Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission File No. 1-13998

Administaff, Inc.

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

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

     As of August 7, 2002, 27,822,321 shares of the registrant’s common stock, par value $0.01 per share, were outstanding.

Table of Contents

TABLE OF CONTENTS

- -2-

Table of Contents

ADMINISTAFF, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

ASSETS

- -3-

Table of Contents

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

LIABILITIES AND STOCKHOLDERS’ EQUITY

See accompanying notes.

- -4-

Table of Contents

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

See accompanying notes.

- -5-

Table of Contents

ADMINISTAFF, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
SIX MONTHS ENDED JUNE 30, 2002
(in thousands)
(Unaudited)

See accompanying notes.

- -6-

Table of Contents

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

- -7-

Table of Contents

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

See accompanying notes.

- -8-

Table of Contents

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2002

1. Basis of Presentation

     Administaff, Inc. (“the Company”) is a professional employer organization (“PEO”) that provides a comprehensive Personnel Management System that encompasses a broad range of services, including benefits and payroll administration, health and workers’ compensation insurance programs, personnel records management, employer liability management, employee recruiting and selection, performance management, and training and development services to small and medium-sized businesses in strategically selected markets. For the six months ended June 30, 2002 and 2001, revenues from the Company’s Texas markets represented 41% and 46% of the Company’s total revenues, respectively.

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

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

     The accompanying consolidated financial statements should be read in conjunction with the Company’s audited consolidated financial statements for the year ended December 31, 2001. The consolidated balance sheet at December 31, 2001, has been derived from the audited financial statements at that date but does not include all of the information or footnotes required by generally accepted accounting principles for complete financial statements. The Company’s consolidated balance sheet at June 30, 2002, and the consolidated statements of operations, cash flows and stockholders’ equity for the interim periods ended June 30, 2002 and 2001, have been prepared by the Company without audit. In the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to present fairly the consolidated financial position, results of operations and cash flows have been made. The results of operations for the interim periods are not necessarily indicative of the operating results for a full year or of future operations. Historically, the Company’s earnings pattern has included losses in the first quarter, followed by improved profitability in subsequent quarters throughout the year. This pattern is due to the effects of employment-related taxes which are based on each employee’s cumulative earnings up to specified wage levels, causing employment-related taxes to be highest in the first quarter and then decline over the course of the year.

     Certain prior year amounts have been reclassified to conform with current year presentation.

- -9-

Table of Contents

2. Accounting Policies

     The following accounting policies reflect only new or modified accounting policies the Company has adopted during 2002, as a result of new contractual arrangements or the adoption of newly issued accounting pronouncements.

Health Insurance Costs

     The Company provides health insurance coverage to its worksite employees through a national network of carriers including UnitedHealthcare (“United”), PacifiCare, Kaiser Permanente, Cigna and Blue Cross and Blue Shield of Georgia, all of which are fully-insured policies. The policy with United provides the majority of the Company’s health insurance coverage. Pursuant to the terms of the Company’s annual contract with United, within a 195 days after contract termination, a final accounting of the plan will be performed and the Company will receive a refund for any accumulated surplus or will be liable for any accumulated deficit in the plan, up to the amount of the Company’s security deposit with United. As a result, the Company accounts for this plan using a partially self-funded insurance accounting model, under which the Company must estimate its incurred but not reported (“IBNR”) claims at the end of each accounting period to determine the existence of any accumulated deficit or surplus. Any resulting accumulated deficit or surplus is recorded as a liability or asset, respectively, on its balance sheet. As of June 30, 2002, the Company has recorded an estimated accumulated deficit liability of approximately $175,000.

Workers’ Compensation Costs

     The Company’s workers’ compensation insurance policy for the two-year period ending September 30, 2003 is a guaranteed-cost policy under which premiums are paid for full-insurance coverage of all claims incurred during the policy. This policy also contains a dividend feature for each policy year, under which the Company is entitled to a refund of a portion of its premiums if, four years after the end of the policy year, claims paid by the insurance carrier for any policy year are less than an amount set forth in the policy. In accordance with Emerging Issues Task Force (“EITF”) Topic D-35, FASB Staff Views on EITF No. 93-6, “Accounting for Multiple-Year Retrospectively Rated Contracts by Ceding and Assuming Enterprises,” the Company estimates the amount of refund, if any, that has been earned under the dividend feature, based on the actual claims incurred to date and a factor used to develop those claims to an estimate of the ultimate cost of the incurred claims during that policy year. As of June 30, 2002, a $1.5 million estimated dividend receivable has been recorded as a long-term asset.

Cash and Cash Equivalents

     Cash and cash equivalents include bank deposits and short-term investments with original maturities of three months or less at the date of purchase. All of the Company’s cash and cash

- -10-

Table of Contents

equivalents are available to fund the Company’s current operations, except for minimum balances required under the Company’s revolving credit agreement.

Marketable Securities

     At June 30, 2002, the Company’s marketable securities consisted of debt securities issued by corporate and governmental entities, with contractual maturities ranging from 91 days to five years from the date of purchase. All of the Company’s investments in marketable securities are classified as available-for-sale, and as a result, are reported at fair value. All of the Company’s marketable securities are available to fund the Company’s current operations, except for minimum balances required under the Company’s revolving credit agreement. Unrealized gains and losses are reported, net of tax, as a component of accumulated other comprehensive income in stockholders’ equity.

Property and Equipment

     On January 1, 2002, the Company adopted Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 requires than an impairment loss be recognized for assets to be disposed or held-for-use when the carrying amount of the asset is not recoverable. The adoption of SFAS No. 144 did not have an impact on the Company’s results of operations or financial position.

3. Property and Equipment

     During the first quarter of 2002, the Company purchased substantially all of the assets of Virtual Growth, Inc. through bankruptcy proceedings for a total cost of $1.6 million. The purchase price was allocated to the assets purchased based on their estimated fair market value at the date of acquisition. The primary assets purchased included computer hardware and software and intellectual property, including capitalized software development costs.

4. Deposits

     As of June 30, 2002, the Company has made cash security deposits totaling $20 million with its primary health insurance carrier, United. The Company’s contract with United provides for an additional deposit of $5 million to be made prior to September 30, 2002. Unless amended in writing by the parties, beginning January 1, 2004 and each year thereafter, the security deposit will be adjusted to the greater of $22.5 million or 7.5% of the estimated annual premiums for that contract year. In the event of a default or termination of the Company’s contract with United, a default pursuant to the revolving credit agreement or the reduction of the Company’s current ratio to an amount below 0.60, United may draw against the security deposit to collect any unpaid health insurance premiums or any accumulated deficit in the plan.

- -11-

Table of Contents

5. Other Assets

     The Company has an investment in eProsper, Inc. (“eProsper”), a development stage company, totaling $3.1 million at June 30, 2002, including a $500,000 investment that was made in April 2002 in connection with eProsper’s $1.5 million convertible preferred stock offering. This investment is recorded under the cost method. Under the cost method, the Company periodically evaluates the realizability of this investment based on its review of the investee’s financial condition, financial results, financial projections and availability of additional financing sources. If, based on its review, the Company were to determine that the investment’s estimated fair market value had declined below its carrying value for a reason that was other than temporary, the Company would be required to write down the value of the investment to its estimated fair market value in the period such determination was made.

6. Revolving Credit Agreement

     On June 25, 2002, the Company entered into a $30 million revolving credit agreement that expires on December 23, 2002, replacing its former $21 million cash-secured line of credit. As of June 30, 2002, the Company has borrowed $21 million under this credit agreement, the proceeds of which have been used to finance the construction of a new facility at the Company’s corporate headquarters. Amounts borrowed under the credit agreement accrue interest based on a rate determined at the time of borrowing (weighted average rate of 2.4% at June 30, 2002). As of June 30, approximately $275,000 of interest expense related to the current and former credit agreements have been capitalized as part of construction in progress. Borrowings under the revolving credit agreement are secured by real estate and related improvements at the Company’s headquarters, a corporate-owned aircraft and a third party note receivable. Under the terms of the agreement, the Company is required to maintain daily cash and marketable securities balances, held in custody by Morgan Stanley and JPMorgan Chase Bank, totaling at least $7.5 million through August 2002. As of June 30, 2002, the balance in these accounts was $19.5 million. The minimum required balances increase to $12 million and $15 million in September 2002 and November 2002. Additionally, the Company is required to maintain a ratio of funded debt to consolidated EBITDA for the most recent twelve month period of 1.5 to 1.0.

7. Stockholders’ Equity

     On March 6, 2002, American Express Travel Related Services Company, Inc. (“American Express”) exercised warrants to purchase 526,271 shares of common stock at $25 per share. The shares were issued from treasury stock held by the Company. The Company repurchased the 526,271 shares of common stock from American Express for $27.02 per share at a total cost of $14.2 million.

     The Company’s Board of Directors has authorized the repurchase of up to 5,000,000 shares of the Company’s outstanding common stock. As of June 30, 2002, the Company has repurchased

- -12-

Table of Contents

3,968,000 shares at a total cost of approximately $57.4 million, including the 526,271 shares repurchased from American Express.

8. Net Income (Loss) Per Share

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

9. Commitments and Contingencies

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

State Unemployment Taxes

     In January 2002, as a result of a corporate restructuring plan, Administaff filed for a partial transfer of compensation experience used to determine unemployment tax rates with nine states, including Texas. The Company estimated and recorded its unemployment tax expense during the first six months of 2002 using tax rates in those states that were based on its expectation that these partial transfer applications would be approved. All states have approved the Company’s applications with the exception of Texas. Pending completion of the approval process, Administaff has paid its unemployment taxes to the State of Texas at the higher new employer rate as required. The Company, however, has continued to record its expense at the expected lower rate and has recorded a current asset totaling approximately $6 million for the refund expected to be received upon approval of the application. In June 2002, the Company received an initial determination from the Texas Workforce Commission (“TWC”) that its partial transfer application was denied. The Company is vigorously pursuing an appeal of this ruling with the TWC. At this time, in the opinion of the Company’s outside counsel, it is more likely than not that the Company will ultimately succeed in having its application approved. If facts or events were to indicate that it was probable

- -13-

Table of Contents

that Administaff’s application would ultimately be denied, the Company would be required to recognize this asset as additional payroll tax expense in the period of such determination.

Health Insurance Costs

     On November 5, 2001, the Company filed a lawsuit against Aetna US Healthcare (“Aetna”). The Company has asserted claims against Aetna for breach of contract, economic duress, negligent misrepresentation, breach of good faith and fair dealing, and violations of the Texas Insurance Code. The Company has alleged that during the third quarter of 2001, Aetna placed the Company under economic duress by threatening, without any legal right, to terminate the Company’s health insurance plan if Administaff did not pay immediate and retroactive rate increases, even though Aetna had not provided at least two quarters advance notice as required under the contract. In addition, the Company has alleged that Aetna failed to properly manage the health plan and to produce timely and accurate reports regarding the health plan’s claims data and financial condition. While the Company is still in the process of quantifying its damages, it intends to seek damages in excess of $42 million, including approximately $12.7 million related to increased health insurance costs in the third and fourth quarters of 2001.

     On January 28, 2002, Aetna filed its answer denying the claims asserted by the Company and, as anticipated by the Company, filed a counterclaim. In the counterclaim, Aetna has alleged that the Company has violated the Employee Retirement Income Security Act (“ERISA”), breached its contractual obligations by failing to pay premiums owed to Aetna, and made material misrepresentations during its negotiations of rates with Aetna for the purpose of delaying rate increases while the Company sought a replacement health insurance carrier. On February 20, 2002, the Company received Aetna’s initial disclosures related to the lawsuit and counterclaim, in which Aetna stated its preliminary calculation of damages at approximately $30 million.

     While the Company cannot predict the ultimate outcome or the timing of a resolution of this dispute or the related lawsuit and counterclaim, the Company plans to vigorously pursue its case. In addition, the Company believes that Aetna’s allegations in the counterclaim are without merit and intends to defend itself vigorously. However, an adverse outcome in this dispute could have a material adverse effect on the Company’s results of operations or financial condition.

Workers’ Compensation Insurance

     In October 2001, the Company’s former workers’ compensation insurance carrier, Reliance National Indemnity Co. (“Reliance”), was forced into bankruptcy liquidation. At December 31, 2001, the estimated outstanding claims under these policies totaled approximately $8.8 million. State laws regarding the handling of the open claims of liquidated insurance carriers vary. Most states have established funds through guaranty associations to pay such remaining claims. However, several states have provisions that could be construed to return the liability for open claims to the companies that had policies with the liquidated insurance carrier, typically based on net worth. In anticipation of this situation, the Company secured insurance coverage totaling $1.8 million from its

- -14-

Table of Contents

current workers’ compensation insurance carrier to cover potential claims returned to the Company. While the Company believes, based on its analysis of applicable state provisions, that its insurance coverage will be adequate to cover any potential losses, it is possible that such losses could exceed the Company’s insurance coverage limit.

401(k) Plan

     On May 21, 2002, Administaff entered into a Closing Agreement with the Internal Revenue Service (“IRS”) related to an audit of its 401(k) Plan for the year ended December 31, 1993. The agreement recognizes and preserves Administaff’s ability to maintain its current plan structure through December 31, 2003. As a result of the agreement, the IRS has closed its audit of the plan and granted full relief from retroactive disqualification on the exclusive benefit rule issue raised during the audit. For periods after December 31, 2003, the Company intends to comply with IRS Revenue Procedure 2002-21, which was issued on April 24, 2002 and provides guidance regarding the operation of defined contribution plans by PEOs. The Company expects that the required changes to the plan will not have a material adverse effect on its financial condition or results of operation.

- -15-

Table of Contents

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

     The following discussion should be read in conjunction with the 2001 annual report on Form 10-K, as well as with the consolidated financial statements and notes thereto included in this quarterly report on Form 10-Q.

Critical Accounting Policies and Estimates

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

     The Company believes the following critical accounting policies reflect the more significant judgments and estimates used in the preparation of its consolidated financial statements:

•		Revenue recognition – The Company’s revenues are derived from its comprehensive service fees, which are based upon each worksite employee’s gross pay and a markup computed as a percentage of the gross pay. The Company includes the component of its comprehensive service fees related to the gross pay of its worksite employees as revenue based on its analysis of EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent. In accordance with the EITF consensus, the Company is deemed to be a principal in its personnel management services because it assumes a significant number of risks as a co-employer of its worksite employees. Among the more significant of those risks is the Company’s assumption of risk for the payment of its direct costs, including the gross pay of its worksite employees, regardless of whether the Company’s clients pay their comprehensive service fees on a timely basis or at all. If the Company were deemed to be an agent in its personnel management services, the Company could be required to record its revenues net of the gross payroll cost component of its comprehensive service fees. In such an event, there would be no effect on the Company’s net income.
•		Benefits costs – The Company provides health insurance coverage to its worksite employees through a national network of carriers including UnitedHealthcare (“United”), PacifiCare, Kaiser Permanente, Cigna and Blue Cross and Blue Shield of Georgia, all of which are fully-insured policies. The policy with United provides the majority of the Company’s health insurance coverage. Pursuant to the terms of the Company’s annual contract with United, within 195 days after contract termination, a final accounting of the plan will be performed and the Company will

- -16-

Table of Contents

		receive a refund for any accumulated surplus or will be liable for any accumulated deficit in the plan, up to the amount of the Company’s security deposit with United which totaled $20 million at June 30, 2002. As a result, the Company accounts for this plan using a partially self-funded insurance accounting model, under which the Company must estimate its incurred but not reported (“IBNR”) claims at the end of each accounting period. If the estimated IBNR claims, paid claims, taxes and administrative fees are collectively greater than the premiums paid to United, an accumulated deficit in the plan would be incurred and the Company would be required to accrue the additional necessary liability on its balance sheet, which would increase benefits expense and decrease net income in the period that such determination was made. On the other hand, if the estimated IBNR claims, paid claims, taxes and administrative fees are collectively less than the premiums paid to United, an accumulated surplus in the plan would be incurred and the Company would record this surplus as a current asset, which would reduce benefits expense and increase net income in the period that such determination was made. The Company’s second quarter 2002 benefits expense includes the effect of a $2.4 million increase in the incurred but not reported (“IBNR”) component of the United plan, pertaining to a change in estimated health insurance claims resulting from a higher than expected level of claims paid during the second quarter that were incurred in the first quarter. As of June 30, 2002, the Company has estimated an IBNR component at approximately $32 million, which resulted in the Company recording an estimated accumulated deficit liability of approximately $175,000. For the six months ended June 30, 2002, the Company’s total United Plan costs were approximately $135 million.
•		State unemployment taxes – The Company records its state unemployment tax expense based on taxable wages and tax rates assigned by each state. State unemployment tax rates vary by state and are determined, in part, based on prior years’ compensation experience in each state. In the first quarter of each calendar year, the Company must estimate its expected tax rate in those states for which tax rate notices have not been received. The need for such estimates was increased in 2002 due to a corporate restructuring plan completed in January 2002. In conjunction with the restructuring, the Company filed for a partial transfer of compensation experience with nine states, including Texas. The partial transfers, once approved, were expected to result in an assigned rate in these states that was significantly lower than the standard rates typically assigned to newly registered companies.
		The Company estimated and recorded its unemployment tax expense during the first six months of 2002 using tax rates in these states that were based on its expectation that these partial transfer applications would be approved. All states have approved the Company’s applications with the exception of Texas. Pending completion of the approval process, the Company has paid its unemployment taxes to the State of Texas at the higher new employer rate as required. The Company, however, has continued to record its unemployment tax expense at the expected lower rate and has recorded an asset totaling approximately $6 million for the refund expected to be received upon approval of the application. In June 2002, the Company received an initial determination from the Texas Workforce Commission (“TWC”) that its partial transfer application was denied. The Company is vigorously pursuing an appeal of the ruling with the

- -17-

Table of Contents

		TWC. As this time, in the opinion of the Company’s outside counsel, it is more likely than not that the Company will ultimately succeed in having its application approved. In accordance with SFAS No. 5, Accounting for Contingencies, the Company has assessed the degree of probability of an unfavorable outcome of its appeal with the TWC as reasonably possible, but not probable. If facts or events were to indicate that is was probable the Company’s application would ultimately be denied, the Company would be required to recognize this $6 million asset as additional payroll tax expense in the period of such determination.
•		Workers’ compensation costs – The Company’s workers’ compensation insurance policy for the two-year period ending September 30, 2003 is a guaranteed-cost policy under which premiums are paid for full-insurance coverage of all claims incurred during the policy. This policy also contains a dividend feature for each policy year, under which the Company is entitled to a refund of a portion of its premiums if, four years after the end of the policy year, claims paid by the insurance carrier for the policy year are less than an amount set forth in the policy. In accordance with Emerging Issues Task Force (“EITF”) Topic D-35, FASB Staff Views on EITF No. 93-6, “Accounting for Multiple-Year Retrospectively Rated Contracts by Ceding and Assuming Enterprises,” the Company estimates the amount of refund, if any, that has been earned under the dividend feature, based on the actual claims incurred to date and a factor used to develop those claims to an estimate of the ultimate cost of the incurred claims during that policy year. If the Company’s estimates were to indicate that an additional dividend had been earned, the Company would be required to record a receivable for the amount of that dividend and decrease its workers’ compensation insurance expense, which would increase net income in the period that such determination was made. On the other hand, if the Company’s estimates were to indicate that the amount of any recorded dividend receivable had been reduced due to greater than anticipated claims experience, the Company would be required to increase its workers’ compensation insurance expense, which would reduce net income in the period that such determination was made. As of June 30, 2002, the Company has recorded a long-term asset totaling $1.5 million related to this dividend feature. This estimated dividend receivable was unchanged during the second quarter of 2002.
•		Allowance for doubtful accounts – The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to pay its comprehensive service fees. The Company believes that the success of its business is heavily dependent on its ability to collect these comprehensive service fees for several reasons, including (i) the large volume and dollar amount of transactions processed by the Company; (ii) the periodic and recurring nature of payroll, upon which the comprehensive service fees are based; and (iii) the fact that the Company is at risk for the payment of its direct costs regardless of whether its clients pay their comprehensive service fees. To mitigate this risk, the Company has established very tight credit policies. The Company generally requires its clients to pay their comprehensive service fees no later than one day prior to the applicable payroll date. In addition, the Company maintains the right to terminate its Client Service Agreement and associated worksite employees, or to require prepayment, letters of credit or other collateral, upon deterioration in a client’s financial position or upon nonpayment by a client. As a result of these efforts, the outstanding balance of accounts

- -18-

Table of Contents

		receivable and subsequent losses related to customer nonpayment have historically been very low as a percentage of revenues. However, if the financial condition of the Company’s customers were to deteriorate rapidly, resulting in nonpayment, the Company’s accounts receivable balances could grow and the Company could be required to provide for additional allowances, which would decrease net income in the period that such determination was made.
•		Marketable securities – The Company’s investments in marketable securities consist of exchange-traded debt securities which are managed by professional investment management companies. These investment managers are guided by the Company’s investment policy, which is designed to maximize after-tax interest income while preserving its principal investment. As of December 31, 2001, all of the Company’s investments in marketable securities are classified as available-for-sale, and as a result, are reported at fair value as determined by the professional investment management companies. In accordance with SFAS No. 115, Accounting for Investments in Certain Debt and Equity Securities, unrealized gains related to increases in the fair value of investments and unrealized losses related to decreases in fair value are included in comprehensive income as reported on the Company’s statement of stockholders’ equity. However, changes in the fair value of investments impacts the Company’s net income only when such investments are sold.
•		Property and equipment – The Company’s property and equipment relate primarily to its facilities and related improvements, furniture and fixtures, computer hardware and software and capitalized software development costs. These costs are depreciated or amortized over the estimated useful lives of the assets. If the useful lives of these assets were determined to be shorter than their current estimates, the Company’s depreciation and amortization expense could be accelerated, which would decrease net income in the periods following such a determination. In addition, the Company periodically evaluates these costs for impairment in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. SFAS No. 144 requires that an impairment loss be recognized for assets to be disposed of or held-for-use when the carrying amount of an asset is not recoverable. If events or circumstances were to indicate that any of the Company’s long-lived assets might be impaired, the Company would be required to analyze the estimated undiscounted future cash flows from the applicable asset. In addition, the Company would be required to record an impairment loss, which would reduce net income, to the extent that the carrying value of the asset exceeded the fair value of the asset.
•		Investment valuation – The Company has an equity investment in a privately held development stage company whose operations fit within the Company’s strategic focus. This investment is recorded using the cost method. Under the cost method, the Company periodically evaluates the realizability of this investment based on its review of the investee’s financial condition, financial results, financial projections and availability of additional financing sources. If, based on its review, the Company were to determine that the investment’s estimated fair market value had declined below its carrying value for a reason that was other than temporary, the Company would be required to write down the value of the investment to its estimated fair market value which would reduce net income in the period that such determination was made.

- -19-

Table of Contents

•		Deferred taxes – The Company’s deferred tax assets are reported at the amount that is more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for a valuation allowance, the Company’s ability to realize its deferred tax assets could change from its current estimates. If the Company was able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to reduce the valuation allowance would increase net income in the period that such determination was made. Likewise, should the Company determine that it would not be able to realize all or part of its net deferred tax assets in the future, an adjustment to increase the valuation allowance would reduce net income in the period that such determination was made. At June 30, 2002, the Company has recorded a deferred tax asset valuation allowance of $1.4 million related to a long-term capital loss generated from the write-off of the Company’s investment in VGI during 2001.
•		Contingent liabilities – The Company accrues or discloses contingent liabilities in accordance with SFAS No. 5, which requires accrual of contingent liabilities that are considered probable to occur and that can be reasonably estimated. Contingent liabilities that are considered reasonably possible to occur require financial statement disclosure, including the range of possible loss if it can be reasonably determined. The Company has disclosed in its financial statements several issues that it believes are reasonably possible to occur, although it cannot determine the range of possible loss in all cases. As these issues develop, the Company will continue to evaluate the probability of future loss and the potential range of such losses. If such evaluation were to indicate that a loss was probable and the loss could be reasonably estimated, the Company would be required to accrue its estimated loss, which would reduce net income in the period that such determination was made. For a discussion of certain contingent liabilities that may affect the Company, see Note 9 to the Consolidated Unaudited Financial Statements.

- -20-

Table of Contents

Results of Operations

     Three Months Ended June 30, 2002 Compared to Three Months Ended June 30, 2001.

     The following table presents certain information related to the Company’s results of operations for the three months ended June 30, 2002 and 2001.

     Revenues

     The Company’s revenues for the three months ended June 30, 2002 increased 11.1% over the same period in 2001 due to a 12.7% increase in the average number of worksite employees paid per month, partially offset by a 0.9% decrease in fee revenue per worksite employee per month.

     The Company’s unit growth rate is affected by three primary sources – new client sales, client retention and the net change in existing clients through new hires and layoffs. During the second quarter of 2002, paid worksite employees from new client sales increased proportionately with the increase in trained sales representatives. Client retention improved over the 2001 period due primarily to a reduction in client company business failures and financial defaults, along with a reduction in client-elected terminations driven by cost factors. The net change in existing clients also improved over the 2001 period as new hires were level with layoffs during the 2002 period.

     The 2.0% decrease in fee payroll cost per worksite employee per month was primarily due to (i) the addition of new clients with worksite employees that had a lower average base pay than the existing client base; and (ii) a slight decrease in the average payroll cost of worksite employees at

- -21-

Table of Contents

existing clients which was driven by the replacement of terminated personnel with new employees at an average wage level 6% lower than the terminated worksite employees. In addition, for worksite employees active in both the 2001 and 2002 periods, the average pay raise continued to decline. The average pay raise was 2.4% in the 2002 period compared to 8.0% in the 2001 period.

     By region, the Company’s revenue growth over the second quarter of 2001 and revenue distribution for the quarter ended June 30, 2002 were as follows:

     In the southwest region, where 25% of the Company’s sales representatives produced 36% of the worksite employees paid from new client sales in the second quarter of 2002, revenues declined by 1.8%. The decline was a result of layoffs exceeding new hires during the last half of 2001 and first half of 2002, which were at a level significantly higher than those experienced in the Company’s other regions.

     Gross Profit

     Gross profit for the second quarter of 2002 decreased 12.0% to $36.6 million compared to the second quarter of 2001. Gross profit per worksite employee decreased 22.1% to $159 per month in the 2002 period from $204 per month in the 2001 period. The Company’s pricing objectives attempt to maintain or improve the gross profit per worksite employee by matching or exceeding changes in its primary direct costs with increases in the gross markup per worksite employee.

     The company failed to achieve its pricing objectives in the second quarter of 2002 due to rapidly increasing health insurance costs. The Company has implemented immediate pricing increases in response to health insurance cost increases. However, due to annual contract limitations, pricing for existing customers can only be increased upon contract renewal. Accordingly, the Company expects that its pricing objectives will not be achieved until 2003. As a result, the Company expects its gross profit per worksite employee to be less than the levels achieved during 2001 for the remainder of 2002 and that gross profit per worksite employee will gradually return to 2001 levels during 2003. However, changes in health insurance claim trends which underlie the Company’s direct costs could enhance or hinder the Company’s ability to meet its pricing objectives.

     Gross markup per worksite employee per month, which represents the Company revenues less the payroll cost of worksite employees, increased 4.2% to $886 in the 2002 period versus $850

- -22-

Table of Contents

in the 2001 period. This increase was primarily the result of price increases in response to higher health insurance costs, which were partially offset by the lower average payroll per worksite employee.

     The Company’s primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 12.2% to $735 per worksite employee per month in the 2002 period versus $655 in the 2001 period. The primary components changed as follows:

•		Payroll tax costs – Payroll taxes decreased $8 per worksite employee per month over the second quarter of 2001. The overall cost of payroll taxes as a percentage of payroll cost decreased to 7.40% in the 2002 period from 7.41% in the 2001 period. The results reflect the effects of the Company’s corporate restructuring completed in January 2002. The Company estimated and recorded its state unemployment tax expense during the first six months of the 2002 using tax rates in certain states, including Texas, that were based on its expectation that a partial transfer application, resulting from its restructuring, would be approved. The Company has received an initial determination from Texas that its partial transfer application was denied and is now vigorously pursing an appeal. See “Critical Accounting Policies and Estimates” on page 16 for a discussion of this matter.
•		Benefits costs – The cost of health insurance and related employee benefits increased $89 per worksite employee per month over the second quarter of 2001. This increase is due to a 28.1% increase in the cost per covered employee and a slight increase in the percentage of worksite employees covered under the Company’s health insurance plans to 74.4% in the 2002 period from 72.1% in the 2001 period. The 28.1% increase in cost per covered employee includes the effect of a $2.4 million increase in the incurred but not reported (“IBNR”) component of the United plan, pertaining to a change in estimated health insurance claims resulting from a higher than expected level of claims paid during the second quarter that were incurred in the first quarter. As of June 30, 2002, the Company has recorded an estimated accumulated deficit liability of approximately $175,000 related to the Company’s health insurance plan with United. See “Critical Accounting Policies and Estimates” on page 16 for a discussion of the Company’s accounting for health insurance costs.
•		Workers’ compensation costs – Workers’ compensation costs remained consistent on a per worksite employee per month basis over the second quarter of 2001, and increased to 1.26% of fee payroll cost in the 2002 period from 1.24% in the 2001 period. The Company’s estimated dividend receivable under the policy’s dividend feature remained unchanged in the second quarter. See “Critical Accounting Policies and Estimates” on page 16 for a discussion of the Company’s accounting for workers’ compensation costs.

- -23-

Table of Contents

     Operating Expenses

     The following table presents certain information related to the Company’s operating expenses for the three months ended June 30, 2002 and 2001.