##### **UNITED STATESSECURITIES 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****July 9, 2005**                                                                                                                  |
|       |       |                                                                                                                                                                |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                       |
|       |       |                                                                                                                                                                |
|       |       | **For the transition period  from           to          ** |

 

**Commissionfile number 0-24990**

 

**WESTAFF, INC.**

(Exact name ofregistrant as specified in its charter)

 
| **Delaware**                                                | ** ** | **94-1266151**          |
|-------------------------------------------------------------|------------|-------------------------|
| (State or other  jurisdiction                               |       | (I.R.S.employer         |
| of incorporation  or organization)                          |       | identification  number) |
|                                                        |       |                    |
| **298  North Wiget Lane**                                   |
| **Walnut  Creek, California 94598-2453**                    |
| (Address of  registrant’s principal executive offices) |
|                                                        |       |                    |
| **(925) 930-5300**                                          |
| (Registrant’s telephone  number)                       |

 

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

 

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

 

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

 
| **Class**                     | ** ** | **Outstanding at August 22, 2005** |
|-------------------------------|------------|------------------------------------|
|                          |       |                               |
| Common Stock,  $.01 par value |       | 16,353,271  shares                 |

 

 

----

 

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

##### ** **

**INDEX**

 
| ** **   | ** **                                                                                                | **PAGE**   |
|--------------|-----------------------------------------------------------------------------------------------------------|------------|
| **Part I.**  | **Financial Information**                                                                                 | ** ** |
| ** **   | ** **                                                                                                | ** ** |
| Item 1.      | Financial Statements (Unaudited)                                                                          |       |
|         |                                                                                                      |       |
|         | Condensed  Consolidated Balance Sheets -   July 9, 2005 and October 30, 2004                              |  3    |
|         |                                                                                                      |       |
|         | Condensed  Consolidated Statements of Operations -   12 and 36 weeks ended July 9, 2005 and July 10, 2004 |  4    |
|         |                                                                                                      |       |
|         | Condensed  Consolidated Statements of Cash Flows -   36 weeks ended July 9, 2005 and July 10, 2004        |  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                                                                                                  | 21         |
|         |                                                                                                      |       |
| Signatures   |                                                                                                      | 22         |

 

2

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**Part l.  Financial Information**

 

**Item 1.  Financial Statements**

 

**Westaff, Inc.**

 

**Condensed Consolidated BalanceSheets (Unaudited)**(In thousands except per share amounts)

 
| ** **                                                                                                                                                                                                                     | ** ** | **July 9,** | ** ** | **October 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|------------|-----------------|------------|
| ** **                                                                                                                                                                                                                     | ** ** | **2005**    | ** ** | **2004**        | ** ** |
| **ASSETS**                                                                                                                                                                                                                     |       |        |       |            |       |
| Current assets:                                                                                                                                                                                                                |       |        |       |            |       |
| Cash and cash  equivalents                                                                                                                                                                                                     |       | $           | 3,627      |            | $          | 4,386 |   |
| Trade accounts  receivable, less allowance for doubtful accounts of $1,005 and $1,085                                                                                                                                          |       | 74,991      |       | 83,107          |       |
| Income taxes  receivable                                                                                                                                                                                                       |       | 193         |       | 795             |       |
| Deferred income  taxes                                                                                                                                                                                                         |       | 284         |       | 286             |       |
| Prepaid expenses                                                                                                                                                                                                               |       | 2,766       |       | 4,272           |       |
| Assets of  discontinued operations                                                                                                                                                                                             |       |        |       | 4,850           |       |
| Other current  assets                                                                                                                                                                                                          |       | 1,117       |       | 818             |       |
| Total current  assets                                                                                                                                                                                                          |       | 82,978      |       | 98,514          |       |
| Property and  equipment, net                                                                                                                                                                                                   |       | 12,326      |       | 10,100          |       |
| Goodwill                                                                                                                                                                                                                       |       | 11,756      |       | 11,760          |       |
| Other long-term  assets                                                                                                                                                                                                        |       | 11,389      |       | 2,034           |       |
| Total Assets                                                                                                                                                                                                                   |       | $           | 118,449    |            | $          | 122,408 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                                                                                 |       |        |       |            |       |
| Current  liabilities:                                                                                                                                                                                                          |       |        |       |            |       |
| Borrowing under  revolving credit facilities                                                                                                                                                                                   |       | $           | 12,011     |            | $          | 15,734 |   |
| Current portion  of capital lease obligations                                                                                                                                                                                  |       | 256         |       | 465             |       |
| Accounts payable                                                                                                                                                                                                               |       | 2,351       |       | 2,562           |       |
| Accrued expenses                                                                                                                                                                                                               |       | 42,784      |       | 42,989          |       |
| Income taxes  payable                                                                                                                                                                                                          |       | 639         |       | 632             |       |
| Liabilities of  discontinued operations                                                                                                                                                                                        |       | 102         |       | 2,528           |       |
| Total current  liabilities                                                                                                                                                                                                     |       | 58,143      |       | 64,910          |       |
| Note payable to  related party                                                                                                                                                                                                 |       | 2,000       |       | 2,000           |       |
| Long-term capital  lease obligations                                                                                                                                                                                           |       | 56          |       | 125             |       |
| Other long-term  liabilities                                                                                                                                                                                                   |       | 15,897      |       | 15,526          |       |
| Total  liabilities                                                                                                                                                                                                             |       | 76,096      |       | 82,561          |       |
| 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: 16,339 shares at  July 9, 2005 and 16,047 shares at October 30, 2004 |       | 163         |       | 160             |       |
| Additional  paid-in capital                                                                                                                                                                                                    |       | 37,476      |       | 36,768          |       |
| Deferred stock  compensation                                                                                                                                                                                                   |       | (60         | )          |            |       |
| Retained  earnings                                                                                                                                                                                                             |       | 5,373       |       | 3,025           |       |
| Accumulated  other comprehensive loss                                                                                                                                                                                          |       | (599        | )          | (106            | )          |
| Total  stockholders’ equity                                                                                                                                                                                               |       | 42,353      |       | 39,847          |       |
| Total  Liabilities and Stockholders’ Equity                                                                                                                                                                               |       | $           | 118,449    |            | $          | 122,408 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

3

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**Westaff, Inc.**

 

**Condensed Consolidated Statementsof Operations (Unaudited)**(In thousands except per share amounts)

 
| ** **                                             | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                             | ** ** | **July 9,**        | ** ** | **July 10,**       | ** ** | **July 9,** | ** ** | **July 10,** | ** ** |
| ** **                                             | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                   |       |               |       |               |       |   |   |   |   |
| Revenue                                                |       | $                  | 141,053    |               | $          | 139,345 |   | $ | 411,879 |   | $ | 388,277 |   |
| Costs of  services                                     |       | 116,425            |       | 115,414            |       | 341,240 |   | 322,730 |   |
| Gross profit                                           |       | 24,628             |       | 23,931             |       | 70,639 |   | 65,547 |   |
| Franchise  agents’ share of gross profit          |       | 4,391              |       | 4,313              |       | 12,422 |   | 12,099 |   |
| Selling and  administrative expenses                   |       | 17,595             |       | 16,319             |       | 52,569 |   | 47,526 |   |
| Depreciation and  amortization                         |       | 934                |       | 1,008              |       | 2,849 |   | 3,132 |   |
| Operating income  from continuing operations           |       | 1,708              |       | 2,291              |       | 2,799 |   | 2,790 |   |
| Interest expense                                       |       | 343                |       | 485                |       | 1,021 |   | 1,348 |   |
| Interest income                                        |       | (28                | )          | (21                | )          | (71 | ) | (43 | ) |
| Income from  continuing operations before income taxes |       | 1,393              |       | 1,827              |       | 1,849 |   | 1,485 |   |
| Provision for  income taxes                            |       | 314                |       | 307                |       | 530 |   | 515 |   |
| Income from  continuing operations                     |       | 1,079              |       | 1,520              |       | 1,319 |   | 970 |   |
| Discontinued  operations:                              |       |               |       |               |       |   |   |   |   |
| Income (loss)  from discontinued operations            |       | (29                | )          | 235                |       | (134 | ) | 48 |   |
| Gain on sale,  net of income taxes of $34              |       | 1,163              |       |               |       | 1,163 |   |   |   |
| Total  discontinued operations, net of income taxes    |       | 1,134              |       | 235                |       | 1,029 |   | 48 |   |
| Net income                                             |       | $                  | 2,213      |               | $          | 1,755 |   | $ | 2,348 |   | $ | 1,018 |   |
|                                                   |       |               |       |               |       |   |   |   |   |
| Earnings per  share - basic and diluted:               |       |               |       |               |       |   |   |   |   |
| Continuing  operations                                 |       | $                  | 0.07       |               | $          | 0.09 |   | $ | 0.08 |   | $ | 0.06 |   |
| Discontinued  operations                               |       | $                  | 0.07       |               | $          | 0.01 |   | $ | 0.06 |   | $ | — |   |
| Net income                                             |       | $                  | 0.14       |               | $          | 0.11 |   | $ | 0.14 |   | $ | 0.06 |   |
|                                                   |       |               |       |               |       |   |   |   |   |
| Weighted average  shares outstanding - basic           |       | 16,339             |       | 16,033             |       | 16,229 |   | 16,027 |   |
| Weigthed average  shares outstanding - diluted         |       | 16,391             |       | 16,068             |       | 16,384 |   | 16,033 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

4

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**Westaff, Inc.**

 

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

 
| ** **                                                                                | ** ** | **36 Weeks Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                                                | ** ** | **July 9,**        | ** ** | **July 10,** | ** ** |
| ** **                                                                                | ** ** | **2005**           | ** ** | **2004** | ** ** |
| **Cash  flows from operating activities**                                                 |       |               |       |   |   |
| Net income                                                                                |       | $                  | 2,348      |   | $ | 1,018 |   |
| Adjustments to  reconcile net income to net cash provided (used) by operating activities: |       |               |       |   |   |
| Gain on sale of  discontinued operations, net of income taxes                             |       | (1,163             | )          |   |   |
| Depreciation and  amortization                                                            |       | 2,877              |       | 3,199 |   |
| Provision for  losses on doubtful accounts                                                |       | 364                |       | 782 |   |
| Gain on sale or  disposal of assets                                                       |       | (18                | )          | (677 | ) |
| Income from  sales of affiliate operations                                                |       | (19                | )          | (16 | ) |
| Other                                                                                     |       | (103               | )          | (148 | ) |
| Changes in  assets and liabilities:                                                       |       |               |       |   |   |
| Trade accounts  receivable                                                                |       | 6,874              |       | (2,545 | ) |
| Other assets                                                                              |       | (7,571             | )          | (7,725 | ) |
| Accounts payable  and accrued expenses                                                    |       | (584               | )          | 5,589 |   |
| Income taxes  payable                                                                     |       | (28                | )          | (77 | ) |
| Other  liabilities                                                                        |       | (67                | )          | 282 |   |
| Net cash  provided (used) by operating activities                                         |       | 2,910              |       | (318 | ) |
| **Cash  flows from investing activities**                                                 |       |               |       |   |   |
| Capital  expenditures                                                                     |       | (5,161             | )          | (1,291 | ) |
| Proceeds from  sales of affiliate operations                                              |       | 1,062              |       | 26 |   |
| Proceeds from  sales of property & equipment                                          |       |               |       | 1,938 |   |
| Proceeds from  sale of discontinued operations, net of cash acquired by purchaser         |       | 1,238              |       |   |   |
| Other, net                                                                                |       | 155                |       | 26 |   |
| Net cash (used)  provided by investing activities                                         |       | (2,706             | )          | 699 |   |
| **Cash  flows from financing activities**                                                 |       |               |       |   |   |
| Net repayments  under line of credit agreements                                           |       | (3,706             | )          | (2,560 | ) |
| Principal  payments on capital lease obligations                                          |       | (353               | )          | (296 | ) |
| Proceeds from  notes payable to related parties                                           |       |               |       | 1,000 |   |
| Issuance of  common stock                                                                 |       | 646                |       | 32 |   |
| Payment of debt  issuance costs                                                           |       | (11                | )          | (139 | ) |
| Net cash used by  financing activities                                                    |       | (3,424             | )          | (1,963 | ) |
| Effect of  exchange rate changes on cash                                                  |       | (146               | )          | 268 |   |
| Net change in  cash and cash equivalents                                                  |       | (3,366             | )          | (1,314 | ) |
| Cash and cash  equivalents at beginning of period                                         |       | 6,993              |       | 4,759 |   |
| Cash and cash  equivalents at end of period                                               |       | $                  | 3,627      |   | $ | 3,445 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

5

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**Westaff, Inc.**

 

**Notes to Condensed Consolidated FinancialStatements (Unaudited)**(In thousands except per share amounts)

 

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

 

The accompanyingcondensed consolidated financial statements of Westaff, Inc. and its domesticand foreign subsidiaries (together, the Company), as of July 9, 2005 and forthe 12 and 36 week periods ended July 9, 2005 and July 10, 2004 are unaudited.

 

The condensedconsolidated financial statements, in the opinion of management, reflect alladjustments, which are of a normal recurring nature, necessary for a fairpresentation of the financial position, results of operations and cash flowsfor the periods presented.  The condensedconsolidated balance sheet as of October 30, 2004 presented herein, has beenderived from the audited balance sheet included in the Company’s Annual Reporton Form 10-K for the fiscal year ended October 30, 2004.

 

Certain financialinformation which is normally included in annual financial statements preparedin accordance with accounting principles generally accepted in the UnitedStates, but which is not required for interim reporting purposes, has beencondensed or omitted.  The accompanyingcondensed consolidated financial statements should be read in conjunction withthe financial statements and notes thereto included in the Company’s AnnualReport on Form 10-K for the fiscal year ended October 30, 2004.

 

The Company’s fiscal yearis a 52 or 53 week period ending the Saturday nearest the end of October.  For interim reporting purposes, the firstthree fiscal quarters comprise 12 weeks each, while the fourth fiscal quarterconsists of 16 or 17 weeks.  The resultsof operations for the 12 and 36 week periods ended July 9, 2005 are notnecessarily indicative of the results to be expected for the full fiscal yearor for any future period.

 

In June 2005, theCompany sold its subsidiary operations in Norway and Denmark, and during fiscalyear 1999, the Company sold its medical business, primarily operated throughWestern Medical Services, Inc., a wholly owned subsidiary of the Company.  As a result, the Company has classified theseoperations as discontinued operations and, accordingly, has segregated theassets, liabilities, revenue and expenses of these discontinued operations inthe accompanying condensed consolidated financial statements and notesthereto.  Cash flows pertaining todiscontinued operations are not disclosed separately in the condensedconsolidated statements of cash flows. Cash balances of the discontinued operations at October 30, 2004 areincluded in assets of discontinued operations on the condensed consolidatedbalance sheet for October 30, 2004.

 

Certain amounts inthe July 10, 2004 financial statements have been reclassified to conform to theJuly 9, 2005 presentation.

 

**2.**              Stock-basedCompensation

 

TheCompany measures compensation cost for employee stock options and similarequity instruments using the intrinsic value-based method of accountingprescribed by Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees”(APB 25), and follows the disclosure-only provisions ofSFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS No.148, “Accounting for Stock-Based Compensation – Transition and Disclosure”.  As all options have been granted at fairvalue, no compensation cost has

 

6

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beenrecognized in the financial statements. The following table represents pro forma net income and pro forma incomeper share had compensation cost been determined using the fair value method:

 
| ** **                                                       | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                       | ** ** | **July 9,**        | ** ** | **July 10,**       | ** ** | **July 9,** | ** ** | **July 10,** | ** ** |
| ** **                                                       | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                             |       |               |       |               |       |   |   |   |   |
| Net income as  reported                                          |       | $                  | 2,213      |               | $          | 1,755 |   | $ | 2,348 |   | $ | 1,018 |   |
| Stock based  compensation determined under the fair value method |       | (80                | )          | (102               | )          | (113 | ) | (310 | ) |
| Pro forma net  income                                            |       | $                  | 2,133      |               | $          | 1,653 |   | $ | 2,235 |   | $ | 708 |   |
|                                                             |       |               |       |               |       |   |   |   |   |
| Income per  common share:                                        |       |               |       |               |       |   |   |   |   |
| Basic and  diluted - as reported                                 |       | $                  | 0.14       |               | $          | 0.11 |   | $ | 0.14 |   | $ | 0.06 |   |
| Basic and  diluted - pro forma                                   |       | $                  | 0.13       |               | $          | 0.10 |   | $ | 0.14 |   | $ | 0.04 |   |

 

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

 

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

 

**The change in the carrying amount of goodwill for the 36weeks ended July 9, 2005 is due to the effect of changes in foreign currencytranslation rates. The Company performs its annual impairment evaluation in thefourth quarter of each fiscal year.**

 

**4.**              DiscontinuedOperations

 

Effective June 15, 2005,the Company sold its Norway (Westaff AS-Norway) and Denmark (Westaff A/S -Denmark) subsidiary operations to Personalhuset AS, a recruitment and staffingcompany headquartered in Norway, for approximately $2,700.  Additionally, as a part of the saletransaction, Westaff AS-Norway repaid approximately $610 of intercompany debttoWestaff USA. Of the total proceeds, approximately $220 is being held in aninterest bearing escrow account as security for potential Westaff AS-Norwayclaims, which the Company currently estimates to be zero.  The escrowed funds, net of any claimpayments, will be remitted to the Company in June 2007. The Company recorded anet gain on the sale of $1,163.

 

As required by the termsof the Company’s Multicurrency Credit Agreement, the net proceeds on the saleof the Norway and Denmark operations, including the intercompany debtrepayment, were used to pay down borrowings on the Company’s revolving creditfacility.   In accordance with EITF87-24, the Company has allocated interest expense to the discontinuedoperations of $34 and $92, respectively, for the 12 and 36 weeks ended July 9,2005 and $26 and $77, respectively, for the 12 and 36 weeks ended July 10,2004.

 

7

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Summarized information on the Norway and Denmarkdiscontinued operations is as follows:

 
| ** **                                  | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|---------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                  | ** ** | **July 9,**        | ** ** | **July 10,**       | ** ** | **July 9,** | ** ** | **July 10,** | ** ** |
| ** **                                  | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                        |       |               |       |               |       |   |   |   |   |
| Revenue                                     |       | $                  | 2,067      |               | $          | 3,048 |   | $ | 7,808 |   | $ | 8,019 |   |
| Costs and  expenses                         |       | 2,096              |       | 2,813              |       | 7,942 |   | 7,971 |   |
| Income (loss)  from discontinued operations |       | $                  | (29        | )                  | $          | 235 |   | $ | (134 | ) | $ | 48 |   |

 
| ** **                              | ** ** | ** ** | ** ** | **October 30,** | ** ** |
|-----------------------------------------|------------|------------|------------|-----------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **2004**        | ** ** |
|                                    |       |       |       |            |       |
| Cash and cash  equivalents              |       |       |       | $               | 2,607      |   |
| Trade accounts  receivable, net         |       |       |       | 1,605           |       |
| Prepaid expenses                        |       |       |       | 258             |       |
| Property and  equipment, net            |       |       |       | 84              |       |
| Other assets                            |       |       |       | 296             |       |
| Assets of  discontinued operations      |       |       |       | $               | 4,850      |   |
|                                    |       |       |       |            |       |
| Accounts payable                        |       |       |       | $               | 169        |   |
| Accrued expenses                        |       |       |       | 2,180           |       |
| Other  liabilities                      |       |       |       | 179             |       |
| Liabilities of  discontinued operations |       |       |       | $               | 2,528      |   |

 

Duringfiscal 1999, the Company sold certain of its franchise agent and Company-ownedmedical offices and entered into a termination agreement with one of itsmedical licensees. During the fourth quarter of fiscal 1999, the Companycompleted the sale of the remaining medical business to Intrepid U.S.A. Inc.under an asset purchase agreement.   Asof July 9, 2005, there are remaining current liabilities of the discontinuedmedical operations of $102, primarily for settled but unpaid claims.

 

8

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

 

The Company isresponsible for and pays workers’ compensation costs for its temporary andregular employees and is self-insured for the deductible amount related to workers’compensation claims ($500 per claim for fiscal 2005 and $750 per claim forfiscal year 2004.)  The Company accruesthe estimated costs of workers’ compensation claims based upon the expectedloss rates within the various temporary employment categories provided by theCompany.  At least annually, the Companyobtains an independent actuarial valuation of the estimated costs of claimsreported but not settled, and claims incurred but not reported, and adjusts theaccruals based on the results of the valuations.  As of July 9, 2005 and October 30, 2004,workers’ compensation liabilities were $18,517 and $16,382, respectively, ofwhich $11,900 is included in other long-term liabilities on each of therespective balance sheets for obligations which are not expected to be paid inthe following fiscal year.

 

Eachpolicy year the terms of the agreement with the insurance carrier arerenegotiated.  The insurance carrierrequires the Company to collateralize its recorded obligations through the useof irrevocable letters of credit, surety bonds or cash.  At July 9, 2005, the Company had $22,375 ofletters of credit securing its domestic workers’ compensation obligations.  In addition to premium and claim payments,the Company is cash collaterizing its fiscal 2005 policy year through paymentstotaling $15,775, of which $11,498 has been paid as of July 9, 2005.   Effective April 20, 2005, the Company’sinsurance carrier reduced its collateral requirements through the cancellationof a $3,843 surety bond.

 

**6.**              EarningsPer Share

 

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

 
| ** **                                                                                              | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                                                                                              | ** ** | **July 9,**        | ** ** | **July 10,**       | ** ** | **July 9,** | ** ** | **July 10,** | ** ** |
| ** **                                                                                              | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income from  continuing operations                                                                      |       | $                  | 1,079      |               | $          | 1,520 |   | $ | 1,319 |   | $ | 970 |   |
| Denominator for  basic earnings per share - weighted average shares                                     |       | 16,339             |       | 16,033             |       | 16,229 |   | 16,027 |   |
| Effect of  dilutive securities: stock options and awards                                                |       | 52                 |       | 35                 |       | 155 |   | 6 |   |
| Denominator for  diluted earnings per share - adjusted weighted average shares and assumed  conversions |       | 16,391             |       | 16,068             |       | 16,384 |   | 16,033 |   |
| Basic and  diluted earnings per share from continuing operations                                        |       | $                  | 0.07       |               | $          | 0.09 |   | $ | 0.08 |   | $ | 0.06 |   |
|                                                                                                    |       |               |       |               |       |   |   |   |   |
| Anti-dilutive  weighted shares excluded from diluted earnings per share                                 |       | 104                |       | 422                |       | 84 |   | 999 |   |

 

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

 

Comprehensiveincome consists of the following:

 
| ** **                        | ** ** | **12 Weeks Ended** | ** ** | **36 Weeks Ended** | ** ** |
|-----------------------------------|------------|--------------------|------------|--------------------|------------|
| ** **                        | ** ** | **July 9,**        | ** ** | **July 10,**       | ** ** | **July 9,** | ** ** | **July 10,** | ** ** |
| ** **                        | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
|                              |       |               |       |               |       |   |   |   |   |
| Net income                        |       | $                  | 2,213      |               | $          | 1,755 |   | $ | 2,348 |   | $ | 1,018 |   |
| Currency  translation adjustments |       | (5                 | )          | (17                | )          | 263 |   | 624 |   |
| Comprehensive  income             |       | $                  | 2,208      |               | $          | 1,738 |   | $ | 2,611 |   | $ | 1,642 |   |

 

**8.****              CreditAgreement**

 

On May 17, 2002, theCompany entered into agreements with GE Capital, as primary agent, to providesenior secured credit facilities totaling $65,000, expiring in May 2007.  The facilities comprise a five-year syndicatedMulticurrency Credit Agreement consisting of a $50,000 US Revolving LoanCommitment, a £2,740 UK Revolving Loan Commitment (US dollar equivalent ofapproximately $4,000 at the date of the agreement), and a $5,000 term loan (theTerm Loan), which was repaid during fiscal 2003.  In addition, a five-year Australian dollarfacility agreement (the A$ Facility Agreement) was executed on May 16, 2002,consisting of an A$12,000 revolving credit facility (US dollar equivalent ofapproximately $6,000 at the date of the agreement).  Each agreement includes a letter of creditsublimit.  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 August 19, 2005, the Company and its lenders executed aseventh amendment to the Multicurrency Credit Agreement.  The amendment allows an add-back ofapproximately $1,000 to the EBITDA covenant relating to separation andrestructuring costs incurred or to be incurred during fiscal 2005.  The amendment also allows the gain from thesale of the Company’s Norway and Denmark operations of $1,163 to be included indetermining compliance with the EBITDA and fixed charge covenants.  Additionally, the amendment increases themaximum capital expenditures allowed for fiscal 2005 from $6,000 to $8,500 andalso increases the letter of credit sublimit from $35,000 to $40,000.

 

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

 

On September 25, 2003 theCompany executed a one-year unsecured subordinated draw down note with itsprincipal stockholder and Chairman of the Board of Directors.  The note provided for the Chairman to makeadvances to the Company upon request, at his sole discretion and with noobligation to do so, in an aggregate principal amount not to exceed $1,000outstanding at any one time.  On December23, 2003 the Chairman made a $1,000 advance to the Company under the terms ofthe note.  The advance plus accruedinterest was repaid on August 3, 2004.

 

The Company also has anunsecured subordinated promissory note payable to its principal stockholder andChairman of the Board of Directors dated May 17, 2002 in the amount of$2,000.  The note has a maturity date ofAugust 18, 2007 and an interest rate equal to an indexed rate as calculatedunder the Company’s credit facilities plus seven percent, compounded monthlyand payable 60 calendar days after the end of each of the Company’s fiscalquarters.  The interest rate in

 

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effect on July 9, 2005was 13.25%.  Payment of interest iscontingent on the Company meeting minimum availability requirements under itscredit facilities. Additionally, payments of principal or interest are prohibitedin the event of any default under the credit facilities.

 

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

 

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

 

The following tablesummarizes reporting segment data with the 12 and 36 weeks ended July 10, 2004restated to exclude the Norway and Denmark operations:

 
| ** **                                   | ** ** | **Domestic**       | ** ** | ** **         | ** ** | ** **    | ** ** | **Other**         | ** ** | **Continuing** | ** ** |
|----------------------------------------------|------------|--------------------|------------|--------------------|------------|---------------|------------|-------------------|------------|----------------|------------|
| ** **                                   | ** ** | **Business Svcs.** | ** ** | **United Kingdom** | ** ** | **Australia** | ** ** | **International** | ** ** | **Operations** | ** ** |
|                                         |       |               |       |               |       |          |       |              |       |           |       |
| 12 Weeks Ended  July 9, 2005                 |       |               |       |               |       |          |       |              |       |           |       |
| Revenue                                      |       | $                  | 107,958    |               | $          | 9,412         |       | $                 | 22,045     |           | $          | 1,638 |   | $ | 141,053 |   |
| Operating income  from continuing operations |       | $                  | 1,127      |               | $          | 164           |       | $                 | 301        |           | $          | 116 |   | $ | 1,708 |   |
|                                         |       |               |       |               |       |          |       |              |       |           |       |
| 12 Weeks Ended  July 10, 2004                |       |               |       |               |       |          |       |              |       |           |       |
| Revenue                                      |       | $                  | 111,979    |               | $          | 10,726        |       | $                 | 15,209     |           | $          | 1,431 |   | $ | 139,345 |   |
| Operating income  from continuing operations |       | $                  | 1,247      |               | $          | 829           |       | $                 | 158        |           | $          | 57 |   | $ | 2,291 |   |
|                                         |       |               |       |               |       |          |       |              |       |           |       |
| 36 Weeks Ended  July 9, 2005                 |       |               |       |               |       |          |       |              |       |           |       |
| Revenue                                      |       | $                  | 313,706    |               | $          | 29,184        |       | $                 | 63,514     |           | $          | 5,475 |   | $ | 411,879 |   |
| Operating income  from continuing operations |       | $                  | 1,078      |               | $          | 635           |       | $                 | 793        |           | $          | 293 |   | $ | 2,799 |   |
|                                         |       |               |       |               |       |          |       |              |       |           |       |
| 36 Weeks Ended  July 10, 2004                |       |               |       |               |       |          |       |              |       |           |       |
| Revenue                                      |       | $                  | 308,779    |               | $          | 29,013        |       | $                 | 45,884     |           | $          | 4,601 |   | $ | 388,277 |   |
| Operating income  from continuing operations |       | $                  | 859        |               | $          | 1,424         |       | $                 | 424        |           | $          | 83 |   | $ | 2,790 |   |

 

**11.**       Commitmentsand Contingencies

** **

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

 

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

 

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

 

In December 2004, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting StandardsNo. 123 (revised 2004) “Share-Based Payment” (SFAS 123 (R)).  SFAS 123 (R) replaces FASB Statement No. 123 “Accountingfor Stock-Based Compensation”, and supersedes APB Opinion No 25 “Accounting forStock Issued to Employees”. The statement establishes standards for accountingfor share-based payment transactions. Share-based payment transactions are those in which an entity exchangesits equity instruments for goods or services or in which an entity incursliabilities in exchange for goods or services that are based on the fair valueof the entity’s equity instruments or that may be settled by the issuance ofthose equity instruments.  SFAS 123(R)covers a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights and employee share purchase plans.  SFAS 123(R) requires a public entity tomeasure the cost of employee services received in exchange for an award ofequity instruments based on the fair value of the award on the grant date (withlimited exceptions).  That cost will berecognized in the entity’s financial statements over the period during whichthe employee is required to provide services in exchange for the award.  The Company is required to adopt SFAS 123(R)in the first quarter of fiscal 2006, and has not currently evaluated the impactof adoption on its overall results of operations or financial position.

 

In May 2005, the FASB issued SFAS No. 154 “AccountingChanges and Error Corrections.”  SFAS No.154 replaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements” and changes therequirements of the accounting for and reporting of a change in accountingprinciple.  SFAS No. 154 also providesguidance on the accounting for and reporting of error corrections.  The provisions of this statement areapplicable for accounting changes and error corrections made in fiscal yearsbeginning after December 15, 2005.

 

In June 2005, the Emerging Issues Task Force (“EITF”)reached a consensus on Issue No. 05-6, “Determining the Amortization Period forLeasehold Improvements,” which requires that leasehold improvements acquired ina business combination or purchased subsequent to the inception of a lease beamortized over the lesser of the useful life of the assets or a term thatincludes renewals that are reasonably assured at the date of the businesscombination or purchase.  EITF No. 05-6is effective for periods beginning after June 29, 2005.  The Company does not expect the provisions ofthis consensus to have a material impact on the Company’s financial position orresults of operations.

 

**13.****           SubsequentEvent**

 

On July 25, 2005 the Company announced a series of restructuring,growth and performance enhancement measures designed to streamline itsoperations and organizational structure, improve profitability and supportexpansion.  The planned actions includethe elimination of several corporate and field management positions.  The Company expects to incur severance costsassociated with the restructuring of approximately $500 in the fourth quarterof fiscal 2005.

 

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

 

### **Cautionary Statement**

 

This notice is intendedto take advantage of the “safe harbor” provided by the Private SecuritiesLitigation Reform Act of 1995 with respect to forward-looking statements.Except for the historical information contained herein, the matters discussedshould be considered forward-looking statements and readers are cautioned notto place undue reliance on those statements. Any forward-looking statements inthis discussion are made based on information available as of the date hereofand are subject to a number of risks and uncertainties that could cause theCompany’s actual results and financial position to differ materially from thoseexpressed or implied in the forward-looking statements and to be below theexpectations of public market analysts and investors. These risks anduncertainties include, but are not limited to, those discussed in Item 1 “FactorsAffecting Future Operating Results” and elsewhere in the Company’s AnnualReport on Form 10-K for the fiscal year ended October 30, 2004.  The Company undertakes no obligation topublicly release the results of any revisions to these forward-lookingstatements to reflect events or circumstances after the date hereof or toreflect the occurrence of unanticipated events, except as required byapplicable laws and regulations.

 

The following discussionis intended to assist in the understanding and assessment of significantchanges and trends related to the results of operations and financial conditionof Westaff, Inc., together with its consolidated subsidiaries. Thisdiscussion and analysis should be read in conjunction with the Company’sConsolidated Financial Statements and Notes thereto included elsewhere in thisForm 10-Q and in the Company’s Annual Report on Form 10-K for the fiscal yearended October 30, 2004.

 

### **Critical Accounting Policies**

 

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

 

TheCompany’s critical accounting policies are described in Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” andin the notes to the consolidated financial statements in the Company’spreviously filed Annual Report on Form 10-K for the fiscal year ended October30, 2004.  There were no changes to thesepolicies during the 36 week period ended July 9, 2005.

 

### **Executive Overview**

 

Domestic revenuedecreased 3.6% for the third quarter of fiscal 2005 as compared to the fiscal2004 period.  This decrease is partiallyattributable to a focused shift in business mix in an effort to increase grossmargins.  Additionally, the decreasereflects the effect of the divestiture of one of the Company’s franchise agentoperations during the first quarter of fiscal 2005.  In July 2005, the Company announced a seriesof measures intended to promote future growth and profitability for its domesticoperations.  Among these

 

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measures is areorganization of the Company’s domestic field operations’ structure,streamlining reporting responsibilities and creating a select team of sales andoperations staff to maximize the performance of branch offices and to assist inthe development of key markets and expansion into new markets.  Management believes these recent actions,coupled with ongoing sales and marketing programs, should stabilize domesticrevenue trends and may well return them to growth beginning as early as thefourth quarter of fiscal 2005.   Domesticrevenue growth for the first period of the fourth quarter of fiscal 2005 wasimproved as compared to the third quarter revenue growth.

 

Domestic permanentplacement revenue for the third quarter of fiscal 2005 grew nearly 73% over theprior year quarter and 47.1% over the prior year to date, although it stillcomprises under 1% of total domestic revenue.  The Company is aggressively promoting its permanent placement businesswith the goal of continued strong growth.

 

During the third quarterof this fiscal year, the Company sold its subsidiary operations in Norway andDenmark.  The sale of these operations,which comprised approximately 9% of fiscal 2004 international revenue, willenable the Company to focus on its key international markets in Australia, NewZealand and the United Kingdom.  Fiscalyear to date local currency growth over prior year was more than 30% forAustralia and 7% for New Zealand, while the United Kingdom operations were down3.5%.

 

The implementation of thenew, fully integrated, domestic business process management software platformis moving forward, with the human resources module fully in place and the corefinancials module anticipated to be up and running at the beginning of Novemberof this year.  The final phase of theproject, which includes front-office modules and payroll and billing fortemporary employees, is currently scheduled for the second quarter of fiscal2006.

 

The Company continues toenjoy a strong liquidity position with aggregate available borrowing capacityof $22.4 million at July 9, 2005.

 

**DiscontinuedOperations**

 

Effective June 15, 2005,the Company sold its Norway (Westaff AS-Norway) and Denmark (Westaff A/S -Denmark) subsidiary operations to Personalhuset AS, a recruitment and staffingcompany headquartered in Norway. Net proceeds from the sale were approximately$2.7 million. Additionally, as a part of the sale transaction, WestaffAS-Norway repaid approximately $0.6 million of intercompany debt to WestaffUSA.  Of the total proceeds,approximately $0.2 million is being held in an interest bearing escrow accountas security for potential Westaff AS-Norway claims.  The escrowed funds, net of any claimpayments, will be remitted to the Company in June 2007. The Company recorded anet gain on the sale of $1.2 million. The Company has classified the operationsas discontinued operations and, accordingly, has segregated the assets,liabilities, revenue and expenses of these discontinued operations in the accompanyingfinancial statements and notes thereto. Cash flows pertaining to discontinued operations are not disclosedseparately in the condensed consolidated statements of cash flows.

 

As required under theterms of the Company’s Multicurrency Credit Agreement, the net proceeds fromthe sale of the Norway and Denmark operations were used to pay down borrowingson the Company’s revolving credit facility. Interest expense has been allocated to these discontinued operations inaccordance with EITF 87-24.

 

During fiscal 1999, theCompany sold certain of its franchise agent and company-owned medical officesand entered into a termination agreement with one of its medicallicensees.  During the fourth quarter offiscal 1999, the Company completed the sale of the remaining medical businessto Intrepid U.S.A. Inc.

 

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under an asset purchaseagreement.  As of July 9, 2005, there areremaining current liabilities of the discontinued medical operations of $0.1million, primarily for settled but unpaid claims.

 

**Results of Continuing Operations**

 

**Fiscal Quarter Ended July 9, 2005compared to Fiscal Quarter Ended July 10, 2004**

 

Revenue increased $ 1.7million or 1.2% for the third fiscal quarter of 2005 as compared to the fiscal2004 quarter.  Domestic revenue decreased3.6 %, while international revenue increased 20.9%, assisted by the effect offavorable exchange rates.

 

The decrease in domesticrevenue is the result of a decrease in billed hours of 5.9%, partially offsetby an increase in average bill rates of 2.2% for temporary services and anincrease in permanent placement revenue of 72.7%.  The decrease in billed hours is partially theresult of decreased sales from some higher volume, lower margin business as theCompany continues its focus on servicing higher margin accounts.  Domestic revenue was also negatively impactedby the November 2004 divestiture of one of the Company’s franchise operations.

 

Substantially all of theinternational revenue increase is attributable to the Company’s Australiaoperations that achieved a 31.5% increase in billed hours over the fiscal 2004quarter as a result of both new business and increases in existingbusiness.  Approximately 6% of thereported increase in international revenue is the result of foreign currencyexchange rate fluctuations.

 

Costs of services includehourly wages of temporary employees, employer payroll taxes, state unemploymentand workers’ compensation insurance and other employee-related costs.  Costs of services increased $1.0 million, or0.9%, in the 2005 fiscal quarter as compared to 2004.  Gross margin for domestic operations was17.2% for the fiscal 2005 quarter compared to 16.1% for the fiscal 2004quarter.   The increase is partiallyattributable to domestic average bill rate increases outpacing average pay rateincreases, as well as increases in permanent placement fees.  International gross margin for the currentfiscal quarter was 18.2% as compared to 21.6% for the fiscal 2004 quarter.   The lower international margins primarilyreflect an increase in high volume yet lower margin accounts in the Australiaoperations.

 

Franchise agents’ shareof gross profit represents the net distribution paid to franchise agents basedeither on a percentage of the sales or gross profit generated by the franchiseagents’ operations. As a percentage of consolidated revenue, franchise agents’share of gross profit was 3.1%  for bothfiscal quarters.

 

Selling andadministrative expenses increased $1.3 million, or 7.8% for the 2005 quarter ascompared to the 2004 quarter.  As apercentage of revenue, selling and administrative expenses were 12.5% for thefiscal 2005 quarter and 11.7% for the fiscal 2004 quarter.  The increase is primarily due to increaseddomestic salary costs.  Subsequent to thesecond quarter of fiscal 2004, in light of positive economic indicators for theU.S. economy’s growth, the Company loosened its restrictions on hiring and wageincreases for its full-time employees and reinstated full salaries for certain managementemployees whose salaries were reduced during fiscal 2003. The Company iscontinuing its investment in its field office staff, increasing full-timeequivalent positions by approximately 5% as of the end of the third quarter offiscal 2005 compared to the prior year quarter end.  Additionally, the Company has increasedstaffing to support the implementation of its new business process managementsystem currently in progress.

 

On July 25, 2005 the Company announced a series of restructuring,growth and performance enhancement measures designed to streamline itsoperations and organizational structure, improve profitability and supportexpansion.  The planned actions includethe elimination of several corporate and

 

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field management positions.  TheCompany expects to incur severance costs associated with the restructuring ofapproximately $0.5 million in the fourth quarter of fiscal 2005; however, theCompany also anticipates future cost savings as a result of the restructuring.

 

Interest expensedecreased $0.1 million primarily as a result of decreased average borrowingsduring the fiscal 2005 quarter somewhat offset by higher average interestrates.

 

**36 Weeks Ended July 9, 2005compared to 36 Weeks Ended July 10, 2004**

 

Revenue growth for the 36weeks ended July 9, 2005 as compared to same period in 2004 was 1.7% fordomestic operations and 23.5% for international operations. In localcurrencies, the total international revenue growth was 17.3%.  The revenue growth was primarily attributableto an increase in average bill rates of 2.3% for domestic operations andincreases in both average bill rates and billed hours for the internationaloperations.

 

Gross margin for the 36week period in fiscal 2005 was 17.2% as compared to 16.9% for the fiscal 2004period.  The increase is due to thedomestic growth in revenue while holding costs associated with its temporaryworkforce relatively flat between the two fiscal periods.

 

The Company’s workers’compensation costs tend to vary depending upon the mix of business betweenclerical/administrative and light industrial staffing.  In the past several years, unexpected adversedevelopment of claims reported but not yet settled, and increases in claimsincurred but not yet reported, have resulted in the need for additional chargesto be recorded to increase its accrual levels. Based on the Company’s interim actuarial valuation for fiscal 2005, theCompany believes there is evidence that workers’ compensation costs may bestabilizing.

 

As a percentage ofconsolidated revenue, franchise agents’ share of gross profit was 3.0% for the36 week period of fiscal 2005 and 3.1% for the comparable period of fiscal2004.   The November 2004 divestiture ofone of the Company’s franchise operations contributed to the percentagedecrease.

 

Selling andadministrative expenses increased $5.0 million, or 10.6%, for the fiscal 2005period as compared to the fiscal 2004 period. The increase is attributable to higher average exchange rates used totranslate international local currency expenses into U.S. dollars and increaseddomestic salary costs which include severance costs of $0.5 million for theCompany’s former chief executive officer. In addition, selling and administrative expenses in the fiscal 2004period were reduced by a $0.7 million gain on the sale of the executiveheadquarters building in Walnut Creek, California.

 

For the 36 week period offiscal 2005 as compared to the fiscal 2004 period, depreciation expense and netinterest expense each decreased $0.3 million. The provision for income taxes was $0.5 million in each of the fiscal2005 and 2004 periods.

 

**Liquidity and Capital Resources**

 

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

 

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The Company finances itsoperations primarily through cash generated by its operating activities andborrowings under its revolving credit facilities. Net cash provided (used) byoperating activities was $2.9 million for the 36 weeks ended July 9, 2005 and$(0.3)  million for the 36 weeks endedJuly 10, 2004.  Higher net income for thefiscal 2005 period, and increased collections on accounts receivable ascompared to the prior year period, were substantially offset by cash paymentsof $11.5 million as collateral for the Company’s 2005 workers’ compensationobligations (see further discussion below.)

 

Cash used for capitalexpenditures, which are primarily for business process management (BPM) systeminitiatives, other software, computers and peripherals, and office furnitureand equipment, totaled $5.2 million for the 36 weeks ended July 9, 2005 ascompared to $1.3 million for the same period in fiscal 2004. The increase incapital expenditures during fiscal 2005 is primarily due to work in process onthe implementation of a new BPM system that the Company began in late fiscal2004.  The Company currently anticipatescapital expenditures will be in the range of $6.0 million to $8.5 million for the fiscal 2005 year.

 

From time to time, theCompany has generated cash through sales of Company-owned offices to franchiseowners or sales of franchise agent and license offices back to the franchiseagent or license owner.  During the firstquarter of fiscal 2005, the Company sold one of its franchise operations backto the franchise agent for cash proceeds of $1.0 million.  The Company secured the franchise agents’note payable obligation to the bank that funded the purchase through a $1.0million letter of credit that will decline as the note obligation is paid bythe franchise agent.  The $1.0 milliongain on the sale of the franchise operations has been deferred, and will berecognized as the note obligation payments are made.  During the fourth quarter of fiscal 2005, theCompany sold an additional franchise agent’s operations to the franchise agentfor cash proceeds of $0.5 million.

 

In February 2004, theCompany sold its remaining unoccupied corporate headquarters’ for cash proceedsof $1.9 million.  The $0.7 million gainon the sale is included in selling and administrative expenses for the 36 weekperiod ended July 10, 2004.

 

As noted above in “DiscontinuedOperations”, effective June 15, 2005, the Company sold its Norway and Denmarksubsidiary operations for net proceeds of approximately $2.7 million, with anadditional $0.6 million repayment of intercompany debt.  Of the total proceeds, approximately $0.2million is being held in an interest bearing escrow account as security forpotential claims under Norway’s pension plans. The escrowed funds, net of any claim payments, will be remitted to theCompany in June 2007.  The proceedsreceived were used to pay down borrowings under the Company’s revolving creditfacility.  The Company recorded a netgain on the sale of $1.2 million.

 

In May 2002, theCompany entered into agreements with GE Capital, as primary agent, to provide seniorsecured credit facilities totaling $65.0 million, expiring in May 2007.  The facilities comprise a five-yearsyndicated Multicurrency Credit Agreement consisting of a $50.0 million USRevolving Loan Commitment, a £2.7 million UK Revolving Loan Commitment (USdollar equivalent of approximately $4.0 million at the date of the agreement),and a $5.0 million term loan (the Term Loan), which was repaid during fiscal2003.  In addition, a five-yearAustralian dollar facility agreement (the A$ Facility Agreement) was executedon May 16, 2002, consisting of an A$12.0 million revolving credit facility (USdollar equivalent of approximately $6.0 million at the date of theagreement).  Each agreement includes aletter of credit sublimit.  Letters ofcredit under the agreements expire one year from date of issuance but areautomatically renewed for one additional year unless written notice is given toor from the holder.

 

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The creditfacilities are secured by substantially all of the assets of the Company. GECapital, in its role as primary agent under the credit facilities, has soledominion and control over the Company’s primary U.S., United Kingdom andAustralia cash receipts accounts.  Cashreceipts into these accounts are applied against the Company’s respectiveoutstanding obligations under the facilities, with additional borrowings underthe revolving facilities directed into the Company’s disbursement accounts.

 

On January 5, 2005, a sixth amendment to the Multicurrency CreditAgreement was executed.  The amendment,among other things, allows a $1.4 million add-back adjustment to the rolling13-period earnings before interest, taxes, depreciation and amortization(EBITDA) covenant at October 30, 2004 for additional workers’ compensationcharges the Company incurred during the fourth quarter of fiscal 2004 relatingto adverse loss development on historical claims.

 

Effective August 19, 2005, the Company and its lenders executed aseventh amendment to the Multicurrency Credit Agreement.  The amendment allows an add-back ofapproximately $1.0 million to the EBITDA covenant relating to separation andrestructuring costs incurred or to be incurred during fiscal 2005.  The amendment also allows the gain from thesale of the Company’s Norway and Denmark operations of $1.2 million to beincluded in determining compliance with the EBITDA and fixed chargecovenants.  Additionally, the amendmentincreases the maximum capital expenditures allowed for fiscal 2005 from $6.0 millionto $8.5 million and also increases the letter of credit sublimit from $35.0 millionto $40.0 million.

 

As of July 9, 2005, theCompany had $12.0 million outstanding under its credit facilities withavailable borrowing capacity of $22.5 million consisting of $11.9 million forthe U.S. operations, $3.9 million for the U.K. operations and $6.7 million forthe Australia operations.

 

The Company has anunsecured subordinated promissory note payable to its principal stockholder andChairman of the Board of Directors in the amount of $2.0 million with amaturity date of August 18, 2007, and an interest rate equal to an indexedrate as calculated under the Company’s credit facilities plus seven percent,compounded monthly and payable 60 calendar days after the end of each of theCompany’s fiscal quarters.  The interestrate in effect on July 9, 2005 was 13.25%. Payment of interest is contingent on the Company meeting minimumavailability requirements under its credit facilities.  Additionally, payments of principal orinterest are prohibited in the event of any default under the creditfacilities.

 

On September 25,2003 the Company executed a one-year unsecured subordinated draw down note withits principal stockholder and Chairman of the Board of Directors.  The note provided for the Chairman to makeadvances to the Company upon request, at his sole discretion and with noobligation to do so, in an aggregate principal amount not to exceed $1.0million outstanding at any one time.  OnDecember 23, 2003 the Chairman made a $1.0 million advance to the Company underthe terms of the note. The advance plus accrued interest was repaid on August3, 2004.

 

The Company works to balance its worldwide cash needs through dividendsfrom and loans to its international subsidiaries.  These loans and dividends are limited by theimmediate future cash availability and needs of each respective subsidiary,restrictions imposed by the Company’s senior secured debt facilities and, insome cases, statutory regulations of the subsidiary.  The US operations cannot directly draw on theexcess borrowing availability of the UK or Australian operations; however, theCompany may request dividends from the UK. The US can also request repayments on intercompany balances due from itsinternational subsidiaries, subject to their cash flow needs and regulatoryrestrictions.  As a result of positiveoperating performance in Australia in fiscal 2003 and fiscal 2004,

 

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during the second quarter of fiscal 2005 the Company’s Australianlender substantially reduced restrictions on repayments of its intercompanybalances.

 

The Company isresponsible for and pays workers’ compensation costs for its temporary andregular employees and is self-insured for the deductible amount related toworkers’ compensation claims ($500,000 per claim for fiscal 2005 and $750,000per claim for fiscal 2004.)  Each policyyear the terms of the agreement with the insurance carrier are renegotiated.  The insurance carrier requires the Company tocollateralize its obligations through the use of irrevocable standby letters ofcredit, surety bonds or cash.  At July 9,2005 the Company had $22.4 million of outstanding letters of credit securingits domestic workers compensation obligations for policy years 2004 andearlier.  Effective April 20, 2005, theCompany’s insurance carrier reduced its collateral requirements for the Companythrough the cancellation of a $3.8 million surety bond.

 

Under the terms of its2005 policy year agreement, the Company will make cash payments totaling $20.6million to be paid in monthly installments, which commenced on November 1, 2004in the amounts of $2.7 million for the first three installments and $1.4million for the remaining nine installments. Of these payments, $15.8 million will serve to cash collateralize theCompany’s fiscal 2005 obligations in lieu of issuance of additional letters ofcredit.  Cash payments for 2005 policyyear claims will be paid out of this cash collateral fund.  The Company will also make ongoing cashpayments for claims for all other open policy years except 2003, which wasfully funded although subject to annual retroactive premium adjustments basedon actual claims activity.

 

The terms of the Company’s2005 workers’ compensation policy allow the Company the ability to exchange the2005 policy cash collateral with letters of credit.  During the fourth quarter of fiscal 2005, theCompany intends to request a refund of its net cash collateral deposit inexchange for letters of credit.  Therefund of the cash collateral will be used to pay down debt under the revolvingcredit agreement.  The Company currentlyestimates that the cash collateral as of the end of fiscal 2005, net of claimpayments, will be approximately $12 million.

 

During the fourth quarterof fiscal 2004, the Company received an unfavorable arbitration ruling relatingto a contract dispute with one of its vendors. Total costs associated with the claim, including the arbitration awardplus related attorneys’ fees were $1.1 million. Payments of $0.9 million for the award plus remaining related attorneys’fees were paid during the first quarter of fiscal 2005.

 

During the first quarterof fiscal 2005, the Company received $0.5 million of domestic federal income taxrefunds relating to carryback provisions.

 

The Company has a stockoption/stock issuance plan that provides for the granting of stock options,awards and appreciation rights to certain key employees at the discretion ofits Board of Directors.   The Companyalso has an employee stock purchase plan whereby eligible employees mayauthorize payroll deductions for semi-annual purchases of the Company’s stockat a discount.  During the 36 weeks endedJuly 9, 2005,  cash proceeds of $0.6million were received for purchases of 271,618 shares of the Company’s commonstock under these plans.

 

The Company believes thatthe current borrowing capacity provided under its credit facilities, togetherwith cash generated through operations, will be sufficient to meet the Company’sworking capital needs for the foreseeable future.

 

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

 

The Company is exposed tocertain market risks from transactions that are entered into during the normalcourse of business.  The Company’sprimary market risk exposure relates to interest rate risk.  At July 9, 2005, the Company’s outstandingdebt under variable-rate interest borrowings was approximately $14.0million.  A change of 2% in the interestrates would cause a change in interest expense of approximately $0.3 million onan annual basis.  The Company’s exposureto market risk for changes in interest rates is not significant with respect tointerest income, as its investment portfolio is not material to its

 

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consolidated balancesheet.  The Company currently has noplans to hold an investment portfolio that includes derivative financialinstruments.

 

For the 36 weeks endedJuly 9, 2005, the Company’s continuing international operations comprised 23.8%of its revenue and, as of the end of that period, 22.5% of its totalassets.  The Company is exposed toforeign currency risk primarily due to its investments in foreign subsidiaries.  The Company’s multicurrency credit facility,which allows the Company’s Australia and United Kingdom subsidiaries to borrowin local currencies, partially mitigates the exchange rate risk resulting fromfluctuations in foreign currency denominated net investments in thesesubsidiaries in relation to the U.S. dollar. The Company does not currently hold any market risk sensitiveinstruments entered into for hedging transaction risks related to foreigncurrencies.  In addition, the Company hasnot entered into any transactions with derivative financial instruments fortrading purposes.

 

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

 

TheCompany carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperations of the Company’s “disclosure controls and procedures” (as definedunder Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934,as amended).  Based on this evaluation,the Chief Executive Officer and Chief Financial Officer concluded that, as ofJuly 9, 2005 (the end of the period covered by this report) the Company’sdisclosure controls and procedures are effective in timely alerting them tomaterial information required to be included in this report.  There was no change in the Company’s internalcontrol over financial reporting that occurred during the fiscal period endedJuly 9, 2005, that has materially affected, or is reasonably likely tomaterially affect, the Company’s internal controls over financial reporting.

 

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

 

The Company is notcurrently a party to any material litigation. However, from time to time theCompany has been threatened with or named as a defendant in lawsuits, includingcountersuits brought by former franchise agents or licensees, andadministrative claims and lawsuits brought by employees or former employees.

 

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

 

None.

 

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

 

Not applicable.

 

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

 

None.

 

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

 

No events.

 

**Item 6. Exhibits**

 

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

 
| 10.3.10.1 |   | Third Amendment to  Employment Contract by and between the Company and Stephen Russo dated August  17, 2005, Second Amendment to Employment Contract by and between the Company  and Stephen Russo dated July 1, 2004, First Amendment to Employment Contract  by and between the Company and Stephen Russo dated July 1, 2004, and  Employment Contract by and between the Company and Stephen Russo dated July  1, 2004. |
|-----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|      |   |                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 31.1      |   | Certification of the  Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                                                                                                                  |
| 31.2      |   | Certification of the  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of  2002.                                                                                                                                                                                                                                                                                                                  |
| 32.1      |   | Certification of the  Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as Adopted  Pursuant to   Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                  |
| 32.2      |   | Certification of the  Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as Adopted  Pursuant to   Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                  |

 

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**SIGNATURES**

 

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

 
|            | WESTAFF, INC.                                      |   |
|-----------------|----------------------------------------------------|--------|
|            |                                               |   |
|            |                                               |   |
| August 23, 2005 |                                               |   | /s/ Dirk A. Sodestrom |   |   |
| Date            |                                               |   |   Dirk A. Sodestrom |   |   |
|            | Senior Vice  President and Chief Financial Officer |   |

 

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