Westaff 10-K 2007
Documents found in this filing:
WASHINGTON, D.C. 20549
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED OCTOBER 28, 2006
Commission File Number 000-24990
(Exact name of registrant as specified in its charter)
298 NORTH WIGET LANE, WALNUT CREEK, CA 94598-2453
(Address of principal executive offices, including zip code)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $0.01 par value per share
(Title of class)
Securities registered pursuant to Section 12(g) of the Act:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes o No x
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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
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.
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
As of April 15, 2006, the aggregate market value of the registrants common stock held by non-affiliates of the registrant was $38,806,262 based on the closing sale price as reported on the Nasdaq National Market.
As of January 25, 2007, the Registrant had outstanding 16,595,920 shares of Common Stock.
The following documents (or portions thereof) are incorporated herein by reference:
Portions of the Registrants Proxy Statement for the 2007 Annual Meeting of Stockholders are incorporated herein by reference into Part III of this Form 10-K Report.
This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, which are subject to a number of risks and uncertainties. All statements that are not historical facts are forward-looking statements, including statements about our business strategy, the timing of the introduction of our services, the effect of Generally Accepted Accounting Principles (GAAP) pronouncements, uncertainty regarding our future operating results and our profitability, anticipated sources of funds and all plans, objectives, expectations and intentions and the statements regarding revenue, expected domestic revenue growth rates for fiscal 2007, gross margins and our prospects for fiscal 2007. These statements appear in a number of places and can be identified by the use of forward-looking terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict, future, intend, or certain or the negative of these terms or other variations or comparable terminology, or by discussions of strategy.
Actual results may vary materially from those in such forward-looking statements as a result of various factors that are identified in Item 7Managements Discussion and Analysis of Financial Condition and Results of Operations, Item 1A.Risk Factors and elsewhere in this document. No assurance can be given that the risk factors described in this Annual Report on Form 10-K are all of the factors that could cause actual results to vary materially from the forward-looking statements. All forward-looking statements speak only as of the date of this Annual Report on Form 10-K. Readers should not place undue reliance on these forward-looking statements and are cautioned that any such forward-looking statements are not guarantees of future performance. We assume no obligation to update any forward-looking statements.
References in this Annual Report on Form 10-K to (i) the Company, the Registrant, Westaff, we, our, and us refer to Westaff, Inc., its predecessor and their respective subsidiaries, unless the context otherwise requires, and (ii) franchise agents refer to the Companys franchisees in their roles as limited agents of the Company in recruiting job applicants, soliciting job orders, filling those orders and assisting with collection matters upon request, but otherwise refer to the Companys franchisees in their roles as independent contractors of the Company.
This Annual Report on Form 10-K includes service marks of Westaff, Inc. Products or service names of other companies mentioned in this Annual Report on Form 10-K may be trademarks or registered trademarks of their respective owners. Investors and security holders may obtain a free copy of the Annual Report on Form 10-K and other documents filed by Westaff with the Securities and Exchange Commission (SEC) at the SECs website at http://www.sec.gov. Free copies of the Annual Report on Form 10-K and other documents filed by Westaff with the SEC may also be obtained from Westaff by directing a request to Westaff, Attention: Linda Gaebler, Vice President, Marketing and Communications, 298 North Wiget Lane, Walnut Creek, CA 94598-2453, (925) 930-5300.
We provide staffing services primarily in suburban and rural markets (secondary markets), as well as in the downtown areas of certain major urban centers (primary markets) in the United States, the United Kingdom, Australia and New Zealand. Through our network of Company-owned, franchise agent and licensed offices, we offer a wide range of staffing solutions, including permanent placement, replacement, supplemental and on-site temporary programs to businesses and government agencies. Our primary focus is on recruiting and placing clerical/administrative and light industrial personnel. We have over 50 years of experience in the staffing industry and, as of October 28, 2006, operated through 239 offices in 45 states and three foreign countries. As of October 28, 2006, 75% of these offices were owned by us and 25% were operated by franchise agents and one licensee.
We have four reportable segments: Domestic Business Services, United Kingdom, Australia and New Zealand. Domestic Business Services provides a variety of staffing services, primarily in clerical and light industrial positions, through a network of company-owned and franchise agent offices. The segment consists of eight geographically diverse company regions under the direction of regional managers and one combined franchise region. The international reportable segments comprise company-owned offices, primarily providing clerical and light industrial staffing services. We employ a managing director who oversees operations in the United Kingdom and a managing director who oversees operations in Australia and New Zealand. Revenue is attributed to each country based on the location of the respective countrys principal offices. Please see discussions in Note 14 to our consolidated financial statements attached to this Annual Report of Form 10-K for a discussion on financial information on our segments for the past three fiscal years.
We were founded in 1948 and incorporated in California in 1954. In October 1995, we reincorporated in Delaware. Our corporate name was changed to Westaff, Inc. in September 1998. Our executive offices are located at 298 North Wiget Lane, Walnut Creek, California 94598-2453, and our telephone number is (925) 930-5300. We transact business through our subsidiaries, the largest of which is Westaff (USA), Inc., a California corporation, which is the primary operating entity.
During the third quarter of fiscal 2005, we sold our operations in Norway and Denmark, and, during fiscal 1999, we sold our medical business, primarily operated through Western Medical Services, Inc. (Western Medical), a wholly owned subsidiary of us. As a result, we have classified these operations as discontinued operations in our consolidated financial statements.
Our service offerings are focused primarily on placing clerical/administrative and light industrial personnel into both temporary and permanent positions.
Clerical/Administrative Services. Clerical/administrative services personnel are placed for a broad range of general business positions including receptionists, administrative assistants, data entry operators, word processors, customer service representatives, telemarketers and various other general office, accounting, bookkeeping and clerical staff. Clerical/administrative positions also include call center agents, such as customer service, help desk and technical support staff.
Light Industrial Services. Light industrial services personnel are placed for a variety of assignments including general factory and manufacturing work (including production, assembly and support workers, merchandise packers and machine operators), warehouse work (such as general laborers, stock clerks, material handlers, order pickers, forklift operators and shipping/receiving clerks), technical work (such as lab technicians, inspectors, quality control technicians and drafters) and general services (such as maintenance and repair personnel, janitors and food service workers).
Permanent Placement Services. Permanent placement services are typically contingent fee-based services to recruit and fill regular staff positions for customers. These services include locating, screening and assessing candidates on behalf of customers. If the candidate is hired by the customer, we are generally paid a fee based on a percentage of the annual starting compensation for the candidate placed.
Management believes that clerical/administrative and light industrial staffing services are the foundation of the staffing industry and will remain a significant market for the foreseeable future. Management also believes that employees performing clerical/administrative and light industrial staffing functions are, and will remain, an integral part of the labor market in local, regional and national economies in which we operate.
We also provide other services within the clerical/administrative and light industrial staffing market such as temp-to-hire services, payrolling, on-site and on-location services, and other professional services including skills and behavioral assessments and coordination of drug testing and background checking.
· Temp-to-hire services represent the placement of temporary staff with a customer with the option to convert the temporary staff to a permanent customer employee at a later date.
· Payrolling typically involves the transfer of some of the customers short-term seasonal or special use employees to our payroll for a designated period.
· On-site programs provide administrative services for our customers such as coordinating all temporary staffing services throughout a customers location, including skills assessment and training.
· On-location programs provide for an independent branch office located at the customers facility. They are typically intended for large non-seasonal accounts with more than $1.0 million in annual revenue. This type of branch office is generally staffed by at least one manager-level employee.
Both on-site and on-location relationships provide customers with dedicated account management, which can more effectively meet the customers changing staffing needs with high quality, consistent service. These programs tend to have comparatively lower operating expenses and relatively longer customer relationships.
To complement our service offerings, we utilize a number of tools focused on increasing the pool of qualified candidates using advanced selection procedures for potential candidates (Talent Trak®) as well as technology-based management services that allow clients to maximize workforce productivity (Time Trak®). We believe that these tools enhance our competitive edge and position us to more effectively pursue high growth market niches such as financial services, customer interaction centers and high-end administrative placement.
Talent Trak®. To ensure high quality placements for customers and employees, we use Talent Trak® to strengthen the quality of our selection process. This comprehensive selection process includes flexible recruiting methods, interviewing and reference checking. We conduct advanced skills and behavioral assessments using Talent Trak®, and also provide the option for both background and drug testing that can be customized to meet a customers specific needs. We maintain contracts with national drug testing and background testing service providers to help ensure high quality and consistency in assessing our candidates.
Time Trak®. This tool provides customers with a web-based management system to assist in maximizing workforce productivity. Time Trak® is a flexible system allowing customers access to information to track a variety of performance measurements such as workforce hours, labor costs, attendance and staff performance. Time Trak® also includes features to automate timecard and payroll processing.
We provide staffing services primarily in secondary markets, as well as in the downtown areas of certain primary markets in the United States, the United Kingdom, Australia and New Zealand.
We capitalize on our presence in secondary markets to build market share by targeting small to medium-sized customers, including divisions of Fortune 500 companies. We believe that in many cases, such markets are less competitive and less costly to operate in than in the more central areas of primary markets, where a large number of staffing services companies frequently compete for business and occupancy costs are relatively high. In addition, management believes that secondary markets are more
likely to provide the opportunity to sell commercial and recurring business that is characterized by relatively higher gross margins.
We augment this concentration on secondary markets by also focusing on selected national contracts with customers having a large presence in these marketplaces. Such accounts include large clients in multiple locations supported by a dedicated corporate-level business relationship manager. We currently have existing national accounts across many different business sectors such as manufacturing, government, financial services, technology and communications. We maintain a professional sales team that services and leverages existing relationships to retain and grow these accounts. In addition, we continue to develop aggressive marketing programs to target and acquire additional clients that fit our branch system footprint. Management believes that our geographic alignment allows us to effectively compete for some of these national contracts.
We market our staffing services to local and regional customers through a network of Company-owned and franchise agent offices, as well as through our on-site and on-location service locations and through one licensed office. Domestically, our national marketing campaigns are coordinated through our corporate headquarters in cooperation with U.S. field offices. Marketing efforts for regional and international markets are generally conducted at the local level. New customers are developed by the field offices primarily through direct sales efforts and referrals. We have a robust targeted marketing program and a consultative sales process that includes telemarketing, e-mail marketing and direct mail campaigns.
We believe that a key component of our success is the ability to recruit and maintain a pool of qualified personnel and regularly place them into desirable and appropriate positions. We use comprehensive methods to identify, assess, select and, when appropriate, measure the skills of our temporary employees and permanent placement candidates to meet the needs of our customers. Domestically, we believe one of our key competitive advantages in attracting and retaining staffing personnel is our payroll system, which provides us with the ability to print payroll checks at virtually all of our branch offices within 24 hours after receipt of a timecard. Most Company-owned offices offer temporary employees a benefit package, including a service bonus and holiday pay. Franchise agent offices have the option to offer this benefit. All eligible temporary employees have the option to participate in our 401(k) plan and discounted employee stock purchase plan.
We operate each Company-owned office as a separate profit center and provide managers considerable operational autonomy and financial incentives. We also operate franchise agent offices in appropriate markets. Managers focus on business opportunities within markets and are provided centralized support to achieve success in those markets. We believe that this structure allows us to recruit and retain highly motivated managers who have demonstrated the ability to succeed in a competitive environment. This structure also allows managers and staff to focus on market development while relying on centralized services for support in back-office operations, such as risk management programs and unemployment insurance, credit, collections, accounting, advice on legal and regulatory matters, quality standards and marketing.
As of October 28, 2006, we operated through a network of 239 offices in 45 states and three foreign countries. In addition, from time to time we establish recruiting offices both for recruiting candidates and for testing demand for our services in new market areas. Our operations are decentralized with branch, market and district managers, regional vice presidents and franchise agents enjoying considerable autonomy in hiring, determining business mix and advertising.
The following table sets forth information as to the number of offices in operation as of the dates indicated:
(1) Excludes Company-owned recruiting offices.
Company-Owned Offices. Employees of each Company-owned office typically report to a branch or market manager who is responsible for day-to-day operations and the profitability of a market that consists of one to several offices. Domestically, branch or market managers typically report to district managers or regional vice presidents. District managers report to regional vice presidents who, in turn, report to the President and Chief Executive Officer. As of December 31, 2006, there were six regional vice presidents and eight district managers. We have a variety of incentive plans in place for our domestic and international offices. One or more of these plans may be offered to branch staff as well as market and district managers and regional vice presidents. These plans are designed to motivate employees to maximize the growth and profitability of their office, district or region, as well as to achieve budgeted goals. Management believes that our incentive-based compensation plans encourage employees in our Company-owned offices to increase sales and profits, resulting in a creative and committed team.
Franchise Agent Offices. Our franchise agents have the exclusive right by contract to sell certain of our services and to use our service marks, business names and systems in a specified geographic territory. Our franchise agent agreements generally allow franchise agents to open multiple offices within their exclusive territories. As of October 28, 2006, our 29 franchise agents operated 58 franchise agent offices. Sales generated by franchise agent operations and related costs are included in our consolidated revenue and costs of services, respectively, and during fiscal 2004, 2005, and 2006 franchise agent sales represented 29.0%, 28.1%, and 27.5% respectively, of our revenue.
The franchise agent, as an independent contractor, is responsible for establishing and maintaining an office and paying related administrative and operating expenses, such as rent, utilities and salaries of its branch office staff. Each franchise agent functions as a limited agent of the Company in recruiting job applicants, soliciting job orders, filling those orders and assisting and cooperating with collection matters upon request, but otherwise functions as an independent contractor. As franchisor, we are the employer of the temporary employees and the owner of the customer accounts receivable and are responsible for paying the wages of the temporary employees and all related payroll taxes and insurance. As a result, we provide a substantial portion of the working capital needed for the franchise agent operations.
Franchise agents are required to follow our operating procedures and standards in recruiting, screening, classifying and retaining temporary personnel.
Our sale of franchises is regulated by the Federal Trade Commission and by state business opportunity and franchise laws. We have filed registrations, been exempted from registration or filed a notice in all 15 states that require pre-sale registration or a notice filing under franchise investment laws in
order to offer the sale of franchises. We have not sought registration in one state in which no pre-sale notice is required.
Licensed Offices. As of October 28, 2006, one licensee operated one licensed office. We are no longer offering the license program. The licensee is the employer of the temporary employees and the owner of the customer accounts receivable. We finance the licensees temporary employee payroll, payroll taxes and insurance. This indebtedness is secured by a pledge of the licensees accounts receivable, tangible and intangible assets, and the license agreement. Borrowings under the lines of credit bear interest at a rate equal to the reference rate of Bank of America, N.A. plus two percentage points. Interest is charged on the borrowings only if the outstanding balance exceeds certain specified limits. The licensee is required to operate within the framework of our policies and standards, but must obtain its own workers compensation, liability, fidelity bonding and state unemployment insurance coverage, which determines its payroll costs.
Our franchise and license agreements have an initial term of five years and are renewable for multiple five-year terms. The agreements generally contain two-year non-competition covenants which we vigorously seek to enforce. Efforts to enforce the non-competition covenants have resulted in litigation brought by us following termination of certain franchise agent and license agreements.
We have experienced significant fluctuations in our operating results and anticipate that these fluctuations will continue. Operating results may fluctuate due to a number of factors, including seasonality, the demand for our services, the level of competition within our markets, our ability to increase the productivity of our existing offices, control costs and expand operations and the availability of qualified personnel. In addition, our results of operations could be, and have in the past been, adversely affected by severe weather conditions. Our fourth fiscal quarter generally consists of 16 weeks, while our first, second and third fiscal quarters consist of 12 weeks each. Moreover, our results of operations have also historically been subject to seasonal fluctuations. Demand for our services historically has been greatest during our fourth fiscal quarter due largely to the planning cycles of many of our customers. Furthermore, sales for the first fiscal quarter are typically lower due to national holidays as well as customer shutdowns during and after the holiday season. These shutdowns and post-holiday season declines in economic activity negatively impact job orders received by us, particularly in the light industrial sector.
We service small and medium-sized companies as well as divisions of Fortune 500 companies and local, state and federal government agencies. As is common in the staffing industry, our engagements to provide temporary services to our customers are generally of a non-exclusive, short-term nature and subject to termination by the customer with little or no notice. During fiscal 2006, no single customer accounted for more than 3.8% of our revenue. Our ten highest volume customers in fiscal 2006 accounted for an aggregate of 15.1% of our revenue.
The staffing industry is highly competitive with few barriers to entry. We believe that the majority of commercial staffing companies are local, full-service or specialized operations with less than five offices. Within local markets, typically no single company has a dominant share of the market. We also compete for qualified candidates and customers with larger, national full-service and specialized competitors in local, regional, national and international markets. The principal national competitors are Adecco SA, Spherion Corporation (commercial staffing segment), Kelly Services, Inc., Manpower Inc., Remedy
Intelligent Staffing, Express Personnel Services, Inc., and Randstad North America. Many of our principal competitors have greater financial, marketing and other resources than us. In addition, there are a number of medium-sized firms which compete with us in certain markets where they may have a stronger presence, such as regional or specialized markets.
We believe that the competitive factors in obtaining and retaining customers include understanding customers specific job requirements, providing qualified temporary personnel and permanent placement candidates in a timely manner, monitoring quality of job performance and pricing of services. We believe that the primary competitive factors in obtaining qualified candidates for temporary employment assignments are wages, benefits and flexibility and responsiveness of work schedules.
Our domestic management information systems provide support to both branch office locations and the corporate back-office. Branch offices utilize a proprietary application designed to assist in candidate searches, recruiting, customer order management, customer service, sales management and payroll entry and submission. The application also provides for the sharing of information between branch offices and corporate headquarters. Utilizing this system, field offices capture and input customer, employee, billing and payroll information. This information is electronically captured on centralized servers where payroll, billing and financial information is processed. These systems allow us to print checks at our branch offices within 24 hours or less after receipt of the timecard. Invoices are also processed daily and distributed from our centralized corporate office. These systems also support branch office operations with daily, weekly, monthly and quarterly reports that provide information ranging from customer activity to office profitability.
Each of our international operations have implemented customized or third-party front office and/or back office operating systems that are designed to meet the specific information technology and reporting requirements within the local jurisdiction.
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 our regular 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. In addition, we made certain technology infrastructure upgrades in our Australian operation during fiscal 2006 and are in the process of implementing a new front office system in our United Kingdom operation.
Domestically, we are responsible for all employee-related expenses for the temporary staff employees of our Company-owned and franchise agent offices including workers compensation, unemployment insurance, social security taxes, state and local taxes and other general payroll expenses.
We provide workers compensation insurance covering our domestic regular and temporary employees through a long-term relationship with Travelers Property Casualty Company of America (Travelers). For fiscal years 2005 and 2006, we retained a $500,000 deductible per occurrence for these policies. This retention was $750,000 per claim for fiscal 2004. We also purchase workers compensation insurance coverage based upon actual payroll classifications in the monopolistic state of North Dakota, and we are self-insured in the states of Ohio and Washington.
We are contractually required to collateralize our recorded obligations under the workers compensation insurance contracts with Travelers through irrevocable letters of credit, surety bonds or cash. As of October 28, 2006, these aggregate collateral requirements have been satisfied through $35 million of letters of credit.
Our nationwide risk management program is managed by our Risk Management Department consisting of risk management and workers compensation professionals as well as claim administrators who monitor the disposition of all claims and oversee, through an on-line system, all workers compensation claim activity. The department utilizes a variety of creative and aggressive workers compensation loss prevention and claim management strategies. The risk management program includes safety programs, claim strategy reviews with the carrier and third-party administrator, a return-to-work modified duty program, pre-placement customer safety evaluations and light industrial job approvals, the use of personal protective equipment, and the use of individual local office expense allocation formulas.
As of October 28, 2006, we had approximately 24,700 temporary employees on assignment and employed 809 regular staff. Our employees are not covered by any collective bargaining agreements. Management believes that its relationships with its employees are good.
We have various service marks registered with the United States Patent and Trademark Office, with the State of California and in various foreign countries, including our primary Westaff® service mark.
We also own other service marks, including the Westaff® logo, Talent Trak®, Time Trak®, Ms. Carmen Courtesy®, and Staff for Business Jobs for People®. We have filed applications to register the service marks Learning TrakSM and West-TekSM.
Federal and state service mark registrations may be renewed indefinitely as long as the underlying mark remains in use.
We file electronically with the Securities and Exchange Commission, or SEC, our annual report on From 10-K, quarterly interim reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. We maintain a site on the worldwide web at http://www.westaff.com; however, information found on our website is not incorporated by reference into this report. We make available free of charge on or through our website our SEC filings, including our annual report on Form 10-K, quarterly interim reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC. Further, a copy of this Annual Report on Form 10-K is located at the Securities and Exchange Commissions Public Reference Rooms at 100 F Street, N.E., Washington, D.C. 20549. Information on the operation of the Public Reference Room can be obtained by calling the Securities and Exchange Commission at 1-800-SEC-0330. The Securities and Exchange Commission maintains a website that contains reports, proxy and information statements and other information regarding our filings at http://www.sec.gov. Furthermore, we will provide electronic or paper copies of filings free of charge upon written request to our Chief Financial Officer or Investor Relations representative.
This Form 10-K 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. Numerous factors could cause actual results to differ significantly from the results described in these forward-looking statements, including the following risk factors.
Investing in our securities involves risk. The following risk factors, issues and uncertainties should be considered when evaluating our future prospects. In particular, please consider these risk factors when reading forward-looking statements which appear throughout this report. Forward-looking statements relate to our expectations for future events and time periods. Generally, words such as expect, intend, anticipate and similar expressions identify forward-looking statements. Each of these forward-looking statements involves risks and uncertainties, and future events and circumstances could differ significantly from those anticipated in the forward-looking statements. 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.
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 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.
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 October 28, 2006, 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, 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.
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.
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 October 28, 2006, our total borrowing capacity was $19.8 million consisting of $10.6 million for the domestic operations, $4.7 million for the United Kingdom operations and $4.5 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. 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 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.
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 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 fiscal 2006, 27.5% 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 21.6% of our revenue during fiscal 2006. 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.
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.
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.
Our Founder and Chairman controls a significant amount of our outstanding stock thus allowing him to exert significant influence on our management and affairs.
Our Chairman and Founder, W. Robert Stover, beneficially owns directly or indirectly, or has voting power over, in excess of 39% of our outstanding stock. As the principal stockholder of Westaff, Mr. Stover has 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, Mr. Stover has the ability to sell his shares independently and to strongly influence the election of the Board of Directors and the appointment of executive management. He 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 Mr. Stover 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.
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 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.
We lease three adjacent buildings in Walnut Creek, California, consisting of approximately 50,000 square feet, which house our executive and administrative offices. The lease is for a term of seven years commencing on January 12, 2003, with an additional five-year option to renew.
In addition, we lease space for our Company-owned offices in the United States and abroad. The majority of the leases are for fixed terms of one to five years and contain customary terms and conditions. Management believes that its facilities are adequate for its current needs and does not anticipate any difficulty replacing such facilities or locating additional facilities, if needed.
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, subject to and upon the terms and conditions of our various insurance policies, 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 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. 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.
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 former employees. Management believes the resolution of these matters will not have a material adverse effect on our financial statements.
Market Information. Our Common Stock has been included for quotation in the Nasdaq National Market (NASDAQ) under the symbol WSTF since April 30, 1996. The following table sets forth, for the periods indicated, the high and low closing sales prices of the Common Stock as reported on NASDAQ.
On January 20, 2007, the last reported sales price on NASDAQ for our Common Stock was $4.96 per share. As of January 20, 2007, there were approximately 73 shareholders of record.
Sales of Unregistered Securities. During fiscal 2006, we did not sell any unregistered securities.
Issuer Purchases of Equity Securities. None during the fourth quarter of fiscal 2006.
Dividends. We did not declare or pay dividends during fiscal 2005 or fiscal 2006. Further, our current credit facilities prohibit payment of dividends, so we are not currently contemplating a dividend declaration.
Securities Authorized Under Equity Plans. The following table sets forth securities authorized for issuance under equity compensation plans as of October 28, 2006. All applicable equity compensation plans were previously approved by security holders.
(1) Fiscal 2005 includes the reversal of $16,681 of domestic deferred tax valuation allowance ($1.02 per diluted share).
(2) At the beginning of fiscal 2003, we adopted Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets.
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 Companys Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report on Form 10-K for the fiscal year ended October 28, 2006.
This notice is intended to take advantage of the safe harbor provided by the Private Securities Litigation Reform Act of 1995 with respect to forward-looking statements. 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. The forward-looking statements in this discussion are made based on information available as of the date hereof and are subject to a number of risks and uncertainties that could cause the Companys 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. These risks and uncertainties include, but are not limited to, those discussed in Item 1A.Risk Factors under the heading Factors Affecting Future Operating Results. 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 preparation of our Consolidated Financial Statements and Notes thereto requires management to make estimates and assumptions that affect the amounts and disclosures reported within those financial statements. On an ongoing basis, management evaluates its estimates, including those related to revenue recognition, workers compensation costs, collectibility of accounts receivable, impairment of goodwill and intangible assets, contingencies, litigation and income taxes. Management bases its estimates and judgments on historical experiences and on various 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.
Management believes the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of our consolidated financial statements. There have been no material changes to these policies during fiscal 2006.
Revenue Recognition. We record revenue from the sale of temporary staffing, permanent placement fees, and temp-to-hire fees by our Company-owned and franchised operations. Temporary staffing revenue and the related labor costs and payroll taxes are recorded in the period in which the services are performed. Temp-to-hire fees are generally recorded when the temporary employee is hired directly by the customer. Permanent placement fees are recorded when the candidate commences full-time employment and, if necessary, sales allowances are established to estimate losses due to placed candidates not remaining employed for the permanent placement guarantee period, which is typically four weeks.
We account for our revenue and the related direct costs of our franchise arrangements in accordance with Emerging Issues Task Force (EITF) 99-19, Recording Revenue Gross as a Principal versus Net as an Agent. We first assess whether we act as a principal in our transactions or as an agent acting on the behalf of others. When we are the principal in a transaction and have the risks and rewards of ownership, we record the transaction gross in our income statement. Where we act merely as an agent, only the net fees earned are recorded in the income statement. Under our traditional franchise agreement, we have the
direct contractual arrangements with our customers and the contracts are binding on us. We are also the employer of all temporary employees in the franchise agents operations and, as such, are obligated for the temporary employee payroll, related payroll taxes and the risk of loss for accounts receivable collection. As we retain the risks and rewards of ownership, the revenue and costs of services of our franchise agents are included in our Results of Operations. Each accounting period, we remit to each franchisee either a portion of the gross profit or a portion of the sales generated by its office(s), based on what the relevant franchise agreement dictates. Franchise agents sales represented 27.5%, 28.1% and 29.0% of the Companys total revenue for fiscal 2006, 2005 and 2004, respectively. Franchise agents share of gross profit represents the net distribution paid to the franchise agents for their services in marketing to customers, recruiting temporary employees and servicing customer accounts.
We also have a licensing program in which the lone licensee has the direct contractual relationships with the customers, holds title to the related customer receivables and is the legal employer of the temporary employees. Accordingly, revenue and costs of services generated by the license operation are not included in our consolidated financial statements. We advance funds to our licensee for payroll, payroll taxes, insurance and other related items. Fees are paid to us based either on a percentage of revenue or of gross profit generated by the licensee and such license fees are recorded by us as license fees and included in revenue. We are no longer offering license agreements to new prospects.
Workers Compensation Reserves. We self-insure the deductible amount related to domestic workers compensation claims, which was $500,000 per claim for policy years 2006 and 2005, and $750,000 per claim for policy year 2004. We maintain reserves for workers compensation costs based upon actuarial methods utilized to estimate the remaining undiscounted liability for the deductible portion of all claims, including those incurred but not reported. This process includes establishing loss development factors based on our historical claims experience and the staffing industry, and applying those factors to current claims information to derive an estimate of our ultimate claims liability. The calculated ultimate liability is computed for each policy year and is then reduced by the cumulative claims payments to determine the required reserves. We evaluate the reserve and the underlying assumptions regularly throughout the year and make adjustments accordingly. At least annually, we obtain an independent actuarially determined calculation of the estimated costs of claims actually made to date, as well as claims incurred but not yet reported. If the actual costs of such claims and related expenses exceed the amounts estimated, additional reserves may be required. These reserves amounted to $24.3 million and $19.6 million at October 28, 2006, and October 29, 2005, respectively. While we believe that the recorded reserves are adequate, there can be no assurances that future, unfavorable changes to estimates relied upon in the determination of these reserves will not occur.
Collectibility of Accounts Receivable. We provide an allowance for uncollectible accounts receivable based on an estimation of losses which could occur if customers are unable to make required payments. We evaluate this allowance on a regular basis throughout the year and make adjustments as the evaluation warrants. If the financial condition of our customers were to deteriorate resulting in an impairment of their ability to make payments, additional allowances may be required. These allowances were $0.8 million at October 28, 2006, and $1.0 million at October 29, 2005. Our estimates are influenced by numerous factors including our large, diverse customer base, which is disbursed across a wide geographical area. No single customer accounted for more than 10% of accounts receivable for fiscal year 2006.
Goodwill and Other Intangible Assets. Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets (SFAS No. 142) requires that goodwill and certain intangible assets with indefinite useful lives no longer be amortized but instead be subject to an impairment test performed on an annual basis or whenever events or circumstances indicate that impairment may have occurred. Intangible assets with finite useful lives continue to be amortized over their useful lives. We utilize an independent third-party valuation firm to determine the fair value of our individual reporting units. The valuation methodologies considered include analyses of discounted cash
flows at the reporting unit level, publicly traded companies multiples within the temporary staffing industry and historical control premiums paid by acquirers purchasing companies similar to ours. We perform our annual impairment tests in the fourth quarter of each fiscal year.
Income Taxes. We account for income taxes by utilizing an asset and liability approach that requires recording deferred tax assets and liabilities for the future year consequences of events that have been recognized in our financial statements or tax returns. As required under SFAS No. 109, Accounting for Income Taxes, we measure these expected future tax consequences based upon provisions of tax law as currently enacted. The effects of future changes in tax laws are not anticipated. Variations in the actual outcome of these future tax consequences could materially impact our financial position or our results of operations. We also provide a reserve for tax contingencies when we believe a probable and estimatable exposure exists. At October 30, 2004, substantially all of our net deferred tax assets were offset with a valuation allowance of $18.7 million. During the fourth quarter of fiscal 2005, we assessed the realizability of our deferred tax assets. As a result of our positive domestic earnings in fiscal 2004 and 2005, the favorable projected earnings outlook, our long-term history of profitability as well as the improvements in our financial position, we determined that it is more likely than not that the deferred tax asset will be realized. Accordingly, during the fourth quarter of fiscal 2005, we reversed our full domestic deferred tax asset valuation allowance of $16.7 million.
Reserves for Legal and Regulatory Liabilities. There are various claims, lawsuits and pending actions against us incident to our operations for which we have recorded liabilities that we believe are appropriate. We evaluate this reserve regularly throughout the year and make adjustments as needed. If the actual outcome of these matters is different than expected, an adjustment is charged or credited to expense in the period the outcome occurs or the period in which the estimate changes. Whereas management believes the recorded liabilities are adequate, there are inherent limitations in the estimation process whereby future actual losses may exceed projected losses, which could materially adversely affect our financial condition.
Fiscal 2006 marks our highest revenue since fiscal 2000 and the highest gross profit since fiscal 2001. We are also very pleased to report a third consecutive profitable year following three challenging years in fiscal 2001 through 2003.
Our gross profit grew steadily quarter-over-quarter during the year to conclude at a 3% increase over fiscal 2005 and a 10% increase over fiscal 2004. Gross margins mirrored these results, increasing from 16.8% in fiscal 2004 to 17.3% in fiscal 2005 and to 17.7% in fiscal 2006. Our continued success with permanent placement revenue, which increased 38% as compared to fiscal 2005, along with a focus on higher-margin business are the predominant reasons underlying these increases. At this point, we believe margins will continue to grow into fiscal 2007, although there can be no assurance this will occur.
We closed fiscal 2006 with an improved financial position, including working capital of $41.9 million and borrowing capacity of $19.8 million. These, coupled with strong cash flow from our operating activities, should be more than sufficient to meet expected working capital requirements for fiscal 2007.
We believe that we are well positioned, both strategically and financially, to continue generating improved operating results in fiscal 2007.
Effective June 15, 2005, we sold our Norway and Denmark operations to Personalhuset AS, a recruitment and staffing company headquartered in Norway. Net proceeds from the sale were 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. The escrowed funds, net
of any claim payments, will be remitted to us in June 2007. We recorded a net gain on the sale of $1.2 million. We have classified the operations as discontinued operations in the accompanying financial statements and notes thereto.
As required under the terms of our Multicurrency Credit Agreement, the net proceeds from the sale of the Norway and Denmark operations were used to pay down borrowings on our revolving credit facility. Interest expense has been allocated to these discontinued operations in accordance with EITF 87-24.
During fiscal 1999, we discontinued our medical business (Western Medical) principally through a sale to Intrepid U.S.A. Under the terms of the sale, we retained the majority of accounts receivable, including trade and Medicare accounts receivable balances. During the third quarter of 2004, we resolved certain significant legal and liability claims and evaluated future risks associated with remaining pending claims and, as a result, recorded $0.2 million of income from the medical discontinued operations. As of October 28, 2006, there are remaining current liabilities of the discontinued medical operations of $23,000, primarily for settled but unpaid claims.
The table below sets forth, for the three most recent fiscal years, certain results of continuing operations data as a percentage of revenue.
* less than 0.1%
Revenue increased $2.1 million or 0.3% for fiscal 2006 as compared to fiscal 2005. Domestic revenue increased $11.2 million or 2.4%, largely due to an increase in average bill rates of 2.0%, coupled with an increase in permanent placement revenue of 84%. These increases were partially offset by a slight decrease in billed hours of 0.1%, which reflects the effects of a shift in business mix in an effort to increase gross margin. The increase in average bill rates primarily stems from a bill rate increase implemented in May 2006, coupled with a generally more positive economic environment in fiscal 2006 compared to fiscal 2005, which allowed us to price new business at higher rates as compared to fiscal 2005. Further, the increase in our domestic permanent placement revenue is the result of both our focused training efforts and having a full compliment of permanent placement consultants in place for fiscal 2006. The hiring of these consultants commenced in the latter half of fiscal 2005, and we intend to maintain or increase the
number of these consultants during fiscal 2007. As a percentage of revenue, domestic permanent placement fees increased to 1.0% in fiscal 2006 as compared to 0.6% in fiscal 2005. Based on our continuing efforts in this service line, coupled with a relatively low domestic unemployment rate, we are optimistic we can increase this revenue during fiscal 2007.
Offsetting the domestic revenue growth was a decrease in international revenue of $9.1 million or 6.4%. The largest cause of this decrease was a $6.5 million decrease in revenue from our Australian subsidiary, primarily due to decreased revenue from several large, national accounts. Billed hours decreased 8% in Australia, and the average bill rate remained essentially the same in fiscal 2006 as it had been in fiscal 2005. Partially offsetting this decrease in temporary services revenue, Australias permanent placement revenue increased 45% or $0.7 million.
In addition to the decrease noted in Australia, revenue from our United Kingdom operations decreased $1.4 million, or 3.4%. This is primarily the result of a 3.9% decrease in billable hours and average bill rates remaining essentially the same in fiscal 2006 as compared to fiscal 2005. The United Kingdom operations were without a Managing Director for much of fiscal 2006 and, consequently, the operation did not have as robust a focus on sales as it should have, resulting in an overall decrease in revenue.
Finally, revenue from our New Zealand operations decreased $1.2 million, or 16%. Billable hours for temporary services decreased 9.5% while the average bill rate decreased 6.4%, primarily due to the loss of one national account, the volume of which was not replaced during the fiscal year.
Costs of Services and Gross Profit
Costs of services include hourly wages of temporary employees, employer payroll taxes, state unemployment and workers compensation insurance and other employee-related costs. On a consolidated basis, costs of services decreased $0.9 million, or 0.2%, in fiscal 2006 as compared to fiscal 2005. This decrease is primarily attributable to an overall decrease in billable hours of 1.3%, partially offset by an overall increase in average pay rates of 1.1%. This overall decrease in costs of services, coupled with the increase in revenue noted above, caused gross profit to increase $3.0 million, or 2.8%, and also caused gross margin to increase to 17.7% as compared to 17.3% for fiscal 2005. Gross margin increased primarily as a result of bill rate increases and increases in permanent placement revenue, both explained above, coupled with stabilization of workers compensation costs and state unemployment insurance costs as explained below.
Our domestic workers compensation costs tend to vary depending upon the mix of business between clerical/administrative and light industrial. Unexpected adverse development of open claims and increases in our incurred but not reported (IBNR) claims can also significantly affect workers compensation costs. We monitor claim activity and evaluate actuarial estimates to ensure that accruals and resulting costs remain appropriate in light of loss trends. Further, we aggressively work to close out claims on terms that are favorable to us and continually monitor costs and accrual rates in light of actual loss trends. However, there can be no assurance that our efforts to control workers compensation costs will be effective or that loss development trends will not require additional increases in workers compensation accruals in future periods. As a percent of direct labor, domestic workers compensation costs remained stable at 5.4% for both fiscal 2006 and 2005.
As a percent of domestic direct labor costs, state unemployment rates remained stable at 3.1% for both fiscal 2006 and fiscal 2005. This stabilization assisted our efforts to manage consolidated costs of services in fiscal 2006.
We continue to focus our efforts on improving gross margin through development of our permanent placement service line and movement of our business mix to those opportunities offering higher margins.
These efforts, coupled with both low domestic unemployment rates and strong national economies in the United Kingdom, Australia and New Zealand, should allow us to continue improving gross margins into fiscal 2007. However, there can be no assurance we will be successful in that regard.
Franchise agents share of gross profit
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. As a percentage of consolidated revenue, franchise agents share of gross profit decreased from 3.1% of revenue for fiscal 2005 to 3.0% for fiscal 2006, primarily due to the conversion of two franchised operations into company-owned operations. During the second fiscal quarter of 2006, we acquired our Houston, Texas, franchised operations and at the beginning of our third fiscal quarter, we acquired our Raleigh, North Carolina, franchised operation. Therefore, upon acquisition, we maintained revenue streams from these operations yet were no longer paying out a portion of the gross profits.
Selling and administrative expenses
Selling and administrative expenses increased $4.6 million, or 6.0%, for the 2006 fiscal year as compared to fiscal 2005. As a percentage of revenue, selling and administrative expenses increased to 13.2% in fiscal 2006 from 12.5% in fiscal 2005. The increase is due to a combination of cost increases, including increased domestic salaries relating to revenue-producing staff placed into our field offices in the amount of $1.1 million, an enhanced field incentive plan to stimulate domestic sales growth in the amount of $1.2 million, increased employee health-related benefits of $0.6 million, an increase in bank service charges of $0.4 million and increased remote server hosting costs to support our Business Process Management, or BPM, system of $0.3 million. In addition, throughout fiscal 2006 a number of management personnel were replaced and some positions eliminated both domestically and internationally, which led to severance costs for the departed employees in the amount of $1.0 million.
Depreciation and amortization
Depreciation and amortization increased $0.6 million or 15.6%, primarily due to higher depreciation associated with portions of our domestic BPM system that have been placed into service. Currently, we anticipate depreciation expense to increase in fiscal 2007 as a result of additional modules of the BPM system being placed in service, which will activate depreciation and amortization on these modules.
Interest expense decreased $0.3 million for fiscal 2006 as compared to fiscal 2005 primarily as a result of lower average borrowings outstanding during the year partially offset by higher average interest rates. Contingent on maintaining or reducing our outstanding debt, coupled with no significant increase in interest rates, our interest expense would be expected to decline in fiscal 2007.
Income tax provision
We record income taxes using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. A valuation allowance is established when management determines it is more likely than not that a deferred tax asset is not realizable in the foreseeable future. During the fourth quarter of fiscal 2005, management assessed the realizability of its deferred tax assets. As a result of our positive domestic earnings in fiscal 2004 and 2005, the favorable projected earnings outlook, our long-term history of profitability as well as the improvements in our financial position, management determined that it is more likely than not that the deferred tax asset will be realized. Accordingly, during the fourth quarter of fiscal 2005, we reversed our full, domestic deferred tax asset valuation allowance of $16.7 million, which resulted in an increase in net income for fiscal 2005 of $16.7 million, or $1.02 per diluted share. No similar reversal was expected or recorded during fiscal 2006. The income tax provision recorded during fiscal 2006 differs from statutory rates primarily due to federal tax credits we take advantage of, primarily as a result of the workers opportunity tax credit program.
Revenue increased $23.0 million or 3.9% for fiscal 2005 as compared to fiscal 2004. Domestic revenue increased $0.6 million or 0.1%, while international revenue increased 18.8% over fiscal 2004.
The domestic revenue increase is the result of a decrease in billed hours of 2.6%, which was offset by an increase in average bill rates of 2.6%. The decline in domestic billed hours reflects the effects of the November 2004 divestiture of one of our franchises, the August 2005 divestiture of another of our franchises and a shift in business mix in an effort to increase gross margin. The increase in average bill rates reflects the generally more positive economic environment with lower national unemployment rates, which allows us to pass along bill rate increases to customers in certain circumstances.
Permanent placement fees increased from $6.1 million in fiscal 2004 to $7.1 million in fiscal 2005, an increase of 16.1%. This increase is virtually all attributable to our domestic operations, which grew from $1.7 million in fees in fiscal 2004 to $2.7 million in fiscal 2005, an increase of 58.5%. As a percentage of revenue, permanent placement fees in the U.S. were 0.6% in fiscal 2005 as compared to 0.4% in fiscal 2004.
Of the 18.8% increase in international revenue noted above, 5.3% is attributable to higher currency exchange rates. International billed hours increased 7.9% and average bill rates increased 5.8%. Local currency revenue from Australia increased 28.4% as a result of strong national account sales growth. Local currency revenue in the U.K. declined 7.7% during fiscal 2005, primarily due to off-shoring of certain staffing functions by a number of Westaffs U.K. customers.
Costs of Services
Costs of services include hourly wages of temporary employees, employer payroll taxes, state unemployment and workers compensation insurance and other employee-related costs. Costs of services increased $16.4 million, or 3.3%, in fiscal 2005 as compared to fiscal 2004. Fiscal 2005 gross profit increased $6.6 million, or 6.7%, and gross margin increased to 17.3% as compared to 16.8% for fiscal 2004. Gross margin increased primarily as a result of stabilization of workers compensation costs as noted below, bill rate increases, changes in business mix and increased permanent placement fees as noted above, partially offset by higher state unemployment insurance costs.
Our domestic workers compensation costs tend to vary depending upon the mix of business between clerical/administrative and light industrial staffing. Unexpected adverse development of open claims and
increases in our IBNR claims can also significantly affect the level of accruals needed to cover workers compensation costs. We review interim and annual actuarial estimates and monitor claim activity to ensure that accruals remain appropriate in light of loss trends. However, unanticipated adverse loss development trends can result in a need for additional charges to be recorded. As a percent of direct labor, domestic workers compensation costs decreased from 5.9% in fiscal 2004 to 5.4% in fiscal 2005. The fiscal 2004 fourth quarter included a charge of $1.7 million to increase our domestic workers compensation reserves as a result of unfavorable loss development trends. During fiscal 2005, we increased our basic accrual rates for workers compensation which, combined with more stable loss trends, resulted in no such charge in fiscal 2005. We aggressively work to close out claims on terms that are favorable to us and continually monitor our costs and accrual rates in light of actual loss trends.
As a percent of direct labor, domestic state unemployment rates increased from 2.6% in fiscal 2004 to 3.1% in fiscal 2005. This increase is largely due to an increase in the unemployment tax rate assessed in the State of California. During the fourth quarter of fiscal 2005, we were notified by the EDD that our California unemployment tax rates would be increased retroactively for both calendar years 2005 and 2004. This rate increase was based on the EDD finding that our wholly-owned domestic operating subsidiaries would be considered as a single reporting entity for California unemployment tax reporting purposes. 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. We accrued a portion of the increased tax during the fourth quarter of fiscal 2005. However, management believes that it has strong defenses and legal arguments with respect to approximately $0.9 million of the assessment and accordingly has not accrued for that portion of the assessment as of October 29, 2005 or October 28, 2006.
Franchise agents share of gross profit
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. As a percentage of consolidated revenue, franchise agents share of gross profit was 3.1% for both fiscal 2005 and fiscal 2004. In November 2004, we sold one of our franchise agents operations, representing four franchise offices, back to the franchise agent. Revenue for this franchise agent comprised 3.2% of total domestic revenue for the fiscal year ended October 30, 2004. In August 2005, we sold one additional franchise agent operation, representing two franchise offices, back to the franchise agent. Year-to-date fiscal 2005 revenue for this franchise agent through the date of the sale comprised approximately 0.7% of our fiscal 2005 domestic revenue.
Selling and administrative expenses
Selling and administrative expenses increased $6.8 million, or 9.7%, for the 2005 fiscal year as compared to fiscal 2004, due primarily to investments in new and existing personnel along with associated benefits and payroll taxes. As a percentage of revenue, selling and administrative expenses increased to 12.5% in fiscal 2005 from 11.8% in fiscal 2004. We are continuing our investment in our field office staff, increasing full-time equivalent positions by approximately 11% as of the end of fiscal 2005 as compared to the prior year end. These staff increases have been made to support the development of our domestic permanent placement line of business along with increasing staff in selected offices to help support future growth and business development. Additionally, we have increased staffing to support the implementation of our new business process management system. The fiscal 2005 fourth quarter included $0.5 million of costs associated with a restructure, while the fiscal 2005 second quarter included separation costs of $0.5 million for our former chief executive officer. Selling and administrative expenses in the second quarter of fiscal 2004 were reduced by a $0.7 million gain on the sale of the executive headquarters building in
Walnut Creek, California. The fiscal 2004 fourth quarter included costs of $0.9 million associated with an unfavorable arbitration ruling.
Depreciation and amortization
Depreciation and amortization decreased $0.2 million or 5.0%, primarily due to assets becoming fully depreciated, partially offset by higher depreciation starting in the fourth quarter associated with the portions of our BPM system that have been placed in service.
Interest expense decreased $0.5 million for fiscal 2005 as compared to fiscal 2004 primarily as a result of lower average borrowings outstanding during the year partially offset by higher average interest rates.
Income tax provision
We record income taxes using an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financial statements or tax returns. A valuation allowance is established when management determines it is more likely than not that a deferred tax asset is not realizable in the foreseeable future. At October 30, 2004, substantially all of our net deferred tax assets were offset with a valuation allowance of $18.7 million. During the fourth quarter of fiscal 2005, we assessed the realizability of our deferred tax assets. As a result of our positive domestic earnings in fiscal 2004 and 2005, the favorable projected earnings outlook, our long-term history of profitability as well as the improvements in our financial position, we determined that it is more likely than not that the deferred tax asset will be realized. Accordingly during the fourth quarter of fiscal 2005, we reversed our full, domestic deferred tax asset valuation allowance of $16.7 million, which resulted in an increase in net income for fiscal 2005 of $16.7 million, or $1.02 per diluted share.
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 and during periods where sales are seasonally high. Temporary personnel are generally 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 $13.2 million for the fiscal year ended October 28, 2006, compared to $7.6 million for the fiscal year ended October 29, 2005. The largest portion of the fiscal 2006 cash provided by operating activities was generated from managing receivables, which provided $7.5 million of the operating cash flow. Our days sales outstanding, or DSO, was significantly reduced as compared to fiscal year end 2005.
Cash used for investing activities was $9.1 million in fiscal 2006 as compared to $4.6 million in fiscal 2005. Capital expenditures, which is primarily for BPM system initiatives, other software, computers and peripherals, and office furniture and equipment, was $5.1 million of this amount during fiscal 2006. 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 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. Capital expenditures
associated with this system implementation were approximately $2.7 million during fiscal year 2006. In addition, we made certain technology infrastructure upgrades in our Australian operation during fiscal 2006 and are also in the process of implementing a new front office system in our United Kingdom operation. Our credit agreement currently allows up to a maximum of $6.0 million in capital expenditures for fiscal 2007.
In addition, cash used by investing activities in fiscal 2006 included $3.8 million for a Westaff franchise located in Houston, Texas. We believe the terms and conditions of the preexisting relationship were consistent with other relationships we have with other franchisees, and accordingly have not recorded a settlement gain or loss. The transaction resulted in us recording $3.4 million of franchise rights, $0.1 million of non-compete agreements, and $0.3 million of goodwill.
We have generated cash in the past through sales of company-owned offices to franchise owners or sales of franchise agent and license offices back to the franchise agent or license owner. In the first quarter of fiscal 2005, we sold one of our franchise agents operations back to the franchise agent for cash proceeds of $1.0 million. We secured the franchise agents note payable obligation to the bank that funded the purchase through a $1.0 million letter of credit that declines as the note obligation is paid by the franchise agent. As of October 28, 2006, the balance on the letter of credit was $0.8 million. The $1.0 million gain on the sale of the franchise operations has been deferred, and is being recognized as the note obligation payments are made. During the fourth quarter of fiscal 2005, we sold an additional franchise agents operations to the franchise agent for cash proceeds and a net gain of $0.5 million.
As noted above in Discontinued Operations, in June 2005, we sold our Norway and Denmark operations for net proceeds of 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 claims under Norways pension plans. The escrowed funds, net of any claim payments, will be remitted to us in June 2007. The proceeds received were used to pay down borrowings under our revolving credit facility. We recorded a net gain on the sale of $1.2 million. No similar sale occurred during fiscal 2006.
Cash used for financing activities was $3.6 million in fiscal 2006 and $6.9 million in fiscal 2005. In both years, the primary cause behind this usage was repayments under our lines of credit, which amounted to $3.9 million in fiscal 2006 and $7.1 million in fiscal 2005.
In May 2002, we entered into agreements with GE Capital, as primary agent, to provide senior secured multicurrency credit facilities that originally expired in May 2007. The credit facility comprised a five-year syndicated Credit Agreement (the Multicurrency Credit Agreement) consisting of a $50.0 million 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 on May 16, 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 Registrants Norway and Denmark operations of approximately $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 for the purpose of determining the financial covenants. The amendment allows for a one-time add-back adjustment of approximately $0.5 million to EBITDA commencing the fiscal quarter ending April 15, 2006, for the separation and transition charges related to the termination of employment for two of our former executives.
On January 2, 2007, we and our lenders executed a Tenth Amendment to the Multicurrency Credit Agreement. Among other things, this amendment reduces the interest rates if certain financial benchmarks are achieved and resets the future minimum EBITDA covenants. The amendment extended the credit facility for one additional year to May 2009. We were not in compliance with its minimum EBITDA covenant as of the end of fiscal 2006, and the amendment included a waiver of this covenant violation.
On January 25, 2007, we and our lenders executed an amendment to the A$ Facility Agreement, which extended the agreement for two additional years to May 2009.
As of October 28, 2006, we had $4.8 million outstanding under our credit facilities all of which was outstanding under the A$ Facility Agreement. We have combined available borrowing capacity under our credit facilities of $19.8 million consisting of $10.6 million for the U.S., $4.7 million for the U.K. and $4.5 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 principal stockholder and Chairman of the Board of Directors in the amount of $2.0 million with a maturity date of August 18, 2007, and an interest rate equal to an indexed rate as calculated under our credit facilities plus seven percent (15.25% at October 28, 2006), 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. During fiscal 2004, the U.K. utilized cash from operations and excess borrowing capacity to pay dividends to the U.S. totaling $2.7 million. 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 $4.2 million as of October 28, 2006, and $4.1 million as of October 29, 2005.
We are responsible for and pay workers compensation costs for our domestic temporary and regular employees and are self-insured for the deductible amount related to workers compensation claims ($500,000 per claim for fiscal years 2006 and 2005 and $750,000 per claim for fiscal 2004). Generally speaking, 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 for us 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.
Under the terms of our 2006 policy year agreement, we made cash payments totaling $4.9 million, paid in equal monthly installments, which commenced on November 1, 2005.
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. 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, we may be required to increase our letters of credit by $5 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.
The following summarizes our contractual cash obligations in future fiscal years (in millions) as of October 28, 2006:
(1) The credit agreement expires in May 2009, but our lenders could require accelerated payment of amounts outstanding under the credit facilities in the event of default on one or more of the debt covenants contained therein.
(2) Payments under the promissory note are subject to certain restrictions regarding borrowing capacity and compliance within our senior secured credit facilities.
(3) Workers compensation obligations for policy year 2007 are based on estimates. If actual results differ from these estimates, we could be required to make additional payments to, or receive refunds from, our insurance carrier in years subsequent to 2007.
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 October 28, 2006, our outstanding debt under variable-rate interest borrowings was approximately $6.8 million. A change of two percentage points in the interest rates would cause a change in interest expense of approximately $0.1 million 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 fiscal year ended October 28, 2006, our international operations comprised 21.6% of our revenue and, as of the end of that period, 19.3% 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 transaction risks related to foreign currencies. In addition, we have not entered into any transactions with derivative financial instruments for trading purposes.
Our Financial Statements and Supplementary Data required by this Item are set forth at the pages indicated at Item 15(a).
We carried out an evaluation, under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined under Rules 13a15(e) and 15d15(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 October 28, 2006 (the end of the period covered by this report) our disclosure controls and procedures are effective in timely alerting them to material information required to be included in this report. There was no change in our internal control over financial reporting that occurred during the fiscal year ended October 28, 2006, that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
The information required by this Item is incorporated herein by reference from our Proxy Statement for the 2007 Annual Meeting of Stockholders. We have adopted a Code of Ethics that applies to all our principal executive, financial and accounting officers. The Code of Ethics is posted on our website at www.westaff.com. We intend to satisfy the requirements under Item 5.05 of Form 8-K regarding disclosure of amendments to, or waivers from, provisions of our Code of Ethics that apply, by posting such information on our website. Copies of the Code of Ethics will be provided, free of charge, upon written request directed to Investor Relations, Westaff, Inc., P.O. Box 9280, Walnut Creek, CA 94598.
The information required by this Item is incorporated herein by reference from our Proxy Statement for the 2007 Annual Meeting of Stockholders.
The information required by this Item is incorporated herein by reference from our Proxy Statement for the 2007 Annual Meeting of Stockholders.
Our wholly-owned subsidiary known as Westaff (USA), Inc., a California corporation (Westaff (USA)) executed an unsecured subordinated promissory note dated April 1, 2002, payable to W. Robert Stover, its principal stockholder and Chairman of the Board of Directors, in the amount of $2.0 million. The initial term of the note was one year with an interest rate of 12% per annum, payable monthly on the last business day of each calendar month. On May 17, 2002, the note was amended and restated to extend the maturity date to August 18, 2007. Additionally, the interest rate and payment schedule were amended to a rate equal to the U.S. Index Rate as calculated under our Multicurrency Credit Agreement with General Electric Capital Corporation (Credit Agreement), plus seven percent, compounded monthly payable 60 calendar days after the end of each of our fiscal quarters. The interest rate in effect on October 28, 2006, was 15.25%. 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 interest paid in fiscal 2006 was $0.3 million.
Any future transactions between us and our officers, directors, and affiliates will be on terms no less favorable to us than can be obtained from unaffiliated third parties. Such transactions with such persons will be subject to approval of our Audit Committee.
The information required by this Item is incorporated herein by reference from our Proxy Statement for the 2007 Annual Meeting of Stockholders.
(a) The following documents have been filed as a part of this Annual Report on Form 10-K.
2. Financial Statement Schedules.
All schedules are omitted because they are not applicable or not required or because the required information is included in the Consolidated Financial Statements or the Notes thereto.
The following exhibits are filed as part of, or incorporated by reference into, this Annual Report:
(1) Incorporated herein by reference to the exhibit with the same number filed with the Companys Registration Statement on Form S-1 (File No. 33-85536) declared effective by the Securities and Exchange Commission on April 30, 1996.
(2) Incorporated herein by reference to the exhibit with the same number filed with the Companys Annual Report on Form 10-K for the fiscal year ended October 31, 1998.
(3) Incorporated herein by reference to the exhibit with the same number filed with the Companys Annual Report on Form 10-K for the fiscal year ended November 3, 2001.
(4) Incorporated herein by reference to the exhibit with the same number filed with the Companys Quarterly Report on Form 10-Q for the quarter ended April 20, 2002.
(5) Incorporated herein by reference to the exhibit with the same number filed with the Companys Quarterly Report on Form 10-Q for the quarter ended July 13, 2002.
(6) Incorporated herein by reference to the exhibit with the same number filed with the Companys Annual Report on Form 10-K for the fiscal year ended November 2, 2002.
(7) Incorporated herein by reference to the exhibit with the same number filed with the Companys Quarterly Report on Form 10-Q for the quarter ended July 12, 2003.
(8) Incorporated herein by reference to the exhibit with the same number filed with the Companys Annual Report on Form 10-K for the fiscal year ended November 1, 2003.
(9) Incorporated herein by reference to the exhibit with the same number filed with the Companys Quarterly Report on Form 10-Q for the quarter ended January 24, 2004.
(10) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated March 1, 2004.
(11) Incorporated herein by reference to the exhibit with the same number filed with the Companys Quarterly Report on Form 10-Q for the quarter ended July 10, 2004.
(12) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated September 20, 2004.
(13) Incorporated herein by reference to the exhibit with the same number filed with the Companys Annual Report on Form 10-K for the fiscal year ended October 20, 2004.
(14) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated January 5, 2005.
(15) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated April 7, 2005.
(16) Incorporated herein by reference to the exhibit with the same number filed with the Companys Quarterly Report on Form 10-Q for the quarter ended April 16, 2005.
(17) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated August 19, 2005.
(18) Incorporated herein by reference to the exhibit with the same number filed with the Companys Annual Report on Form 10-K for the fiscal year ended October 29, 2005.
(19) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated March 1, 2006.
(20) Incorporated herein by reference to Exhibits 10.1, 10.2, and 10.3 filed with the Companys Current Report on Form 8-K dated March 24, 2006.
(21) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated March 31, 2006.
(22) Incorporated herein by reference to Exhibits 10.1, 10.2, 10.3 and 10.4 filed with the Companys Current Report on Form 8-K dated April 19, 2006.
(23) Incorporated herein by reference to Exhibits 10.1 and 10.2 filed with the Companys Current Report on Form 8-K dated April 21, 2006.
(24) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated July 25, 2006.
(25) Incorporated herein by reference to the exhibit with the same number filed with the Companys Current Report on Form 8-K dated January 2, 2007.
To the Board of Directors and Stockholders of Westaff, Inc.
We have audited the accompanying consolidated balance sheets of Westaff, Inc. and subsidiaries (the Company) as of October 28, 2006 and October 29, 2005, and the related consolidated statements of income, stockholders equity, and cash flows for each of the three years in the period ended October 28, 2006. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of Westaff, Inc. and its subsidiaries as of October 28, 2006 and October 29, 2005, and the results of their operations and their cash flows for each of the three years in the period ended October 28, 2006, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Notes 2 and 12 to the consolidated financial statements, effective October 30, 2005, the Company changed its method of accounting for share-based payment arrangements to conform to Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
/s/ DELOITTE & TOUCHE LLP
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.
See accompanying notes to consolidated financial statements.