Diversified Corporate Resources (HIRD) 10-Q 2005 Q3 Quarterly report

U. S. SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

ý QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005

o TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 0-13984

DIVERSIFIED CORPORATE RESOURCES, INC.

(Exact name of registrant as specified in its charter)

Texas	75-1565578
(State or other jurisdiction of incorporation or organization)	(IRS Employer Identification No.)
10670 North Central Expressway, Suite 600, Dallas, Texas	75231
(Address of principal executive offices)	(Zip Code)

972-458-8500

(Issuer’s telephone number, including area code)

Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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.  Yes ý  No o

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes o  No ý

As of November 1, 2005, 5,212,693 shares of the registrant’s common stock were outstanding, plus 501,559 shares of common stock are held by the registrant as treasury stock.

DIVERSIFIED CORPORATE RESOURCES, INC.

3^rd QUARTER 2005 FORM 10-Q

TABLE OF CONTENTS

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

Item 3. Quantitative and Qualitative Disclosure About Market Risk

Item 4. Controls and Procedures

Part II – Other Information

Item 1. Legal Proceedings

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Item 3. Defaults Upon Senior Securities

Item 5. Other Information

Item 6. Exhibits

Signatures

1

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

DIVERSIFIED CORPORATE RESOURCES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

	Three months ended September 30,
	2005			2004
Net service revenues:
Direct placement services	$	1,366		$	2,536
Temporary and contract staffing services	3,757			3,872
	5,123			6,408
Direct cost of temporary and contract staffing services	2,636			2,829
Gross profit	2,487			3,579
Operating expenses:
Selling expenses	1,513			2,113
General and administrative expenses	1,842			2,587
Stock-based employee compensation	65			30
Depreciation and amortization	52			93
	3,472			4,823
Other expense (income) items:
Interest expense, net	375			339
	375			339
Income tax provision	—			—
Loss from continuing operations	(1,360		)	(1,583		)
Income from discontinued operations, net of tax	113			532
Net loss	(1,247		)	(1,051		)
Cumulative preferred stock dividends earned but not declared	(53		)	(53		)
Net loss applicable to common stockholders	$	(1,300	)	$	(1,104	)
Net loss per share from continuing operations applicable to common stockholders – basic and diluted	$	(0.27	)	$	(0.31	)
Net income per share from discontinued operations	$	0.02		$	0.10
Net loss per share applicable to common stockholders – basic and diluted	$	(0.25	)	$	(0.21	)
Weighted average common shares outstanding – basic and diluted	5,213			5,354

See notes to condensed consolidated financial statements.

2

DIVERSIFIED CORPORATE RESOURCES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

	Nine months ended September 30,
	2005			2004
Net service revenues:
Direct placement services	$	4,812		$	6,499
Temporary and contract staffing services	11,079			11,107
	15,891			17,606
Direct cost of temporary and contract staffing services	7,755			8,124
Gross profit	8,136			9,482
Operating expenses:
Selling expenses	4,805			5,779
General and administrative expenses	5,679			8,395
Stock-based employee compensation	107			153
Depreciation and amortization	181			343
	10,772			14,670
Other expense (income) items:
Interest expense, net	1,127			747
Gain on early extinguishment of debt	—			(222		)
	1,127			525
Income tax provision	—			—
Loss from continuing operations	(3,763		)	(5,713		)
Income from discontinued operations, net of tax	452			1,052
Net loss	(3,311		)	(4,661		)
Accretion of discount on preferred stock	—			(448		)
Cumulative preferred stock dividends earned but not declared	(159		)	(114		)
Net loss applicable to common stockholders	$	(3,470	)	$	(5,223	)
Net loss per share from continuing operations applicable to common stockholders – basic and diluted	$	(0.74	)	$	(1.32	)
Net income per share from discontinued operations	$	0.08		$	0.22
Net loss per share applicable to common stockholders – basic and diluted	$	(0.66	)	$	(1.10	)
Weighted average common shares outstanding – basic and diluted	5,298			4,759

See notes to condensed consolidated financial statements.

3

DIVERSIFIED CORPORATE RESOURCES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except par value)

	September 30, 2005			December 31, 2004
	(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents	$	3		$	4
Trade accounts receivable, less allowance for doubtful accounts of $192 and $247, respectively	3,164			3,692
Other current assets	640			147
Total current assets	3,807			3,843
Property and equipment, net	220			363
Other assets:
Intangibles, net	4,183			4,187
Receivables from affiliates	—			311
Other	163			161
Net assets held for sale	5,383			5,655
Total Assets	$	13,756		$	14,520
LIABILITIES AND STOCKHOLDERS’ EQUITY (DEFICIT)
Current liabilities:
Trade accounts payable and accrued expenses	$	8,379		$	7,876
Obligations not liquidated because of outstanding checks	785			315
Borrowings under line of credit agreement	1,624			2,213
Factoring liability	1,230			1,501
Current maturities of long-term debt	2,522			867
Current maturities of capital leases	49			45
Total current liabilities	14,589			12,817
Deferred lease rents	484			481
Capital lease obligations, net of current maturities	25			55
Long-term debt, net of current maturities	14			55
Net liabilities held for sale	3,100			3,011
Total liabilities	18,212			16,419
Commitments and contingencies	—			—
Stockholders’ equity (deficit)
Preferred stock, $1.00 par value; 1,000 shares authorized; none issued	—			—
Preferred stock, $10 par value, 215 shares authorized; 212 shares issued and outstanding in 2005 and 2004	448			448
Common stock, $0.10 par value, 50,000 shares authorized; 5,714 shares issued, 5,213 and 5,354 shares outstanding in 2005 and 2004	571			571
Additional paid-in capital	16,647			15,893
Retained deficit	(21,000		)	(17,689		)
Common stock held in treasury, 501 and 361 shares in 2005 and 2004, at cost	(1,122		)	(907		)
Receivable from related party	—			(215		)
Total stockholders’ equity (deficit)	(4,456		)	(1,899		)
Total Liabilities and Stockholders’ Equity (Deficit)	$	13,756		$	14,520

See notes to condensed consolidated financial statements.

4

DIVERSIFIED CORPORATE RESOURCES, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

	Nine months ended September 30,
	2005			2004
Cash flow from operating activities:
Net loss from continuing operations	$	(3,763	)	$	(5,713	)
Net income from discontinued operations	452			1,052
Adjustments to reconcile net loss to cash provided by (used in) operating activities:
Depreciation and amortization	181			343
Gain on extinguishment of debt	—			(222		)
Provision for allowances	55			48
Deferred lease rents	3			93
Accretion of interest on debts	6			7
Value of warrants issued	307			162
Value of stock-based employee compensation	107			153
Changes in operating assets and liabilities:
Accounts receivable	473			(1,245		)
Prepaid and other assets	(167		)	(167		)
Trade accounts payable and accrued expenses	503			3,447
Net operating cash flow from discontinued operations	361			819
Cash used in operating activities	(1,482		)	(1,223		)
Cash flows from investing activities:
Capital expenditures	(14		)	(37		)
Business acquisition costs, net of cash acquired	—			(207		)
Cash used in investing activities	(14		)	(244		)
Cash flows from financing activities:
Issuance of common stock	—			15
Issuance of preferred stock, net of issue costs	—			1,920
Repayment of debt to related party	—			(200		)
Borrowings from related party	10			138
Repayment of note receivable from related party	311			30
Net borrowings (repayments) on revolving line of credit	(589		)	2,207
Net repayments under factoring arrangement	(271		)	(2,504		)
Obligations not liquidated because of outstanding checks	470			(9		)
Principal payments under debt obligations	(187		)	(371		)
Borrowings under debt obligations	1,785			350
Principal payments under capital lease obligations	(34		)	(64		)
Net financing cash flow from discontinued operations	—			(205		)
Cash flows from financing activities	1,495			1,307
Change in cash and cash equivalents	(1		)	(160		)
Cash and cash equivalents at beginning of year	4			164
Cash and cash equivalents at end of period	$	3		$	4

See notes to condensed consolidated financial statements.

5

DIVERSIFIED CORPORATE RESOURCES, INC. AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

SEPTEMBER 30, 2005

(Unaudited)

NOTE 1 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Going Concern:  These financial statements have been prepared on a going concern basis, which contemplates the realization of the assets of Diversified Corporate Resources, Inc. and subsidiaries (the “Company”) and the satisfaction of its liabilities and commitments in the normal course of business.  However, the Company believes that it will be unable to continue as a going concern for the next twelve months without obtaining additional funds through debt or equity financing or through the sale of assets.  See Note 2 for a discussion of the Company’s ability to continue as a going concern and its plans for addressing those issues.  The inability to obtain additional funds could have a material adverse effect on the Company.

Description of Business:  The Company is a nationwide human resources and employment services firm, providing staffing solutions in specific professional and technical skill sets to Fortune 500 corporations and other large organizations.  The Company offers two kinds of staffing solutions: direct placement services and temporary and contract staffing.

The Company currently operates offices in the following locations:

Arizona	Phoenix
California	Palm Desert
Colorado	Denver
Georgia	Atlanta
Pennsylvania	Philadelphia
Texas	Dallas, Houston and Austin

The offices are responsible for marketing to clients, recruitment of personnel, operations, local advertising, initial customer credit evaluation and customer cash collection follow-up.   Our executive offices, located in Dallas, Texas, provide corporate governance and risk management, as well as certain other accounting and administrative services, for our offices.

Basis of Presentation:  The condensed consolidated financial statements include the accounts of all wholly-owned subsidiaries.  All significant intercompany accounts and transactions have been eliminated in the condensed consolidated financial statements.

The Company’s condensed consolidated balance sheet as of September 30, 2005, the condensed consolidated statements of operations for the three months and nine months ended September 30, 2005 and 2004, and the condensed consolidated statements of cash flows for the nine months ended September 30, 2005 and 2004, are unaudited.  In the opinion of management, these statements have been prepared on the same basis as the audited consolidated financial statements and include all adjustments necessary for the fair presentation of the Company’s financial position, results of operations and cash flows.  Such adjustments were of a normal recurring nature.  The results of operations for the three and nine months ended September 30, 2005, are not necessarily indicative of the results that may be expected for the entire year.  The condensed consolidated balance sheet as of December 31, 2004, was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles.  Additional information is contained in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2004, which was filed with the Securities and Exchange Commission and which should be read in conjunction with this quarterly report.

The preparation of the condensed consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management of the Company to

6

make estimates and assumptions that affect the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities, at the dates of the financial statements and the reported amounts of revenues and expenses during such reporting periods.  Actual results could differ from these estimates.

Significant estimates and assumptions are used for, but not limited to: (i) the allowance for doubtful accounts, (ii) the allowance for estimated losses on realization of direct placements, (iii) the useful lives of property and equipment, (iv) asset impairments including intangibles, (v) self-insurance reserves for health claims, (vi) deferred tax asset valuation allowance, (vii) contingency and litigation reserves, (viii) fair value of financial instruments, and (ix) the fair value calculations involved in determining stock-based employee compensation and the value of warrants issued.

The Company is subject to a number of risks and uncertainties.  For example, management of the Company believes that these following factors, as well as others, could have a significant negative effect on the Company’s future financial position, results of operations and/or cash flows:  risks associated with raising adequate capital for continuing operations; general economic conditions that affect the Company’s target markets, including inflation, recession, interest rates and other economic factors; the availability of qualified personnel; the Company’s ability to successfully integrate acquisitions or joint ventures with its operations (including the ability to successfully integrate businesses that may be diverse as to their type, geographic area or customer base); the level of competition experienced by the Company, especially from companies with greater financial and marketing resources; the Company’s ability to implement its business strategies and to manage its growth; the level of development revenues and expenses; and other factors that may affect the Company and businesses generally.

Cash and Cash Equivalents:  Cash and cash equivalents consist principally of amounts held in demand deposit accounts and amounts invested in financial instruments with initial maturities of three months or less at the time of purchase.

Trade Accounts Receivable:  Trade accounts receivable are reported in the consolidated balance sheets at outstanding gross billings reduced by an allowance for estimated losses on the realization of direct placement fees (principally due to applicants not commencing employment or not remaining in employment for the guaranteed period) and by an allowance for doubtful accounts for potential losses due to credit risk.  The Company establishes the allowance for estimated losses on direct placement fees based on historical experience and charges the allowance against revenue.  The allowance for doubtful accounts is based upon a review of specific customer balances, historical losses and general economic conditions.  Accounts receivable at September 30, 2005 and December 31, 2004, include approximately $366,000 and $215,000, respectively, of unbilled receivables.  The Company generally does not charge interest on past due balances.

Property and Equipment:  Property and equipment is recorded at cost.  Depreciation starts once an asset is placed in service using the straight-line method and is designed to distribute the cost of the asset over its estimated useful life.  Amortization of leasehold improvements and assets under capital leases are included in depreciation and amortization expense.  Upon retirement or sale, the cost and related accumulated depreciation or amortization are removed from the accounts and any resulting gain or loss is included in the consolidated statement of operations.  Maintenance and repair costs are charged to expense as incurred.  Estimated useful lives are from 3 to 4 years for computer equipment and software and from 5 to 7 years for furniture and equipment.  Leasehold improvements are amortized over the lesser of the life of the lease or 5 years.  Assets under capital leases are amortized over the lesser of the life of the lease or the normal life assigned to that asset.

Intangible assets:  Intangible assets consist primarily of goodwill (excess of the purchase price over the fair value of net assets acquired) arising from business combinations.  Goodwill is subject to an annual impairment test, which the Company typically completes during the fourth quarter of its fiscal year.  There have been no events or changes in circumstances since the last impairment test for December 2004 that would indicate that goodwill might be impaired since that time.

7

Capitalized Software:  The Company purchases, and in certain cases develops, and implements new computer software to enhance the performance of its accounting and operating systems.  For computer software that is developed in-house, the Company capitalizes direct internal and external costs subsequent to the preliminary stage of the software project.  Software development costs are reported as a component of computer equipment and software within property and equipment and are amortized over the estimated useful life of the software (typically three years) using the straight-line method.

Impairment of Long-Lived Assets:  The Company reviews long-lived assets and identifiable intangibles for impairment whenever events or circumstances indicate that the carrying value of an asset may not be recoverable.  Recoverability of assets to be held and used is measured by a comparison of the carrying value of an asset to the undiscounted expected future cash flows to be generated by that asset.  If the carrying value exceeds the expected future cash flows of the asset, an impairment exists and is measured by the amount the carrying value exceeds the estimated fair value of the asset.  Management believes no impairment of its long-term assets existed at September 30, 2005, based on their carrying value.

Obligations not liquidated because of outstanding checks:  Under the terms and conditions of the factoring arrangement and the line of credit (see Note 6), all cash receipts deposited in our lockboxes are swept daily by our lenders.  This procedure, combined with our policy of maintaining zero balances in the Company’s operating accounts, results in the Company reporting a balance of obligations not liquidated because of outstanding checks.

Income Taxes:  Deferred tax assets and liabilities are established for temporary differences between financial statement carrying amounts and the taxable basis of assets and liabilities using rates currently in effect.  A valuation allowance is established for any portion of the deferred tax asset for which realization is not likely.  The valuation allowance is reviewed periodically to determine the amount of deferred tax asset considered realizable.

Fair value of Financial Instruments:  The estimated fair value of the Company’s financial instruments was determined by the Company based on available market information and appropriate valuation methodologies.  However, considerable judgment is necessarily required in interpreting market data to develop fair value estimates.  Accordingly, estimates are not necessarily indicative of the amounts the Company may realize in a current market transaction.  The use of different market assumptions or estimates may have a material effect on the estimated fair value.

The recorded values of cash and cash equivalents, trade accounts receivable, accounts payable and other accrued liabilities approximate fair value due to the short term nature of these instruments.  The recorded amount of notes receivable from affiliates approximates fair value due to the value of the collateral for those receivables.  The recorded value of the factoring liability, the line of credit and other current and long-term debt approximate fair value due to the Company’s ability to obtain replacement borrowings at comparable interest rates.

Revenue Recognition and Cost of Services:  The Company derives its revenues from two sources: direct placement and temporary and contract staffing.  The Company records revenues for staffing services at the gross amount billed the customer in accordance with EITF 99-19, Reporting Revenues Gross as a Principal Versus Net as an Agent.  The Company believes this approach is appropriate because the Company itself identifies and hires qualified employees, selects the employees for the staffing assignment, and bears the risk that the services provided by these employees will not be fully paid by customers.

Fees for direct placement of personnel are recognized as income at the time the applicant accepts employment.  Revenue is reduced by an allowance for estimated losses in realization of such fees (principally due to applicants not commencing employment or not remaining in employment for the guaranteed period).  Fees charged to clients are generally calculated as a percentage of the new employee’s annual compensation.  There are no direct costs for direct placements.  Commissions paid by the Company related to direct placements are included in selling expenses.

8

Revenues from temporary and contract staffing are recognized upon performance of services.  The direct costs of these staffing services consist principally of wages and related payroll taxes.

Segment Reporting:  In accordance with Statement of Financial Accounting Standards (“SFAS”) No. 131, Disclosure about Segments of an Enterprise and Related Information, the Company operates in only one segment, that of an employment services firm.  While the Company’s chief operating decision maker receives information by type of revenue, either direct placements or temporary and contract staffing services, the Company does not maintain its books of record so that all operating expenses and assets can be allocated to the types of revenue reported.  Therefore, it is impracticable for the Company to provide segment profit or loss by type of revenue other than on a consolidated basis.  The Company has no operations outside the United States.

Advertising Costs:  Advertising costs are expensed as incurred.  The Company recognized advertising expenses of approximately $59,000 for the three months ended September 30, 2005, and $59,000 for the three months ended September 30, 2004.  For the nine months ended September 30, 2005 and 2004, advertising expenses were approximately $168,000 and $208,000, respectively.

Stock-Based Compensation:  In the fourth quarter of 2003, the Company adopted the fair value recognition provisions of SFAS No. 123, using the modified prospective method as permitted under SFAS No. 148, effective as of January 1, 2003.

Under this fair value method of recognizing stock-based employee compensation, compensation cost is measured at the grant date based on the estimated fair value of the award and is expensed over the vesting period.  The Company begins recognizing such compensation cost as if all grants will entirely vest.

For options issued during the nine months ended September 30, 2005 and 2004, the fair value of each option grant was estimated on the date of grant by using the Black-Scholes option-pricing model.  The fair value of options issued during the nine months ended September 30, 2005 was approximately $0.40 per share and during the nine months ended September 30, 2004 was approximately $1.14 per share.  The following weighted average assumptions were used in valuing the options granted during these periods:

	2005		2004
Expected dividend yield	0.00	%	0.00	%
Expected volatility	229.73	%	107.01	%
Risk-free interest rate	3.88	%	3.00	%
Expected option lives	4.0 years		3.7 years

The Company recognized stock-based employee compensation expense of approximately $65,000 for the three months ended September 30, 2005, and $30,000 for the three months ended September 30, 2004.  For the nine months ended September 30, 2005 and 2004, the Company recognized stock-based employee compensation expense of approximately $107,000 and $153,000, respectively.

Loss per share:  The net loss applicable to common stockholders was used in the calculation of both basic and diluted loss per share.  The weighted average number of common shares outstanding was also the same for calculating both basic and diluted loss per share.  Options to purchase 2,523,084 shares of common stock and warrants to purchase 4,044,329 shares of common stock in 2005, and options to purchase 1,429,402 shares of common stock and warrants to purchase 1,508,495 shares of common stock in 2004, were not included in the computation of diluted loss per share as the effect of including the options and warrants in the calculation would be anti-dilutive.  The conversion feature of the Company’s preferred stock into 2,118,750 shares of common stock was also not included in the calculation of diluted loss per share as it would also have been anti-dilutive.

Comprehensive Loss:  For all periods presented, comprehensive loss is equal to net loss.

Recently Issued Accounting Standards:  In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29.   The guidance in APB Opinion No. 29,

9

Accounting for Nonmonetary Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged.  The guidance included certain exceptions to that principle.  This statement amends Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance.  A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.  This statement shall be effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005.  The Company does not believe that the adoption of this statement will have a material effect on its financial statements.

NOTE 2 - GOING CONCERN AND MANAGEMENT PLANS

As a result of the recession that started in 2000 and the impact it has had on the direct placement and temporary staffing industry, our revenues have declined approximately 67% from levels achieved in 2000.  We reported net losses for the last four fiscal years as a result of the decline in our business, and expect to report a loss for the 2005 fiscal year.  In addition, the Company’s current liabilities of $14.6 million exceed its current assets of $3.8 million.

The Company currently finances itself through factoring of, or lines of credit based on, its accounts receivable.  The amount of funds available under these agreements depends on the amount of accounts receivable accepted by the lenders.  We operate with minimal cash balances as all cash receipts are deposited into our lockboxes, which are swept daily by our lenders.  While we have generally sought to borrow the maximum amounts available from these facilities during 2005, the facilities have been inadequate in providing enough funds to maintain operations, which has resulted in our having to use other measures to continue to fund operations.

During 2004, we reduced staff and closed agencies to reduce funds outflow.  We had also not paid all employer and employee payroll taxes when due.  As a result of these past due payroll tax liabilities, we are in default under one of our lending agreements.  In addition, we are funding operations by not paying all vendors for products and services under normal credit terms, including payments on capital leases and other debt.  The consequences of some of these actions have or may result in penalties and/or fines for late payments or may involve legal actions against us.  However, our management believed that these steps were necessary at the time to maintain the Company while it sought to correct its cash flow issues.

The Company incurred payroll tax liabilities of approximately $3,567,000 in 2004 that have not been paid (excluding any penalty and interest payments due on the underpayment).  The Company first disclosed that it had not paid all payroll taxes when due in June 2004.  Taxes on payrolls after November 3, 2004, have been paid when due as part of an agreement with the Internal Revenue Service (the “IRS”), as discussed below.

In October 2004, the Internal Revenue Service (the “IRS”) placed a lien on the assets of two of our subsidiaries.  The Company and the IRS reached an agreement that subordinates the claims by the IRS to those of our senior lenders so that they can continue to fund our operations.  Our lenders are continuing to fund us.  The Company has entered into a second amendment with one lender that acknowledges the extended subordination agreement with the IRS.  We do not have a formal agreement with our other senior lender, but this lender has continued to fund.  Currently, both lenders may demand repayment at any time.  If we fail to pay all future federal payroll tax liabilities arising after the subordination agreement on a timely basis, the subordination agreement will expire and our senior lenders will stop funding our operations.  This would have a material adverse effect on our ability to continue as a going concern.

In the first quarter of 2004, the Company completed the sale of a new issue of the Company’s preferred stock (see Note 5).  Each share of preferred stock is convertible into ten shares of the Company’s common stock.  The sale was closed in March 2004 and generated net proceeds to the Company of approximately $1.9 million.  This capital was used for general working capital purposes and to acquire certain

10

assets of Medical Resource Network, Inc. (see Note 4).  While this financing provided much needed capital to help offset the Company’s negative cash flow, it did not provide enough funds to overcome this.

The Company is in discussions with several interested parties regarding the sale of one of its subsidiaries, Datatek Group Corporation (“Datatek”), headquartered in Phoenix, Arizona.   The proceeds received from a sale should be adequate to repay most, if not all, of the past due payroll tax liabilities.  Because negotiations are in the early stages, the Company cannot be assured that a sale will occur.  The unit to be sold represented approximately 53% and 59% of our temporary and contract staffing revenue for the nine months ended September 30, 2005 and 2004, respectively.

The Company is continuing to evaluate various other financing and restructuring strategies, including merger candidates and investments through private placements, to maximize shareholder value and to provide assistance to the Company in meeting its capital requirements and pursuing its business strategy.  One of these strategies is to seek acquisitions to replace the revenues that could be lost in the sale of Datatek by acquiring small companies, where their back office operations can be absorbed into the Company’s own.  There can be no assurance that the Company will be successful in implementing the changes necessary to accomplish these objectives, or if it is successful, that the changes will improve its cash flow and liquidity.

If a sale of Datatek takes place, management believes that the Company will be able to secure other financing that will allow it to pursue its acquisition strategy, which when combined with improving market conditions and the restructuring of its present businesses, should eventually produce enough new revenues and gross profit to cover the operating funds shortfall the Company is currently experiencing.  However, the Company cannot guarantee that funds will be available, that any acquisitions will, if made, be accretive to our cash flow, or that the Company’s creditors will give it the time needed to implement its plan.  The inability to obtain additional financing will have a material adverse effect on the Company’s financial condition.  It may cause the Company to delay or curtail its business plans or to seek protection under bankruptcy laws.

The accompanying financial statements have been prepared on a going concern basis, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business.  These financial statements do not include any adjustments to the recoverability and classification of recorded asset amounts or the amount and classification of liabilities that might be necessary should the Company be unable to continue as a going concern.  The Company’s continuation as a going concern is dependent upon its ability to obtain additional financing and ultimately, to attain and maintain profitable operations.

NOTE 3 - DISCONTINUED OPERATIONS

On February 1, 2005, the Company and Axtive Corporation, Inc. (“Axtive”) entered into an asset purchase agreement in which the Company would sell substantially all of the assets of Datatek Group Corporation (“Datatek”), headquartered in Phoenix, Arizona, to a subsidiary of Axtive.  The purchase price was to consist of up to $5 million in cash and 15,333,333 shares of Axtive stock ..  As a result of this agreement, Datatek has been presented as a discontinued operation in accordance with SFAS No. 144 – Accounting for the Disposal or Impairment of Long-lived Assets.  Under this statement, the operating results of Datatek are presented separately from continuing operations in the accompanying financial statements for all periods presented.

On June 15, 2005, the Company received notification from Axtive that they will be unable to satisfy the conditions to closing set forth in the asset purchase agreement.  As of the date of this filing, however, we are in discussions with other interested parties and have received a preliminary letter of intent for the purchase of Datatek from one of these parties.

The Company cannot provide any assurance that these negotiations will ultimately lead to a sale of the subsidiary.

11

Summarized information for Datatek is as follows:

	Three Months Ended September 30, (in thousands)				Nine Months Ended September 30, (in thousands)
	2005		2004		2005		2004
	(unaudited)		(unaudited)		(unaudited)		(unaudited)
Revenue	$	4,152	$	5,048	$	12,460	$	15,895
Gross Profit	$	554	$	862	$	1,775	$	2,349
Income before income taxes	$	113	$	532	$	452	$	1,052

	Balance at, (in thousands)
	9/30/05		12/31/04
	(Unaudited)
Current Assets
Trade Accounts Receivable, net	$	1,932	$	2,203
Long-Term Assets
Intangibles, net	3,448		3,450
Other Assets	2		2
Total Long-Term Assets	3,450		3,452
Total Assets	$	5,382	$	5,655
Current Liabilities
Accounts Payable & Accrued Liabilities	$	3,097	$	3,005
Long-Term Liabilities
Other	3		6
Total Liabilities	$	3,100	$	3,011

NOTE 4 - MEDICAL RESOURCE NETWORK, INC. (“MRN”):

During the third quarter of 2003, and consistent with the Company’s commitment to enter into the healthcare arena, the Company identified and established a relationship with MRN.  MRN was a Southern California-based company specializing in the placement of traveling nurses.  MRN maintained contract relationships with hundreds of hospitals throughout the country but lacked the financial resources to compete and grow.  As a result, the Company structured a transaction in which the employees and nurses became employees of the Company, and the Company began taking over many back office functions of MRN.  The Company maintained this relationship into 2004, allowing it to become thoroughly familiar with the operations, the business, and the traveling nurse industry.

The Company closed its acquisition of the assets of MRN in February 2004.  The following table summarizes the estimated fair value of assets acquired, liabilities assumed, amounts paid for the net assets acquired and the resulting intangible asset based on the Company’s assessment of fair values (amounts in thousands):

Assets received – accounts receivable	$	421
Liabilities assumed – Notes payable	(139		)
Net assets received	282
Cash paid in 2003:
Advances to fund operations of MRN up to December 31, 2003	499
Cash paid in 2004:
To owners of MRN	11
To creditor of MRN to release accounts receivable	329
Cash provided by operations from January 1, 2004 to purchase date	(133		)
Other purchase costs:
Value of warrants issued	174
Total cash paid plus other purchase costs	880
Total amount assignable to intangible assets	598
Amount assigned to non-compete agreements and contracts	(25		)
Amount of goodwill	$	573

12

The liabilities assumed of approximately $139,000 represented notes to certain shareholders of MRN.  The value of the notes represents the discounted value payable, based primarily on an interest rate of 16%, which represented an estimate of an unsecured borrowing rate the Company believed it could have received had it sought outside funds to repay these liabilities.  The gross amount due under the notes was approximately $161,000.  One note for approximately $3,000 was repaid by May 2004.  The other note for approximately $158,000 is being repaid at $5,000 per month and will be fully amortized by December 2006.  The balance of this note as of September 30, 2005, was approximately $67,000.

The stockholders of MRN were issued warrants to purchase 50,000 shares of the Company’s common stock as part of the purchase.  The warrants have a term of 5 years, an exercise price of $0.65, and were immediately vested.  The fair value of the warrants was estimated on the date of grant to be approximately $174,000 using the Black-Scholes option-pricing model.

The amount of the intangibles assigned to the non-compete agreement and contracts purchased was amortized over a one year period, which represented the life of the non-compete agreement.  The remainder of the intangibles representing goodwill will be valued along with the Company’s other goodwill yearly.

In addition to the amounts received at the closing, one of the owners of MRN is entitled to a bonus after certain targets are hit which is equal to the sum of 20% of the gross margin plus 15% of the operating margin, as defined in the agreement.  The first $250,000 of bonus payments earned would not be paid, except for certain minimum amounts due per the agreement.  These bonus payments, when earned and payable, will be expensed by the Company once advances are recouped.

The following table presents the unaudited pro forma results of operations for the nine months ended September 30, 2004, assuming that the purchase of MRN’s assets occurred on January 1 of that year:

	Nine months ended September 30,
	As reported (Unaudited)			Pro forma (Unaudited)
($ in thousands, except per share amounts)	2004			2004
Revenues	$	17,606		$	18,033
Net loss	$	(4,661	)	$	(4,587	)
Net loss applicable to common stockholders	$	(5,223	)	$	(5,149	)
Net loss per share – basic and diluted	$	(1.10	)	$	(1.08	)

The Company estimated the revenue and net income of MRN from January 1, 2004 to the acquisition date would be $427,000 and $74,000, respectively.  These amounts are based on records provided by MRN to the Company, which have not been audited or tested for accuracy, adjusted for amortization of certain acquired intangibles.

NOTE 5 – CONVERTIBLE PREFERRED STOCK

In February 2004, the Board authorized the issuance of up to 215,000 shares of a Series A convertible preferred stock (the “Preferred Stock”), par value $10.  The offering was oversubscribed and closed on March 19, 2004.  The Company issued 209,875 shares of Preferred Stock and received gross proceeds of $2,098,750.  Another 2,000 shares were issued as a fee related to the offering for a total of 211,875 shares outstanding.  Dividends shall be paid on the Preferred Stock at an annual rate of 10%, payable

13

quarterly on the 15^th day following the end of the quarter.  The Preferred Stock has voting rights with each share of Preferred Stock having ten votes on all matters submitted to shareholders of the Company.  If the dividends due on the Preferred Stock are in arrears, the Company cannot pay dividends on, make other distributions to, redeem or purchase its common stock.  Because of the Company’s current cash position, the Board of Directors has not declared any dividends on the Preferred Stock since its issuance.  The cumulative amount of dividends earned but not declared at September 30, 2005, was approximately $325,379 or $1.536 per share of Preferred Stock outstanding.

Each share of Preferred Stock is convertible at the option of the holder into ten shares of common stock.  Each share of Preferred Stock is convertible at the option of the Company at any time after the occurrence of a trade of a share of its common stock on a national securities exchange for a price exceeding $2.00 per share; however, only after at least eight dividend payments have been made.  Each share of Preferred Stock automatically converts after at least 825,000 shares of the Company’s common stock have traded on a national securities exchange for a price exceeding $3.00 per share, subject to the payment of at least eight dividend payments and the common stock into which they are convertible having been registered.   The Company has reserved 2,118,750 shares of its common stock for the conversion of the Preferred Stock.

The Company paid $189,375 out of the proceeds for fees to agents involved in the offering.  In addition, $20,000 of additional Preferred Stock was issued (as discussed above) for a fee to an agent in the offering.  Legal and other fees paid were approximately $14,000, resulting in net cash proceeds to the Company of approximately $1,895,000.

Warrants were issued to certain agents in connection with the offering.  The Company issued warrants for 169,428 shares of the Company’s common stock at $0.80 per share, 235,713 shares at $2.00 per share and 66,964 shares at $3.50 per share.  These warrants have a term of three years from their issue date, which was the date the parties executed their warrants.  The warrant exercise price on the $2.00 per share and $3.50 per share warrants is subject to reduction depending on the net income before taxes reported by the Company for the fiscal year ending December 31, 2004.  Since the Company reported a net loss before taxes for the year ended December 31, 2004, the exercise price for these warrants has been reduced to $0.00.  These warrants were valued at their market value at March 19, 2004 assuming that the exercise price was $0.00, which resulted in an intrinsic value for these warrants of approximately $989,754.  The fair value of warrants with an exercise price of $0.80 was calculated using the Black-Scholes option pricing model with the following average assumptions: an expected term of 2 years, an expected dividend yield of 0.0%, an expected stock price volatility of 107.16% and a risk-free interest rate of 1.72%.  The total fair value of these warrants was $457,340.

The embedded conversion feature in the Preferred Stock was also valued at the date of issuance.  The portion of the proceeds allocated to the conversion feature was to be based on the intrinsic value calculated by subtracting the conversion price based on the discounted recorded value of the Preferred Stock from the market price of the common stock.  Based on this calculation, the intrinsic value of the embedded conversion feature exceeded the value of the Preferred Stock on that date; therefore, the value of the conversion feature was limited to the actual carrying value of the Preferred Stock.

The following table reflects the computation of the carrying value of the Preferred Stock since its issuance:

Cash received – for 211,875 shares of preferred stock issued, including warrants	$	2,098,750
Less: expenses related to preferred stock issuance	(203,295		)
value of warrants issued	(1,447,094		)
Carrying value of preferred stock before value of embedded conversion feature	448,361
Less: value of embedded conversion feature	(448,361		)
Net carrying value of preferred at date of issue	—
Amortization of discount on preferred stock since issuance	448,361
Carrying value of preferred stock at March 31, 2004	$	448,361

14

The discount related to the embedded conversion feature was amortized immediately as the holders of the Preferred Stock are able to convert their Preferred Stock into common stock at their option at any time.  The remainder of the discount is not being amortized as the preferred stock is not required to be redeemed, except in a liquidation or dissolution of the Company, or upon the automatic conversion of the preferred, which payments or conversions are not probable at this time.

NOTE 6 - LINE OF CREDIT AND FACTORING FACILITIES

On December 1, 2003, Wells Fargo Business Credit (“Wells Fargo”) and the Company entered into a secured senior credit agreement (the “Wells Fargo Facility”).  The Wells Fargo Facility is a two-year term factoring facility pursuant to which Wells Fargo advances funds to the Company on accounts receivable invoices it deems eligible. Under the original agreement, the gross face amount of each invoice on which Wells Fargo advances funds is reduced by from 10% for temporary placement invoices to 40% for direct placement invoices.  In addition, the Company pays Wells Fargo for those invoices a discount of 1.1% of the gross face amount of each account for the first thirty days and .035% per day thereafter until paid in full.  The minimum fee due Wells Fargo is $20,000 per month.  The Wells Fargo Facility may be terminated by either party on 60 days notice or by Wells Fargo at any time in case of an event of default.  The average amount borrowed under the Wells Fargo Facility for the three and nine months ended September 30, 2005, was approximately $1,092,000 and $1,142,000, respectively.  The average interest rates on these borrowings for the three and six months ended June 30, 3005, were 28.8% and 30.8%, respectively.  The maximum and minimum amounts borrowed were $1,616,000 and $844,000, respectively, for the nine months ended September 30, 2005.  The balance at September 30, 2005 was approximately $1,230,000.

The maximum amount available under the Wells Fargo Facility is established by individual customer credit limits and as a result, there is no stated maximum.  As receivables are collected, new receivables are added.  Wells Fargo assumes the risk of non-payment of an accepted receivable due to a customer declaring bankruptcy or being put in receivership within 75 days after the date of the invoice.  The Company assumes all other non-payment risk.  All of the assets of the Company and its subsidiaries were pledged to secure this facility, and most of these subsidiaries have guaranteed the repayment of the Company’s obligation.

 On June 14, 2004, Wells Fargo declared that a default currently existed under the Wells Fargo Facility as a result of our not remitting all payroll taxes when due (see Note 2), although they continued to advance funds on accounts receivable from the Company.  However, Wells Fargo lowered the advance rate to 85% as compared to 90% and raised the discount fee by 1%, still subject to the $20,000 a month minimum.  Wells Fargo also continued to advance funds on the Company’s accounts receivable after the IRS subordinated their lien for unpaid payroll taxes to the Company’s senior lenders in November 2004.

Under the factoring facilities from Wells Fargo, the Company believed it retained primary responsibility for losses on the accounts receivable on which Wells Fargo advanced funds because of the guarantees and additional collateral held by the lender.  Therefore, the Company does not show the assets as having been sold, and it accounts for the funds received as current debt on the balance sheet in the caption “Factoring liability”.

Due to certain restrictions applied by Wells Fargo on their accounts receivable facility, the Company entered into a new $5.0 million secured, senior line of credit facility with Greenfield Commercial Credit (“Greenfield”) on March 12, 2004, while still maintaining the credit facility with Wells Fargo.  Wells Fargo and Greenfield entered into an Intercreditor Agreement to clarify their interests in the Company’s receivables and other security interests.   The term of the Greenfield line of credit facility (the “Greenfield Facility”) is due on demand, but if demand is not made, no later than the maturity date, which was March 12, 2005.  On March 12, 2005, the Company has entered into an amendment with Greenfield that extends the maturity date to March 12, 2006.  The Company does not have to be in default under the Greenfield Facility for demand to be made.  All of the assets of the Company and its subsidiaries were also pledged to secure this facility as well as the Wells Fargo Facility, and most of these subsidiaries have also guaranteed the repayment of the Company’s obligation to Greenfield.

15

The interest rate is 8.0% above the prime rate.  There was a $200,000 commitment fee incurred on the closing.  The amount that may be borrowed at any time under the line of credit is based on eligible receivables.  Receivables for temporary and contract services will be advanced at 85% of the receivable.  Originally, receivables for direct placement services were advanced at 60% of the receivable, subject to the lesser of a maximum advance of $1,000,000 or 30% of the gross availability.  All proceeds from the collection of such receivables are deposited into lockboxes controlled by Greenfield.  The average amounts borrowed under the Greenfield Facility for the three and nine months ended September 30, 2005, were approximately $1,767,000 and $1,991,000, respectively.  The average interest rates on these borrowings, including the unused line of credit fee for the three and nine months ended September 30, 2005, were 21.2% and 19.8%, respectively.  The maximum and minimum amounts borrowed were $2,490,000 and $1,480,000, respectively, for the nine months ended September 30, 2005.    In addition, the Company incurred fees of approximately $246,000 for the nine months ended September 30, 2005.  Of these fees, approximately $200,000 were considered debt origination costs and are being amortized to interest expense over a one year period.

As a result of our non-payment of payroll taxes, the Company entered into a Forbearance Agreement with Greenfield on July 27, 2004.  Under the agreement, Greenfield agreed not to enforce its default remedies for 90 days after the date of the agreement.  The Company incurred approximately $51,000 in fees for the agreement.  On October 27, 2004, the Company entered into an Amended Forbearance Agreement that granted the Company until January 27, 2005 to resolve its delinquent payroll tax issues with the IRS.  Greenfield also agreed to increase borrowings on direct placement revenues to 40% of gross availability subject to a cap of $1,250,000.  The Company incurred $50,000 in fees for the amended agreement.  The Amended Forbearance Agreement has not been renewed, but Greenfield continues to fund the Company under its line of credit.  On March 12, 2005, the Company entered into the Second Amendment to the Loan and Security Agreement with Greenfield which acknowledges that the Company has extended the subordination of its lien with the IRS for the payment of the past due taxes; extends the maturity date of the loan agreement to March 12, 2006; and amends the borrowings on direct placement revenues to 35% of net availability subject to a cap of $1,250,000.  As noted above, the Company incurred $200,000 in fees for the amended agreement.

NOTE 7 – SUPPLEMENTAL CASH FLOW AND BALANCE SHEET INFORMATION

The following supplemental cash flow information is provided for interest and income taxes paid and for non-cash transactions related to investing and financing activities for the nine months ended September 30, 2005 and 2004:

($ in thousands)	2005		2004
Interest paid	$	915	$	1,113
Non-cash transactions for investing and financing activities:
Assets acquired under capital leases	8		37
Treasury stock acquired for exchange of note receivable from related party	215		—
Accretion of discount on preferred stock	—		448
Value of warrants issued in private placement to agents or advisors	—		1,447
Prior year deferred issue costs for preferred stock	—		25
Warrants exercised by reduction in debt due to holder of the warrant	—		225
Acquisition of the assets of MRN:
Net assets received	—		282
Value of warrants issued to stockholders of MRN	—		174

16

The following supplemental balance sheet information is provided for other current assets, property and equipment, other long-term assets, accounts payable and accrued expenses, debt, Shareholder’s Equity (Deficit), and Common Stock:

Other current assets

($ In Thousands)	September 30, 2005		December 31, 2004
	(Unaudited)
Prepaid insurance	$	146	$	31
Prepaid software licenses	17		45
Prepaid rent	21		—
Other prepaid expenses	5		11
Debt origination costs	440		60
Other current assets	11		—
Total other current assets	$	640	$	147

Property and equipment

($ In Thousands)	September 30, 2005			December 31, 2004
	(Unaudited)
Computer equipment and software	$	3,805		$	3,783
Furniture and equipment	1,092			1,092
Leasehold improvements	60			120
	4,957			4,995
Less accumulated depreciation and amortization	(4,737		)	(4,632		)
Property and equipment, net	$	220		$	363

The unamortized balance of assets under capital leases was approximately $61,000 and $88,000 at September 30, 2005 and December 31, 2004, respectively.  These assets are included in computer equipment.

Intangibles subject to amortization

Intangibles subject to amortization consist of contracts purchased and non-compete agreements.  These intangibles arose in relation to assets of businesses purchased by the Company.  These intangibles are amortized over their estimated life, which is one year.  The gross carrying amount and accumulated amortization are removed when fully amortized.

($ in Thousands)	September 30, 2005			December 31, 2004
	(Unaudited)
Contracts and non-compete agreements of MRN	25			25
Accumulated amortization	(25		)	(21		)
Net carrying amount	$	—		$	4

Goodwill

There was no change in goodwill for the nine months ended September 30, 2005.

17

Long-term assets

Other assets consist primarily of deposits of $163,000 and $161,000 at September 30, 2005 and December 31, 2004, respectively.  Receivables from affiliates consisted primarily of receivables from J. Michael Moore (“Mr. Moore”), our Chief Executive Officer, and a company related to Mr. Moore, at December 31, 2004.  This note was repaid in the 1^st quarter of 2005.

Trade accounts payable and accrued expenses

	September 30,		December 31,
($ In Thousands)	2005		2004
	(Unaudited)
Trade accounts payable	$	1,878	$	1,651
Accrued expenses	2,466		2,052
Accrued compensation	972		1,293
Accrued payroll expense	3,063		2,880
Total accounts payable and accrued expenses	$	8,379	$	7,876

Included in accrued compensation are accrued commissions, bonuses and contractors’ payroll.  Penalties and interest accrued at September 30, 2005, on the past due taxes of approximately $1,091,000 are included in accrued expenses.  In the future if the penalties and/or interest are abated, this accrual may decrease significantly.

Debt

($ In Thousands)	September 30, 2005			December 31, 2004
	(Unaudited)
Minimum deferred payment obligations:
Texcel acquisition	$	270		$	270
MRN acquisition	67			102
Colpitt Participation Note	550			550
Colpitt Short-Term Promissory Note 1	29			—
Colpitt Line of Credit	975			—
Colpitt Short-Term Promissory Note 2	175			—
Colpitt Short-Term Promissory Note 3	100			—
Colpitt Short-Term Promissory Note 4	100			—
Colpitt Short-Term Promissory Note 5	110			—
Colpitt Short-Term Promissory Note 6	75			—
Various Short-Term Promissory Notes	75			—
Moore Short-Term Promissory Note	10			—
	2,536			922
Less current maturities	(2,522		)	(867		)
Total long-term debt	$	14		$	55

Additions to debt during 2005 represent the following:

Colpitt Short-Term Promissory Note 1 – Short-term note from the James R. Colpitt Trust with an original principal amount of $175,000, dated January 3, 2005.  This note bears interest at a rate of 12% per year.  Repayments during the nine months ended September 30, 2005, have been approximately $146,000 and interest incurred during this same period was approximately $6,000.  Mr. Colpitt and his agent were granted warrants to purchase 200,000 shares of common stock of the Company at an exercise price of $0.50 per share as additional consideration for this financing.

18

Colpitt Line of Credit – Short-term $1 million line of credit dated March 1, 2005.  This line of credit bears interest at the rate of 12% per year, and is secured by a personal non-recourse guaranty by J. Michael Moore, CEO, which guaranty is further secured by a pledge of certain assets owned by Mr. Moore.  In accordance with the line of credit agreement and a board resolution, Mr. Colpitt and Mr. Moore will receive warrants to purchase 0.25 shares of common stock for each $1.00 borrowed, with an exercise price equal to $0.02 above the closing market price on the trading date of such advance.  For each draw under the line of credit that exceeds $150,000, the Company shall issue an additional warrant to purchase 25,000 shares under the same terms as stated above.   Warrants to purchase 385,417 shares of common stock at exercise prices ranging from $0.12 to $0.47 have been issued to the Mr. Colpitt in 2005 in connection with advances on the line of credit.  Mr. Moore has been granted the same amount of warrants with the same terms during 2005.  On July 15, 2005, the Company entered into the 2^nd Amendment to the Line of Credit which increases the amount available to borrow under this line from $1 million to $1.5 million.  In accordance with this line of credit agreement, additional borrowings are subject to (i) the Colpitt Trust’s receipt of any financial information of the Company reasonably requested by the Trust, and (ii) the Colpitt Trust’s determination, in its sole but reasonable discretion, that the Company’s financial condition has not declined materially.  Thus, the availability of additional funds under this line of credit cannot be guaranteed.

Colpitt Short-Term Promissory Note 2 - On July 15, 2005, the Company received $175,000 in financing from the James R. Colpitt Trust and entered into a short-term promissory note.  This note bears interest at the rate of 10% per year and has a maturity date of July 15, 2006.  The note is secured by a personal non-recourse guaranty by J. Michael Moore, CEO, which guaranty is further secured by a pledge of certain assets owned by Mr. Moore.  The Colpitt Trust and Mr. Moore were each issued a warrant to purchase 68,750 shares of common stock at an exercise price of $0.42 as additional consideration for this financing and guaranty.  Additionally, the Colpitt Trust has the right to convert this note into 175,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

Colpitt Short-Term Promissory Note 3 - On August 10, 2005, the Company received $100,000 in financing from the James R. Colpitt Trust and entered into a short-term promissory note.  This note bears interest at the rate of 12% per year and has a maturity date of August 10, 2006, with an optional extension until August 10, 2007.  The note is secured by a personal non-recourse guaranty by J. Michael Moore, CEO, which guaranty is further secured by a pledge of certain assets owned by Mr. Moore.  The Colpitt Trust and Mr. Moore were each issued a warrant to purchase 200,000 shares of common stock at an exercise price of $0.42 as additional consideration for this financing and guaranty.  Additionally, Proliance Group was issued a warrant to purchase 50,000 shares of common stock at an exercise price of $0.42 as consideration for arranging this financing.  The Colpitt Trust has the right to convert this note into 100,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

Colpitt Short-Term Promissory Note 4 - On August 22, 2005, the Company received $100,000 in financing from the James R. Colpitt Trust and entered into a short-term promissory note.  This note bears interest at the rate of 12% per year and has a maturity date of August 22, 2006, with an optional extension until August 22, 2007.  The Colpitt Trust was issued a warrant to purchase 200,000 shares of common stock at an exercise price of $0.42 as additional consideration for this financing.  Additionally, Proliance Group was issued a warrant to purchase 50,000 shares of common stock at an exercise price of $0.42 as consideration for arranging this financing.  The Colpitt Trust has the right to convert this note into 100,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

Colpitt Short-Term Promissory Note 5 - On September 14, 2005, the Company received $110,000 in financing from the James R. Colpitt Trust and entered into a short-term promissory note.  This note bears interest at the rate of 12% per year and has a maturity date of September 14, 2006, with an optional extension until September 14, 2007.  The Colpitt Trust was issued a warrant to purchase 200,000 shares of common stock at an exercise price of $0.48 as additional consideration for this financing.  Additionally, Proliance Group was issued a warrant to purchase 50,000 shares of common stock at an exercise price of $0.48 as consideration for arranging this financing.  The Colpitt Trust has the right to convert this note into 110,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

19

Colpitt Short-Term Promissory Note 6 - On September 23, 2005, the Company received $75,000 in financing from the James R. Colpitt Trust and entered into a short-term promissory note.  This note bears interest at the rate of 2% of the principal balance or $1,500 and has a maturity date of October 3, 2005.  The Company also paid loan fees of $5,000 to the Colpitt Trust for this financing.  The Colpitt Trust has the right to convert this note into 75,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

Various Short-Term Promissory Notes - On September 19, 2005, the Company received $75,000 in financing from 3 individuals and entered into 3 separate short-term promissory notes for 25,000.  These notes bear interest at the rate of 12% per year and have a maturity date of September 19, 2006, with an optional extension until September 19, 2007.  The 3 individuals were each issued a warrant to purchase 12,500 shares of common stock at an exercise price of $0.53 as additional consideration for this financing.  Additionally, each of the individuals has the right to convert their note into 25,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

Moore Short-Term Promissory Notes - On September 19, 2005, the Company received $10,000 in financing from J. Michael Moore, CEO of the Company.  This note bears interest at the rate of 12% per year and has a maturity date of September 19, 2006, with an optional extension until September 19, 2007.  Mr. Moore was issued a warrant to purchase 5,000 shares of common stock at an exercise price of $0.53 as additional consideration for this financing.  Additionally, Mr. Moore has the right to convert this note into 10,000 shares of the Company’s common stock at any time prior to the maturity date in lieu of payment.

Shareholder’s Equity (Deficit)

The Company had a $215,000 note receivable from a former officer that was secured by 141,000 shares of common stock of the Company.  Under the note receivable and at the option of the borrower, the principal and interest balance of up to $215,000 can be paid by the surrender of these shares to the Company.  In the 1^st quarter of 2005, we received a demand letter from the former officer to execute this option.  During the 2^nd quarter, we received the paperwork necessary to transfer the shares to the Company and into treasury stock.  The remaining principal balance of approximately $11,000 has been moved to other current assets.

Common Stock

On June 29, 2005, the Board of Directors approved an increase in the number of authorized common shares from 10 million to 50 million.  This change was approved at the Company’s 2005 Annual Shareholders Meeting on October 28, 2005, and has been reflected in the current financial statements.

On July 20, 2005, the Board of Directors of the Company approved the 2005 Non-Qualified Stock Option Plan.  The number of shares authorized for issuance pursuant to awards granted under the plan is up to 1.5 million.  This plan was approved at the Company’s 2005 Annual Shareholders Meeting.

In September 2005, the Company’s common stock commenced trading on the OTC Bulletin Board.

NOTE 8 – COMMITMENTS AND CONTINGENCIES

The Company is involved in various legal proceedings arising in the normal course of business.  Management believes the outcome of these matters will not materially adversely affect the financial condition, results of operations or cash flows of the Company.

Payroll tax liabilities incurred of approximately $3,567,000 have not been paid (excluding any penalty and interest payments due on the underpayment) through the November 3, 2004 payroll (see Note 2).  Until the past due balance is repaid and our negotiations with the IRS are complete, we are unsure at this time of the total amount of penalties and interest we will pay.  At September 30, 2005, the Company

20

had approximately $1,091,000 in penalties and interest accrued for the past due payroll taxes.  Since entering into the subordination agreement with the IRS (see Note 2), the Company has paid all federal payroll taxes due after that date on a timely basis.  If the Company does not timely pay all payroll taxes, the subordination agreement will be terminated and our senior lenders will not continue to fund the Company.

Certain amounts had not been remitted related to the Company’s 401(k) plan.  At September 30, 2005, approximately $301,000 of contributions to the 401(k) plan had not been paid for the period from October 2004 to September 2005.  There may be some liability for penalties related to the late payment of these amounts.  We cannot at this time estimate the amount of those penalties, if any.

In addition, some deferred compensation payments for employees had not been made to the administrator of that plan.  The amount unpaid at September 30, 2005 was approximately $45,000 for contributions from May 2004 to September 2005.  There may be some liability for penalties related to the late payment of these amounts.  We cannot at this time estimate the amount of those penalties, if any.

NOTE 9 – SUBSEQUENT EVENTS

Annual Shareholders Meeting

The Company held its 2005 Annual Shareholders Meeting on October 28, 2005.  The following proposals were approved at the meeting:

•Election of Directors

•Increase in the number of authorized shares of common stock from 10 million to 50 million

•Appointment of Pender Newkirk & Company as independent accountants for the year ended December 31, 2005

•Approval of certain actions taken by the Board of Directors in connection with the 1998 Non-Employee Director Stock Option Plan

•Approval of the 2005 Nonqualified Stock Option Plan

21

ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS

OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

DIVERSIFIED CORPORATE RESOURCES, INC. AND SUBSIDIARIES

MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SEPTEMBER 30, 2005

(dollars rounded to thousands, except per share amounts)

Overview

We are a nationwide human resources and employment services firm, providing staffing solutions in specific professional and technical skill sets to Fortune 500 corporations and other large organizations.  We offer two kinds of staffing solutions: direct placement services and temporary and contract staffing.

We currently operate offices in the following locations:

Arizona	Phoenix
California	Palm Desert
Colorado	Denver
Georgia	Atlanta
Pennsylvania	Philadelphia
Texas	Dallas, Houston and Austin

The offices are responsible for marketing to clients, recruitment of personnel, operations, local advertising, initial customer credit evaluation and customer cash collection follow-up.   Our executive offices, located in Dallas, Texas, provide corporate governance and risk management, as well as certain other accounting and administrative services, for our offices.

We believe that we will be unable to continue as a going concern for the next twelve months without obtaining additional funds through debt or equity financing or through the sale of assets.  See “Liquidity and Capital Resources” below for a discussion of our ability to continue as a going concern and our plans for addressing those issues.  The inability to obtain additional funds could have a material adverse effect on the Company.

Transformation of Our Business

The changing environment of the job market over the past four years has caused staffing companies to either change with the times or perish.  To adjust with the trends, we have:

•Shifted our revenue mix to focus more on temporary and contract staffing services rather than direct placements;

•Eliminated excess overhead of maintaining local offices to serve customers and realigned our geographic presence into regional offices;

•Exited the high risk telecommunications industry through the sale of one of our agencies in December 2002, and emphasized our servicing to the healthcare industry;

•Focused our sales force on Fortune 500 companies; and

•Reduced fixed expenses to better align our cost structure with lower margin temporary and contract staffing services.

As a result of the changes discussed above, we have largely transformed the Company from its historical roots in direct placement services and dependence on the telecommunications industry to a more balanced revenue model revolving around contract staffing in various industries.  For most of our existence, we routinely generated 80% or more of our annual revenues from direct placement activities.  While the direct placement business is typically capable of generating net margins after commissions of approximately 50%, the revenues are volatile and difficult to forecast and finance.  By the end of 2004, we had

22

largely shifted the composition of our revenues, with 61% of our revenues generated through temporary and contract staffing and 39% of our revenues from direct placement activities.  We have continued this shift during 2005 with 70% of our revenue being generated through temporary and contract staffing services for the nine months ended September 30, 2005.  We have also diversified our industry base targeting high-growth areas, such as the bio-pharmaceutical industry and contract nurse staffing, to augment our more traditional information technology and engineering base.

These strategic changes require us to evaluate our fixed costs to be more in line with our new revenue model.  Gross margins for the quarter ended September 30, 2005, decreased to 49% of revenue as compared to 56% of revenue in the prior year.  For the nine months ended September 30, 2005, gross margins have decreased to 51% of revenue as compared to 54% in 2004.  Direct placement revenues for the quarter ended September 30, 2005, were 27% of total revenue as compared to 40% of total revenue in 2004.  Direct placement revenues for the nine months ended September 30, 2005, have decreased to 30% of total revenue as compared to 37% in 2004.  General and administrative expenses for the quarter ended September 30, 2005, decreased by $0.7 million from 40% of revenues or $2.6 million in 2004, to 36% of revenues or $1.8 million during 2005.  For the nine months ended September 30, 2005, the reduction in costs for the Company have become quite evident as general and administrative expenses have decreased by $2.7 million from 48% of revenues or $8.4 million in 2004, to 36% of revenues or $5.7 million in 2005.  Management expects general & administrative expenses to remain in the 35% - 40% range of revenues in 2005 as we continue to work on cost cutting measures.

We are implementing other plans, as discussed in “Liquidity and Capital Resources” below, which we believe will help solve our current liquidity problems and allow us to improve our cash flow from operations over the next year.  If these changes are not accomplished, we may be unable to continue as a going concern.

Proposed Sale of Datatek

We are in discussions to sell Datatek Group Corporation (“Datatek”), a wholly-owned subsidiary of the Company.  Datatek is primarily involved in temporary and contract staffing and represented approximately 60% of our 2004 temporary and contract staffing gross revenue.  We are reporting Datatek as a discontinued operation in accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets.  If a sale of Datatek is consummated, it should provide needed funds to pay most, if not all, of our past due payroll tax liabilities.  The agency derives most of its revenues from temporary and contract information technology staffing.  A Datatek sale would greatly improve our immediate financial condition; however, it will also remove a significant source of revenue which will have a negative impact on our immediate operating results.  This means that we would have to seek additional revenues through further acquisitions or lower our fixed costs dramatically in order to achieve future profitability.  Because negotiations are in the early stages, the Company cannot be assured that a sale will occur.

Restructuring

In late June 2004, the Board approved a several phase restructuring plan submitted by upper management to reduce costs of the Company on a going-forward basis.  Since severance pay was offered in association with layoffs that occurred in the 3^rd quarter and some phases of the restructuring occurred in later periods, the primary effects of the cost savings were not noticeable until 2005.  Total operating expenses have decreased approximately $3.9 million or 27% in the nine months ended September 30, 2005 as compared to the same period in 2004.  Every office and agency of the Company was evaluated resulting in:  (i) the closure of several under-performing sales offices and agencies, (ii) the downsizing of staff, (iii) newly negotiated contracts at lower rates, including certain leases, and (iv) other cost saving measures.  All of these measures have been implemented to improve operating results, lower losses, improve cash, demonstrate operating efficiencies, and increase our ability to raise future capital.  However, no assurance can be given that this lowered operating expense will continue in this trend in the future.

23

Our Position in the Industry

The staffing industry is highly fragmented with numerous national, regional and small local firms all competing.  Many of these smaller companies either have not repositioned themselves for the changing marketplace or lack the financial resources to continue after four extremely difficult recession years.  As noted, we face competition from several competitors who are larger and have greater financial resources. However, we believe that we have several favorable attributes which give us an advantage over smaller competitors:

•a superior growing database of approximately 850,000 highly specialized individuals in the technology, engineering and healthcare industries;

•the ability to attract Fortune 500 clients; and

•our leadership within the industry organization, National Association of Personnel Services (“NAPS”).

We believe that the worst of the economic downturn is behind us and the industry is primed for increased consolidation.  Accordingly, we believe we are making changes that will leave us well positioned to take advantage of these industry consolidation trends.

Future Growth through Acquisitions

Management decided to move decisively into the healthcare industry by establishing a discreet Healthcare sector, focusing initially on allied health, nursing (credentialed and non-credentialed) and pharmaceutical specialists.  We continue to believe that general demographic trends, forecasted employment trends and the fragmented nature of the healthcare staffing industry favor sustained growth and acceptable margins.  As a result, during the first quarter of 2003, we formed several new operating agencies collectively called Magic Healthcare. We began recruiting professionals from the industry, as well as identifying those individuals within our Company with prior experience in this sector, to specialize in this area.  We also began looking for acquisitions and/or affiliations within the healthcare sector.  The acquisition of the assets of MRN in February 2004 was part of this focus.  In the direct placement market, we have placed additional emphasis on the Bio/Pharm market which has shown and, we believe, will continue to show strong internal growth.

Notwithstanding a Datatek sale which would be designed to provide us with much needed liquidity, we are committed to an acquisition policy going forward.  With the growing industry trend towards lower-margin contract and temporary staffing, size matters.  Management has mapped out a plan to make selective acquisitions, assuming we are able to obtain financing, to re-establish the Company as a nationwide staffing firm and leverage its customer base into new geographical regions.  More importantly, as the size of the company’s revenues increase, fixed costs as a percentage of revenues should decrease.  Although there is no guarantee that this strategy will succeed, we believe that this is the best strategy for the future of the Company.  To achieve this growth, we will have to issue additional equity and/or obtain acquisition financing.  We cannot assure you that we will be able to issue additional equity or obtain additional financing, that we will be able to compete successfully with other companies in acquisitions, or that any acquisition we make will be accretive to our earnings or cash flow.

24

RESULTS OF OPERATIONS

The Three Months Ended September 30, 2005 Compared to the Three Months Ended September 30, 2004

Service Revenues and Gross Profit

($ in thousands)	2005		2004		Difference
For the three months ended September 30,
Direct placements	$	1,366	$	2,536	$	(1,170	)
Temporary and contract staffing	3,757		3,872		(115		)
Net service revenues	5,123		6,408		(1,285		)
Direct costs of temporary and contract staffing	2,636		2,829		(193		)
Gross profit	$	2,487	$	3,579	$	(1,092	)

For the three months ended September 30, 2005, net service revenues decreased $1,285,000, or 20.1%, to $5,123,000 as compared to $6,408,000 for the three months ended September 30, 2004.  Revenues from contract and temporary staffing decreased $115,000, or 3.0%, while direct placement revenue decreased $1,170,000, or 46.1%.  To offset the lack of hiring of permanent employees, management has focused on our temporary and contract staffing business.  In 2005, temporary and contract staffing revenue has grown to approximately 73.3% of total revenue as compared to 60.4% in 2004.  (Reporting Datatek on a discontinued operation basis eliminated approximately $4.1 million of our temporary and contract staffing revenue in 2005 and $5.0 million of our temporary and contract staffing revenue in 2004.)

For the three months ended September 30, 2005, gross profit decreased by $1,092,000 or 30.5% to $2,487,000, as compared to $3,579,000 for the three months ended September 30, 2004.  Since sales expense on direct placements are accounted for as an operating expense, the gross margins on direct placements are typically 100% of sales.  Therefore, when direct placement revenues declined from 2004 to 2005, our gross profit registered a corresponding decline as well.  For the quarter ended September 30, 2005, the decline in direct placement revenues of $1,170,000 was partially offset by an increase of $78,000 in gross profit from temporary and contract staffing.  Temporary and contract staffing margins generally range anywhere from 15% to 36%, depending on our level of overall involvement in the contract.  For the quarter ended September 30, 2005, gross margin on our temporary and contract staffing business increased to 29.8%, as compared to 26.9% in 2004.  The Company has recently focused its efforts on temporary staffing business yielding 30% - 60% gross margins which has helped increase overall temporary and contract margins.  (Reporting Datatek on a discontinued operation basis eliminated approximately $554,000 of gross profit in 2005, as compared to $862,000 in 2004.)

Operating expenses

Operating expenses amounted to $3,472,000 for the three months ended September 30, 2005, a decrease of $1,351,000 or 28.0%, as compared to the three months ended September 30, 2004.  Operating expenses for the three months ended September 30, 2005, included $1,513,000 of selling expenses, a decrease of $600,000 or 28.4%, as compared to $2,113,000 for the three months ended September 30, 2004.  The decrease was due primarily to a decrease in commissions as a direct result of the sales decrease and a decrease in manager salaries & bonuses as a result of the restructuring done in 2004 and the decreased sales in 2005.  In addition, general and administrative expenses decreased by $745,000 or 28.8%, as compared to the previous year.  Primary contributors to this decrease were approximately $376,000 in decreased expenses as a result of the restructuring done in 2004 (salaries, rent, telephone, office supplies, equipment leases, travel & entertainment, advertising, etc.), a $191,000 decrease in general liability and group insurance costs due primarily to lower employee claims experienced in 2005 and less employees covered under the plan due to the restructuring done in 2004, a $140,000 decrease in non-recurring penalties accrued in the 3^rd quarter of 2005 due to the late payment of taxes, and a decrease of $90,000 in legal fees due primarily to decreased billings

25

from litigation settled in the 2^nd quarter of 2005.  (Operating expenses for Datatek were approximately $327,000 for the quarter ended September 30, 2005 as compared to $211,000 in 2004.)

We recorded a stock-based employee compensation charge of approximately $65,000 in the 3^rd quarter of 2005 as compared to approximately $30,000 in 2004 to reflect the expensing of options pursuant to the adoption of fair value accounting for stock-based employee compensation.  Depreciation and amortization expense decreased to $52,000 as compared to $93,000 in the previous year.  The decrease in expense is primarily the result of the increase in property and equipment that is fully-depreciated.

Other expense items

For the three months ended September 30, 2005, net interest expense increased by $36,000 to $375,000, due primarily to the higher cost of our borrowings, the increase in notes payable to $2,536,000 at September 30, 2005, as compared to $647,000 at September 30, 2004, and the cost of warrants issued to reduce cash outflows on financing costs.  The cost of warrants issued on the short-term notes entered into in the 3^rd quarter of 2005 is being expensed over the life of the loans which is primarily 1 year.  (Other expense items for Datatek consisted of interest expense and were approximately $115,000 in 2005 as compared to approximately $119,000 in 2004.)

Income Taxes

We did not report any income tax benefit from our losses before income taxes in the current or prior year due to our determination that we would not be able to realize the full benefit of our deferred tax assets.

Income from discontinued operations

In accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we are reporting our Datatek subsidiary as discontinued operations for all periods presented.  For the quarter ended September 30, 2005, income from discontinued operations decreased to $113,000 as compared to $532,000 in the previous year quarter.  This decrease was primarily the result of revenue decreasing by approximately $896,000 during the 3^rd quarter of 2005 due to a major contract staffing project that began before 2003 that was completed in the 4^th quarter of 2004.

Dividends on Preferred Stock

We issued preferred stock in March 2004.  The dividend on the preferred stock is due quarterly and is cumulative.  The Board of Directors has not declared or authorized payment of the dividends that have accrued to September 30, 2005.  However, the results of operations have been adjusted to reflect the amount of dividends that would be due had they been declared.

26

The Nine Months Ended September 30, 2005 Compared to the Nine Months Ended September 30, 2004

Service Revenues and Gross Profit

($ in thousands)	2005		2004		Difference
For the nine months ended September 30,
Direct placements	$	4,812	$	6,499	$	(1,687	)
Temporary and contract staffing	11,079		11,107		(28		)
Net service revenues	15,891		17,606		(1,715		)
Direct costs of temporary and contract staffing	7,755		8,124		(369		)
Gross profit	$	8,136	$	9,482	$	(1,346	)

For the nine months ended September 30, 2005, net service revenues decreased $1,715,000 or 9.7%, to $15,891,000 as compared to $17,606,000 for the nine months ended September 30, 2004.  To offset the lack of hiring of permanent employees, management has focused on growing our temporary and contract staffing business.  In 2005, temporary and contract staffing revenue has grown to approximately 70% of total revenue as compared to 63% in 2004. (Reporting Datatek on a discontinued operation basis eliminated approximately $12.4 million of our temporary and contract staffing revenue for the nine months ended September 30, 2005, and $15.8 million of our temporary and contract staffing revenue for the nine months ended September 30, 2004.)

For the nine months ended September 30, 2005, gross profit decreased by $1,346,000 or 14.2% to $8,136,000, as compared to $9,482,000 for the nine months ended September 30, 2004.  For the nine months ended September 30, 2005, the decline in direct placement revenues of $1,687,000 was partially offset by an increase in gross profit of $341,000 from temporary and contract staffing.  For the nine months ended September 30, 2005, gross profit as a percent of service revenue decreased to 51.2% of total revenue, as compared to 53.9% of revenue for the nine months ended September 30, 2004.  For the nine months ended September 30, 2005, gross margin on our temporary and contract staffing business increased to 30.0%, as compared to 26.9% in 2004.  (Reporting Datatek on a discontinued operation basis eliminated approximately $1,775,000 of gross profit for the nine months ended September 30, 2005, as compared to $2,349,000 of gross profit for the nine months ended September 30, 2004.)

Operating expenses

Operating expenses amounted to $10,772,000 for the nine months ended September 30, 2005, a decrease of $3,898,000 or 26.6%, as compared to the nine months ended September 30, 2004.  Operating expenses for the nine months ended September 30, 2005, included $4,805,000 of selling expenses, a decrease of $974,000 or 16.9%, as compared to $5,779,000 for the nine months ended September 30, 2004.  The decrease was due primarily to a decrease in commissions due to lower sales in 2005 as compared to 2004 and lower manager compensation as a result of the restructuring that was done in 2004 and the lower sales in 2005.  In addition, general and administrative expenses decreased by $2,716,000 or 32.4%, as compared to the previous year.  Primary contributors to this decrease were approximately $943,000 in decreased expenses as a result of the restructuring done in 2004 (salaries, rent, telephone, office supplies, equipment leases, travel & entertainment, advertising, etc.), an $853,000 decrease in general liability and group insurance costs due primarily to lower employee claims experienced in 2005 and less employees covered under the plan due to the restructuring done in 2004, a $693,000 decrease in professional fees primarily related to the non-recurring increased audit fees during 2004, a $369,000 decrease in non-deductible penalties and interest due to the late payment of taxes in 2004, and a $164,000 decrease in investor relations expenses due to cost cutting efforts in 2005.  These decreases were partially offset by a $320,000 increase in legal fees for the year primarily due to increased billings on litigation settled in the 2^nd quarter of 2005.  Management expects general & administrative expenses to remain in the 35% - 40% range of revenues in 2005 as we continue to work on cost cutting measures.  (Operating expenses for Datatek were approximately $915,000 in 2005 as compared to $894,000 in 2004.)

27

We recorded a stock-based employee compensation charge of approximately $107,000 in the nine months ended September 30, 2005 as compared to approximately $153,000 in 2004 to reflect the expensing of options pursuant to the adoption of fair value accounting for stock-based employee compensation.  Depreciation and amortization expense decreased to $181,000 in 2005 as compared to $343,000 in the previous year.  The decrease in expense is primarily the result of the increase in property and equipment that is fully-depreciated.

We expect that total operating expenses will decrease in 2005 for the year as compared to 2004.

Other expense items

For the nine months ended September 30, 2005, net interest expense increased by $380,000 to $1,127,000, due primarily to the higher cost of our borrowings, the increase in notes payable to $2,536,000 at September 30, 2005, as compared to $647,000 at September 30, 2004, and the cost of warrants issued to reduce cash outflows on financing costs.  The cost of warrants issued on the short-term notes entered into in the 3^rd quarter of 2005 is being expensed over the life of the loans which is primarily 1 year.  In 2004, we had a gain on the early extinguishment of a debt related to the purchase of one of our agencies.  (Other expense items for Datatek consisted of interest expense and were approximately $408,000 in 2005 as compared to approximately $404,000 in 2004.)

Income Taxes

We did not report any income tax benefit from our losses before income taxes in the current or prior year due to our determination that we would not be able to realize the full benefit of our deferred tax assets.

Income from discontinued operations

In accordance with FAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we are reporting our Datatek subsidiary as discontinued operations for all periods presented.  For the nine months ended September 30, 2005, income from discontinued operations decreased to $452,000 as compared to $1,052,000 in the prior year.  This decrease was primarily due to a major contract staffing project that began before 2003 that was completed in the 4^th quarter of 2004.

Accretion of Discount and Dividends on Preferred Stock

We issued preferred stock in March 2004.  For 2004, we accreted discount equal to the value assigned to the embedded conversion feature in the preferred stock.  Since the preferred stock is not redeemable except upon the happening of certain remote contingencies, we believe that there will be no additional amortization of discount in future periods.  The dividend on the preferred stock is due quarterly and is cumulative.  The Board of Directors has not declared or authorized payment of the dividends that have accrued to September 30, 2005.  However, the results of operations have been adjusted to reflect the amount of dividends that would be due had they been declared.

LIQUIDITY AND CAPITAL RESOURCES

Cash on hand at September 30, 2005 was $3,000.  Because all cash receipts are deposited into our lockboxes and swept daily by our lender, combined with our policy of maintaining zero balances in our operating accounts, we maintain only a minimal amount of cash on hand.  Cash flows from financing activities during the year totaled $1,495,000, principally from an increase in borrowings under debt obligations of $1,785,000.  Cash used by investing activities of $14,000 represented funds used for capital expenditures.  Cash used in operating activities was $1,482,000.

As a result of the recession that started in 2000 and the impact it has had on the direct placement and temporary staffing industry, our revenues have declined approximately 67% from levels achieved in 2000.  We reported net losses for the last four fiscal years as a result of the decline in our business, and

28

expect to report a net loss for the 2005 fiscal year.  In addition, our current liabilities of $14.6 million exceed our current assets of $3.8 million.

 The Company currently finances itself through factoring of, or lines of credit based on, its accounts receivable.  The amount of funds available under these agreements depends on the amount of accounts receivable accepted by the lenders.  We operate with minimal cash balances as all cash receipts are deposited into our lockboxes, which are swept daily by our lenders.  While we have generally sought to borrow the maximum amounts available from these facilities during 2005, the facilities have been inadequate in providing enough funds to maintain operations, which has resulted in our having to use other measures to continue to fund operations.

During 2004, we reduced staff and closed agencies to reduce the funds outflow.  We had also not paid all employer and employee payroll taxes when due.  The amount of unpaid payroll taxes is approximately $3,567,000 plus penalties and interest.  As a result of these past due payroll tax liabilities, we are in default under one of our lending agreements.  In addition, we are funding operations by not paying all vendors for products and services under normal credit terms, including payments on capital leases and other debt.  The consequences of some of these actions have or may result in penalties and/or fines for late payments or may involve legal actions against us.  However, our management believed that these steps were necessary at the time to maintain the Company while we sought to correct our cash flow issues.

In October 2004, the Internal Revenue Service (the “IRS”) placed a lien on the assets of two of our subsidiaries.  The Company and the IRS reached an agreement that subordinates the claims by the IRS to those of our senior lenders so that they can continue to fund our operations.  Our lenders are continuing to fund us.  The Company has entered into a second amendment with one lender that acknowledges the extended subordination agreement with the IRS.  We do not have a formal agreement with our other senior lender, but this lender has continued to fund.  Currently, both lenders may demand repayment at any time.  If we fail to pay all future federal payroll tax liabilities arising after the subordination agreement on a timely basis, the subordination agreement will expire and our senior lenders will stop funding our operations.  This would have a material adverse effect on our ability to continue as a going concern.

We have completed, or are seeking to complete, certain transactions which will partially address the going concern issues we face.

In the 4^th quarter of 2004, the Company received a short-term loan from the James R. Colpitt Trust (the “Colpitt Trust”) that was structured as a $550,000 participation loan in the Greenfield Line of Credit.  In the 1^st and 2^nd quarters of 2005, the Company has received additional loans from the Colpitt Trust in the form of a $175,000 promissory note and a $1 million line of credit.  The balance of the promissory note was approximately $30,000 as of September 30, 2005, and the advances on the line of credit totaled $975,000 for the nine months ending September 30, 2005.  In the 3^rd quarter of 2005, the Company received additional loans of $560,000 from the Colpitt Trust and has amended the line of credit agreement to increase the amount available to borrow from $1 million to $1.5 million.  In accordance with this line of credit agreement, additional borrowings are subject to (i) the Colpitt Trust’s receipt of any financial information of the Company reasonably requested by the Trust, and (ii) the Colpitt Trust’s determination, in its sole but reasonable discretion, that the Company’s financial condition has not declined materially.  Thus, the availability of additional funds under this line of credit cannot be guaranteed.  The Company has also received short-term loans of $75,000 in the 3^rd quarter of 2005 from 3 separate individuals and has received a $10,000 short-term loan from J. Michael Moore, CEO of the Company.  These short-term loans have helped to offset our cash flow issues in 2005 which have been caused primarily by the decline in direct placement revenues.

In the 1^st quarter of 2005, J. Michael Moore, CEO, repaid approximately $324,000 in notes receivable due to the Company.

As discussed above, the Company has generally sought to borrow the maximum amounts available under the factoring and line of credit agreements that are based on our accounts receivable.  During the

29

4^th quarter of 2004 and the 1^st quarter of 2005, the Company has amended the Greenfield line of credit agreement which has increased the borrowings available under this line of credit.

The Company has been focused on reducing expenses in 2004 and 2005.  Based on these efforts, we have reduced operating expenses by approximately $3.9 million for the first nine months of 2005 as compared to the same period in the prior year.

If a sale of Datatek is consummated, the cash received should be adequate to repay most, if not all, of the past due payroll tax liabilities.  We cannot give any assurance at this time that a sale will occur.  Datatek is primarily involved in information technology temporary and contract staffing and represents approximately 53% of our 2005 year to date temporary and contract staffing revenue.

We are continuing to evaluate various other financing and restructuring strategies, including merger candidates and investments through private placements, to maximize shareholder value and to provide assistance in pursuing alternative financing options in connection with our capital requirements and business strategy.  We will also seek acquisitions to replace the revenues lost from a Datatek sale by acquiring small companies where we can absorb their back office operations into our own.  There can be no assurance that we will be successful in implementing the changes necessary to accomplish these objectives, or if we are successful, that the changes will improve our cash flow and liquidity.

If a Datatek sale takes place, management believes that we will be able to secure other financing that will allow us to pursue our acquisition strategy, which, when combined with improving market conditions and the restructuring of our present businesses, should eventually produce enough new revenues and gross profit to cover the operating funds shortfall we are currently experiencing.  However, we cannot guarantee that funds will be available, that any acquisitions will, if made, be accretive to our cash flow, or that our creditors will give us the time needed to implement our plan.

Our common stock was delisted on February 9, 2005, and was trading sporadically on the “pink sheets” inter-dealer trading network until September 2005.  In September 2005, the Company’s common stock commenced trading on the OTC Bulletin Board.  The loss of the AMEX listing has made our ability to use our common stock in acquisitions substantially more difficult.  The inability to obtain additional financing will have a material adverse effect on our financial condition.  It may cause us to delay or curtail our business plans or to seek protection under bankruptcy laws.

Our continuation as a going concern is dependent upon our ability to obtain additional financing and, ultimately, to attain and maintain profitable operations.

CRITICAL ACCOUNTING POLICIES

Revenue Recognition and Cost of Services

We derive our revenues from two sources: direct placement and temporary and contract staffing.  We record revenues for temporary and contract staffing services at the gross amount billed the customer in accordance with EITF 99-19, Reporting Revenues Gross as a Principal Versus Net as an Agent.  We believe this approach is appropriate because we identify and hire qualified employees, select the employees for the staffing assignment, and bear the risk that the services provided by these employees will not be fully paid by customers.

Fees for direct placement of personnel are recognized as income at the time the applicant accepts employment.  Revenue is reduced by an allowance for estimated losses in realization of such fees (principally due to applicants not commencing employment or not remaining in employment for the guaranteed period).  Fees charged to clients are generally calculated as a percentage of the new employee’s annual compensation.  There are no direct costs for direct placements.  Commissions paid by us related to direct placements are included in selling expenses.

30

Revenues from temporary and contract staffing are recognized upon performance of services.  The direct costs of these staffing services consist principally of direct wages and related payroll taxes.

Allowances on Accounts Receivable

The Company accrues an allowance for estimated losses on the realization of direct placement fees (principally due to applicants not commencing employment or not remaining in employment for the guaranteed period) and an allowance for doubtful accounts for potential losses due to credit risk.  The Company establishes the allowance for estimated losses on direct placement fees based on historical experience and charges the allowance against revenue.  The allowance for doubtful accounts is based upon a review of specific customer balances, historical losses and general economic conditions.  Actual losses may be different than the estimates used to calculate the allowances.

Stock-Based Employee Compensation

In the fourth quarter of 2003, effective January 1, 2003, the Company adopted the fair value recognition method of accounting for stock-based employee compensation.  Under the modified prospective method of adoption selected by us, stock-based employee compensation cost recognized since the adoption is the same as that which would have been recognized had the fair value method been applied to all options granted, modified or settled after December 31, 1994.  The actual expense charge depends on the method and factors used to calculate the fair value of the options at their grant date.  We begin recognizing such compensation cost as if all grants will entirely vest.

Prior to our adoption of the fair value method, the Company elected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees.  Under APB 25, no compensation expense was normally recognized for options granted because their exercise price usually equaled the market price of the underlying stock on the date of grant.

Self-Insurance Reserves

We are self-insured for our employee medical coverage.  Provisions for claims under the self-insured coverage are based on our actual claims experience using actuarial assumptions followed in the insurance industry, after consideration of excess loss insurance coverage limits.  Management believes that the amounts accrued are adequate to cover all known and incurred but unreported claims.

Goodwill, Non-Compete Agreements and Property and Equipment

These assets are subject to periodic review to determine our ability to recover their cost.  We must make estimates about their recovery based on future cash flows and other subjective data.  We, in the future, may determine that some of these costs may not be recoverable, which may require us to adjust their capitalized value by writing off all or a portion of their value.  We may also determine that the lives being used to amortize property and equipment do not reflect actual usage of these assets and may adjust their value accordingly.

Income Taxes

Deferred income taxes are provided for temporary differences between the basis of assets and liabilities for tax and financial reporting purposes.  A valuation allowance is established for any portion of the deferred tax asset for which realization is not likely.  We maintain a 100% valuation allowance against our deferred tax assets currently.  The valuation allowance is subject to periodic review, and we may determine that a portion of our deferred tax asset may be realizable in the future.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29.   The guidance in APB Opinion No. 29, Accounting for Nonmonetary

31

Transactions, is based on the principle that exchanges of nonmonetary assets should be measured based on the fair value of the assets exchanged.  The guidance included certain exceptions to that principle.  This statement amends Opinion No. 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance.  A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange.  This statement shall be effective for nonmonetary exchanges occurring in fiscal periods beginning after June 15, 2005.  We do not believe that the adoption of this statement will have a material effect on our financial statements.

FORWARD-LOOKING STATEMENTS

Certain statements in this Form 10-Q are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the Securities Exchange Act of 1934.  The words “estimate,” “continue,” “may,” “should,” “plan,” “intend,” “expect,” “anticipate,” “believe” and similar expressions are intended to identify forward-looking statements.  Such statements reflect our current views with respect to future events and involve known and unknown risks, uncertainties and other factors that may cause our actual results, levels of activity, performance or achievements to be materially different from what management currently believes.  Although we believe that our expectations are based on reasonable assumptions, we can give no assurance that these future events will transpire as expected.  Such risks and uncertainties include, among other things, those described herein and in the “Risk Factors” section and elsewhere in our Form 10-K for the year ended December 31, 2004, which should be read in conjunction with this Form 10-Q.  Should one or more of those risks and uncertainties materialize, or should underlying assumptions prove incorrect, our actual results may vary materially from those described herein.  Subsequent written and oral “forward-looking” statements attributable to the Company, or persons acting on its behalf, are expressly qualified by the Risk Factors.  We disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The Company is exposed to market risks from fluctuations in interest rates and the effects of those fluctuations on the earnings of its cash equivalent short-term investments, as well as interest expense on its line of credit borrowings.  The factoring liability is not based directly on current rates; the factor takes a fee based on a set percentage of the outstanding balance of the accounts receivable accepted.  The Company has no material cash equivalent investments so its interest income is not materially impacted by changes in interest rates.  The Greenfield line of credit and the Colpitt Participation Note are based on prime so that a 1% increase in the prime rate would have an approximately $6,000 impact on our interest expense each quarter based on the average amount borrowed at September 30, 2005.

ITEM 4.  CONTROLS AND PROCEDURES

 At the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of Company’s management, including the principal executive officer and principal financial officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)).  Our principal executive officer and principal financial officer concluded that the Company’s disclosure controls and procedures were effective in timely accumulating, processing, recording and communicating to them material information related to the Company and its consolidated subsidiaries that are required to be disclosed by the Company in reports that it files or submits under the Exchange Act.

The Company’s principal executive officer and principal financial officer believe that the procedures followed by the Company provide the necessary assurance that there are no material misstatements in the Company’s audited consolidated financial statements on Form 10-K or in the Company’s unaudited

32

condensed consolidated financial statements included in this report on Form 10-Q for the quarterly period ended September 30, 2005.  Management believes that there have not been any changes in the Company’s internal controls over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) during the quarter covered by this report that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

PART II – OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS

In September 2005, a settlement was reached in the case known as Oxford Global Resources, Inc. v. Michelle Weekley-Cessnum, et.al. Civil Action No 3:04-CV-0330-N.  Terms of the settlement include the payment of a nominal amount from Management Alliance Group to the attorneys for Oxford.

The Company is involved in various legal proceedings arising in the normal course of business.  Management believes the outcome of these matters will not materially adversely affect the financial condition, results of operations or cash flows of the Company.

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

Warrants

On July 15, 2005, warrants to purchase 68,750 shares of common stock at an exercise price of $0.42 were issued to the Colpitt Trust and Mr. Moore as consideration for the $175,000 short-term borrowing from the Colpitt Trust and the personal guaranty and assets pledged by Mr. Moore for this borrowing.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On August 1, 2005, warrants to purchase 85,000 shares of common stock at an exercise price of $0.42 were issued to a consultant as consideration for past and future investor relations services provided to the Company.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On August 10, 2005, warrants to purchase 200,000 shares of common stock at an exercise price of $0.42 were issued to the Colpitt Trust and Mr. Moore as consideration for the $100,000 short-term borrowing from the Colpitt Trust and the personal guaranty and assets pledged by Mr. Moore for this borrowing.  Additionally, warrants to purchase 50,000 shares of common stock at an exercise price of $0.42 were issued to the Proliance Group for arranging this financing.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On August 18, 2005, warrants to purchase 50,000 shares of common stock at an exercise price of $0.42 were issued to a consultant as consideration for past and future legal services provided to the Company.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On August 22, 2005, warrants to purchase 200,000 shares of common stock at an exercise price of $0.42 were issued to the Colpitt Trust as consideration for a $100,000 short-term borrowing.  Additionally, warrants to purchase 50,000 shares of common stock at an exercise price of $0.42 were issued to the Proliance Group for arranging this financing.  Neither the issuance of the warrants nor the shares to be issued

33

upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On September 14, 2005, warrants to purchase 200,000 shares of common stock at an exercise price of $0.48 were issued to the Colpitt Trust as consideration for a $110,000 short-term borrowing.  Additionally, warrants to purchase 50,000 shares of common stock at an exercise price of $0.42 were issued to the Proliance Group for arranging this financing.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On September 19, 2005, warrants to purchase 12,500 shares of common stock at an exercise price of $0.53 were issued to three separate individuals in consideration for three separate $25,000 short-term loans.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

On September 19, 2005, warrants to purchase 5,000 shares of common stock at an exercise price of $0.53 were issued to J. Michael Moore, CEO of the Company, in consideration for a $10,000 short-term loan.  Neither the issuance of the warrants nor the shares to be issued upon exercise of these warrants have been registered under the Securities Act.  The issuance was exempt from registration pursuant to Section 4(2) of the Securities Act.

Options

On July 20, 2005, the Board of Directors of the Company approved the 2005 Non-Qualified Stock Option Plan.  The number of shares authorized for issuance pursuant to awards granted under the plan is up to 1.5 million and this plan was approved at the Company’s 2005 Annual Shareholders Meeting on October 28, 2005.  Also on July 20, 2005, the Board of Directors granted a total of 1,216,750 options to employees and non-employee directors of the Company under the 2005 Plan and the existing stock option plans.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES

Dividends due on the Company’s Series A convertible preferred stock, par value $10, of $52,969 have not been declared or paid for the quarter ended September 30, 2005.  The cumulative arrearage from the date of issuance through September 30, 2005, amounts to $325,379 or $1.536 per share of Preferred Stock outstanding.

ITEM 5.  OTHER INFORMATION

The Company’s common stock was traded on the American Stock Exchange (“AMEX”) under the symbol “HIR”.  We asked the AMEX to halt trading in our common stock on June 4, 2004, to prevent trading until the Company had made public certain material information.  The halt in trading continued in place until November 9, 2004, when the AMEX suspended trading in our common stock as part of a process to delist our common stock for being in violation of certain listing requirements.  Our common stock was ultimately delisted on February 9, 2005, and was trading sporadically on the “pink-sheets” inter-dealer trading network until September 2005.  In September 2005, the Company’s common stock commenced trading on the OTC Bulletin Board.

34

ITEM 6.  EXHIBITS

Exhibits

The following exhibits are provided pursuant to provisions of Item 601 of Regulation S-K:

31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act.
31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of the Securities Exchange Act.
32.1	Certification Required by 18 U.S.C. Section 1350 (as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002).

35

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.

		Diversified Corporate Resources, Inc.
	By	/s/ Michael C. Lee
		Michael C. Lee
November 14, 2005		Vice President, Treasurer, Secretary and Chief Financial Officer
		(Principal Financial and Accounting Officer)

36