Insperity - 10-Q quarterly report FY

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 x No o

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

     As of August 8, 2003, 26,627,003 shares of the registrant’s common stock, par value $0.01 per share, were outstanding.

TABLE OF CONTENTS

ADMINISTAFF, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

ASSETS

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

LIABILITIES AND STOCKHOLDERS’ EQUITY

See accompanying notes.

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

See accompanying notes.

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ADMINISTAFF, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
SIX MONTHS ENDED JUNE 30, 2003
(in thousands)
(Unaudited)

See accompanying notes.

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

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

See accompanying notes.

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ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
June 30, 2003

1. Basis of Presentation

     Administaff, Inc. (“the Company”) is a professional employer organization (“PEO”). As a PEO, the Company provides a bundled comprehensive service for its clients in the area of personnel management. The Company provides its comprehensive service through its Personnel Management System, which encompasses a broad range of human resource functions, including payroll and benefits administration, health and workers’ compensation insurance programs, personnel records management, employer liability management, employee recruiting and selection, employee performance management, and employee training and development. For the six months ended June 30, 2003 and 2002, revenues from the Company’s Texas markets represented 41% and 43% 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, 2002. The consolidated balance sheet at December 31, 2002, 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, 2003, and the consolidated statements of operations, cash flows and stockholders’ equity for the interim periods ended June 30, 2003 and 2002, 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 results in subsequent quarters throughout the year. This pattern is due to the effects of employment-related taxes that are based on each employee’s cumulative earnings up to specified wage levels, causing employment-related tax costs to be highest in the first quarter and then decline over the course of the year. Since the Company’s revenues related to each employee have been generally earned

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and collected at a relatively constant rate throughout the year, payment of such tax obligations has a substantial impact on the Company’s financial condition and results of operations during the first six months of the year. Other factors that affect direct costs could mitigate or enhance this trend.

     Effective January 1, 2003, the Company implemented a new pricing and billing system for new and renewing clients. For clients active on the new system in January of any year, the system includes a feature that accelerates invoicing of the payroll tax component of the comprehensive service fee to more closely reflect the pattern of incurred payroll tax costs. Accordingly, the impact of new and renewing clients invoiced on the new billing system in January 2003, which represented approximately 20% of the Company’s client base, has resulted in the partial offset of the Company’s historical earnings pattern in the first half of 2003. All clients will be invoiced by the new system by January 2004.

     Certain prior year amounts have been reclassified to conform to current year presentation. Effective December 31, 2002, the Company changed its method of reporting its revenues under Emerging Issues Task Force (“EITF”) 99-19,Reporting Revenues Gross as a Principal Versus Net as an Agent. Previously, the Company reported its entire gross billings as revenue and reported the payroll cost of its worksite employees as a component of direct costs. The Company’s revenues are now reported net of worksite employee payroll cost (net method). To conform to the net method, the Company reclassified worksite employee payroll costs of $956 million and $1.9 billion for the three months and six months ended June 30, 2002, respectively, from direct costs to an offset of revenues. This reclassification had no effect on gross profit, operating income (loss), or net income (loss).

Stock-Based Compensation

     At June 30, 2003, the Company has three stock-based employee compensation plans. The Company accounts for these plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25,Accounting for Stock Issued to Employees, and related interpretations. No stock-based compensation cost is reflected in net loss, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect of net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

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     The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing model. For options granted during the periods above, the following assumptions were used: volatility ranging from 66% to 93%, expected life of five years, risk free interest rate ranging from 3.0% – 4.5% and a dividend yield of 0%. The weighted average fair value of options granted in the six months ended June 30, 2003 and 2002 was $4.71 and $10.34, respectively.

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

2. Accounting Policies

Health Insurance Costs

     The Company provides health insurance coverage to its worksite employees through a national network of carriers including UnitedHealthcare (“United”), Cigna, PacifiCare, Kaiser Permanente and Blue Cross and Blue Shield of Georgia, all of which provide 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 receive a refund for any accumulated surplus or will be liable for any accumulated deficit in the

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plan, up to the amount of the Company’s security deposit with United. Accordingly, 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 current liability or asset, respectively, on its balance sheet. During the three months ended June 30, 2003, the Company has recorded an estimated surplus of $6.1 million, resulting in an accumulated surplus from the inception of the plan of approximately $7.7 million as of June 30, 2003.

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 period. 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 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. In May 2003, the Company’s workers’ compensation carrier’s rating was downgraded by A.M. Best Co. (“Best”) from a “B” or “fair” rating to a “C++” or “marginal” rating. In June 2003, Best further downgraded the carrier to a “D” or “poor” rating. Best’s rating represents an opinion on the insurer’s financial strength and ability to meet its ongoing obligations to its policyholders. As a result of these downgrades, the Company elected to accelerate the termination of its contract from September 30, 2003 to September 1, 2003. The Company is currently in the process of reviewing final proposals for replacement coverage which is scheduled to be effective September 1, 2003. In addition, the Company recorded a charge of $2.5 million in the second quarter of 2003 to write-off its dividend receivable from its workers’ compensation carrier due to the uncertainty of the carrier’s ultimate ability to pay this dividend. This charge resulted in the reduction of other assets by $2.5 million.

3. Operations Held for Sale

     During the first quarter of 2002, the Company purchased substantially all of the assets of Virtual Growth, Inc. (“VGI”) through bankruptcy proceedings for a total cost of $1.6 million. The Company established a subsidiary, Administaff Financial Management Services, Inc. (“FMS”), to provide outsourced accounting and bookkeeping services using the assets acquired from VGI. In January 2003, the Company committed to a plan to sell FMS and initiated a program to market the division and locate a buyer. As a result, FMS operating results have been included in discontinued operations in the accompanying consolidated statements of operations. As of June 30, 2003, the assets of FMS held for sale was as follows:

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4. Stockholders’ Equity

     On February 25, 2003, the Company repurchased 1,286,252 shares of common stock from American Express at $6 per share.

     The Company’s Board of Directors has authorized the repurchase of up to 6,000,000 shares of the Company’s outstanding common stock. As of June 30, 2003, the Company has repurchased 5,341,523 shares under this authorization at a total cost of approximately $65.6 million, including the 1,286,252 shares repurchased from American Express.

5. 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:

6. 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.

Aetna Healthcare Litigation

     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

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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 administer the health plan and to produce timely and accurate reports regarding the health plan’s claims data and financial condition. The Company is seeking damages in excess of $42 million.

     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, as amended, 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. Aetna is alleging damages of approximately $35 million.

     Both the Company and Aetna have filed motions for summary judgment, which could result in the court dismissing some or all of the Company’s claims and/or Aetna’s counterclaim. 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.

     The Company has a fiduciary liability insurance policy (“the policy”) issued by National Union Fire Insurance Company of Pittsburgh, Pennsylvania (“National Union”). The policy provides for the reimbursement of defense related legal fees and costs (“defense costs”) associated with the Aetna counterclaim. National Union has recognized its duty to defend the Company under a reservation of rights and to date has reimbursed the Company for $200,000 in defense costs. However, National Union and the Company disagree about the scope of National Union’s defense obligations. On January 29, 2003, the Company filed a lawsuit against National Union requesting the court to determine National Union’s obligations to reimburse the Company for defense costs. On June 17, 2003 National Union filed its Original Answer and Counterclaim, generally seeking, among other remedies; (1) a declaration that the Aetna counterclaim is not covered by the policy; (2) a declaration that Administaff is not entitled to a defense under the policy; and (3) reimbursement of the previously advanced defense costs. Through June 30, 2003, the Company has submitted claims for approximately $3.5 million in defense costs to National Union for reimbursement. Although the Company believes that it is entitled to full reimbursement of the amount submitted, all defense costs, net of amounts reimbursed, have been expensed.

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Reliance National Indemnity Co. Bankruptcy Liquidation

     In October 2001, the Company’s former workers’ compensation insurance carrier, Reliance National Indemnity Co. (“Reliance”), was forced into bankruptcy liquidation. At June 30, 2003, the estimated outstanding claims under the Company’s former policies with Reliance totaled approximately $7.5 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, the guaranty associations in some states, including Texas, have asserted that state law returns the liability for open claims under policies with the liquidated insurance carrier to the Company. In Texas, the Company disputes the right of the guaranty association to be reimbursed for such claims. The Company initially secured $1.8 million in insurance coverage from its current workers’ compensation insurance carrier to cover potential claims returned to the Company related to its Reliance policies. As of June 30, 2003, the Company had $1.3 million in insurance coverage remaining. While the Company believes, based on its analysis of applicable state provisions, that its insurance coverage will be adequate to cover any probable losses, it is possible that such losses could exceed the Company’s insurance coverage limit resulting in an increase to workers’ compensation expense which would reduce net income.

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 the state of Texas. On October 30, 2002, the Texas Workforce Commission (“TWC”) approved Administaff’s application for a partial transfer of compensation experience.

     Pending computation of the Company’s Texas unemployment tax rate, the Company paid its unemployment taxes to the state of Texas at the higher new employer rate as required by state law, resulting in a $6.0 million prepayment balance as of December 31, 2002. In July 2003, in lieu of requesting a refund, the TWC allowed the Company to apply the prepayment balance to the estimated first quarter and second quarter 2003 tax liabilities, resulting in a remaining prepaid balance of $1.7 million at June 30, 2003. The Company also received its initial 2002 and 2003 unemployment tax rate computations from the TWC in July 2003. While the Company is currently reviewing the computations with the TWC, it does not expect the final rates to have any negative impact to the estimates used to record payroll taxes.

Class Action Litigation

     On June 13, 2003, a class action lawsuit was filed against the Company in the United States District Court for the Southern District of Texas on behalf of purchasers of the Company’s common stock alleging violations of the federal securities laws. After that date, six similar class actions were filed against the Company in that court. Those lawsuits also named as defendants certain of the Company’s officers and directors. Those lawsuits generally allege that the

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Company and certain of its officers and directors made false and misleading statements or failed to make adequate disclosures concerning, among other things: (1) the Company’s pricing and billing systems with respect to recalibrating pricing for clients that experienced a decline in average payroll cost per worksite employee; (2) the matching of price and cost for health insurance on new and renewing client contracts; and (3) the Company’s former method of reporting worksite employee payroll costs as revenue. The Complaints seek unspecified damages, among other remedies. The Company believes these claims are without merit and intends to vigorously defend this litigation, which is in its preliminary stages.

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

     The following discussion should be read in conjunction with the 2002 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, client 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 accounting policies are critical and/or require significant judgments and estimates used in the preparation of its consolidated financial statements:

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Results of Operations

     Three Months Ended June 30, 2003 Compared to Three Months Ended June 30, 2002.

     The following table presents certain information related to the Company’s results of operations for the three months ended June 30, 2003 and 2002.

     Revenues

     The Company’s revenues for the three months ended June 30, 2003 increased 7.0% over the same period in 2002 due to a 9.0% increase in revenues per worksite employee per month, offset by a 1.8% decrease in the average number of worksite employees paid 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 worksite employee new hires and layoffs. During the second quarter of 2003, both paid worksite employees from new client sales and client retention declined as compared to the 2002 period. The net change in existing clients increased slightly over the 2002 period.

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     The 9.0%, or $80 increase in revenues per worksite employee per month was primarily due to $82 per worksite employee per month in pricing increases on new and renewing clients over the last year, offset by a $2 per worksite employee per month decline in revenue relating to those clients that were invoiced on the new billing system beginning January 1, 2003. This decline is consistent with the related decline in payroll tax costs as wage limits are met.

     By region, the Company’s revenue growth over the second quarter of 2002 and revenue distribution for the quarter ended June 30, 2003 were as follows:

     Gross Profit

     Gross profit for the second quarter of 2003 increased 28.7% to $46.8 million compared to the second quarter of 2002. Gross profit per worksite employee increased 30.8% to $208 per month in the 2003 period from $159 per month in the 2002 period. This increase was primarily the result of the $80 increase in revenue per worksite employee per month discussed above, offset by increases of $13 in benefits cost, $17 in workers’ compensation costs (including the write-off of the workers’ compensation dividend of $11) and $1 in payroll taxes and other direct costs per worksite employee per month. The Company’s pricing objectives attempt to maintain or improve the gross profit per worksite employee by increasing revenue per worksite employee to match or exceed changes in its primary direct costs and its operating costs.

     While the Company’s revenues per worksite employee per month increased 9.0%, the Company’s primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 4.2% to $765 per worksite employee per month in the second quarter of 2003 versus $734 in the second quarter of 2002.

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     Gross profit, measured as a percentage of revenue, increased to 21.4% in the 2003 period from 17.7% in the 2002 period.

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     Operating Expenses

     The following table presents certain information related to the Company’s operating expenses for the three months ended June 30, 2003 and 2002.

     Operating expenses increased 5.5% over the second quarter of 2002 to $44.1 million. Operating expense per worksite employee increased to $196 per month in the 2003 period from $182 in the 2002 period. The components of operating expenses changed as follows:

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     Other Income

     Other income decreased from $747,000 in the second quarter of 2002 to $161,000 in the 2003 period, primarily due to interest expense related to the Company’s long-term debt borrowings and reduced interest income as a result of reduced levels of cash and marketable securities. Offsetting the decline in other income was a $457,000 gain related to proceeds from the sale of the Company’s investment in eProsper, Inc., which had been previously written off in 2002.

     Income Tax Expense

     The Company’s provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses. The effective income tax rate for the 2003 period was 33.3% compared to 39.5% in the 2002 period. The decline in the effective tax rate is primarily due to utilization of previously unrecognized capital loss carryforwards on the $457,000 gain from the sale of the Company’s investment in eProsper, Inc.

     Net Income (Loss) from Continuing Operations

     Operating and net income from continuing operations per worksite employee per month was $12 and $9 in the 2003 period, versus operating and net loss from continuing operations of $24 and $12 in the 2002 period.

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     Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002.

     The following table presents certain information related to the Company’s results of operations for the six months ended June 30, 2003 and 2002.

     Revenues

     The Company’s revenues for the six months ended June 30, 2003 increased 10.9% over the same period in 2002 due to a 1.0% increase in the average number of worksite employees paid per month and a 9.8% increase in revenues 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 worksite employee new hires and layoffs. While the average number of worksite employees paid per month increased during the first half of 2003, paid worksite employees from all three primary sources declined as compared to the 2002 period.

     The 9.8%, or $87 increase in revenues per worksite employee per month was primarily due to $76 per worksite employee per month in pricing increases on new and renewing clients

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over the last year. The remaining $11 per worksite employee per month was due to the accelerated collection of the payroll tax allocation component of the comprehensive service fee for those clients that were invoiced on the new billing system beginning January 1, 2003. This increase is consistent with the higher payroll tax costs typically incurred during the first half of the year.

     By region, the Company’s revenue growth over the first half of 2002 and revenue distribution for the six months ended June 30, 2003 were as follows:

     Gross Profit

     Gross profit for the first half of 2003 increased 23.9% to $82.8 million compared to the first half of 2002. Gross profit per worksite employee increased 22.1% to $182 per month in the 2003 period from $149 per month in the 2002 period. This increase was primarily the result of the $87 increase in revenue per worksite employee per month discussed above, offset by increases of $33 in benefits cost, $15 in workers’ compensation costs (including the write-off of the workers’ compensation dividend of $6) and $6 in payroll taxes and other direct costs per worksite employee per month. The Company’s pricing objectives attempt to maintain or improve the gross profit per worksite employee by increasing revenue per worksite employee to match or exceed changes in its primary direct costs and its operating costs.

     While the Company’s revenues per worksite employee per month increased 9.8%, the Company’s primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 7.3% to $796 per worksite employee per month in the first half of 2003 versus $742 in the first half of 2002.

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     Gross profit, measured as a percentage of revenue, increased to 18.6% in the 2003 period from 16.7% in the 2002 period.

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     Operating Expenses

     The following table presents certain information related to the Company’s operating expenses for the six months ended June 30, 2003 and 2002.

     Operating expenses increased 5.8% over the first six months of 2002 to $86.6 million. Operating expense per worksite employee increased to $191 per month in the 2003 period from $182 in the 2002 period. The components of operating expenses changed as follows:

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     Other Income (Expense)

     Other income (expense) decreased from income of $1.4 million in the first half of 2002 to a net expense of $84,000 in the 2003 period. This decline is primarily due to interest expense related to the Company’s long-term debt borrowings and reduced interest income as a result of reduced levels of cash and marketable securities. Offsetting the decline in other income was a $457,000 gain related to proceeds from the sale of the Company’s investment in eProsper, Inc., which had been previously written off in 2002.

     Income Tax Benefit

     The Company’s provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses. During periods of reported losses, the Company records an income tax benefit. The effective income tax benefit rate increased from 39.5% in the 2002 period to 44.1% in the 2003 period due to the additional benefit from the utilization of previously unrecognized capital loss carryforwards on the $457,000 gain from the sale of the Company’s investment in eProsper, Inc. in 2003.

     Net Income (Loss) from Continuing Operations

     Operating loss and net loss from continuing operations per worksite employee per month was $8 and $5 in the 2003 period, versus $33 and $18 in the 2002 period.

Liquidity and Capital Resources

     The Company periodically evaluates its liquidity requirements, capital needs and availability of resources in view of, among other things, expansion plans, debt service requirements and other operating cash needs. As a result of this process, the Company has in the past sought, and may in the future seek, to raise additional capital or take other steps to increase or manage its liquidity and capital resources. The Company currently believes that its cash on hand, marketable securities and cash flows from operations and will be adequate to meet its liquidity requirements for the remainder of 2003. The Company will rely on these same sources, as well as public and private debt or equity financing, to meet its longer-term liquidity and capital needs.

     The Company has experienced significant increases in health insurance costs and may continue to experience significant increases in future periods. The Company’s pricing objectives attempt to maintain or improve gross profit per worksite employee per month by matching or exceeding changes in its primary direct costs with increases in its revenue per worksite employee. The Company has implemented pricing increases designed to match the anticipated health insurance cost increases. However, due to annual contract commitments, pricing for current customers can only be increased upon contract renewal. Changes in health insurance claim trends that underlie the Company’s direct costs could enhance or hinder the Company’s ability to

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meet its pricing objectives during 2003. Failure to achieve its pricing objectives could have a material adverse effect on the Company’s financial position.

     As of June 30, 2003, the Company has made cash security deposits totaling $25 million with its primary health insurance carrier, United. In January 2004, the security deposit will be adjusted to $17.5 million, at which time the $7.5 million reduction, plus accrued interest, is to be returned to the Company. In the event of a default or termination of the Company’s contract with United or the reduction of the Company’s current ratio below 0.60, United may draw against the security deposit to collect any unpaid health insurance premiums or any accumulated deficit in the plan.

     As a result of the existing workers’ compensation carrier’s recent credit rating downgrades, the Company has elected to accelerate the termination of its contract from September 30, 2003 to September 1, 2003. The Company is currently in the process of reviewing final proposals for replacement coverage which is scheduled to be effective September 1, 2003, and will likely involve terms different from the existing policy including increased costs and significant collateral requirements.

     The Company had $74.8 million in cash and cash equivalents and marketable securities at June 30, 2003, of which approximately $31.4 million was payable in July 2003 for withheld federal and state income taxes, employment taxes and other payroll deductions. At June 30, 2003, the Company had working capital of $47.9 million compared to $42.5 million at December 31, 2002.

     Cash Flows From Operating Activities

     The $16.4 million increase in net cash flows from operating activities was primarily the result of changes in the Company’s operating asset and liability accounts and the decrease in the Company’s net loss for the first half of 2003 as compared to 2002.

     Cash Flows From Investing Activities

     The Company invested $4.0 million in marketable securities, net of maturities and dispositions, and approximately $3.2 million in capital expenditures, primarily related to computer hardware and software, during the 2003 period. In addition, the Company collected a $2.7 million note receivable and $584,000 from the sale of assets during the first half of 2003.

     Cash Flows From Financing Activities

     Cash flows used in financing activities primarily related to the repurchase of $8.2 million in treasury stock.

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Other Matters

     Investments in Other Companies

     In January 2002, the Company purchased substantially all of the assets of VGI through bankruptcy proceedings for a total cost of approximately $1.6 million. The Company established a new subsidiary, known as FMS, to provide outsourced accounting and bookkeeping services using the assets acquired from VGI. In January 2003, the Company committed to a plan to sell FMS and initiated a program to market the division and locate a buyer during 2003. As a result, FMS is being reported as a discontinued operation in 2003. As of June 30, 2003, the net book value of FMS was approximately $1.1 million. The Company expects the sales proceeds to exceed the net book value of FMS at June 30, 2003.

     Health Insurance Costs

     The Company provides health insurance coverage to its worksite employees through a national network of providers including United, Cigna Healthcare, PacifiCare, Kaiser Permanente and Blue Cross and Blue Shield, all of which are fully insured policies. The policy with United provides the majority of the Company’s health insurance coverage. As of June 30, 2003, the Company has made cash security deposits totaling $25 million with United. In January 2004, the security deposit will be adjusted to $17.5 million, at which time the $7.5 million reduction, plus accrued interest, is to be returned to the Company.

     Pursuant to the terms of the Company’s annual contract with United, within 195 days following the termination of the contract, a final accounting of the plan will be performed. The final accounting will assess the premiums paid to United and the total administrative fees, taxes and claims incurred during the policy term. The incurred claims will include those paid plus an estimate of claims incurred but not processed within 180 days after the contract termination date. In the event that the incurred claims, administrative fees and taxes are collectively less than the premiums paid, the Company will receive a refund equal to the amount of such accumulated surplus. In the event that the incurred claims, administrative fees and taxes are collectively greater than the premiums paid, the Company will be liable for such accumulated deficit up to the amount of its security deposit.

     In the event of a default or termination of the Company’s contract with United or the reduction of the Company’s current ratio below 0.60, United may draw against the security deposit to collect any unpaid health insurance premiums or any accumulated deficit in the plan.

     Because the Company has a contractual right to collect an accumulated surplus and is liable for an accumulated deficit up to the amount of its security deposit with United, the Company accounts for the United plan using a partially self-funded insurance accounting model. Under this approach, 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, collectively, exceed the premiums paid to United, an accumulated deficit in

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the plan would be incurred and the Company would be required to accrue the estimated accumulated deficit on its balance sheet, which would increase benefits expense and decrease net income in the period that such determination is made. On the other hand, if the estimated IBNR claims, paid claims, taxes and administrative fees, collectively, are less than the premiums paid to United, an accumulated surplus in the plan would exist 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 is made. As of June 30, 2003, the Company has recorded an estimated accumulated surplus from the inception of the plan of approximately $7.7 million.

     Workers’ Compensation Costs

     In May 2003, the Company’s workers’ compensation carrier’s rating was downgraded by A.M. Best Co. (“Best”) from a “B” or “fair” rating to a “C++” or “marginal” rating. In June 2003, Best further downgraded the carrier to a “D” or “poor” rating. Best’s rating represents an opinion on the insurer’s financial strength and ability to meet its ongoing obligations to its policyholders. A small number of the Company’s clients require an “A” rating in order to comply with various contractual commitments. In certain instances the Company has obtained supplemental insurance coverage in order to assist its clients to comply with their contractual obligations, and the Company may be required to obtain additional coverage for other clients as well. In addition, the Company’s ability to attract and retain clients could be adversely impacted by the downgrade. As a result of the downgrades in the Company’s workers’ compensation carrier’s rating, the Company wrote-off its $2.5 million dividend receivable in the second quarter of 2003 and has elected to accelerate the termination of its contract from September 30, 2003 to September 1, 2003. The Company is currently in the process of reviewing final proposals for replacement coverage which is scheduled to be effective September 1, 2003 and will likely involve terms different from the existing policy including increased costs and significant collateral requirements.

     Securities Class Action Suits

     On June 13, 2003, a class action lawsuit was filed against the Company in the United States District Court for the Southern District of Texas on behalf of purchasers of the Company’s common stock alleging violations of the federal securities laws. After that date, six similar class actions were filed against the Company in that court. Those lawsuits also named as defendants certain of the Company’s officers and directors. Those lawsuits generally allege that the Company and certain of its officers and directors made false and misleading statements or failed to make adequate disclosures concerning, among other things: (1) the Company’s pricing and billing systems with respect to recalibrating pricing for clients that experienced a decline in average payroll cost per worksite employee; (2) the matching of price and cost for health insurance on new and renewing client contracts; and (3) the Company’s former method of reporting worksite employee payroll costs as revenue. The Complaints seek unspecified damages, among other remedies. The Company believes these claims are without merit and intends to vigorously defend this litigation, which is in its preliminary stages.

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Seasonality, Inflation and Quarterly Fluctuations

     Historically, the Company’s earnings pattern includes 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 tax costs to be highest in the first quarter and then decline over the course of the year. Since the Company’s revenues related to an individual employee have been generally earned and collected at a relatively constant rate throughout the year, payment of such tax obligations has a substantial impact on the Company’s financial condition and results of operations during the first six months of each year. Other factors that affect direct costs could mitigate or enhance this trend.

     Effective January 1, 2003, the Company implemented a new pricing and billing system for new and renewing clients. For clients active on the new system in January of any year, the new system includes a feature that accelerates invoicing of the payroll tax component of the comprehensive service fee to more closely reflect the pattern of incurred payroll tax costs. Accordingly, the impact of new and renewing clients invoiced on the new billing system in January 2003, which represented approximately 20% of the Company’s client base, has resulted in the partial offset of the Company’s historical earnings pattern in the first half of 2003. All clients will be invoiced by the new system by January 2004.

     The Company believes the effects of inflation have not had a significant impact on its results of operations or financial condition.

Factors That May Affect Future Results and the Market Price of Common Stock

     The statements contained herein that are not historical facts are forward-looking statements within the meaning of the federal securities laws (Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934). You can identify such forward-looking statements by the words “expects,” “intends,” “plans,” “projects,” “believes,” “estimates,” “likely,” “possibly,” “probably,” “goal,” and “assume,” and similar expressions. Forward-looking statements involve a number of risks and uncertainties. In the normal course of business, Administaff, Inc., in an effort to help keep its stockholders and the public informed about the Company’s operations, may from time to time issue such forward-looking statements, either orally or in writing. Generally, these statements relate to business plans or strategies, projected or anticipated benefits or other consequences of such plans or strategies, or projections involving anticipated revenues, earnings, unit growth, profit per worksite employee, pricing, operating expenses or other aspects of operating results. Administaff bases the forward-looking statements on its current expectations, estimates and projections. These statements are not guarantees of future performance and involve risks and uncertainties that Administaff cannot predict. In addition, Administaff has based many of these forward-looking statements on assumptions about future events that may prove to be inaccurate. Therefore, the actual results of the future events described in such forward-looking statements could differ materially from those

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stated in such forward-looking statements. Among the factors that could cause actual results to differ materially are: (i) changes in general economic conditions; (ii) regulatory and tax developments, including, but not limited to the Company’s ability to comply with Revenue Procedure 2002-21, and possible adverse application of various federal, state and local regulations; (iii) changes in the Company’s direct costs and operating expenses including, but not limited to, increases in health insurance premiums, increases in underlying health insurance claims trends, workers’ compensation rates and state unemployment tax rates, liabilities for employee and client actions or payroll-related claims, changes in the costs of expanding into new markets, and failure to manage growth of the Company’s operations; (iv) the estimated costs and effectiveness of capital projects and investments in technology and infrastructure, including the Company’s ability to maintain adequate financing for such projects; (v) the Company’s ability to effectively implement its 401(k) recordkeeping services; (vi) the effectiveness of the Company’s sales and marketing efforts, including the Company’s marketing arrangements with American Express and other companies; (vii) the failure to sell Administaff Financial Management Services, Inc.; (viii) changes in the competitive environment in the PEO industry, including the entrance of new competitors and the Company’s ability to renew or replace client companies; (ix) the Company’s liability for worksite employee payroll and benefits costs; and (x) an adverse final judgment or settlement of claims against the Company, including the Aetna lawsuit. These factors are discussed in detail in the Company’s 2002 annual report on Form 10-K and elsewhere in this report. Any of these factors, or a combination of such factors, could materially affect the results of the Company’s operations and whether forward-looking statements made by the Company ultimately prove to be accurate.

ITEM 4. CONTROLS AND PROCEDURES.

     In accordance with Exchange Act Rules 13a-15 and 15d-15, the Company carried out an evaluation, under the supervision and with the participation of management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of June 30, 2003, in all material respects, to provide reasonable assurance that information required to be disclosed in the Company’s reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

     There has been no change in the Company’s internal controls over financial reporting that occurred during the three months ended June 30, 2003 that has materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

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PART II

ITEM 1. LEGAL PROCEEDINGS.

     See Note 6 to financial statements, which is incorporated herein by reference.

ITEM 4. SUBMISSION OF MATERS TO A VOTE OF SECURITY HOLDERS.

     An Annual Meeting of Stockholders of the Company was held on May 8, 2003. At the Meeting, holders of 24,282,573 shares of common stock were present in person or by proxy, which constituted a quorum thereof. The vote of stockholders in respect of the two proposals voted on at the Meeting, both of which were approved, is set for the below:

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

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SIGNATURES

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

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