Westaff (WSTF) 10-Q 2007 Q1 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D. C.  20549

FORM 10-Q

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.
	For the quarterly period ended January 20, 2007
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from                 to

Commission file number 0-24990

WESTAFF, INC.
(Exact name of registrant as specified in its charter)

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

298 North Wiget Lane

Walnut Creek, California  94598-2453

(Address of registrant’s principal executive offices)

(925) 930-5300

(Registrant’s telephone number)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes x    No o

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

Large accelerated file o   Accelerated filer o   Non-accelerated filer x

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

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

Class	Outstanding at March 2, 2007
Common Stock, $0.01 par value	16,609,603 shares

WESTAFF, INC. AND SUBSIDIARIES

INDEX

		PAGE
Part I.	Financial Information
Item 1.	Financial Statements (Unaudited)
	Condensed Consolidated Balance Sheets - January 20, 2007 and October 28, 2006	3
	Condensed Consolidated Statements of Operations - 12 weeks ended January 20, 2007 and January 21, 2006	4
	Condensed Consolidated Statements of Cash Flows - 12 weeks ended January 20, 2007 and January 21, 2006	5
	Notes to Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	19
Item 4.	Controls and Procedures	19
Part II.	Other Information
Item 1.	Legal Proceedings	20
Item 1A.	Risk Factors	20
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27
Item 3.	Defaults Upon Senior Securities	27
Item 4.	Submission of Matters to a Vote of Security Holders	27
Item 5.	Other Information	27
Item 6.	Exhibits	27
	Signatures	29

Part l.  Financial Information

Item 1.  Financial Statements

Westaff, Inc.

Condensed Consolidated Balance Sheets (Unaudited)

	January 20,		October 28,
	2007		2006
	(In thousands, except
	per share amounts)
ASSETS
Current assets:
Cash and cash equivalents	$	4,843	$	3,545
Trade accounts receivable, less allowance for doubtful accounts of $765 and $811	72,899		76,267
Deferred income taxes	6,083		5,834
Prepaid expenses	4,541		4,732
Other current assets	3,153		4,694
Total current assets	91,519		95,072
Property and equipment, net	14,783		15,046
Deferred income taxes	12,420		12,404
Goodwill	12,406		12,367
Intangible assets	3,420		3,425
Other long-term assets	1,116		951
Total Assets	$	135,664	$	139,265
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Borrowing under revolving credit facilities	$	4,890	$	4,790
Current portion of capital lease obligations	358		345
Note payable to related party	2,000		2,000
Accounts payable	4,837		5,245
Accrued expenses	35,346		39,695
Income taxes payable	1,177		1,105
Total current liabilities	48,608		53,180
Long-term capital lease obligations	745		833
Other long-term liabilities	19,293		19,243
Total liabilities	68,646		73,256
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.01 par value; authorized and unissued: 1,000,000 shares
Common stock, $0.01 par value; authorized: 25,000,000 shares; issued and outstanding: 16,595,920 shares at January 20, 2007 and 16,561,520 at October 28, 2006	166		166
Additional paid-in capital	38,776		38,617
Retained earnings	27,674		27,270
Accumulated other comprehensive income (loss)	402		(44		)
Total stockholders’ equity	67,018		66,009
Total Liabilities and Stockholders’ Equity	$	135,664	$	139,265

See accompanying notes to condensed consolidated financial statements.

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Westaff, Inc.

Condensed Consolidated Statements of Operations (Unaudited)

	12 Weeks Ended
	January 20,			January 21,
	2007			2006
	(In thousands, except per share amounts)
Revenue	$	129,949		$	138,600
Costs of services	107,032			115,363
Gross profit	22,917			23,237
Franchise agents’ share of gross profit	3,539			4,333
Selling and administrative expenses	17,810			17,957
Depreciation and amortization	915			1,169
Operating income (loss)	653			(222		)
Interest expense	319			309
Interest income	(35		)	(18		)
Income (loss) before income taxes	369			(513		)
Income tax benefit	(35		)	(117		)
Net income (loss)	$	404		$	(396	)
Earnings (loss) per share:
Basic and diluted	$	0.02		$	(0.02	)
Weighted average shares outstanding - basic	16,590			16,378
Weighted average shares outstanding - diluted	16,658			16,378

See accompanying notes to condensed consolidated financial statements.

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Westaff, Inc.

Condensed Consolidated Statements of Cash Flows (Unaudited)

	12 Weeks Ended
	January 20,			January 21,
	2007			2006
	(In thousands)
Cash flows from operating activities
Net income (loss)	$	404		$	(396	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization	915			1,169
Stock-based compensation	41			66
Provision for losses on doubtful accounts	(28		)	207
Amortization of deferred gain on sale-leaseback	(172		)	(172		)
Amortization of debt issuance costs	75			91
Deferred income taxes	(244		)	1
Amortization of deferred gain from sales of affiliate operations	(42		)	(48		)
Loss on sale or disposal of assets	2			12
Changes in assets and liabilities:
Trade accounts receivable	3,978			8,132
Other assets	1,630			2,256
Accounts payable and accrued expenses	(4,624		)	(4,427		)
Income taxes payable	69			(264		)
Other liabilities	258			(20		)
Net cash provided by operating activities	2,262			6,607
Cash flows from investing activities
Capital expenditures	(906		)	(1,787		)
Payments for the purchase of affiliate operations	(140		)	—
Proceeds from sales of affiliate operations	10			10
Other, net	17			(337		)
Net cash used in investing activities	(1,019		)	(2,114		)
Cash flows from financing activities
Net repayments under line of credit agreements	(45		)	(3,857		)
Principal payments on capital lease obligations	(75		)	(66		)
Payment of debt issuance costs	(61		)	—
Proceeds from the issuance of common stock	117			—
Net cash used in financing activities	(64		)	(3,923		)
Effect of exchange rate changes on cash	119			(8		)
Net change in cash and cash equivalents	1,298			562
Cash and cash equivalents at beginning of period	3,545			3,014
Cash and cash equivalents at end of period	$	4,843		$	3,576

See accompanying notes to condensed consolidated financial statements.

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Westaff, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited)

1.Basis of Presentation

The accompanying condensed consolidated financial statements of Westaff, Inc. and its domestic and foreign subsidiaries (together, the Company), as of January 20, 2007 and for the 12-week periods ended January 20, 2007 and January 21, 2006 are unaudited.

The condensed consolidated financial statements, in the opinion of management, reflect all adjustments, which are of a normal recurring nature, necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented.  The condensed consolidated balance sheet as of October 28, 2006 presented herein, has been derived from the audited balance sheet included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 28, 2006.

The Company’s critical accounting policies are described in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in the notes to the consolidated financial statements in the Company’s previously filed Annual Report on Form 10-K for the fiscal year ended October 28, 2006. There were no changes to these policies during the 12-week period ended January 20, 2007. Certain financial information normally included in annual financial statements prepared in accordance with accounting principles generally accepted in the United States that is not required for interim reporting purposes has been condensed or omitted. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the fiscal year ended October 28, 2006.

The Company’s fiscal year is a 52 or 53-week period ending the Saturday nearest the end of October. For interim reporting purposes, the first three fiscal quarters comprise 12 weeks each, while the fourth fiscal quarter consists of 16 or 17 weeks. The results of operations for the 12-week period ended January 20, 2007 are not necessarily indicative of the results to be expected for the full fiscal year or for any future period.

2.     Stock-Based Compensation

Stock options and restricted stock.  In April 2006, the Company’s stockholders approved the 2006 Stock Incentive Plan to replace the 1996 Stock Option/Stock Issuance Plan, which terminated in April 2006. The 2006 Stock Incentive Plan provides for the granting of incentive and nonqualified stock options, restricted stock awards and stock appreciation rights. The 2006 Stock Incentive Plan also provides for the automatic grant of stock options to each non-employee director at pre-established times and at a predetermined value. Incentive stock options may be granted at a price not less than 100% of the fair market value of the Company’s common stock at the date of grant. Although nonqualified options may be granted at a price not less than 85% of the fair market value of the Company’s common stock at the date of grant, the Company has historically issued option grants with exercise prices equal to fair market value on the date of grant. The options’ vesting schedules vary subject to the participant’s period of future service or to the Company’s or the option holder’s attainment of designated performance goals, or otherwise at the discretion of the Board of Directors. Standard vesting is over four years with 25% of the options vesting upon completion of one year of service from the vesting commencement date, and the remaining options vesting in 36 equal monthly installments. No option may have a term in excess of 10 years. As of January 20, 2007, 20,000 options were outstanding under the 2006 Stock Incentive Plan. The Company may grant restricted shares to officers and employees. The fair value of these shares at the date of grant is expensed on a straight-line basis over the vesting period. No restricted shares have been granted under the 2006 Stock Incentive Plan.

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Employee Stock Purchase Plan.  In July 2006, the Board of Directors adopted and approved an amendment and restatement of the Company’s 1996 Employee Stock Purchase Plan. The Purchase Plan was bifurcated into the Company’s Employee Stock Purchase Plan and the Company’s International Employee Stock Purchase Plan, (together the “Purchase Plans”). Under the Purchase Plans, eligible employees may authorize payroll deductions of up to 10% of eligible compensation for the purchase of the Company’s common stock during each semiannual purchase period. The purchase price for shares purchased under the Purchase Plans is equal to 90% of the lower of the fair market value at the beginning of the purchase period or the fair market value on the last day of the purchase period. The Purchase Plans provide for the issuance of up to 750,000 shares of the Company’s common stock. As of January 20, 2007, shares issued under the Purchase Plans totaled 663,457.

Stock-based compensation.  Effective with the beginning of the first quarter of fiscal 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004) "Share-Based Payment" (SFAS 123(R)) using the modified prospective method of adoption, which does not require restatement of prior periods. SFAS 123(R) requires the Company to recognize compensation expense for its stock options, restricted stock awards and employee stock purchase shares outstanding, but not yet vested, as of the date of adoption and for future stock option and award grants and employee stock purchase shares.

The determination of the fair value of stock options and ESPP shares, using the Black-Scholes model, is affected by the Company’s stock price as well as assumptions as to the Company’s expected stock price volatility over the term of the awards, actual and projected employee stock option exercise behavior, the risk-free interest rate, and expected dividends.

The Company estimates the expected term of options granted taking into account historical and expected future exercise, cancellations and forfeiture behavior. The Company estimates the volatility of the common stock by using historical volatility over a period equal to the award’s expected term. The risk-free interest rates that are used in the valuation models are based upon yields of the U.S. Treasury constant maturities at the time of grant having a term that approximates the expected life of the options. Dividend yield is zero as we did not declare or pay dividends during fiscal 2007 or fiscal 2006, and our current credit facilities prohibit payment of dividends.

SFAS No. 123(R) requires companies to estimate future expected forfeitures at the date of grant and revise those estimates in subsequent periods if actual forfeitures differ from those estimates. In previous years, the Company had recognized the impact of forfeitures as they occurred. Now, the Company uses historical data to estimate pre-vesting forfeiture rates in determining the amount of stock-based compensation expense to recognize. All stock-based compensation awards are amortized on a straight-line basis over the requisite service periods of the awards.

The fair value of stock options granted during the 12 weeks ended January 20, 2007 were estimated using the Black-Scholes option pricing model and the following weighted average assumptions:

	12 Weeks Ended
Stock Options	January 20, 2007
Expected life from grant date (years)	4.8
Expected volatility	70	%
Risk-free interest rate	4.6	%
Dividend Yield	—

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The Company did not grant any stock options for the 12-week period ending January 21, 2006, and had no stock issuances from the employee stock purchase plan for the 12-week periods ended January 20, 2007 and January 21, 2006.

The Company recorded stock-based compensation of $41,000 ($30,000 net of related income tax benefit) for the quarter ended January 20, 2007 and $66,000 ($49,000 net of related income tax benefit) for the quarter ended January 21, 2006, which is included in selling and administrative expenses. The total compensation cost related to nonvested stock options and awards not yet recognized is currently expected to be a combined total of approximately $0.2 million over the next 3.1 years.

The weighted average fair value per share of stock options granted for the 12-week period ended January 20, 2007 was $2.63.

Stock option activity. The following table summaries stock option activity for the 12-weeks ended January 20, 2007:

	Shares		Weighted average exercise price
	(In 000's)
Options outstanding at October 28, 2006	417		$	3.39
Granted	20		4.35
Exercised	(35	)	3.30
Cancelled	(2	)	9.50
Options outstanding at January 20, 2007	400		$	3.41

The following table summarizes information about the weighted average remaining contractual life (in years) and the weighted average exercise prices for stock options both outstanding and exercisable as of January 20, 2007:

	Options Outstanding				Options Exercisable
Exercise price range	Number of Shares	Remaiming Life	Exercise Price		Number of Shares	Exercise Shares
	(In 000's)				(In 000's)
$  2.20  to  $   2.56	37	5.74	$	2.39	37	$	2.39
$  3.15  to  $   3.15	97	5.56	3.15		97	3.15
$  3.20  to  $   3.20	3	4.34	3.20		3	3.20
$  3.22  to  $   3.22	200	8.21	3.22		40	3.22
$  3.50  to  $ 16.17	63	6.25	5.00		29	5.64
Totals	400	7.00	$	3.41	206	$	3.38

The aggregate intrinsic value (the difference between the market price and the option’s exercise price) of options outstanding and options exercisable as of January 20, 2007 was $0.7 million and $0.4 million, respectively.

Restricted stock activity.  At January 20, 2007, the Company had 20,000 restricted stock shares outstanding with an intrinsic value of $35,000. The unamortized compensation expense at January 20, 2007 was $14,000.

Employee stock purchase plan activity.  At January 20, 2007, the Company had recorded liabilities for withholdings of $53,000 under its employee stock purchase plan representing 33,000 shares at a weighted average exercise price of $3.10 with an estimated aggregate intrinsic value of $61,000.

3.Goodwill

The following summarizes the change in goodwill during the fiscal quarter ended January 20, 2007:

	Domestic
	Business Services		Australia		Total
	(In thousands)
Balance at October 28, 2006	$	11,369	$	998	$	12,367
Effect of foreign currency translation	—		39		39
Balance at January 20, 2007	$	11,369	$	1,037	$	12,406

The Company performs its annual impairment evaluation in the fourth quarter of each fiscal year.

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4.Discontinued Operations

In June 2005, the Company sold its Norway and Denmark operations to Personalhuset AS, a recruitment and staffing company headquartered in Norway, for approximately $2.7 million. Of the total proceeds, approximately $0.2 million is being held in an interest bearing escrow account as security for potential Westaff Norway pension claims, which the Company currently estimates to be zero. The escrowed funds, net of any claim payments, are scheduled to be remitted to the Company in June 2007.

5.Workers’ Compensation

The Company is responsible for and pays workers’ compensation costs for its temporary and regular employees and is self-insured for the deductible amount related to workers’ compensation claims ($500,000 per claim for fiscal 2007 and fiscal 2006.) The Company accrues the estimated costs of workers’ compensation claims based upon the expected loss rates within the various temporary employment categories provided by the Company. At least annually, the Company obtains an independent actuarial valuation of the estimated costs of claims reported but not settled, and claims incurred but not reported, and adjusts the accruals based on the results of the valuations. As of January 20, 2007 and October 28, 2006, workers’ compensation liabilities were approximately $22.4 million and $24.3 million respectively, of which $16.4 million is included in other long-term liabilities on each of the respective balance sheets for obligations that are not expected to be paid within one year of the balance sheet date.

Periodically, the terms of the agreement with the insurance carrier are renegotiated.  The insurance carrier requires the Company to collateralize its recorded obligations through the use of irrevocable letters of credit, surety bonds or cash.  At January 20, 2007, the Company had $35.3 million of letters of credit securing its domestic workers’ compensation obligations.

6.Earnings Per Share

The following table sets forth the computation of basic and diluted earnings per share:

	12 Weeks Ended
	January 20,		January 21,
	2007		2006
	(In thousands, except per share amounts)
Net income (loss)	$	404	$	(396	)
Denominator for basic earnings per share - weighted average shares	16,590		16,378
Effect of dilutive securities: stock options and awards	68		—
Denominator for diluted earnings per share - adjusted weighted average shares and assumed conversions	16,658		16,378
Earnings (loss) per share
Basic	$	0.02	$	(0.02	)
Diluted	$	0.02	$	(0.02	)
Anti-dilutive weighted shares excluded from diluted earnings per share	182		359

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7.Comprehensive Income

Comprehensive income consists of the following:

	12 Weeks Ended
	January 20,		January 21,
	2007		2006
	(In thousands)
Net income (loss)	$	404	$	(396	)
Currency translation adjustments	446		(60		)
Comprehensive income (loss)	$	850	$	(456	)

8.Credit Agreement

The Company has credit facilities with GE Capital, as primary agent, expiring in May 2009. The facilities comprise a five-year syndicated Multicurrency Credit Agreement consisting of a $55 million U.S. Revolving Loan Commitment and a £2.74 million U.K. Revolving Loan Commitment.  In addition, the Company’s Australian subsidiary maintains a $12 million Australian dollar facility agreement (the “A$ Facility Agreement”) that expires in May 2009. Each agreement includes a letter of credit sub-facility. Letters of credit under the agreements expire one year from date of issuance, but are automatically renewed for one additional year unless written notice is given to or from the holder.

On January 2, 2007, the Company and its lenders executed a Tenth Amendment to its Multicurrency Credit Agreement. This amendment reduced the interest rates within the first level of the pricing grid implemented with the Eighth Amendment, resets future minimum earnings before interest, taxes, depreciation and amortization (“EBITDA”) covenants and reduced some of the reporting requirements provided minimum borrowing requirements are met. Further, the amendment extended the credit facility for one additional year to May 2009. Finally, the Company was not in compliance with its minimum EBITDA covenant as of the end of the fiscal year 2006, and the amendment included a waiver of this covenant violation.

On January 25, 2007, the Company and its lender executed an amendment to the A$ Facility Agreement, which extended the Agreement for two additional years to May 2009.

9.Related Party Transactions

The Company has an unsecured subordinated promissory note payable to its Chairman of the Board of Directors dated May 17, 2002 in the amount of $2.0 million. The note has a maturity date of August 18, 2007 and an interest rate equal to an indexed rate as calculated under the Company’s credit facilities plus seven percent, compounded monthly and payable 60 calendar days after the end of each of the Company’s fiscal quarters. The interest rate in effect on January 20, 2007 was 15.25%. The Company recorded $71,000 of interest expense for the 12 weeks ended January 20, 2007. Payment of interest is contingent on the Company meeting minimum availability requirements under its credit facilities. Additionally, payments of principal or interest are prohibited in the event of any default under the credit facilities.

10.Operating Segments

The following table summarizes reporting segment data:

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	Domestic			United					New
	Business Svcs.			Kingdom			Australia		Zealand		Total
	(In thousands)
12 Weeks Ended January 20, 2007
Revenue	$	97,202		$	9,262		$	21,712	$	1,773	$	129,949
Operating income (loss)	$	598		$	(166	)	$	147	$	74	$	653
12 Weeks Ended January 21, 2006
Revenue	$	107,784		$	8,915		$	20,566	$	1,335	$	138,600
Operating income (loss)	$	(587	)	$	305		$	44	$	16	$	(222	)

11.Commitments and Contingencies

In the ordinary course of its business, the Company is periodically threatened with or named as a defendant in various lawsuits. The principal risks that the Company insures against are workers’ compensation, general liability, automobile liability, property damage, alternative staffing errors and omissions, fiduciary liability and fidelity losses.

During the fourth quarter of fiscal 2005, the Company was notified by the California Employment Development Department (“EDD”) that Westaff’s domestic operating subsidiaries unemployment tax rates would be increased retroactively for both calendar years 2005 and 2004, which would result in additional unemployment taxes of approximately $0.9 million. The Company believes that it has properly calculated its unemployment insurance tax and is in compliance with all applicable laws and regulations. The Company has timely appealed the ruling by the EDD and is working with its outside counsel to resolve this matter. The Company believes that it has strong defenses and legal arguments with respect to the unaccrued assessment and, accordingly, has not accrued for that portion of the assessment as of January 20, 2007.

Other than the action listed above, the Company is not a party to any material litigation. However, from time to time the Company has been threatened with, or named as a defendant in, litigation brought by former franchisees or licensees, and administrative claims and lawsuits brought by employees or former employees. Management believes the resolution of these matters will not have a material adverse effect on the Company’s financial statements.

12.Recent Accounting Pronouncements

In June 2006, the Financial Accounting Standards Board (“FASB’) issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes – an interpretation of FASB Statement No. 109” (“FIN 48’). FIN 48 prescribes a recognition threshold and measurement process for recording in the financial statements uncertain tax positions taken or expected to be taken in a tax return in accordance with SFAS No. 109, “Accounting for Income Taxes.” Tax positions must meet a more-likely-than-not recognition threshold at the effective date to be recognized upon the adoption of FIN 48 and in subsequent periods. The accounting provisions of FIN 48 will be effective for the Company beginning in fiscal year 2008. The Company has not yet completed its evaluation of the impact of adoption on the Company’s financial position or results of operations.

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

Cautionary Statement

This Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Except for the historical information contained herein, the matters discussed should be considered forward-looking statements and readers are cautioned not to place undue reliance on those statements. These statements are only predictions, and actual events or results may differ materially. The forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to current facts. They use words such as “will,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “target,” “forecast,” and other words and terms of similar meaning in connection with any discussion of future operating or financial performance. These forward-looking statements are made based on information available as of the date of this report and are subject to a number of risks and uncertainties that could cause the Company’s actual results and financial position to differ materially from those expressed or implied in the forward-looking statements and to be below the expectations of public market analysts and investors. Investors should bear this in mind as they consider forward-looking statements.

These risks and uncertainties include, but are not limited to, those discussed in Part II Item 1A “Risk Factors” and elsewhere in this Form 10-Q. You should understand that it is not possible to predict or identify all such factors. Consequently, you should not consider any such list to be a complete set of all potential risks or uncertainties faced by us.

The Company undertakes no obligation to publicly release the results of any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events, except as required by applicable laws and regulations.

The following discussion is intended to assist in the understanding and assessment of significant changes and trends related to the results of operations and financial condition of Westaff, Inc., together with its consolidated subsidiaries. This discussion and analysis should be read in conjunction with the Company’s Consolidated Financial Statements and Notes included elsewhere in this Form 10-Q and in the Company’s Annual Report on Form 10-K for the fiscal year ended October 28, 2006.

Company Overview

We provide staffing services primarily in suburban and rural markets through a network of Company-owned, franchise agent and licensed offices in the United States, United Kingdom, Australia and New Zealand. We offer a wide range of staffing solutions, including permanent placement, replacement and temporary staffing, primarily focused on recruiting and placing clerical/administrative and light industrial personnel. We have over 58 years of experience in the staffing industry and annually put more than 125,000 people to work through more than 230 field offices in 45 states and three foreign countries. Our corporate headquarters provides support services to the field offices in areas such as marketing, human resources, risk management, legal, strategic sales, accounting, and information technology.

To complement our service offerings, which include temporary staffing, permanent placement, temp-to-hire services, payroll services and on-location programs; we utilize a number of tools focused on increasing our pool of qualified candidates. Additionally, we employ a robust, targeted marketing program as well as a consultative sales process, and both of these tools assist in our sales efforts to new and existing customers.

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Management believes all of these tools enhance our competitive edge and position us to effectively pursue high growth market niches.

The staffing industry is highly competitive with generally few barriers to entry, which contributes to significant price competition as competitors attempt to maintain or gain market share. While the price competition continues in 2007, we have noted consolidated margin improvements as compared to the prior year. On a prospective basis, we believe our focus on increasing permanent placement services, increasing clerical/administrative sales, improving results from underperforming field offices and prudently managing costs will permit us to improve our operating margins.

It is important to note that our business tends to be seasonal with sales for the first fiscal quarter typically lower than other fiscal quarters due to it containing traditional holidays as well as customer shutdowns during the holiday season. These shutdowns and post-holiday season declines in business activity negatively impacts orders received from customers, particularly in the light industrial sector. Demand for staffing services has historically tended to grow during the second and third fiscal quarters and has been greatest during the fourth fiscal quarter due largely to customers’ planning cycles. Furthermore, our fourth fiscal quarter consists of 16 or 17 weeks, while the first, second and third fiscal quarters consist of 12 weeks each.

Domestically, payroll taxes and related benefits fluctuate with the level of payroll costs, but tend to represent a smaller percentage of revenue and payroll costs later in our fiscal year as federal and state statutory wage limits for unemployment and social security taxes are exceeded on a per employee basis.  Workers’ compensation expense, which is incurred domestically and in Australia, generally varies with both the frequency and severity of workplace injury claims reported during a quarter and the estimated future costs of such claims. Adverse and positive loss development of prior period claims during a subsequent quarter may also contribute to the volatility in our estimated workers’ compensation expense.

Our operating results may fluctuate due to a number of factors such as:

·seasonality, especially in our light industrial business,

·wage limits on statutory payroll taxes,

·claims experience for workers’ compensation,

·demand and competition for our services, and

·the effects of acquisitions.

In addition, our operating results have also historically tended to follow seasonal sales trends with the bulk of annual operating profits falling within the third and fourth fiscal quarters.

Management believes that, as a result of the typical sales cycle within the staffing industry, it is critical to invest in field office staff and growth initiatives during the second fiscal quarter in order to benefit from these investments during the third and fourth quarters of the fiscal year.

We were advised at our February 28, 2007 Board Meeting by W. Robert Stover, our Chairman of the Board of Directors, that all of our common stock held by Mr. Stover and his children were sold in a private transaction to H.I.G. Capital LLC and its affiliates (collectively, the “Investors”). According to the Form 4 filed by Mr. Stover on March 5, 2007, these shares were sold at a price of $4.10 per share. Representatives of the Investors have further advised our Board of Directors that H.I.G. Capital LLC, with its affiliates, have acquired additional shares of our common stock on the open market and the total shares of our common stock acquired by the Investors is 8,263,196 shares as of March 1, 2007, which constitutes approximately 49.7% of our outstanding common stock. At this time, we are not aware of the total consideration for all of the shares purchased by the Investors or their source of funds. Mr. Stover has indicated to us that he was asked to remain on the Board by the Investors. We are beginning discussions with the Investors regarding prospective, mutual goals and are not aware of any other arrangements or understandings between Mr. Stover and the Investors regarding election of directors or other matters.

Critical Accounting Policies

The preparation of our financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions affecting the amounts and disclosures reported within those financial statements. These estimates are evaluated on an ongoing basis by management and generally affect revenue recognition, workers’ compensation costs, collectibility of accounts receivable, impairment of goodwill and intangible assets, contingencies, litigation and income taxes. Management’s estimates and assumptions are based on historical experiences

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and other factors believed to be reasonable under the circumstances. Actual results under circumstances and conditions different than those assumed could result in differences from the estimated amounts in the financial statements.

Our critical accounting policies are described in Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and in the notes to the consolidated financial statements in the Company’s previously filed Annual Report on Form 10-K for the fiscal year ended October 28, 2006. There were no changes to these policies during the 12-week period ended January 20, 2007.

Executive Overview

We are pleased to report net income for the first quarter of fiscal 2007.  Historically, it has been challenging for us to generate a profit in our first quarter, which is traditionally our slowest quarter. We are also pleased to report our gross margin has increased from 16.8% to 17.6%, which is consistent with one of our initiatives. We were successful with another initiative, to prudently manage costs, as our operating costs have decreased from the first quarter of last year. Additionally, permanent placement revenue increased from the first quarter of last year and all of these achievements caused our operating income to improve $875,000 from the first quarter of the prior year. Further, our working capital and cash balance both increased as compared to our most recent fiscal year end, which is also an achievement in light of the first quarter being our slowest quarter.

Whereas we are delighted to report all of these items, the fact remains that we have other issues to improve upon going forward. Whereas we expected our total revenue to be less than the prior year’s first quarter, we did expect them to be higher than they actually were. This shortfall was largely isolated to the United States with the bulk of it occurring towards the latter part of the quarter. Much of this shortfall can be attributable to the holiday season having a larger effect than expected. Therefore, we believe a portion of this shortfall can be isolated to the holiday season and, therefore, should not be ongoing into the remainder of fiscal 2007. We also have implemented other initiatives designed to increase domestic sales prospectively, which should assist in growing domestic revenue over the first quarter’s results.

In addition to this, we are not satisfied with the operating results of our United Kingdom operations, which generated an operating loss in the first quarter. As compared to the prior year, our gross margins in the United Kingdom have deteriorated, partially due to a shift in revenue volume away from commercial accounts, coupled with growth in two large, national accounts, which generate lower margins for us. We have implemented plans to improve these operating results on a prospective basis and are optimistic that future quarters will show an improvement over the first quarter results.

Notwithstanding these issues, we continue to believe we are well positioned to report improved operating results as compared to the prior year in future quarters of fiscal 2007.

Results of Operations - Fiscal Quarter ended January 20, 2007 and Fiscal Quarter ended January 21, 2006

Revenue decreased $8.7 million or 6.2% for the first fiscal quarter of 2007 as compared to the first fiscal quarter of 2006. Domestic revenue decreased $10.6 million, or 9.8%, driven largely by a 13.5% decrease in billed hours. This decrease was experienced in most geographical areas and is largely attributable to a decrease in lower margin, high-volume, light industrial accounts. The effect of the billable hours decrease was partially offset by an increase of 4.2% in average, domestic bill rates. In addition, domestic permanent

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placement revenue increased 23% as compared to the first quarter of the prior year, also offsetting a portion of the billable hours decrease.

International revenue increased by 6.3%, due to a 3.9% increase in the United Kingdom, a 5.6% increase in Australia and a 32.8% increase in New Zealand. The United Kingdom and New Zealand increases are primarily attributable to increased sales volumes at large national accounts, whereas the increase in Australia is largely due to increases in commercial sales to retail customers.

Costs of services include hourly wages of temporary employees, employer payroll taxes, state unemployment and workers’ compensation costs and other temporary employee-related costs. Costs of services decreased $8.3 million or 7.2% for the fiscal 2007 quarter as compared to the fiscal 2006 quarter.  Because this percentage decrease was higher than the percentage decrease in revenue, consolidated gross margin increased from 16.8% in the first quarter of fiscal 2006 to 17.6% in the first quarter of fiscal 2007.  Domestic gross margin increased from 16.4% in the fiscal 2006 quarter to 17.7% in fiscal 2007, due largely to a shift in business away from lower margin, light industrial business towards higher margin, clerical/administrative business. In addition, the 23% increase in permanent placement revenue aided the gross margin increase. Internationally, the gross margin in Australia increased from 12.9% to 13.2%, primarily due to a shift away from large, national accounts to higher margin, commercial accounts.  Gross margins for the United Kingdom and New Zealand decreased, as a higher portion of their revenue were generated at large, national accounts.

Franchise agents’ share of gross profit represents the net distribution paid to franchise agents based either on a percentage of the sales or gross profit generated by the franchise agents’ operations. Franchise agents’ share of gross profit decreased $0.8 million or 18.3% primarily as a result of the Company having acquired two franchisees during the last fiscal year. Both of these franchisees received a share of gross profits in the first quarter of fiscal 2006 but not in the first quarter of fiscal 2007 as these offices were operated as Company-owned offices.  As a percentage of consolidated revenue, franchise agents’ share of gross profit decreased from 3.1% for the fiscal 2006 quarter to 2.7% for the fiscal 2007 quarter.

Selling and administrative expenses decreased $0.1 million, or 0.8%, for the 2007 quarter as compared to the 2006 quarter. This decrease is primarily attributable to decreased salary and related costs, as a result of decreased headcount. In addition, we incurred lower communications and services costs, largely due to improvements made in our information systems infrastructure. Offsetting a portion of the overall decreases were increases in incentive compensation, employee benefits and recruiting expenses. As a percentage of revenue, selling and administrative expenses were 13.7% for the fiscal 2007 quarter, compared to 13.0% for the fiscal 2006 quarter. The increase is primarily due to the decreased level of sales. In addition, the Company operated two markets in the first quarter of fiscal 2007 that were franchised operations in the first quarter of fiscal 2006. Therefore, the operating expenses associated with these operations are included in selling and administrative expenses this quarter, but were not in the prior quarter.

Depreciation and amortization decreased $0.3 million or 21.7% primarily as a result of certain fixed assets becoming fully depreciated by the end of fiscal 2006 and remaining in service. Therefore, no new depreciation expenses were incurred for these assets in the first quarter of fiscal 2007. Further, no new business process management system modules were placed into service, although we are currently anticipating implementing some new modules in the fourth quarter of fiscal 2007. Upon implementation, we anticipate depreciation expense will increase.

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For the fiscal quarter ended January 20, 2007, we recorded a consolidated income tax benefit of $35,000 on pre-tax income of $0.4 million. This benefit was largely driven by domestic workers’ opportunity tax benefits of $0.4 million related to 2006, largely offset by income taxes from various domestic and international jurisdictions. The prior year quarter’s tax benefit was $82,000 higher than this year’s, primarily because of the pre-tax loss generated in the first quarter of the prior year.

Due to the aforementioned items, net income was $0.4 million for the first quarter of fiscal 2007 as compared to a net loss of $0.4 million in the first quarter of fiscal 2006. This caused basic and diluted earnings per share to be $0.02 in the first quarter of 2007 as compared to a basic and diluted loss per share of $0.02 in the first quarter of the prior year.

Liquidity and Capital Resources

We require significant amounts of working capital to operate our business and to pay expenses relating to employment of temporary employees. Our traditional use of cash is for financing of accounts receivable, particularly during periods of economic upswings and growth, when sales are seasonally high. Temporary personnel are typically paid on a weekly basis while payments from customers are generally received 30 to 60 days after billing.

We finance our operations primarily through cash generated by our operating activities and borrowings under our revolving credit facilities. Net cash provided by operating activities was $2.3 million for the first quarter of 2007, compared to $6.6 million for the first quarter of fiscal 2006. This $4.3 million decrease is primarily attributable to a decrease in cash provided from managing our accounts receivables, which provided $4.0 million of the operating cash flow in this quarter as compared to $8.1 million in the prior quarter. During fiscal 2006, we consciously managed receivables to improve cash flow and as a result of those efforts, $7.5 million of operating cash flow was generated during fiscal 2006. Although we will continue to manage these going forward, we believe the opportunities for increasing operating cash flow going forward will not be as dramatic as they were during the prior year.

Cash used for investing activities was $1.0 million in the first quarter of fiscal 2007, as compared to $2.1 million in the first quarter of fiscal 2006. Capital expenditures, which are primarily for information system initiatives both domestically and internationally, represented the majority of this in both quarters. We continue to invest in enhancements and upgrades to our computer-based technologies. During fiscal 2004, we entered into a license agreement for a domestic business process management, or BPM, system which is being implemented in three phases. The initial phase, which consisted of the human resources system for regular Westaff employees, was successfully implemented in July 2005. The second phase, which includes the core financial systems and the accounts receivable module, went live in the beginning of fiscal year 2006. The final phase, which will include fully integrated front office functionality along with payroll and billing for temporary associates, is currently scheduled to go live in the fourth quarter of fiscal 2007. Our credit agreement currently allows up to a maximum of $6.0 million in capital expenditures for fiscal 2007.

Cash used for financing activities was $64,000 in the first quarter of fiscal 2007 as compared to $3.9 million in the first quarter of fiscal 2006. In the prior year quarter, the primary cause behind this usage was repayments under our lines of credit. As of the beginning and the end of the first quarter 2007, the only borrowing under our lines of credit was in Australia, and those borrowings remained relatively constant at the beginning and end of the quarter.

In May 2002, we entered into agreements with GE Capital, as primary agent, to provide senior secured credit facilities that originally expired in May 2007. The credit facility comprised a five-year syndicated Multicurrency Credit Agreement (the ‘Multicurrency Credit Agreement”) consisting of a $50.0 million

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U.S. Revolving Loan Commitment, a £2.74 million U.K. Revolving Loan Commitment (U.S. dollar equivalent of approximately $4.0 million at the date of the agreement), and a $5.0 million term loan, which was repaid during fiscal 2003. In addition, a five-year Australian dollar facility agreement (the “A$ Facility Agreement”) was executed in May 2002, consisting of an A$12.0 million revolving credit facility (U.S. dollar equivalent of approximately $6.0 million at the date of the A$ Facility Agreement).

In August 2005, the Multicurrency Credit Agreement was amended to allow an add-back of approximately $1.0 million to the earnings before income taxes, depreciation and amortization, or EBITDA, covenant relating to separation and restructuring costs incurred or to be incurred during fiscal 2005. The amendment also allowed the gain from the sale of the Registrant’s Norway and Denmark operations of $1.1 million to be included in determining compliance with the EBITDA and fixed charge covenants. Additionally, the amendment increased the maximum capital expenditures allowed for fiscal 2005 from $6.0 million to $8.5 million and also increased the letter of credit sub-limit from $35.0 million to $40.0 million.

In March 2006, we and our lenders executed an Eighth Amendment to the Multicurrency Credit Agreement. Among other things, the amendment reset minimum EBITDA covenants for fiscal 2006 and beyond, adjusted the fixed charge coverage ratio for our second quarter of fiscal 2006, extended the credit facility for one additional year to May 2008 and added an additional pricing grid that will allow us to benefit from reduced interest rates and letter of credit fees upon achieving certain minimum EBITDA targets. Additionally, the amendment increased the maximum amount of the U.S. Revolving Loan Commitment by $5.0 million to $55.0 million and increased the letter of credit sub-limit from $40.0 million to $45.0 million.

In July 2006, we and our lenders executed a Ninth Amendment to the Multicurrency Credit Agreement solely for the purpose of determining the financial covenants. The amendment allows for a one-time add-back adjustment of approximately $0.5 million to EBITDA commencing the fiscal quarter ending April 15, 2006, for the separation and transition charges related to the termination of employment for two of our former executives.

On January 2, 2007, we and our lenders executed a Tenth Amendment to our Multicurrency Credit Agreement. Among other things, this amendment reduces the interest rates if certain financial benchmarks are achieved and resets the future minimum EBITDA covenants. The amendment extended the credit facility for one additional year to May 2009. We were not in compliance with its minimum EBITDA covenant as of the end of fiscal 2006, and the amendment included a waiver of this covenant violation.

On January 25, 2007, we and our lenders executed an amendment to the A$ Facility Agreement, which extended the agreement for two additional years to May 2009.

As of January 20, 2007, we had $4.9 million outstanding under our credit facilities all of which was outstanding under the A$ Facility Agreement. We have combined available borrowing capacity under our credit facilities of $14.9 million consisting of $6.0 million for the U.S., $4.2 million for the U.K. and $4.7 million for Australia.

In February 2004, we completed the sale of our former corporate headquarters’ building for cash proceeds of $1.9 million. The proceeds were used to pay down outstanding borrowings under our revolving credit facilities. We have an outstanding $0.7 million irrevocable standby letter of credit as a security deposit for the December 2002 sale leaseback of the land and buildings housing our administrative offices.

We have an unsecured subordinated promissory note payable to our Chairman of the Board of Directors in the amount of $2.0 million with a maturity date of August 18, 2007, and an

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interest rate equal to an indexed rate as calculated under the Company’s credit facilities plus seven percent (15.25% at January 20, 2007), compounded monthly and payable 60 calendar days after the end of each of our fiscal quarters. Payment of interest is contingent on us meeting minimum availability requirements under our credit facilities. Additionally, payments of principal or interest are prohibited in the event of any default under the credit facilities. The Sixth Amendment to our Multicurrency Credit Agreement provides for optional prepayment of the note subject to certain borrowing availability limits on the U.S. revolving loan commitment portion of the credit facilities.

We work to balance our worldwide cash needs through dividends from and loans to our international subsidiaries. These loans and dividends are limited by the cash availability and needs of each respective subsidiary, restrictions imposed by our senior secured debt facilities and, in some cases, statutory regulations of the subsidiary. The U.S. operations cannot directly draw on the excess borrowing availability of the U.K. or Australian operations; however, we may request dividends from the U.K. The U.S. can also request repayments on its intercompany loan to Australia, along with intercompany interest and royalties, although remittances from Australia may be limited by certain covenants under the terms of the Australia credit facility. Outstanding principal on the intercompany loan to Australia was $4.3 million as of January 20, 2007.

We are responsible for and pay workers’ compensation costs for our domestic temporary and regular employees and are self-insured for the $500,000 deductible amount related to workers’ compensation claims. Typically, each policy year the terms of the agreement with the insurance carrier are renegotiated. The insurance carrier requires us to collateralize our obligations through the use of irrevocable standby letters of credit, surety bonds or cash. In April 2005, our insurance carrier reduced our collateral requirements through the cancellation of a $3.8 million surety bond thereby eliminating any remaining outstanding surety bond. Currently, we do not believe that surety bonds will be available or required in the foreseeable future to secure workers’ compensation obligations.

During the fourth quarter of fiscal 2005, we and our insurance carrier negotiated the return of $11.0 million of the fiscal 2005 cash collateral and we issued $11.0 million of letters of credit in its place. During the first quarter of fiscal 2006, we issued an additional $1.9 million of letters of credit in exchange for $1.2 million in cash, which represented all of the cash remaining in the 2005 collateral fund.

For our 2007 policy year insurance program, we anticipate total cash payments of $4.8 million will be paid during fiscal 2007 in equal monthly installments, which commenced on November 1, 2006. Cash payments for 2007 policy year claims will be paid directly by us. Through January 20, 2007, we have made payments of $1.2 million on the 2007 policy year. As of January 2007, we had outstanding $35.3 million of letters of credit to secure all outstanding obligations under our workers’ compensation program for all years except 2003, which is fully funded although subject to annual retroactive premium adjustments based on actual claims activity. Under certain circumstances including a change of ownership and or senior management, we may be required to increase our letters of credit to $40 million. We will also make ongoing cash payments for claims for all other open policy years (except for 2003 as noted above).

We continue to evaluate other opportunities to further strengthen our financial position. However, we believe that the borrowing capacity provided under the amended credit agreement, together with cash generated through our operating performance, will be sufficient to meet our working capital needs for the foreseeable future.

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Item 3.  Quantitative and Qualitative Disclosures About Market Risk

We are exposed to certain market risks from transactions that are entered into during the normal course of business. Our primary market risk exposure relates to interest rate risk. At January 20, 2007, our outstanding debt under variable-rate interest borrowings was approximately $6.9 million. A change of two percentage points in the interest rates would cause a change in interest expense of approximately $0.1million on an annual basis. Our exposure to market risk for changes in interest rates is not significant with respect to interest income, as our investment portfolio is not material to our consolidated balance sheet. We currently have no plans to hold an investment portfolio that includes derivative financial instruments.

For the 12 weeks ended January 20, 2007, our international operations comprised 25.2% of our revenue and, as of the end of that period, 20.7% of our total assets. We are exposed to foreign currency risk primarily due to our investments in foreign subsidiaries. Our multicurrency credit facility, which allows our Australian and United Kingdom subsidiaries to borrow in local currencies, partially mitigates the exchange rate risk resulting from fluctuations in foreign currency denominated net investments in these subsidiaries in relation to the U.S. dollar. We do not currently hold any market risk sensitive instruments entered into for hedging risks related to foreign currencies. In addition, we have not entered into any transactions with derivative financial instruments for trading purposes.

Item 4.  Controls and Procedures

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operations of the Company’s “disclosure controls and procedures” (as defined under Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of January 20, 2007 (the end of the period covered by this report), the Company’s disclosure controls and procedures are effective in timely alerting them to material information required to be publicly reported. There was no change in the Company’s internal control over financial reporting that occurred during the fiscal period ended January 20, 2007, that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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Part II.   Other Information

Item 1.    Legal Proceedings

In the ordinary course of our business, we are periodically threatened with or named as a defendant in various lawsuits.  The principal risks that we insure against are workers’ compensation, general liability, automobile liability, property damage, alternative staffing errors and omissions, fiduciary liability and fidelity losses.

During the fourth quarter of fiscal 2005, we were notified by the California Employment Development Department (“EDD”) that Westaff’s domestic operating subsidiaries unemployment tax rates would be increased retroactively for both calendar years 2005 and 2004, which would result in additional unemployment taxes of approximately $0.9 million. Management believes that it has properly calculated its unemployment insurance tax and is in compliance with all applicable laws and regulations. We have timely appealed the ruling by the EDD and are working with our outside counsel to resolve this matter. Management believes that it has strong defenses and legal arguments with respect to the unaccrued assessment and, accordingly, has not accrued for that portion of the assessment as of January 20, 2007.

Other than the action listed above, we are not currently a party to any material litigation. However, from time to time we have been threatened with, or named as a defendant in litigation brought by former franchisees or licensees, and administrative claims and lawsuits brought by employees or former employees. Management believes the resolution of these matters will not have a material adverse effect on our financial statements.

Item 1A.  Risk Factors

This Form 10-Q contains forward-looking statements concerning our future programs, products, expenses, revenue, liquidity and cash needs as well as our plans and strategies. These forward-looking statements are based on current expectations and we assume no obligation to update this information, except as required by applicable laws and regulations. Any one of the following risks could harm our operating results or financial condition and could result in a significant decline in value of an investment in us. Further, additional risks and uncertainties that have not yet been identified or which we currently believe are immaterial may also harm our operating results and financial condition. Numerous factors could cause actual results to differ significantly from the results described in these forward-looking statements, including the following updated risk factors.

One large shareholder with its affiliates controls a significant amount of our outstanding stock thus allowing them to exert significant influence on our management and affairs.

We were advised on February 28, 2007, that H.I.G. Capital LLC and its affiliates had acquired and beneficially own, directly or indirectly, or has voting power over, in excess of 49% of our outstanding common stock. As the principal stockholder of Westaff, H.I.G. Capital and its affiliates will have the ability to materially influence all matters submitted to the stockholders for approval and to exert significant influence on our management and affairs. For example, H.I.G. Capital has the ability to sell its shares independently and to strongly influence the election of the Board of Directors and the appointment of executive management. It also has the ability to strongly influence any merger, consolidation, sale of substantially all of our assets or other strategic decisions affecting us or the market value of the stock. This concentration of stock and voting power could be used by H.I.G. Capital to delay or prevent an acquisition of Westaff or other strategic action or result in strategic decisions that could negatively impact the value and liquidity of our outstanding stock.

Price competition in the staffing industry continues to be intense, and pricing pressures from both competitors and customers could adversely impact our financial results.

The staffing industry is highly competitive with limited barriers to entry and continues to undergo consolidation. We compete in regional and local markets with large full service agencies, specialized temporary and permanent placement services agencies and small local companies. While some competitors are smaller than us, they may enjoy an advantage in discrete geographic markets because of a stronger local presence. Other competitors have greater marketing, financial and other resources than us that, among other things, could enable them to attempt to maintain or increase their market share by reducing prices. Furthermore, in past years there has been an increase in the number of customers consolidating their staffing services purchases with a single provider or with a small number of providers. The trend to consolidate staffing services purchases has in some cases made it more difficult for us to obtain or retain business.

We expect the level of competition to remain high in the future, and competitive pricing pressures will continue to make it difficult for us to raise our prices to immediately and fully offset increased costs of doing business, including increased labor costs, costs for workers’

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compensation and, domestically, state unemployment insurance. If we are not able to effectively compete in our targeted markets, our operating margins and other financial results will be harmed and the price of our securities could decline.

We have significant working capital requirements and are heavily dependent upon our ability to borrow money to meet these working capital requirements.

We require significant amounts of working capital to operate our business and to pay expenses relating to employment of temporary employees. Temporary personnel are generally paid on a weekly basis while payments from customers are generally received 30 to 60 days after billing. As a result, we must maintain sufficient cash availability to pay temporary personnel prior to receiving payment from customers.

We finance our operations primarily through borrowings under our revolving credit facilities and also through cash generated by our operating activities. As of January 20, 2007, our total borrowing capacity was $14.9 million consisting of $6.0 million for the domestic operations, $4.2 million for the United Kingdom operations and $4.7 million for the Australian operations.

The amount we are entitled to borrow under our revolving credit facilities is calculated daily and is dependent on eligible trade accounts receivable generated from operations, which are affected by financial, business, economic and other factors, as well as by the daily timing of cash collections and cash outflows. If we experience a significant and sustained drop in operating profits, or if there are unanticipated reductions in cash inflows or increases in cash outlays, we may be subject to cash shortfalls. If such a shortfall were to occur for even a brief period of time, it may have a significant adverse effect on our business. Furthermore, our receivables may not be adequate to allow for borrowings for other corporate purposes, such as capital expenditures or growth opportunities, and we would be less able to react to changes in the market or industry conditions.

The credit facilities contain covenants which, among other things, require us to maintain a minimum fixed charge coverage ratio and minimum earnings before interest, taxes, depreciation and amortization, or EBITDA. At the end of fiscal 2006, the minimum EBITDA covenant increased to $13.0 million on a trailing thirteen period basis. We failed to comply with that covenant and were required to obtain a waiver from our lenders, which we did in conjunction with our Tenth Amendment executed January 2, 2007. Any future failure to comply with the covenants under our credit facilities could result in an event of default which, if not cured or waived, could trigger prepayment obligations. In addition, a change of control is defined as an event of default and also could trigger prepayment obligations. If we were forced to refinance borrowings under the current facilities, there can be no assurance that such financing would be available or that such financing would not have a material adverse effect on our business and financial condition. Even if such refinancing were available, the terms could be less favorable and our results of operations and financial condition could be adversely affected by increased costs and rates.

We typically experience significant seasonal and other fluctuations in our borrowings and borrowing availability, particularly in the United States, and have, in the past, been required to

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aggressively manage our cash to ensure adequate funds to meet working capital requirements. Such steps included working to improve collections and adjusting the timing of cash expenditures, reducing operating expenses where feasible and working to generate cash from a variety of other sources.

We have historically experienced periods of negative cash flow from operations and investment activities, especially during seasonal peaks in revenue experienced in the third and fourth fiscal quarters of the year. In addition, we are required to pledge amounts to secure letters of credit that collateralize certain workers’ compensation obligations, and these amounts may increase in future periods. Any such increase in pledged amounts or sustained negative cash flows would decrease amounts available for working capital purposes and could have an adverse effect on our liquidity and financial condition.

The amount of collateral that we are required to maintain to support our workers’ compensation obligations could increase, reducing the amount of capital that we have available to support and grow our field operations.

We are contractually obligated to collateralize our workers’ compensation obligations under our workers’ compensation program through irrevocable letters of credit, surety bonds or cash. As of January 20, 2007 our aggregate collateral requirements under these contracts have been secured through $35.3 million of letters of credit; however, under certain circumstances, such as an inability to maintain minimum borrowing availability or a change in ownership and or senior management, we could be required to increase our letters of credit by $5 million. Further, our workers’ compensation program expires November 1, 2008, and as part of the renewal, could be subject to an increase in collateral. These collateral requirements are significant and place pressure on our liquidity and working capital capacity. We believe that our current sources of liquidity are adequate to satisfy our immediate needs for these obligations; however, our available sources of capital are limited. Depending on future changes in collateral requirements, we could be required to seek additional sources of capital in the future, which may not be available on commercially reasonable terms.

Our reserves for workers’ compensation claims may be inadequate to cover our ultimate liability, and we may incur additional charges if the actual amounts exceed the reserved amounts.

We maintain reserves to cover our estimated liabilities for workers’ compensation claims based upon actuarial estimates of the future cost of claims and related expenses which have been reported but not settled, and that have been incurred but not yet reported. The determination of these reserves is based on a number of factors, including current and historical claims activity, medical cost trends and developments in existing claims. Reserves do not represent an exact calculation of liability and are affected by both internal and external events, such as adverse development on existing claims, changes in medical costs, claims handling procedures, administrative costs, inflation, legal trends and legislative changes. Reserves are adjusted as necessary to reflect new claims and existing claims development, and such adjustments are reflected in the results of the periods in which the reserves are adjusted. While we believe our judgments and estimates are adequate, if our reserves are insufficient to cover our actual losses, an adjustment could be charged to expense that may be material to our earnings.

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Workers’ compensation costs for temporary employees may continue to rise and reduce margins and require more liquidity.

In the United States, we are responsible for and pay workers’ compensation costs for our regular and temporary employees. In recent years, these costs have risen substantially as a result of increased claims, general economic conditions, increases in healthcare costs and governmental regulations. In fiscal 2006, the increase in the volume of claims has fallen despite an increase in our domestic revenue, yet the increases in cost per claim have continued. Under our workers’ compensation insurance program, we maintain “per occurrence” insurance, which only covers claims for a particular event above a $500,000 deductible. Our workers’ compensation insurance policy expires November 1, 2008 and we cannot guarantee that we will be able to successfully renew such policy. Further, there are covenants associated with the continuation of the policy and there can be no guarantee that we will continue to meet those covenants going forward. Should our workers’ compensation premium costs continue to increase in the future, there can be no assurance that we will be able to increase the fees charged to our customers to keep pace with increased costs or if we were unable to obtain insurance on reasonable terms or forced to significantly increase our deductible per claim, our results of operations, financial condition and liquidity could be adversely affected.

Any significant economic downturn could result in our customers using fewer staffing services, which could materially adversely affect our business.

Demand for staffing services is significantly affected by the general level of economic activity. As economic activity slows, many customers reduce their utilization of temporary employees before undertaking layoffs of their regular full-time employees. Further, demand for permanent placement services also slows as the labor pool directly available to our customers increases, making it easier for them to identify new employees directly. Typically, we may experience increased pricing pressures from other staffing companies during periods of economic downturn, which could have a material adverse effect on our financial condition. The domestic economic recession of 2001 and 2002 did have a material adverse effect on our business. Additionally, in geographic areas where we derive a significant amount of business, a regional or localized economic downturn could adversely affect our operating results and financial position.

We assume the obligation to make wage, tax, and regulatory payments to our temporary employees and are then exposed to accounts receivable risks from our customers.

We generally assume responsibility for and manage the risks associated with our payroll obligations, including liability for payment of salaries and wages, payroll taxes as well as group health insurance. These obligations are fixed and become a liability of ours, whether or not the associated client where these employees have been assigned makes payments required by our service agreement, which exposes us to credit risks. We attempt to mitigate this risk by billing on a frequent basis, which typically occurs daily or weekly. In addition, we establish an allowance for doubtful accounts for estimated losses resulting from the inability of our customers to make required and timely payments. Further, we carefully monitor the timeliness of our customers’ payments and impose strict credit standards. Finally, the majority of our accounts receivable is used to secure our revolving credit facilities, which we rely on for liquidity. If we fail to

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adequately manage our credit risks associated with accounts receivable, our financial position could be adversely impacted.

We derive a significant portion of our revenue from franchise agent operations.

Franchise agent operations comprise a significant portion of our revenue. For the first fiscal quarter of 2007, 25.0% of our total revenue was derived from franchise agent operations. In addition, our ten largest franchise agents for fiscal 2006 (based on sales volume) accounted for 17.3% of our revenue. There can be no assurances that we will be able to attract new franchisees or that we will be able to retain our existing franchisees. The loss of one or more of our franchise agents and any associated loss of customers and sales could have a material adverse effect on our results of operations.

We are subject to business risks associated with international operations and fluctuating exchange rates.

We presently have operations in the United Kingdom, Australia and New Zealand, which comprised 25.2% of our revenue during the first fiscal quarter of 2007. Operations in foreign markets are inherently subject to certain risks, including in particular:

·      different cultures and business practices,

·      overlapping or differing tax structures,

·      economic and political uncertainties,

·      compliance issues associated with accounting and reporting requirements, and

·      changing, complex or ambiguous foreign laws and regulations, particularly as they relate to employment.

All of our sales outside of the United States are denominated in local currencies and, accordingly, we are subject to risks associated with fluctuations in exchange rates, which could cause a reduction in our profits. There can be no assurance that any of these factors will not have a material adverse effect on our business, results of operations, cash flows or financial condition.

The loss of any of our key personnel could harm our business.

Our future financial performance is significantly impacted by our ability to attract, motivate and retain key management personnel including our Chief Executive Officer and other members of the senior management team. Competition for qualified management personnel is very competitive and in the event that we experience turnover in senior management positions, we cannot assure you that we will be able to recruit suitable replacements on a timely basis. We must also successfully integrate all new management and other key positions within our organization to achieve our operating objectives. Even if we are successful, turnover in key management positions could temporarily harm our financial performance and results of operations until the new management becomes familiar with our business.

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Our success is impacted by our ability to attract and retain qualified temporary and permanent candidates.

We compete with other staffing services to meet our customers’ needs, and we must continuously attract reliable candidates to meet the staffing requirements of our customers. Consequently, we must continuously evaluate and upgrade our base of available qualified personnel to keep pace with changing customer needs and emerging technologies. Furthermore, a substantial number of our temporary employees during any given year will terminate their employment with us and accept regular staff employment with our customers. Competition for individuals with proven skills remains intense, and demand for these individuals is expected to remain strong for the foreseeable future. There can be no assurance that qualified candidates will continue to be available to us in sufficient numbers and on acceptable terms to us. The failure to identify, recruit, train and place candidates as well as retain qualified temporary employees over a long period of time could materially adversely affect our business.

Our service agreements may be terminated on short notice, leaving us vulnerable to loss of a significant amount of customers in a short period of time.

Our service agreements are generally cancellable with little or no notice by the customer to us. As a result, our customers can terminate their agreement with us at any time, making us particularly vulnerable to a significant decrease in revenue within a short period of time that could be difficult to quickly replace.

The cost of unemployment insurance for temporary employees may rise and reduce our margins.

In the United States, we are responsible for and pay unemployment insurance premiums for our temporary and regular employees. At times, these costs have risen as a result of increased claims, general economic conditions and government regulations. Should these costs continue to increase, there can be no assurance that we will be able to increase the fees charged to our customers in the future to keep pace with the increased costs, and if we do not, our results of operations and liquidity could be adversely affected.

Our information technology systems are critical to the operations of our business.

Our information management systems are essential for data exchange and operational communications with branches spread across large geographical distances. We have replaced key component hardware and software including backup systems within the past twelve months and are currently working towards replacing further key components over the next twelve to eighteen months. Any interruption, impairment or loss of data integrity or malfunction of these systems could severely impact our business, especially our ability to timely and accurately pay employees and bill customers. Further, any significant delay in our plans to replace the remaining key components could adversely affect the business. Issues with either would require that we commit significant additional capital as well as management resources in order to resolve the interruption or delay.

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We may be exposed to employment-related claims and costs that could materially adversely affect our business.

We are in the business of employing people and placing them in the workplace of other businesses on either a temporary or permanent basis. As a result, we are subject to a large number of laws and regulations relating to employment. The risks related to engaging in such business include but are not limited to:

·      claims of discrimination and harassment,

·      violations of wage and hour laws,

·      criminal activity,

·      claims relating to actions by customers including property damage and personal injury, misuse of proprietary information and misappropriation of assets, and

·      immigration related claims.

In addition, some or all of these claims may give rise to litigation, which could be time-consuming to our management team, and therefore, could have a negative effect on our business. In some instances, we have agreed to indemnify our customers against some or all of these types of liabilities. We have policies and guidelines in place to help reduce our exposure to these risks and have purchased insurance policies against certain risks in amounts that we currently believe to be adequate. However, there can be no assurance that our insurance will be sufficient in amount or scope to cover these types of liabilities or that we will be able to secure insurance coverage for such risks on affordable terms. Furthermore, there can be no assurance that we will not experience these issues in the future or that they could have a material adverse effect on our business.

The market for our stock may be limited, and the stock price may continue to be extremely volatile.

The average daily trading volume for our common stock on the NASDAQ Global Market was approximately 33,000 shares from January 1, 2006, through December 31, 2006. Accordingly, the market price of our common stock is subject to significant fluctuations that have been, and may continue to be, exaggerated because an active trading market has not developed for the stock. We believe that the common stock price has also been negatively affected by the fact that our stock is thinly traded and also due to the absence of analyst coverage. The lack of analyst reports about our stock may make it difficult for potential investors to make decisions about whether to purchase our stock and may make it less likely that investors will purchase the stock, thus further depressing the stock price. These negative factors may make it difficult for stockholders to sell our common stock, which may result in losses for investors.

The compliance costs associated with Section 404 of the Sarbanes-Oxley Act regarding internal control over financial reporting could be substantial, while failure to achieve and maintain compliance could have an adverse effect on our stock price.

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and current Securities and Exchange Commission (“SEC”) regulations and proposed rules, beginning with our Annual

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Report for the fiscal year ended November 1, 2008, we expect to be required to furnish a report by our management on our internal control over financial reporting. Further, we expect that our external auditors will be required to audit our internal control over financial reporting report and include their attestation on that report in our annual report on Form 10-K starting from our annual report for the 2009 fiscal year. The process of fully documenting and testing our internal control procedures in order to satisfy these requirements will result in increased general and administrative expenses and may shift management time and attention from profit-generating activities to compliance activities. Furthermore, during the course of our internal control testing, we may identify deficiencies which we may not be able to remediate in time to meet the reporting deadline under Section 404. Failure to achieve and maintain an effective internal control environment or complete our Section 404 certifications could have a material adverse effect on our stock price.

We are involved in an action taken by the California Employment Development Department.

During the fourth quarter of fiscal 2005, we were notified by the California Employment Development Department, or EDD, that our domestic operating subsidiaries unemployment tax rates would be increased retroactively for both calendar years 2005 and 2004, which would result in additional unemployment taxes of approximately $0.9 million. We have timely appealed the ruling by the EDD and are working with our outside counsel to resolve this matter. Although we believe that we have properly calculated our unemployment insurance tax and are in compliance with all applicable laws and regulations, there can be no assurances this will be settled in our favor.

We are a defendant in a variety of litigation and other actions from time to time, which may have a material adverse effect on our business, financial condition and results of operations.

We are regularly involved in a variety of litigation arising out of our business and, in recent years, have paid significant amounts as a result of adverse arbitration awards. We do not have insurance for some of these claims, and there can be no assurance that the insurance coverage we have will cover all claims that may be asserted against us. Should the ultimate judgments or settlements not be covered by insurance or exceed our insurance coverage, they could have a material adverse effect on our results of operations, financial position and cash flows. There can also be no assurance that we will be able to obtain appropriate and sufficient types or levels of insurance in the future or that adequate replacement policies will be available on acceptable terms, if at all.

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

Not applicable.

Item 3.    Defaults Upon Senior Securities

Not applicable.

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

None.

Item 5.    Other Information

No events.

Item 6.    Exhibits

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

10.3.13.1	Employment Agreement by and between Westaff Support, Inc. and Jeffrey A. Elias dated November 28, 2006.
10.3.14.1	Employment Contract by and between Westaff (USA), Inc./Westaff Support, Inc. and Eric Person dated August 14, 2006.
31.1	Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

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32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to 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.

		WESTAFF, INC.
March 6, 2007	/s/ John P. Sanders
Date	John P. Sanders
	Senior Vice President, Chief Financial Officer and Treasurer

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EXHIBIT INDEX

Exhibit No.	Description of Document
10.3.13.1	Employment Agreement by and between Westaff Support, Inc. and Jeffrey A. Elias dated November 28, 2006.
10.3.14.1	Employment Contract by and between Westaff (USA), Inc./Westaff Support, Inc. and Eric Person dated August 14, 2006.
31.1	Certification of the Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2	Certification of the Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1	Certification of the Chief Executive Officer pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2	Certification of the Chief Financial Officer pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.