Insperity (NSP) 10-Q 2006 Q3 Quarterly report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

þ Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2006.

or

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 No. 1-13998

Administaff, Inc.

(Exact name of registrant as specified in its charter)

Delaware
(State or other jurisdiction of
incorporation or organization) 76-0479645
(I.R.S. Employer
Identification No.)

19001 Crescent Springs Drive
Kingwood, Texas
(Address of principal executive offices) 77339
(Zip Code)

(Registrant’s Telephone Number, Including Area Code): (281) 358-8986

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yesþ Noo

     Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filero      Accelerated filerþ     Non-accelerated filero

     Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yeso Noþ

     As of October 27, 2006, 27,824,674 shares of the registrant’s common stock, par value $0.01 per share, were outstanding.

TABLE OF CONTENTS

	Part I
Item 1.	Financial Statements	3
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 4.	Controls and Procedures	31
	Part II
Item 1.	Legal Proceedings	32
Item 1a.	Risk Factors	32
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	33
Item 6.	Exhibits	34
Certification of CEO pursuant to Section 302
Certification of CFO pursuant to Section 302
Certification of CEO pursuant to Section 906
Certification of CFO pursuant to Section 906

PART I

ITEM 1. FINANCIAL STATEMENTS

ADMINISTAFF, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

ASSETS

	September 30,			December 31,
	2006			2005
	(Unaudited)
Current assets:
Cash and cash equivalents	$	107,185		$	137,407
Restricted cash		34,858			27,580
Marketable securities		81,763			57,973
Accounts receivable, net:
Trade		2,816			5,225
Unbilled		113,795			91,258
Other		1,969			1,928
Prepaid insurance		10,049			9,218
Other current assets		6,934			4,664
Income taxes receivable		1,768			—
Deferred income taxes		1,816			3,308
Total current assets		362,953			338,561
Property and equipment:
Land		2,920			2,920
Buildings and improvements		59,592			58,264
Computer hardware and software		61,411			58,194
Software development costs		20,069			18,435
Furniture and fixtures		29,964			28,748
Vehicles and aircraft		22,138			22,366
		196,094			188,927
Accumulated depreciation and amortization		(114,233	)		(105,307	)
Total property and equipment, net		81,861			83,620
Other assets:
Prepaid insurance		11,000			11,000
Deposits — healthcare		2,161			954
Deposits — workers’ compensation		42,857			55,421
Goodwill and other intangible assets		4,957			5,018
Other assets		678			865
Total other assets		61,653			73,258
Total assets	$	506,467		$	495,439

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ADMINISTAFF, INC.
CONSOLIDATED BALANCE SHEETS (Continued)
(in thousands)

LIABILITIES AND STOCKHOLDERS’ EQUITY

	September 30,			December 31,
	2006			2005
	(Unaudited)
Current liabilities:
Accounts payable	$	3,392		$	4,979
Payroll taxes and other payroll deductions payable		80,489			101,293
Accrued worksite employee payroll cost		101,352			78,393
Accrued health insurance costs		4,013			3,495
Accrued workers’ compensation costs		36,391			30,212
Accrued corporate payroll and commissions		14,422			17,801
Other accrued liabilities		8,840			7,453
Current portion of long-term debt		573			1,700
Total current liabilities		249,472			245,326
Noncurrent liabilities:
Long-term debt		1,316			33,190
Accrued workers’ compensation costs		37,321			32,692
Deferred income taxes		4,257			1,802
Total noncurrent liabilities		42,894			67,684
Commitments and contingencies
Stockholders’ equity:
Common stock		309			309
Additional paid-in capital		135,108			119,573
Deferred compensation expense		—			(2,931	)
Treasury stock, at cost		(58,073	)		(45,614	)
Accumulated other comprehensive loss, net of tax		(130	)		(153	)
Retained earnings		136,887			111,245
Total stockholders’ equity		214,101			182,429
Total liabilities and stockholders’ equity	$	506,467		$	495,439

See accompanying notes.

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ADMINISTAFF, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(Unaudited)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2006			2005			2006			2005
Revenues (gross billings of $1.990 billion, $1.622 billion, $5.813 billion and $4.756 billion, less worksite employee payroll cost of $1.652 billion, $1.337 billion, $4.776 billion and $3.892 billion, respectively)	$	338,421		$	285,202		$	1,036,835		$	864,062
Direct costs:
Payroll taxes, benefits and workers’ compensation costs		266,557			227,031			828,762			695,528
Gross profit		71,864			58,171			208,073			168,534
Operating expenses:
Salaries, wages and payroll taxes		30,393			25,471			88,057			73,436
Stock-based compensation		1,011			360			2,368			1,765
General and administrative expenses		14,722			12,476			44,573			39,077
Commissions		2,722			2,610			8,264			7,462
Advertising		2,819			2,956			8,521			7,355
Depreciation and amortization		3,896			3,693			11,620			11,099
		55,563			47,566			163,403			140,194
Operating income		16,301			10,605			44,670			28,340
Other income (expense):
Interest income		2,567			1,645			8,384			4,097
Interest expense		(14	)		(594	)		(1,076	)		(1,709	)
Other, net		13			(84	)		125			(97	)
Income before income taxes		18,867			11,572			52,103			30,631
Income tax expense		6,754			4,389			18,952			11,574
Net income	$	12,113		$	7,183		$	33,151		$	19,057
Basic net income per share of common stock	$	0.44		$	0.28		$	1.21		$	0.74
Diluted net income per share of common stock	$	0.43		$	0.26		$	1.17		$	0.72

See accompanying notes.

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ADMINISTAFF, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2006
(in thousands)
(Unaudited)

														Accumulated
	Common Stock				Additional			Deferred						Other
	Issued				Paid-In			Compensation			Treasury			Comprehensive			Retained
	Shares		Amount		Capital			Expense			Stock			Income (Loss)			Earnings			Total
Balance at December 31, 2005		30,839	$	309	$	119,573		$	(2,931	)	$	(45,614	)	$	(153	)	$	111,245		$	182,429
Purchase of treasury stock		—		—		—			—			(23,780	)		—			—			(23,780	)
Exercise of stock options		—		—		3,212			—			11,954			—			—			15,166
Income tax benefit from stock-based compensation		—		—		11,697			—			—			—			—			11,697
Cumulative effect of change in accounting principle		—		—		(684	)		2,931			(2,296	)		—			—			(49	)
Stock-based compensation expense		—		—		949			—			1,468			—			—			2,417
Other		—		—		361			—			195			—			—			556
Dividends paid		—		—		—			—			—			—			(7,509	)		(7,509	)
Change in unrealized gain on marketable securities, net of tax:
Unrealized gain		—		—		—			—			—			23			—			23
Net income		—		—		—			—			—			—			33,151			33,151
Comprehensive income																					33,174
Balance at September 30, 2006		30,839	$	309	$	135,108		$	—		$	(58,073	)	$	(130	)	$	136,887		$	214,101

See accompanying notes.

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ADMINISTAFF, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)

	Nine Months Ended
	September 30,
	2006			2005
Cash flows from operating activities:
Net income	$	33,151		$	19,057
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		11,767			11,422
Stock-based compensation		2,368			1,765
Deferred income taxes		3,932			680
Changes in operating assets and liabilities:
Restricted cash		(7,278	)		(7,219	)
Accounts receivable		(20,169	)		(21,506	)
Prepaid insurance		(831	)		(11,584	)
Other current assets		(2,270	)		(1,774	)
Other assets		11,349			20,168
Accounts payable		(1,587	)		323
Payroll taxes and other payroll deductions payable		(20,804	)		3,506
Accrued worksite employee payroll expense		22,959			15,556
Accrued health insurance costs		518			469
Accrued workers’ compensation costs		10,808			15,473
Other accrued liabilities		(1,992	)		2,748
Income taxes payable/receivable		(1,768	)		1,367
Total adjustments		7,002			31,394
Net cash provided by operating activities		40,153			50,451
Cash flows from investing activities:
Marketable securities:
Purchases		(56,710	)		(27,314	)
Proceeds from maturities		32,916			650
Proceeds from dispositions		50			7,492
Cash exchanged for note receivable		—			(616	)
Property and equipment:
Purchases		(9,853	)		(6,867	)
Proceeds from dispositions		93			140
Net cash used in investing activities		(33,504	)		(26,515	)

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ADMINISTAFF, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(in thousands)
(Unaudited)

	Nine Months Ended
	September 30,
	2006			2005
Cash flows from financing activities:
Purchase of treasury stock	$	(23,780	)	$	(12,200	)
Dividends paid		(7,509	)		(5,493	)
Principal repayments on long-term debt and capital lease obligations		(33,001	)		(1,232	)
Proceeds from the exercise of stock options		15,166			21,620
Income tax benefit from stock-based compensation		11,697			—
Other		556			447
Net cash provided by (used in) financing activities		(36,871	)		3,142
Net increase (decrease) in cash and cash equivalents		(30,222	)		27,078
Cash and cash equivalents at beginning of period		137,407			81,740
Cash and cash equivalents at end of period	$	107,185		$	108,818
Supplemental disclosures:
Cash paid for income taxes	$	5,439		$	10,021
Cash paid for interest	$	1,031		$	1,628

See accompanying notes.

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ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
September 30, 2006

1. Basis of Presentation

     Administaff, Inc. (“Administaff” or the “Company”) is a professional employer organization (“PEO”). As a PEO, the Company provides a bundled comprehensive service for its clients in the area of personnel management. The Company provides its comprehensive service through its Personnel Management System, which encompasses a broad range of human resource functions, including payroll and benefits administration, health and workers’ compensation insurance programs, personnel records management, employer liability management, employee recruiting and selection, employee performance management, and employee training and development. For the nine months ended September 30, 2006 and 2005, revenues from the Company’s Texas markets represented 36% and 39%, respectively, of the Company’s total revenues.

     The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.

     The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

     The accompanying consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2005. The Consolidated Balance Sheet at December 31, 2005, has been derived from the audited financial statements at that date, but does not include all of the information or footnotes required by accounting principles generally accepted in the United States for complete financial statements. The Company’s Consolidated Balance Sheet at September 30, 2006, and the Consolidated Statements of Operations, Cash Flows and Stockholders’ Equity for the periods ended September 30, 2006 and 2005, have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting only of normal recurring adjustments necessary to present fairly the consolidated financial position, results of operations and cash flows, have been made.

     The results of operations for the interim periods are not necessarily indicative of the operating results for a full year or of future operations.

Stock-Based Compensation

     At September 30, 2006, the Company has three stock-based employee compensation plans. Prior to January 1, 2006, the Company accounted for these plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations. Effective January 1, 2006, the Company

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began accounting for these plans under the recognition and measurement principles of Financial Accounting Standards Board (FASB) Statement No. 123 (revised 2004),Share-Based Payment(“Statement 123(R)”). Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. The Company adopted Statement 123(R) using the “modified prospective” method in which compensation cost is recognized beginning with the effective date: (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date; and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.

     During the first quarter of 2005, the Company accelerated the vesting of all outstanding stock options, resulting in the recognition of $790,000 ($487,000, net of taxes) of stock-based compensation expense. Because the Company accelerated the vesting of all outstanding stock options during the first quarter of 2005, the adoption of SFAS 123(R) did not have a material impact on our results of operations in 2006. The cumulative effect of the change in accounting principle associated with the adoption of Statement 123(R) resulted in a $50,000 reduction in stock-based compensation and the reclassification of $2.9 million in previously recognized deferred compensation to additional paid-in capital and treasury stock.

     The Company generally makes annual grants of restricted and unrestricted stock under its stock-based incentive compensation plans to its directors, officers and other management. Restricted stock grants to officers and other management vest over three to five years from the date of grant. Annual stock grants issued to directors are 100% vested on the grant date. Shares of restricted stock are based on fair value on date of grant and the associated expense net of estimated forfeitures is recognized over the vesting period. During the first nine months of 2006 and 2005, the Company recognized $2,368,000 ($1.5 million net of taxes), and $975,000 ($607,000 net of taxes), respectively, of stock-based compensation expense associated with the stock grants. As of September 30, 2006, unrecognized compensation expense associated with the non-vested shares outstanding was $9.4 million and is expected to be recognized over a weighted average period of thirty months.

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     The following table illustrates the effect on net income and net income per share in the third quarter and first nine months of 2005 had the Company applied the fair value recognition provisions of Statement 123(R) to stock-based employee compensation.

	Three Months Ended		Nine Months Ended
	September 30, 2005		September 30, 2005
	(in thousands except per share amounts)
Net income as reported	$	7,183	$	19,057
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		—		(506	)
Pro forma net income	$	7,183	$	18,551
Net income per share:
Basic — as reported	$	0.28	$	0.74
Basic — pro forma	$	0.28	$	0.72
Diluted — as reported	$	0.26	$	0.72
Diluted — pro forma	$	0.26	$	0.70

     The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. Because the Company’s employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in the Company’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options.

2. Accounting Policies

Health Insurance Costs

     The Company provides health insurance coverage to its worksite employees through a national network of carriers including UnitedHealthcare (“United”), Cigna Healthcare, PacifiCare, Kaiser Permanente, Blue Cross and Blue Shield of Georgia, Blue Shield of California and Tufts, all of which provide fully insured policies or service contracts.

     The policy with United, which was first obtained in January 2002, provides the majority of the Company’s health insurance coverage. As a result of certain contractual terms, the Company has accounted for this plan since its inception using a partially self-funded insurance accounting model. Accordingly, Administaff records the costs of the United Plan, including an estimate of the incurred claims, taxes and administrative fees (collectively the “Plan Costs”) as benefits expense in the Consolidated Statements of Operations. The estimated incurred claims are based upon: (i) the level of claims processed during the quarter; (ii) recent claim

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development patterns under the plan; and (iii) the number of participants in the plan. Each reporting period, changes in the estimate of ultimate costs resulting from claims trends, plan design and migration, participant demographics and other factors are incorporated into the reported benefits costs.

     Additionally, since the plan’s inception in January 2002, under the terms of the contract, United establishes cash funding rates 90 days in advance of the beginning of a reporting quarter. If the Plan Costs for a reporting quarter are greater than the cash funded to United, a deficit in the plan would be incurred and the Company would accrue a liability for the excess costs on its Consolidated Balance Sheet. On the other hand, if the Plan Costs for the reporting quarter are less than the cash funded to United, a surplus in the plan would be incurred and the Company would record an asset for the excess premiums on its Consolidated Balance Sheet. The terms of the arrangement require Administaff to maintain an accumulated cash surplus in the plan of $11 million, which is reported as long-term prepaid insurance. As of September 30, 2006, Plan Costs were less than the net cash funded to United by $13.9 million. As this amount is in excess of the agreed-upon $11 million surplus maintenance level, the $2.9 million balance is included in prepaid insurance, a current asset, on the Company’s Consolidated Balance Sheet.

Workers’ Compensation Costs

     In September 2006, the Company renewed its workers’ compensation program with selected member insurance companies of American International Group, Inc. (“AIG”). Under its arrangement with AIG, which ends on September 30, 2007, the Company bears the economic burden for the first $1 million layer of claims per occurrence. AIG bears the economic burden for all claims in excess of such first $1 million layer. The policies are fully insured, whereby AIG has the responsibility to pay all claims incurred under the policies regardless of whether the Company satisfies its responsibilities.

     Under its arrangement with AIG, the Company makes monthly payments to AIG comprised of premium costs and funds to be set aside for payment of future claims (“claim funds”). The claim funds are retained and held by AIG until claims are submitted and processed for payment to the insured. During 2006, $29.7 million in excess funding was returned to Administaff from AIG. As of September 30, 2006, the total funds held by AIG was $77.7 million, of which $34.9 million is included in restricted cash and $42.8 million is included in deposits in the Company’s Consolidated Balance Sheets.

     The Company employs a third party actuary to estimate its workers’ compensation claims cost based on worksite employee payroll levels, the nature of the worksite employees’ job responsibilities, historical paid claim data and other actuarial assumptions. Each reporting period, changes in the actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into the Company’s workers’ compensation claims cost estimates. During the nine months ended September 30, 2006, the Company reduced workers’ compensation costs by $5.5 million for changes in estimated losses and tax surcharges related to prior reporting periods. As of September 30, 2006, the Company has estimated $72.2 million in outstanding workers’ compensation claims, net of paid claims, and recorded such amounts in accrued workers’ compensation costs in the Company’s Consolidated Balance Sheets. During the nine month period ended September 30, 2006, workers’ compensation cost estimates were

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discounted to present value at an average rate of 4.8%. Workers’ compensation costs are accreted over the estimated claim payment period, and included as a component of workers’ compensation costs in the Company’s Consolidated Statements of Operations.

     The following table provides the activity and balances related to accrued workers’ compensation claims for the nine months ended September 30, 2006 (in thousands):

December 31, 2005	$	60,272
Accrued claims		32,310
Present value discount		(4,757	)
Paid claims		(15,646	)
September 30, 2006	$	72,179
Current portion of accrued claims	$	34,858
Long-term portion of accrued claims		37,321
	$	72,179

3. Debt Obligations

     In May 2006, the Company repaid the $32.3 million outstanding balance on its variable rate mortgage.

4. Stockholders’ Equity

     In May 2006, the Company’s Board of Directors authorized an additional 500,000 shares in its share repurchase program, increasing the total share authorization to 8,500,000 shares of the Company’s outstanding common stock. The Company repurchased 604,911 shares at a total cost of $23.8 million during the nine months ended September 30, 2006. Since 1999, the Company has repurchased 8,006,534 shares under this authorization at a total cost of $118.7 million.

     During each quarter of 2006, the board of directors declared quarterly dividends of $0.09 per share of common stock. During the nine months ended September 30, 2006, a total of $7.5 million in dividend payments have been made.

5. Income Taxes

     The Company’s provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses. The income tax rate for the nine months ended September 30, 2006 was 36.4%.

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6. Net Income Per Share

     The numerator used in the calculations of both basic and diluted net income per share for all periods presented was net income. The denominator for each period presented was determined as follows:

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2006		2005		2006		2005
Basic net income per share - weighted average shares outstanding		27,544		26,068		27,471		25,655
Effect of dilutive securities — treasury stock method:
Common stock options		624		1,124		832		741
Restricted stock awards		91		124		99		62
		715		1,248		931		803
Diluted net income per share — weighted average shares outstanding plus effect of dilutive securities		28,259		27,316		28,402		26,458
Potentially dilutive securities not included in weighted average share calculation due to anti-dilutive effect		657		600		219		2,213

7. Commitments and Contingencies

     The Company is a defendant in various lawsuits and claims arising in the normal course of business. Management believes it has valid defenses in these cases and is defending them vigorously. While the results of litigation cannot be predicted with certainty, management believes the final outcome of such litigation will not have a material adverse effect on the Company’s financial position or results of operations, except as set forth below.

Class Action Litigation

     On June 13, 2003, a class action lawsuit was filed against the Company in the United States District Court for the Southern District of Texas on behalf of purchasers of the Company’s common stock alleging violations of the federal securities laws. After that date, six similar class actions were filed against the Company in that court. Those lawsuits also named as defendants certain of the Company’s officers and directors. In May 2004, the lead plaintiff filed its Consolidated Complaint, which amended and consolidated the seven previously filed cases. In June 2004, the Company filed a motion to dismiss the Consolidated Complaint. On March 30, 2006, the court granted the Company’s motion to dismiss and thereafter entered a final order of dismissal with prejudice. The lead plaintiff did not file a notice of appeal by the deadline to do so. Accordingly, this matter is now concluded.

State Unemployment Taxes

     The Company records its state unemployment (“SUI”) tax expense based on taxable wages and tax rates assigned by each state. State unemployment tax rates vary by state and are determined, in part, based on prior years’ compensation experience in each state. Prior to the receipt of final tax rate notices, the Company estimates its expected SUI tax rate in those states for which tax rate notices have not yet been received.

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     In December 2001, as a result of the 2001 corporate reorganization, the Company filed for a transfer of its reserve account with the Employment Development Department of the State of California (“EDD”). The EDD approved the Company’s request for transfer of its reserve account in May 2002 and also notified the Company of its new contribution rates based upon the approved transfer. In December 2003, the Company received a Notice of Duplicate Accounts and Notification of Assessment (“Notice”) from the Employment Development Department of the State of California (“EDD”). The Notice stated that the EDD was collapsing the accounts of the Company’s subsidiaries into the account of the entity with the highest unemployment tax rate. The Notice also retroactively imposed the higher unemployment insurance rate on all the Company’s California employees for 2003, resulting in an assessment of $5.6 million. In January 2004, the Company filed a petition with an administrative law judge of the California Unemployment Insurance Appeals Board (“ALJ”) to protest the Notice. Pending a resolution of its protest, in the fourth quarter of 2003 the Company accrued and recorded at the higher assessed rate for all of 2003.

     In June 2004, the Company agreed to settle its dispute with the EDD for $3.3 million (“Settlement”). Based upon receipt of written acknowledgement of this agreement, the Company reduced its accrued payroll tax liability and payroll tax expense by $2.3 million during the quarter ended June 30, 2004. The Settlement was subject to the final approval by EDD’s legal department, the California Attorney General’s office and the ALJ. In October 2004, the legal department of the EDD verbally indicated they considered the previously agreed-upon settlement amount to be insufficient and suggested a settlement amount of $5.2 million. The Company and the State of California continued discussions, but in February 2005, the Company was notified that the EDD had rejected the Company’s settlement offer and that the matter will proceed with the appeals process with the ALJ. If the outcome of the appeals process is unfavorable and the Company is assessed additional interest and penalties, the Company may recognize an increase in its payroll tax expense in a future period. Conversely, if the outcome of the appeals process is favorable to the Company, the Company may recognize a decrease in its payroll tax expense in a future period.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

     The following discussion should be read in conjunction with our 2005 annual report on Form 10-K, as well as with our consolidated financial statements and notes thereto included in this quarterly report on Form 10-Q.

Critical Accounting Policies and Estimates

     Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to health and workers’ compensation insurance claims experience, state unemployment taxes, client bad debts, income taxes, property and equipment and contingent liabilities. Management bases these estimates on historical experience and on various other assumptions that management believes to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.

     We believe the following accounting policies are critical and/or require significant judgments and estimates used in the preparation of our consolidated financial statements:

•	Benefits costs– We provide health insurance coverage to our worksite employees through a national network of carriers including UnitedHealthcare (“United”), Cigna Healthcare, PacifiCare, Kaiser Permanente, Blue Cross and Blue Shield of Georgia, Blue Shield of California and Tufts, all of which provide fully insured policies or service contracts.
	The policy with United, which was first obtained in January 2002, provides the majority of our health insurance coverage. As a result of certain contractual terms, we have accounted for this plan since its inception using a partially self-funded insurance accounting model. Accordingly, we record the costs of the United Plan, including an estimate of the incurred claims, taxes and administrative fees (collectively the “Plan Costs”), as benefits expense in the Consolidated Statements of Operations. The estimated incurred claims are based upon: (i) the level of claims processed during the quarter; (ii) recent claim development patterns under the plan; and (iii) the number of participants in the plan. Each reporting period, changes in the estimate of ultimate costs resulting from claims trends, plan design and migration, participant demographics and other factors are incorporated into the reported benefits costs.
	Additionally, since the plan’s inception in January 2002, under the terms of the contract, United establishes cash funding rates 90 days in advance of the beginning of a reporting quarter. If the Plan Costs for a reporting quarter are greater than the cash funded to United, a deficit in the plan would be incurred and we would accrue a liability for the excess costs on our Consolidated Balance Sheet. On the other hand, if the Plan Costs for the reporting

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	quarter are less than the cash funded to United, a surplus in the plan would be incurred and we would record an asset for the excess premiums on our Consolidated Balance Sheet. The terms of the arrangement require Administaff to maintain an accumulated cash surplus in the plan of $11 million, which is reported as long-term prepaid insurance. As of September 30, 2006, Plan Costs were less than the net cash funded to United by $13.9 million. As this amount is in excess of the agreed-upon $11 million surplus maintenance level, the $2.9 million balance is included in prepaid insurance, a current asset, on the Company’s Consolidated Balance Sheet.
•	State unemployment taxes– We record our state unemployment (“SUI”) tax expense based on taxable wages and tax rates assigned by each state. State unemployment tax rates vary by state and are determined, in part, based on prior years’ compensation experience in each state. Prior to the receipt of final tax rate notices, we estimate our expected SUI tax rate in those states for which tax rate notices have not yet been received.
	In December 2001, as a result of the 2001 corporate reorganization, we filed for a transfer of our reserve account with the Employment Development Department of the State of California (“EDD”). The EDD approved our request for transfer of our reserve account in May 2002, and notified us of our new contribution rates based upon the approved transfer. In December 2003, we received a Notice of Duplicate Accounts and Notification of Assessment (“Notice”) from the Employment Development Department of the State of California (“EDD”). The Notice stated that the EDD was collapsing the accounts of Administaff’s subsidiaries into the account of the entity with the highest unemployment tax rate. The Notice also retroactively imposed the higher unemployment insurance rate on all our California employees for 2003, resulting in an assessment of $5.6 million. In January 2004, we filed a petition with an administrative law judge of the California Unemployment Insurance Appeals Board (“ALJ”) to protest the Notice. Pending a resolution of our protest, in the fourth quarter of 2003 we accrued and recorded at the higher assessed rate for all of 2003.
	In June 2004, we agreed to settle our dispute with the EDD for $3.3 million (“Settlement”). Based upon receipt of written acknowledgement of this agreement, we reduced our accrued payroll tax liability and payroll tax expense by $2.3 million during the quarter ended June 30, 2004. The Settlement was subject to the final approval by EDD’s legal department, the California Attorney General’s office and the ALJ. In October 2004, the legal department of the EDD verbally indicated they considered the previously agreed-upon settlement amount to be insufficient and suggested a settlement amount of $5.2 million. We continued discussions with the State of California, but in February 2005, we were notified that the EDD had rejected our settlement offer and that the matter will proceed with the appeals process with the ALJ. If the outcome of the appeals process is unfavorable and we are assessed additional interest and penalties, we may recognize an increase in our payroll tax expense in a future period. Conversely, if the outcome of the appeals process is favorable to us, we may recognize a decrease in our payroll tax expense in a future period.
•	Workers’ compensation costs– In September 2006, the Company renewed its annual workers’ compensation policy with selected member insurance companies of American International Group, Inc. (“AIG”). Under our arrangement with AIG, we bear the economic

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	burden for the first $1 million layer of claims per occurrence. AIG bears the economic burden for all claims in excess of such first $1 million layer. The policies are fully insured whereby AIG has the responsibility to pay all claims incurred under the policies regardless of whether we satisfy our responsibilities.
	Because we bear the economic burden of the first $1 million layer of claims per occurrence, such claims, which are the primary component of our workers’ compensation costs, are recorded in the period incurred. Workers compensation insurance includes ongoing healthcare and indemnity coverage whereby claims are paid over numerous years following the date of injury. Accordingly, the accrual of related incurred costs in each reporting period includes estimates, which take into account the ongoing development of claims and therefore requires a significant level of judgment. Our management estimates our workers’ compensation costs by applying an aggregate loss development rate to worksite employee payroll levels.
	We employ a third party actuary to estimate our loss development rate, which is primarily based upon the nature of worksite employees’ job responsibilities, the location of worksite employees, the historical frequency and severity of workers compensation claims, and an estimate of future cost trends. Each reporting period, changes in the actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into the Company’s workers’ compensation claims cost estimates. During the nine months ended September 30, Administaff reduced workers’ compensation costs by $5.5 million in 2006 and $3.7 million in 2005 for changes in estimated losses and tax surcharges related to prior reporting periods. Workers’ compensation cost estimates are discounted to present value at a rate based upon the U.S. Treasury rates that correspond with the weighted average estimated claim payout period (the average discount rate utilized in 2006 and 2005 was 4.8% and 3.7%, respectively) and are accreted over the estimated claim payment period and included as a component of direct costs in our Consolidated Statements of Operations.
•	Contingent liabilities– We accrue and disclose contingent liabilities in our consolidated financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5,Accounting for Contingencies. SFAS No. 5 requires accrual of contingent liabilities that are considered probable to occur and can be reasonably estimated. For contingent liabilities that are considered reasonably possible to occur, financial statement disclosure is required, including the range of possible loss if it can be reasonably determined. We have disclosed in our financial statements several issues that we believe are reasonably possible to occur, although we cannot determine the range of possible loss in all cases. As these issues develop, we will continue to evaluate the probability of future loss and the potential range of such losses. If such evaluation were to determine that a loss was probable and the loss could be reasonably estimated, we would be required to accrue our estimated loss, which would reduce net income in the period such determination was made.
•	Deferred taxes– We have recorded a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, our ability to realize our deferred tax assets could change from our current estimates. If we determine we will be able to realize our deferred tax assets

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in the future in excess of our net recorded amount, an adjustment to reduce the valuation allowance would increase net income in the period that such determination is made. Likewise, should we determine we will not be able to realize all or part of our net deferred tax assets in the future, an adjustment to increase the valuation allowance would reduce net income in the period such determination is made.

•

Allowance for doubtful accounts– We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our clients to pay our comprehensive service fees. We believe the success of our business is heavily dependent on our ability to collect these comprehensive service fees for several reasons, including:

• the fact that we are at risk for the payment of our direct costs and worksite employee payroll costs regardless of whether our clients pay their comprehensive service fees;

• the large volume and dollar amount of transactions we process; and

• the periodic and recurring nature of payroll, upon which the comprehensive service fees are based.

	To mitigate this risk, we have established very tight credit policies. We generally require our clients to pay their comprehensive service fees no later than one day prior to the applicable payroll date. In addition, we maintain the right to terminate our Client Service Agreement and associated worksite employees or to require prepayment, letters of credit or other collateral upon deterioration in a client’s financial position or upon nonpayment by a client. As a result of these efforts, losses related to client nonpayment have historically been low as a percentage of revenues. However, if our clients’ financial condition were to deteriorate rapidly, resulting in nonpayment, our accounts receivable balances could grow and we could be required to provide for additional allowances, which would decrease net income in the period that such determination was made.
•	Property and equipment– Our property and equipment relate primarily to our facilities and related improvements, furniture and fixtures, computer hardware and software and capitalized software development costs. These costs are depreciated or amortized over the estimated useful lives of the assets. If the useful lives of these assets were determined to be shorter than their current estimates, our depreciation and amortization expense could be accelerated, which would decrease net income in the periods of such a determination. In addition, we periodically evaluate these costs for impairment in accordance with SFAS No. 144,Accounting for Impairment or Disposal of Long-Lived Assets. If events or circumstances were to indicate that any of our long-lived assets might be impaired, we would analyze the estimated undiscounted future cash flows to be generated from the applicable asset. In addition, we would record an impairment loss, which would reduce net income, to the extent the carrying value of the asset exceeded the fair value of the asset. Fair value is generally determined using an estimate of discounted future net cash flows from operating activities or upon disposal of the asset.
•	Goodwill and other intangibles– The December 2005 acquisition of HRTools.com and associated software applications included certain identifiable intangible assets and goodwill implied in the purchase price. The goodwill and intangible assets are subject to the provisions of SFAS No. 142, “Goodwill and Other Intangible Assets” (“SFAS 142”). In

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accordance with SFAS 142, goodwill is tested for impairment on an annual basis and between annual tests in certain circumstances, and written down when impaired. Furthermore, SFAS 142 requires purchased intangible assets other than goodwill to be amortized over their useful lives unless these lives are determined to be indefinite. Our purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, five to ten years.

New Accounting Pronouncements

     Effective January 1, 2006, the Company adopted Statement No. 123(R). Statement 123(R) supersedes APB Opinion No. 25,Accounting for Stock Issued to Employees, and amends FASB Statement No. 95,Statement of Cash Flows. Generally, the approach in Statement 123(R) is similar to the approach described in Statement 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative. We adopted Statement 123(R) using the “modified prospective” method in which compensation cost is recognized beginning with the effective date: (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date; and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.

     Because the Company accelerated the vesting of all outstanding stock options during the first quarter of 2005, the adoption of SFAS 123(R) did not have a material impact on our results of operations in 2006. The cumulative effect of the change in accounting principle associated with the adoption of Statement 123(R) resulted in a $50,000 reduction in stock-based compensation and the reclassification of $2.9 million in previously recognized deferred compensation to additional paid-in capital and treasury stock related to restricted stock awards.

     In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”), an interpretation of FASB Statement No. 109, “Accounting for Income Taxes.” FIN 48 requires that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not (i.e. a likelihood of more than fifty percent) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than fifty percent likely of being realized upon ultimate settlement. The effective date for the Company is January 1, 2007. Upon adoption, the cumulative effect of applying the recognition and measurement provisions of FIN 48, if any, shall be reflected as an adjustment to the opening balance of retained earnings. We are currently evaluating the impact of the adoption of FIN 48 on our results of operations and consolidated balance sheets.

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Results of Operations

     Three Months Ended September 30, 2006 Compared to Three Months Ended September 30, 2005.

     The following table presents certain information related to Administaff’s results of operations for the three months ended September 30, 2006 and 2005.

	Three months ended
	September 30,
	2006		2005		% Change
	(in thousands, except per share and statistical data)
Revenues (gross billings of $1.990 billion and $1.622 billion, less worksite employee payroll cost of $1.652 billion and $1.337 billion, respectively)	$	338,421	$	285,202		18.7	%
Gross profit		71,864		58,171		23.5	%
Operating expenses		55,563		47,566		16.8	%
Operating income		16,301		10,605		53.7	%
Other income		2,566		967		165.4	%
Net income		12,113		7,183		68.6	%
Diluted net income per share of common stock		0.43		0.26		65.4	%
Statistical Data:
Average number of worksite employees paid per month		102,530		90,493		13.3	%
Revenues per worksite employee per month(1)	$	1,100	$	1,051		4.7	%
Gross profit per worksite employee per month		234		214		9.3	%
Operating expenses per worksite employee per month		181		175		3.4	%
Operating income per worksite employee per month		53		39		35.9	%
Net income per worksite employee per month		39		26		50.0	%

⁽¹⁾ Gross billings of $6,470 and $5,976 per worksite employee per month less payroll cost of $5,370 and $4,926 per worksite employee per month, respectively.

     Revenues

     Our revenues for the third quarter of 2006 increased 18.7% over the 2005 period due to a 13.3% increase in the average number of worksite employees paid per month and a 4.7%, or $49, increase in revenues per worksite employee per month.

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     By region, our revenue growth over the third quarter of 2005 and revenue distribution for the quarter ended September 30, 2006 were as follows:

	Three months ended September 30,							Three months ended September 30,
	2006		2005		% Change			2006			2005
	(in thousands)							(% of total revenues)
Northeast	$	60,242	$	43,532		38.4	%		17.8	%		15.2	%
Southeast		32,022		24,875		28.7	%		9.5	%		8.7	%
Central		47,336		37,835		25.1	%		14.0	%		13.3	%
Southwest		121,309		111,993		8.3	%		35.8	%		39.3	%
West		75,245		65,275		15.3	%		22.2	%		22.9	%
Other revenue		2,267		1,692		34.0	%		0.7	%		0.6	%
Total revenue	$	338,421	$	285,202		18.7	%		100.0	%		100.0	%

     Our growth rate is affected by three primary sources — new client sales, client retention and the net change in existing clients through worksite employee new hires and layoffs. During the third quarter of 2006, new client sales improved, while client retention and the net change in existing clients, measured as a percentage of the worksite employee base, declined slightly compared to the 2005 period.

     Gross Profit

     Gross profit for the third quarter of 2006 increased 23.5% to $71.9 million compared to the third quarter of 2005. The average gross profit per worksite employee increased 9.3% to $234 per month in the 2006 period from $214 per month in the 2005 period. Our pricing objectives attempt to maintain or improve the gross profit per worksite employee by increasing revenue per worksite employee to match or exceed changes in primary direct costs and operating expenses.

     While our revenues increased 4.7% per worksite employee per month, our primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 3.5% to $866 per worksite employee per month in the third quarter of 2006 versus $837 in the third quarter of 2005.

• Payroll tax costs– Payroll taxes increased $20 per worksite employee per month compared to the third quarter of 2005, due to a 9.0% increase in average payroll cost per worksite employee per month. Payroll taxes as a percentage of payroll cost declined from 6.87% in the 2005 period to 6.67% in the 2006 period, as worksite employees reached their taxable wage limit earlier in 2006 due to increased payroll averages and bonus levels. Please read “Critical Accounting Policies and Estimates — State Unemployment Taxes” on page 17 for a discussion of the Company’s accounting for state unemployment taxes.

• Benefits costs– The cost of health insurance and related employee benefits increased $15 per worksite employee per month compared to the third quarter of 2005. This increase was due to a 3.4% increase in the cost per covered employee. The percentage of worksite employees covered under our health insurance plans was 72.0% in both periods. Please read “Critical Accounting Policies and Estimates — Benefits Costs” on page 16 for a discussion of our accounting for health insurance costs.

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• Workers’ compensation costs– Workers’ compensation costs decreased $5 per worksite employee per month compared to the third quarter of 2005. As a percentage of non-bonus payroll cost, workers’ compensation costs decreased to 0.90% in the 2006 period from 1.06% in the 2005 period as a result of favorable trends in both the frequency and severity of workers’ compensation claims. During the 2006 period, the Company recorded reductions in workers’ compensation costs of $2.8 million, or 0.18% of non-bonus payroll costs, for changes in estimated losses and tax surcharges compared to $1.9 million, or 0.15% of non-bonus payroll costs, in the 2005 period. Please read “Critical Accounting Policies and Estimates — Workers’ Compensation Costs” on page 17 for a discussion of our accounting for workers’ compensation costs.

     Operating Expenses

     The following table presents certain information related to the Administaff’s operating expenses for the three months ended September 30, 2006 and 2005.

	Three months ended September 30,							Three months ended September 30,
	2006		2005		% change			2006		2005		% change
	(in thousands)							(per worksite employee per month)
Salaries, wages and payroll taxes	$	30,393	$	25,471		19.3	%	$	99	$	94		5.3	%
Stock-based compensation		1,011		360		180.8	%		3		1		200.0	%
General and administrative expenses		14,722		12,476		18.0	%		48		46		4.3	%
Commissions		2,722		2,610		4.3	%		9		10		(10.0	)%
Advertising		2,819		2,956		(4.6	)%		9		11		(18.2	)%
Depreciation and amortization		3,896		3,693		5.5	%		13		13		—
Total operating expenses	$	55,563	$	47,566		16.8	%	$	181	$	175		3.4	%

     Operating expenses increased 16.8% to $55.6 million compared to the third quarter of 2005. Operating expense per worksite employee increased to $181 per month in the 2006 period from $175 in the 2005 period. The components of operating expenses changed as follows:

• Salaries, wages and payroll taxes of corporate and sales staff increased 19.3%, or $5 per worksite employee per month compared to the 2005 period. Corporate headcount, primarily in the sales and service areas of the business, increased 17% in the 2006 period as compared to 2005. In addition, due to improved operating results, the Company increased accrued incentive compensation by $1.2 million over the 2005 period.

• Stock-based compensation expense increased $651,000 or $2 per worksite employee per month. The stock-based compensation expense represents the vesting of restricted stock awards granted to employees. Please read Note 1 to the consolidated financial statements on page 9 for additional information.

• General and administrative expenses increased 18.0% due primarily to higher expenses associated with the increase in corporate and worksite employee headcount, such as travel, bad debt, rent, postage and printing. General and administrative expenses increased $2 per worksite employee per month basis compared to the third quarter of 2005.

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• Commissions expense increased 4.3%, but decreased $1 per worksite employee per month compared to the 2005 period.

• Advertising costs decreased 4.6%, or $2 per worksite employee per month compared to the third quarter of 2005.

• Depreciation and amortization expense increased 5.5% and remained flat on a per worksite employee per month basis compared to the 2005 period.

     Other Income

     Other income increased from $967,000 in the third quarter of 2005 to $2.6 million in the 2006 period. Interest income increased by $922,000, primarily as a result of an increase in cash balances, including cash held in our workers’ compensation program, and higher interest rates in the 2006 period. In addition, repayment of the $32.3 million outstanding variable rate mortgage in May 2006 reduced interest expense by $526,000 as compared to the 2005 period.

     Income Tax Expense

     Our provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses.

     Net Income

     Operating and net income per worksite employee per month was $53 and $39 in the 2006 period, versus $39 and $26 in the 2005 period.

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     Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005.

     The following table presents certain information related to Administaff’s results of operations for the nine months ended September 30, 2006 and 2005.

	Nine months ended
	September 30,
	2006		2005		% Change
	(in thousands, except per share and statistical data)
Revenues (gross billings of $5.813 billion and $4.756 billion, less worksite employee payroll cost of $4.776 billion and $3.892 billion, respectively)	$	1,036,835	$	864,062		20.0	%
Gross profit		208,073		168,534		23.5	%
Operating expenses		163,403		140,194		16.6	%
Operating income		44,670		28,340		57.6	%
Other income		7,433		2,291		224.4	%
Net income		33,151		19,057		74.0	%
Diluted net income per share of common stock		1.17		0.72		62.5	%
Statistical Data:
Average number of worksite employees paid per month		99,459		87,030		14.3	%
Revenues per worksite employee per month (1)	$	1,158	$	1,103		5.0	%
Gross profit per worksite employee per month		232		215		7.9	%
Operating expenses per worksite employee per month		183		179		2.2	%
Operating income per worksite employee per month		50		36		38.9	%
Net income per worksite employee per month		37		24		54.2	%

⁽¹⁾ Gross billings of $6,494 and $6,072 per worksite employee per month less payroll cost of $5,335 and $4,969 per worksite employee per month, respectively.

     Revenues

     Our revenues for the nine months ended September 30, 2006 increased 20.0% over the 2005 period due to a 14.3% increase in the average number of worksite employees paid per month and a 5.0%, or $55, increase in revenues per worksite employee per month.

     By region, our revenue growth over the first nine months of 2005 and revenue distribution for the nine months ended September 30, 2006 were as follows:

	Nine months ended September 30,							Nine months ended September 30,
	2006		2005		% Change			2006			2005
	(in thousands)							(% of total revenues)
Northeast	$	180,134	$	131,148		37.4	%		17.4	%		15.2	%
Southeast		96,725		74,866		29.2	%		9.3	%		8.7	%
Central		145,118		113,033		28.4	%		14.0	%		13.1	%
Southwest		375,254		339,782		10.4	%		36.2	%		39.3	%
West		232,824		200,048		16.4	%		22.5	%		23.1	%
Other revenue		6,780		5,185		30.8	%		0.6	%		0.6	%
Total revenue	$	1,036,835	$	864,062		20.0	%		100.0	%		100.0	%

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     Our growth rate is affected by three primary sources — new client sales, client retention and the net change in existing clients through worksite employee new hires and layoffs. During the nine months ended September 30, 2006, new client sales and the net change in existing clients improved, while client retention, measured as a percentage of the worksite employee base, declined slightly compared to the 2005 period.

     Gross Profit

     Gross profit for the first nine months of 2006 increased 23.5% to $208.1 million compared to the first nine months of 2005. The average gross profit per worksite employee increased 7.9% to $232 per month in the 2006 period from $215 per month in the 2005 period. Our pricing objectives attempt to maintain or improve the gross profit per worksite employee by increasing revenue per worksite employee to match or exceed changes in primary direct costs and operating expenses.

     While our revenue increased 5.0% per worksite employee per month, our primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 4.3% to $926 per worksite employee per month in the first nine months of 2006 versus $888 in the first nine months 2005.

• Payroll tax costs– Payroll taxes increased $23 per worksite employee per month compared to the first nine months of 2005, primarily due to a 7.4% increase in average payroll cost per worksite employee per month. Payroll taxes as a percentage of payroll cost decreased in the 2006 period to 7.83% from 7.95% in the 2005 period, as worksite employees reached their taxable wage limit earlier in 2006 due to increased payroll averages and bonus levels. Please read “Critical Accounting Policies and Estimates - State Unemployment Taxes” on page 17 for a discussion of the Company’s accounting for state unemployment taxes.

• Benefits costs– The cost of health insurance and related employee benefits increased $20 per worksite employee per month to $446 compared to 2005. This increase is due to a 4.3% increase in the cost per covered employee and an increase in the percentage of worksite employees covered under our health insurance plans to 72.5% in the 2006 period from 72.3% in the 2005 period. Please read “Critical Accounting Policies and Estimates — Benefits Costs” on page 16 for a discussion of our accounting for health insurance costs.

• Workers’ compensation costs– Workers’ compensation costs decreased $5 per worksite employee per month compared to the first nine months of 2005. As a percentage of non-bonus payroll cost, workers’ compensation costs decreased to 0.95% in the 2006 period from 1.13% in the 2005 period as a result of favorable trends in both the frequency and severity of workers’ compensation claims. During the 2006 period the Company recorded reductions in workers’ compensation costs of $5.5 million, or 0.13% of non-bonus payroll costs, for changes in estimated loss and tax surcharges compared to $3.7 million, or 0.10% of non-bonus payroll costs, in the 2005 period. Please read “Critical Accounting Policies and Estimates - Workers’ Compensation Costs” on page 17 for a discussion of our accounting for workers’ compensation costs.

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     Operating Expenses

     The following table presents certain information related to the Administaff’s operating expenses for the nine months ended September 30, 2006 and 2005.

	Nine months ended September 30,							Nine months ended September 30,
	2006		2005		% change			2006		2005		% change
	(in thousands)							(per worksite employee per month)
Salaries, wages and payroll taxes	$	88,057	$	73,436		19.9	%	$	98	$	94		4.3	%
Stock-based compensation		2,368		1,765		34.2	%		3		2		50.0	%
General and administrative expenses		44,573		39,077		14.1	%		50		50		—
Commissions		8,264		7,462		10.7	%		9		10		(10.0	)%
Advertising		8,521		7,355		15.9	%		10		9		11.1	%
Depreciation and amortization		11,620		11,099		4.7	%		13		14		(7.1	)%
Total operating expenses	$	163,403	$	140,194		16.6	%	$	183	$	179		2.2	%

     Operating expenses increased 16.6% to $163.4 million compared to the first nine months of 2005. Operating expense per worksite employee increased to $183 per month in the 2006 period from $179 in the 2005 period. The components of operating expenses changed as follows:

• Salaries, wages and payroll taxes of corporate and sales staff increased 19.9%, or $4 on a per worksite employee per month basis compared to the 2005 period. Corporate headcount, primarily in the sales and service areas of the business, increased 16% in the 2006 period as compared to 2005. In addition, due to improved operating results, the Company increased accrued incentive compensation by $1.1 million over the 2005 period.

• Stock-based compensation expense increased 34.2%, or $1 per worksite employee per month. Stock-based compensation expense primarily represents the vesting of restricted stock awards. The 2006 expense also includes $280,000 related to an unrestricted stock grant to the board of directors. The 2005 amount also includes $790,000 related to the acceleration of stock option vesting during the first quarter of 2005. Please read Note 1 to the consolidated financial statements on page 9 for additional information.

• General and administrative expenses increased 14.1%, due primarily to higher expenses associated with the increase in corporate and worksite employee headcount and expenses, such as travel, supplies and training.

• Commissions expense increased 10.7%, but declined $1 per worksite employee per month, compared to the 2005 period.

• Advertising costs increased 15.9% or $1 per worksite employee per month.

• Depreciation and amortization expense increased 4.7%, but decreased $1 per worksite employee per month, compared to the 2005 period.

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     Other Income

     Other income increased from $2.3 million in the first nine months of 2005 to $7.4 million in the 2006 period. Interest income increased by $4.3 million, primarily as a result of an increase in cash balances, including cash held in our workers’ compensation program, and higher interest rates in the 2006 period.

     Income Tax Expense

     Our provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses.

     Net Income

     Operating and net income per worksite employee per month was $50 and $37 in the 2006 period, versus $36 and $24 in the 2005 period.

Non-GAAP Financial Measures

     Non-bonus payroll cost is a non-GAAP financial measure that excludes the impact of bonus payrolls paid to our worksite employees. Bonus payroll cost varies from period to period, but has no direct impact to our ultimate workers’ compensation costs under the current program. As a result, our management refers to non-bonus payroll cost in analyzing, reporting and forecasting our workers’ compensation costs. Non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles (“GAAP”) and may be different from non-GAAP financial measures used by other companies. Non-GAAP financial measures should not be considered as a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP. We include these non-GAAP financial measures because we believe they are useful to investors in allowing for greater transparency related to the costs incurred under our current workers’ compensation program. Investors are encouraged to review the reconciliation of the non-GAAP financial measures used to their most directly comparable GAAP financial measures as provided in the table below.

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	Three months ended							Nine months ended
	September 30,							September 30,
	2006		2005		% change			2006		2005		% change
Payroll cost (GAAP)	$	1,651,694	$	1,337,230		23.5	%	$	4,775,737	$	3,891,756		22.7	%
Less: Bonus payroll cost		120,620		71,302		69.2	%		382,728		302,877		26.4	%
Non-bonus payroll cost	$	1,531,074	$	1,265,928		20.9	%	$	4,393,009	$	3,588,879		22.4	%
Payroll cost per worksite employee (GAAP)	$	5,370	$	4,926		9.0	%	$	5,335	$	4,969		7.4	%
Less: Bonus payroll cost per worksite employee		392		263		49.0	%		427		387		10.3	%
Non-bonus payroll cost per worksite employee	$	4,978	$	4,663		6.8	%	$	4,908	$	4,582		7.1	%

Liquidity and Capital Resources

     We periodically evaluate our liquidity requirements, capital needs and availability of resources in view of, among other things, expansion plans, dividends, debt service requirements and other operating cash needs. To meet short and long-term liquidity requirements, including payment of direct costs, operating expenses and repaying debt, we rely primarily on cash from operations. However, we have in the past sought, and may in the future seek, to raise additional capital or take other steps to increase or manage our liquidity and capital resources. We had $188.9 million in cash and cash equivalents and marketable securities at September 30, 2006, including approximately $73.0 million for withheld federal and state income taxes, employment taxes and other payroll deductions, and $9.7 million in customer prepayments that were payable in October 2006. At September 30, 2006, we had working capital of $113.5 million compared to $93.2 million at December 31, 2005. We currently believe that our cash on hand, marketable securities and cash flows from operations will be adequate to meet our liquidity requirements for the remainder of 2006. We will rely on these same sources, as well as public and private debt or equity financing, to meet our longer-term liquidity and capital needs.

     Cash Flows From Operating Activities

     Our cash flows from operating activities in 2006 decreased $10.3 million from 2005 to $40.2 million. Our primary source of cash from operations is the comprehensive service fee and payroll funding we collect from our clients. The level of cash and cash equivalents, and thus our reported cash flows from operating activities are significantly impacted by various external and internal factors, which are reflected in part by the changes in our balance sheet accounts. These include the following:

• Operating results– Our net income has a significant impact on our operating cash flows. Our net income increased 74.0% to $33.2 million in 2006 compared to 2005. Please readResults of Operations – Nine Months Ended September 30, 2006 Compared to Nine Months Ended September 30, 2005on page 25.

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• Timing of customer payments / payrolls –We typically collect our comprehensive service fee, along with the client’s payroll funding, from clients at least one day prior to the payment of worksite employee payrolls. Therefore, the date of the last day of a reporting period has a substantial impact on our reporting of operating cash flows. For example, many worksite employees are paid on Fridays; therefore, operating cash flows decline in the reporting periods that end on a Friday, such as in September 2006, when client prepayments were $9.7 million and accrued worksite employee payroll was $101.4 million. However, for those reporting periods that end on a Thursday, our cash flows are higher due to the collection of the comprehensive service fee and client’s payroll funding prior to processing the large number worksite employees’ payrolls one day subsequent to quarter-end.

• Medical plan funding –Our healthcare contract with United establishes participant cash funding rates 90 days in advance of the beginning of a reporting quarter. Therefore, changes in the participation level of the United Plan have a direct impact on our operating cash flows. In addition, changes to the funding rates, which are solely determined by United based primarily upon recent claim history and anticipated cost trends, also have a significant impact on our operating cash flows. Since inception of the United Plan in January 2002, cash funded to United has exceeded Plan Costs, resulting in a $13.9 million surplus, $2.9 million of which is reflected as a current asset, and $11.0 million of which is reflected as a long-term asset on our Consolidated Balance Sheet at September 30, 2006.

• Workers’ compensation plan funding– Under our arrangement with AIG, we make monthly payments to AIG comprised of premium costs and funds to be set aside for payment of future claims (“claim funds”). These pre-determined amounts are stipulated in our agreement with AIG, and are based primarily on anticipated worksite employee payroll levels and workers compensation loss rates during the policy year. Changes in payroll levels from that which was anticipated in the arrangement with AIG can result in changes in the amount of the cash payments to AIG, which will impact our reporting of operating cash flows. Our claim funds paid to AIG, based upon anticipated worksite employee payroll levels and workers’ compensation loss rates, were $37.4 million, less claims paid of $15.6 million in 2006, and $38.4 million, less claims paid of $12.6 million for the 2005 period. This compares to our estimate of workers’ compensation loss costs of $27.6 million and $26.8 million in 2006 and 2005, respectively. Additionally, during 2006 Administaff received $29.7 million in excess funds from AIG.

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     Cash Flows Used in Investing Activities

     Cash flows used in investing activities increased $7.0 million from 2005 to $33.5 million. We invested a net $23.8 million in marketable securities and approximately $9.9 million in capital expenditures during the first nine months of 2006.

     Cash Flows Used in Financing Activities

     Cash flows used in financing activities increased $40.0 million from 2005 to $36.9 million. We repaid the $32.3 million on the Company’s outstanding variable rate mortgage. Additionally, we repurchased $23.8 million in treasury stock and paid $7.5 million in dividends, offset by the receipt of $15.2 million in proceeds from the exercise of employee stock options and $11.7 million in income tax benefit from stock-based compensation.

Other Matters

     As previously disclosed, after capital constraints and downgrades from various rating agencies, our former workers’ compensation insurance carrier, Lumbermens Mutual Casualty Company, a unit of Kemper Insurance Companies (“Kemper”) has entered into a “run-off.” If the run-off process is not successful and Kemper is placed into a formal liquidation or a similar proceeding, most states have established guaranty associations to pay the remaining claims. However, the guaranty associations of certain states, including Texas, may attempt to return the liability for such remaining claims to Administaff, which may have a material adverse effect on net income in the reported period. For more information regarding Kemper, as well as the effect on us of the bankruptcy of another former workers compensation insurance carrier, please read “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Factors That May Affect Future Results and the Market Price of Common Stock- Increases in Health Insurance Premiums and Workers’ Compensation Costs” on pages 39 and 40 of our Form 10-K for the year ended December 31, 2005 filed with the SEC. Our 2005 Form 10-K is also available on our Web site atwww.administaff.com.

ITEM 4. CONTROLS AND PROCEDURES.

     In accordance with the Securities Exchange Act of 1934 Rules 13a-15 and 15d-15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2006.

     There has been no change in our internal controls over financial reporting that occurred during the three months ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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PART II

ITEM 1. LEGAL PROCEEDINGS.

     Please read Note 7 to financial statements, which is incorporated herein by reference.

ITEM 1a. RISK FACTORS

     The statements contained herein that are not historical facts are forward-looking statements within the meaning of the federal securities laws (Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). You can identify such forward-looking statements by the words “expects,” “intends,” “plans,” “projects,” “believes,” “estimates,” “likely,” “possibly,” “probably,” “goal,” “objective,” “target,” “assume,” “outlook,” “guidance,” “predicts,” “appears,” “indicator” and similar expressions. Forward-looking statements involve a number of risks and uncertainties. In the normal course of business, Administaff, Inc., in an effort to help keep our stockholders and the public informed about our operations, may from time to time issue such forward-looking statements, either orally or in writing. Generally, these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of such plans or strategies, or projections involving anticipated revenues, earnings, unit growth, profit per worksite employee, pricing, operating expenses or other aspects of operating results. We base the forward-looking statements on our current expectations, estimates and projections. These statements are not guarantees of future performance and involve risks and uncertainties that we cannot predict. In addition, we have based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Therefore, the actual results of the future events described in such forward-looking statements could differ materially from those stated in such forward-looking statements. Among the factors that could cause actual results to differ materially are: (i) changes in general economic conditions; (ii) regulatory and tax developments and possible adverse application of various federal, state and local regulations; (iii) changes in our direct costs and operating expenses including, but not limited to, increases in health insurance premiums and workers’ compensation rates and underlying claims trends, financial solvency of workers’ compensation carriers and other insurers, state unemployment tax rates, liabilities for employee and client actions or payroll-related claims, changes in the costs of expanding into new markets, and failure to manage growth of our operations; (iv) the effectiveness of our sales and marketing efforts; (v) changes in the competitive environment in the PEO industry, including the entrance of new competitors and our ability to renew or replace client companies; (vi) our liability for worksite employee payroll and benefits costs; and (vii) an adverse final judgment or settlement of claims against Administaff. These factors are discussed in detail in our 2005 annual report on Form 10-K and elsewhere in this report. Any of these factors, or a combination of such factors, could materially affect the results of our operations and whether forward-looking statements we make ultimately prove to be accurate.

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ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

     The following table provides information about purchases by Administaff during the three months ended September 30, 2006, of equity securities that are registered by Administaff pursuant to Section 12 of the Exchange Act:

							Maximum
					Total Number of		Number of
					Shares		Shares that May
					Purchased as		Yet Be
	Total Number				Part of Publicly		Purchased
	of Shares		Average Price Paid		Announced		Under the
Period	Purchased(1)		per Share		Program(2)		Program (2)
07/01/2006 – 07/31/2006		—	$	—		7,726,534		773,466
08/01/2006 – 08/31/2006		190,000		36.59		7,916,534		583,466
09/01/2006 – 09/30/2006		90,000		32.57		8,006,534		493,466
Total		280,000	$	35.30		8,006,534		493,466

(1)	Our board of directors has approved the repurchase of up to an aggregate amount of 8,500,000 shares of Administaff common stock, of which 8,006,534 had been repurchased as of September 30, 2006. During the three months ended September 30, 2006, we repurchased 280,000 shares of our common stock.
(2)	Unless terminated earlier by resolution of the board of directors, the repurchase program will expire when we have repurchased all shares authorized for repurchase under the repurchase program.

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ITEM 6. EXHIBITS

(a) List of exhibits.

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

     Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	Administaff, Inc.
Date: November 1, 2006	By:	/s/ Douglas S. SharpDouglas S. Sharp
		Vice President of Finance,
		Chief Financial Officer and Treasurer
		(Principal Financial and Duly Authorized Officer)

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Exhibit Index

31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.