market risk sensitive instruments entered into for hedging transactionrisks related to foreign currencies. In addition, the Company has not enteredinto any transactions with derivative financial instruments for tradingpurposes.

 

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

 

The Company carried out an evaluation, under the supervisionand with the participation of the Company’s management, including the ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operations of the Company’s “disclosure controls and procedures” (asdefined under Rules 13a-15(e) and 15d-15(e) under the SecuritiesExchange Act of 1934, as amended). Based on this evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that, as of January 21,2006 (the end of the period covered by this report) the Company’s disclosurecontrols and procedures are effective in timely alerting them to material informationrequired to be included in this report. There was no change in the Company’sinternal control over financial reporting that occurred during the fiscalperiod ended January 21, 2006, that has materially affected, or isreasonably likely to materially affect, the Company’s internal controls overfinancial reporting.

 

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### **Item 1. Legal Proceedings**

 

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.

 

In September 2005, Westaff’s Australiansubsidiary, together with several other entities, was named in a claim forcontributions asserted by ADI Ltd. The litigation originated in May 1998,when a fire occurred at sea on board an Australian Navy ship. The fire resultedin the death of four crewmen, and extensive damage to the ship. Aninvestigation determined that the fire was caused by the failure of fuel hosesinstalled by ADI in the ship’s engine room. The Commonwealth of Australia fielda claim against ADI which is estimated to have a value of approximately A$31million. The investigation further found that mistakes were made in theinstallation process, including those of a technical supervisor placed byWestaff with ADI. ADI alleges that if it is liable to the Commonwealth, thenWestaff is vicariously liable for the supervisor’s negligence. A defense to theclaim has been filed on behalf of Westaff. Trial is scheduled for September 2006.

 

During the first quarter of fiscal 2006, the Companywas notified by its primary insurance carrier that coverage would be provided,pending confirmation of certain factual information. The Company is continuingto work with its excess carrier to evaluate the extent of potential additionalcoverage available, if necessary.

 

At this stage of the litigation, it is premature togauge the extent of potential liability of ADI and the other defendants,including Westaff, in the event of an unfavorable outcome.

 

Other than the action listed above, the Company isnot currently a party to any material litigation. However, from time to timethe Company has been threatened with, or named as a defendant in litigationbrought by former franchisees or licensees, and administrative claims andlawsuits brought by former employees. Management believes the resolution ofthese matters will not have a material adverse effect on the Company’sfinancial statements.

 

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

 

None.

 

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

### ** **

Notapplicable.

 

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

 

None.

 

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

### ** **

Noevents.

 

21

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**Item 6. Exhibits**

 
|   | Set forth below is a list of the exhibits included  as part of this Quarterly Report: |
|--------|--------------------------------------------------------------------------------------------|
|   |                                                                                       |   |   |
|   | 31.1                                                                                       |   | Certification of  the Chief Executive Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |                                                                                       |   |   |
|   | 31.2                                                                                       |   | Certification of  the Chief Financial Officer pursuant to Section 302 of the  Sarbanes-Oxley Act of 2002. |
|   |                                                                                       |   |   |
|   | 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. |

 

22

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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. |                  |
|---------------------|----------------------------------------------------------|--------------------|-----------------------|
|                |                                                     |               |                  |
| March 7,  2006 |                                                     |               | /s/ Dirk A. Sodestrom |   |   |
| Date                |                                                     | Dirk A. Sodestrom  |                  |   |
|                |  Senior Vice President and Chief Financial  Officer |               |                  |
|                     |                                                          |                    |                       |  |  |  |

 

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