e10vq

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)


þ		Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended September 30, 2005.


o		Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from to

Commission File No. 1-13998

Administaff, Inc.

(Exact name of registrant as specified in its charter)


Delaware (State or other jurisdiction of incorporation or organization)		76-0479645 (I.R.S. Employer Identification No.)

19001 Crescent Springs Drive Kingwood, Texas (Address of principal executive offices)		77339 (Zip Code)

(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 þ No o

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

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

As of October 27, 2005, 26,864,998 shares of the registrant’s common stock, par value $0.01 per share, were outstanding.

ITEM 1. FINANCIAL STATEMENTS.

ADMINISTAFF, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

ASSETS


	September 30,			December 31,
	2005			2004
	(Unaudited)
Current assets:
Cash and cash equivalents	$	108,818		$	81,740
Restricted cash		25,730			18,511
Marketable securities		46,854			27,950
Accounts receivable:
Trade		899			610
Unbilled		85,880			65,149
Other		1,937			1,451
Prepaid insurance		17,351			14,428
Other current assets		6,671			4,731
Income taxes receivable		6,816			489

Total current assets		300,956			215,059

Property and equipment:
Land		2,920			2,920
Buildings and improvements		58,522			57,005
Computer hardware and software		54,721			50,765
Software development costs		18,779			18,622
Furniture and fixtures		28,568			28,412
Vehicles and aircraft		5,355			5,725

		168,865			163,449
Accumulated depreciation		(104,185	)		(94,392	)

Total property and equipment, net		64,680			69,057

Other assets:
Prepaid insurance		11,000			—
Deposits — healthcare		954			18,329
Deposits — workers’ compensation		49,365			52,264
Other assets		1,145			679

Total other assets		62,464			71,272

Total assets	$	428,100		$	355,388

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

LIABILITIES AND STOCKHOLDERS’ EQUITY


	September 30,			December 31,
	2005			2004
	(Unaudited)
Current liabilities:
Accounts payable	$	3,453		$	3,130
Payroll taxes and other payroll deductions payable		67,977			64,471
Accrued worksite employee payroll cost		74,833			59,277
Accrued health insurance costs		4,799			1,991
Accrued workers’ compensation costs		27,822			19,349
Other accrued liabilities		20,209			17,461
Deferred income taxes		2,311			231
Current portion of long-term debt		1,687			1,649

Total current liabilities		203,091			167,559

Noncurrent liabilities:
Long-term debt		33,620			34,890
Accrued workers’ compensation costs		29,912			22,912
Deferred income taxes		2,082			3,498

Total noncurrent liabilities		65,614			61,300

Commitments and contingencies

Stockholders’ equity:
Common stock		309			309
Additional paid-in capital		112,490			101,623
Deferred compensation expense		(3,412	)		—
Treasury stock, at cost		(52,054	)		(63,925	)
Accumulated other comprehensive loss, net of tax		(151	)		(127	)
Retained earnings		102,213			88,649

Total stockholders’ equity		159,395			126,529

Total liabilities and stockholders’ equity	$	428,100		$	355,388

See accompanying notes.

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


	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2005			2004			2005			2004
Revenues (gross billings of $1.622 billion, $1.323 billion, $4.756 billion and $3.861 billion, less worksite employee payroll cost of $1.337 billion, $1.087 billion, $3.892 billion and $3.141 billion, respectively)	$	285,202		$	235,865		$	864,062		$	720,804
Direct costs:
Payroll taxes, benefits and workers’ compensation costs		227,031			188,193			695,528			574,553

Gross profit		58,171			47,672			168,534			146,251

Operating expenses:
Salaries, wages and payroll taxes		25,471			21,779			73,436			65,161
Stock-based compensation		360			—			1,765			—
General and administrative expenses		12,476			12,322			39,077			37,003
Commissions		2,610			2,557			7,462			7,879
Advertising		2,956			1,547			7,355			5,955
Depreciation and amortization		3,693			4,376			11,099			13,497

		47,566			42,581			140,194			129,495

Operating income		10,605			5,091			28,340			16,756

Other income (expense):
Interest income		1,645			606			4,097			1,620
Interest expense		(594	)		(517	)		(1,709	)		(1,566	)
Other, net		(84	)		(37	)		(97	)		8,249


Income before income taxes		11,572			5,143			30,631			25,059

Income tax expense		4,389			1,531			11,574			9,398


Net income	$	7,183		$	3,612		$	19,057		$	15,661


Basic net income per share of common stock	$	0.28		$	0.14		$	0.74		$	0.60


Diluted net income per share of common stock	$	0.26		$	0.14		$	0.72		$	0.58

See accompanying notes.

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ADMINISTAFF, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
NINE MONTHS ENDED SEPTEMBER 30, 2005
(in thousands)
(Unaudited)


													Accumulated
	Common Stock				Additional		Deferred						Other
	Issued				Paid-In		Compensation			Treasury			Comprehensive			Retained
	Shares		Amount		Capital		Expense			Stock			Income (Loss)			Earnings			Total
Balance at December 31, 2004		30,839	$	309	$	101,623	$	—		$	(63,925	)	$	(127	)	$	88,649		$	126,529
Purchase of treasury stock		—		—		—		—			(12,200	)		—			—			(12,200	)
Exercise of stock options		—		—		1,350		—			20,270			—			—			21,620
Income tax benefit from exercise of stock options		—		—		7,694		—			—			—			—			7,694
Sale of treasury stock to Administaff Employee Stock Purchase Plan		—		—		85		—			214			—			—			299
Grant of restricted common shares from treasury, net of forfeitures		—		—		886		(4,390	)		3,504			—			—			—
Amortization of deferred compensation expense		—		—		—		975			—			—			—			975
Stock option vesting acceleration		—		—		790		—			—			—			—			790
Other		—		—		62		3			83			—			—			148
Dividends paid		—		—		—		—			—			—			(5,493	)		(5,493	)
Change in unrealized gain on marketable securities, net of tax:
Realized loss		—		—		—		—			—			57			—			57
Unrealized loss		—		—		—		—			—			(81	)		—			(81	)
Net income		—		—		—		—			—			—			19,057			19,057

Comprehensive income																				18,976

Balance at September 30, 2005		30,839	$	309	$	112,490	$	(3,412	)	$	(52,054	)	$	(151	)	$	102,213		$	159,395

See accompanying notes.

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


	Nine Months Ended
	September 30,
	2005			2004
Cash flows from operating activities:
Net income	$	19,057		$	15,661
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		11,324			13,659
Stock-based compensation		1,765			—
Bad debt expense		287			358
Deferred income taxes		680			879
Loss on the disposition of assets		98			59
Changes in operating assets and liabilities:
Restricted cash		(7,219	)		(11,209	)
Accounts receivable		(21,793	)		(10,041	)
Prepaid insurance		(11,584	)		10,389
Other current assets		(1,774	)		2,517
Other assets		20,168			(22,617	)
Accounts payable		323			(2,733	)
Payroll taxes and other payroll deductions payable		3,506			(19,380	)
Accrued worksite employee payroll expense		15,556			23,457
Accrued health insurance costs		469			(4,856	)
Accrued workers’ compensation costs		15,473			22,748
Other accrued liabilities		2,748			1,459
Income taxes payable/receivable		1,367			(10,955	)

Total adjustments		31,394			(6,266	)

Net cash provided by operating activities		50,451			9,395

Cash flows from investing activities:
Marketable securities:
Purchases		(27,314	)		(17,922	)
Proceeds from maturities		200			454
Proceeds from dispositions		7,942			13,081
Cash exchanged for note receivable		(616	)		—
Property and equipment:
Purchases		(6,867	)		(4,169	)
Proceeds from dispositions		140			173

Net cash used in investing activities		(26,515	)		(8,383	)

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


	Nine Months Ended
	September 30,
	2005			2004
Cash flows from financing activities:
Purchase of treasury stock	$	(12,200	)	$	(17,153	)
Dividends paid		(5,493	)		—
Principal repayments on long-term debt and capital lease obligations		(1,232	)		(1,390	)
Proceeds from the exercise of stock options		21,620			809
Proceeds from sale of common stock to the Administaff Employee Stock Purchase Plan		299			341
Other		148			120

Net cash provided by (used in) financing activities		3,142			(17,273	)


Net increase (decrease) in cash and cash equivalents		27,078			(16,261	)
Cash and cash equivalents at beginning of period		81,740			104,728

Cash and cash equivalents at end of period	$	108,818		$	88,467


Supplemental disclosures:
Cash paid for income taxes	$	10,021		$	19,670
Cash paid for interest	$	1,628		$	1,470

See accompanying notes.

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ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)
September 30, 2005

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 nine months ended September 30, 2005 and 2004, revenues from the Company’s Texas markets represented 39% of the Company’s total revenues.

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 in the United States 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, 2004. The Consolidated Balance Sheet at December 31, 2004, 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 September 30, 2005, and the Consolidated Statements of Operations, Cash Flows and Stockholders’ Equity for the periods ended September 30, 2005 and 2004, 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.

Certain prior year amounts have been reclassified to conform to the 2005 presentation.

The results of operations for the interim periods are not necessarily indicative of the operating results for a full year or of future operations.

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Stock-Based Compensation

At September 30, 2005, 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. During the first quarter of 2005, the Company accelerated the vesting of all outstanding stock options, resulting in the recognition of $790,000 ($487,000, net of taxes) of stock-based compensation expense. In addition, the Company issued 303,600 restricted common shares that vest over three years. During the first nine months of 2005, the Company recognized $975,000 ($607,000, net of taxes) of stock-based compensation expense associated with the restricted stock grant. The following table illustrates the effect on net income and net income per share if the Company had applied the fair value recognition provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.


	Three Months Ended					Nine Months Ended
	September 30,					September 30,
	2005		2004			2005			2004
	(in thousands)					(in thousands)
Net income as reported	$	7,183	$	3,612		$	19,057		$	15,661
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		—		(581	)		(506	)		(1,904	)

Pro forma net income	$	7,183	$	3,031		$	18,551		$	13,757


Net income per share:
Basic — as reported	$	0.28	$	0.14		$	0.74		$	0.60
Basic — pro forma	$	0.28	$	0.12		$	0.72		$	0.52
Diluted — as reported	$	0.26	$	0.14		$	0.72		$	0.58
Diluted — pro forma	$	0.26	$	0.11		$	0.70		$	0.51

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 88% to 92%, expected life of five years, risk free interest rate ranging from 3.3% to 3.7% and a dividend yield ranging from 0% to 2%. The weighted average fair value of options granted in the nine months ended September 30, 2005 and 2004 was $11.27 and $12.23.

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

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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 Healthcare, PacifiCare, Kaiser Permanente, Blue Cross and Blue Shield of Georgia, Blue Shield of California and Tufts, all of which provide fully insured policies or service contracts.

The policy with United, which was first obtained in January 2002, provides the majority of the Company’s health insurance coverage. As a result of certain contractual terms, the Company has accounted for this plan since its inception using a partially self-funded insurance accounting model. Accordingly, Administaff records the costs of the United Plan, including an estimate of the incurred claims, taxes and administrative fees (collectively the “Plan Costs”) as benefits expense in the Consolidated Statements of Operations. The estimated incurred claims are based upon: (i) the level of claims processed during the quarter; (ii) recent claim development patterns under the plan; and (iii) the number of participants in the plan. Each reporting period, changes in the estimated ultimate costs resulting from changes in the actual claims experience and other trends are incorporated into the benefits costs estimates.

Additionally, since the plan’s inception in January 2002, under the terms of the contract, United establishes cash funding rates 90 days in advance of the beginning of a reporting quarter. If the Plan Costs for a reporting quarter are greater than the cash funded to United, a deficit in the plan would be incurred and the Company would accrue a liability for the excess costs on its Consolidated Balance Sheet. On the other hand, if the Plan Costs for the reporting quarter are less than the cash funded to United, a surplus in the plan would be incurred and the Company would record an asset for the excess premiums on its Consolidated Balance Sheet.

In 2005, Administaff and United entered into a new three-year arrangement, whereby a previous contractual requirement to maintain a security deposit with United was eliminated. Accordingly, the outstanding security deposit at December 31, 2004 of $17.5 million was returned to Administaff during the quarter ended June 30, 2005. The terms of the new arrangement also require Administaff to maintain an accumulated cash surplus in the plan of $11 million, which was the balance of the accumulated surplus at December 31, 2004, and is now reported as long-term prepaid insurance. As of September 30, 2005, Plan Costs were less than the net cash funded to United by $21.1 million. As this amount is in excess of the agreed-upon $11 million surplus maintenance level, the $10.1 million balance is included in prepaid insurance, a current asset, on the Company’s Consolidated Balance Sheet.

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Workers’ Compensation Costs

In September 2005, the Company renewed its workers’ compensation program with selected member insurance companies of American International Group, Inc. (“AIG”). Under its arrangement with AIG, which ends on September 30, 2006, the Company bears the economic burden for the first $1 million layer of claims per occurrence. AIG bears the economic burden for all claims in excess of such first $1 million layer. The policies are fully insured, whereby AIG has the responsibility to pay all claims incurred under the policies regardless of whether the Company satisfies its responsibilities. As of September 30, 2005, the total collateral held by AIG was $7.5 million, which is included in deposits in the Company’s Consolidated Balance Sheets.

Under its arrangement with AIG, the Company makes monthly payments to AIG comprised of premium costs and funds to be set aside for payment of future claims (“claim funds”). The claim funds are retained and held by AIG until claims are submitted and processed for payment to the insured. In June 2005, $16.8 million in excess funding related to the 2003-2004 policy year was returned to Administaff from AIG. As of September 30, 2005, the total claim funds held by AIG was $67.6 million, of which $25.7 million is included in restricted cash and $41.9 million is included in deposits in the Company’s Consolidated Balance Sheets.

The Company employs a third party actuary to estimate its workers’ compensation claims cost based on worksite employee payroll levels, the nature of the worksite employees’ job responsibilities, historical paid claim data and other actuarial assumptions. Each reporting period, changes in the actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into the Company’s workers’ compensation claims cost estimates. During the nine months ended September 30, 2005, the Company reduced accrued workers’ compensation costs by $3.7 million for changes in estimated losses related to prior reporting periods. As of September 30, 2005, the Company has estimated $55.6 million in outstanding workers’ compensation claims, net of paid claims, and accrued such amounts in accrued workers’ compensation costs in the Company’s Consolidated Balance Sheets. During the nine month period ended September 30, 2005, workers’ compensation cost estimates were discounted to present value at an average rate of 3.7%. Workers’ compensation costs are accreted over the estimated claim payment period, and included as a component of workers’ compensation costs in the Company’s Consolidated Statements of Operations.

The following table provides the activity and balances related to accrued workers’ compensation claims for the nine months ended September 30, 2005 (in thousands):


Beginning balance	$	41,423
Accrued claims		29,613
Present value discount		(2,801	)
Paid claims		(12,594	)

Ending balance	$	55,641

Current portion of accrued claims	$	25,730
Long-term portion of accrued claims		29,911

	$	55,641

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New Accounting Standards

In May 2005, the FASB issued Statement No. 154, “Accounting Changes and Error Corrections — a Replacement of APB Opinion No. 20 and FASB Statement No. 3” (“SFAS 154”). SFAS 154 requires retrospective application to prior period financial statements of changes in accounting principle, unless it is impracticable to determine either the period-specific effects or the cumulative effect of the change. SFAS 154 also redefines “restatement” as the revising of previously issued financial statements to reflect the correction of an error. This statement is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. Administaff does not expect the adoption of SFAS 154 to have a material effect on the Company’s consolidated financial position or results of operations.

3. Stockholders’ Equity

The Company’s Board of Directors has authorized the repurchase of up to 8,000,000 shares of the Company’s outstanding common stock. The Company repurchased 649,100 shares at a total cost of $12.2 million during the nine months ended September 30, 2005. As of September 30, 2005, the Company has repurchased 7,401,623 shares under this authorization at a total cost of $95.0 million.

On February 1, 2005, the compensation committee of the board of directors approved accelerating the vesting of all unvested stock options that have an exercise price greater than the Company’s January 31, 2005 closing market price of $14.59. This accelerated vesting affected approximately 733,000 common stock options with a weighted average exercise price of $18.09. In addition, the committee approved accelerating the vesting of all remaining unvested common stock options on February 18, 2005. As a result, the vesting of approximately 1,104,000 common stock options with a weighted average exercise price of $9.16 was accelerated, which resulted in the Company recognizing stock-based compensation expense of $790,000 in the first quarter of 2005. The primary purpose of the accelerated vesting was to eliminate future compensation expense the Company would otherwise recognize in its income statement with respect to these accelerated options subsequent to the January 1, 2006 effective date of FASB Statement No. 123(R).

On February 1, 2005, the compensation committee approved a grant of 303,600 restricted common shares to certain employees and officers of the Company pursuant to the Company’s 2001 Incentive Plan. The restricted common shares had a fair value on the grant date of $14.86 per share and vest over three years. Restricted common shares, under fixed accounting, are generally measured at fair value on the date of grant based on the number of shares granted and the quoted price of the common stock. Such value is recognized as compensation expense over the corresponding vesting period. During the nine months ended September 30, 2005, the Company recognized $975,000 of compensation expense associated with the restricted stock grant.

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During each quarter in 2005, the board of directors has declared quarterly dividends of $0.07 per share of common stock. As of September 30, 2005 a total of $5.5 million in dividend payments has been made.

4. Income Taxes

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 income tax rate for the nine months ended September 30, 2005 was 37.8%.

5. Net Income Per Share

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


	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2005		2004		2005		2004
Basic net income per share — weighted average shares outstanding		26,068		25,882		25,655		26,312
Effect of dilutive securities — treasury stock method:
Common stock options		1,124		564		741		802
Restricted stock awards		124		—		62		—

		1,248		564		803		802

Diluted net income per share — weighted average shares outstanding plus effect of dilutive securities		27,316		26,446		26,458		27,114


Potentially dilutive securities not included in weighted average share calculation due to anti-dilutive effect		600		4,093		2,213		3,880

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, 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, except as set forth below.

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 Company and certain of its officers and directors made false and misleading statements or failed to make adequate disclosures concerning, among other things: (i) the Company’s pricing and billing

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systems with respect to recalibrating pricing for clients that experienced a decline in average payroll cost per worksite employee; (ii) the matching of price and cost for health insurance on new and renewing client contracts; and (iii) the Company’s former method of reporting worksite employee payroll costs as revenue. The complaints sought unspecified damages, among other remedies. On March 31, 2004, the court entered an order consolidating all of the cases and appointing Carpenters Pension Trust for South California as “lead plaintiff” and Lerach Coughlin Stoia Geller Rudman & Robbins LLP as “lead counsel.” The lead plaintiff alleges that its losses are $352,000, although the alleged damages of the purported class have not been specified.

In May 2004, the lead plaintiff filed its Consolidated Complaint, which amended and consolidated the seven previously filed cases. In the Consolidated Complaint, the lead plaintiff has essentially abandoned the allegations of fraud contained in the initial seven lawsuits. Through the Consolidated Complaint, the lead plaintiff now generally asserts, among other things, that the Company and certain of its officers and directors fraudulently made false and misleading statements regarding the cost of its health plan during 2001 and 2002. In June 2004, the Company filed a motion to dismiss the Consolidated Complaint. The Company believes these claims are without merit and intends to vigorously defend this litigation. As a result of the uncertainty regarding the outcome of this matter, no provision has been made in the accompanying consolidated financial statements.

State Unemployment Taxes

The Company records its state unemployment (“SUI”) 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. Prior to the receipt of final tax rate notices, the Company estimates its expected SUI tax rate in those states for which tax rate notices have not yet been received.

In December 2001, as a result of the 2001 corporate reorganization, the Company filed for a transfer of its reserve account with the Employment Development Department of the State of California (“EDD”). The EDD approved the Company’s request for transfer of its reserve account in May 2002 and also notified the Company of its new contribution rates based upon the approved transfer. In December 2003, the Company received a Notice of Duplicate Accounts and Notification of Assessment (“Notice”) from the Employment Development Department of the State of California (“EDD”). The Notice stated that the EDD was collapsing the accounts of the Company’s subsidiaries into the account of the entity with the highest unemployment tax rate. The Notice also retroactively imposed the higher unemployment insurance rate on all the Company’s California employees for 2003, resulting in an assessment of $5.6 million. In January 2004, the Company filed a petition with an administrative law judge of the California Unemployment Insurance Appeals Board (“ALJ”) to protest the Notice. Pending a resolution of its protest, in the fourth quarter of 2003 the Company accrued and recorded at the higher assessed rate for all of 2003.

In June 2004, the Company agreed to settle its dispute with the EDD for $3.3 million (“Settlement”). Based upon receipt of written acknowledgement of this agreement, the Company reduced its accrued payroll tax liability and payroll tax expense by $2.3 million

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during the quarter ended June 30, 2004. The Settlement was subject to the final approval by EDD’s legal department, the California Attorney General’s office and the ALJ. In October 2004, the legal department of the EDD verbally indicated they considered the previously agreed-upon settlement amount to be insufficient and suggested a settlement amount of $5.2 million. The Company and the State of California continued discussions, but in February 2005, the Company was notified that the EDD had rejected the Company’s settlement offer and that the matter will proceed with the appeals process with the ALJ. If the outcome of the appeals process is unfavorable and the company is assessed additional interest and penalties, the Company may recognize an increase in its payroll tax expense in a future period. Conversely, if the outcome of the appeals process is favorable to the Company, the Company may recognize a decrease in its payroll tax expense in a future period.

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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 our 2004 annual report on Form 10-K, as well as with our consolidated financial statements and notes thereto included in this quarterly report on Form 10-Q.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our 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 us 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, we evaluate our estimates, including those related to health and workers’ compensation insurance claims experience, state unemployment taxes, client bad debts, income taxes, property and equipment and contingent liabilities. Management bases these 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.

We believe the following accounting policies are critical and/or require significant judgments and estimates used in the preparation of our consolidated financial statements:

•		Benefits costs — We provide health insurance coverage to our worksite employees through a national network of carriers including UnitedHealthcare (“United”), Cigna Healthcare, PacifiCare, Kaiser Permanente, Blue Cross and Blue Shield of Georgia, Blue Shield of California and Tufts, all of which provide fully insured policies or service contracts.

		The policy with United, which was first obtained in January 2002, provides the majority of our health insurance coverage. As a result of certain contractual terms, we have accounted for this plan since its inception using a partially self-funded insurance accounting model. Accordingly, we record the costs of the United Plan, including an estimate of the incurred claims, taxes and administrative fees (collectively the “Plan Costs”), as benefits expense in the Consolidated Statements of Operations. The estimated incurred claims are based upon: (i) the level of claims processed during the quarter; (ii) recent claim development patterns under the plan; and (iii) the number of participants in the plan. Each reporting period, changes in the estimated ultimate costs resulting from changes in the actual claims experience and other trends are incorporated into the benefits costs estimates.

		Additionally, since the plan’s inception in January 2002, under the terms of the contract, United establishes cash funding rates 90 days in advance of the beginning of a reporting quarter. If the Plan Costs for a reporting quarter are greater than the cash funded to United, a deficit in the plan would be incurred and we would accrue a liability for the excess costs on

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		our Consolidated Balance Sheet. On the other hand, if the Plan Costs for the reporting quarter are less than the cash funded to United, a surplus in the plan would be incurred and we would record an asset for the excess premiums on our Consolidated Balance Sheet.

		In 2005, Administaff and United entered into a new three-year arrangement, whereby a previous contractual requirement to maintain a security deposit with United was eliminated. Accordingly, the outstanding security deposit at December 31, 2004 of $17.5 million was returned to Administaff during the quarter ended June 30, 2005. The terms of the new arrangement also require Administaff to maintain an accumulated cash surplus in the plan of $11 million, which was the balance of the accumulated surplus at December 31, 2004, and is now reported as long-term prepaid insurance. As of September 30, 2005, Plan Costs were less than the net cash funded to United by $21.1 million. As this amount is in excess of the agreed-upon $11 million surplus maintenance level, the $10.1 million balance is included in prepaid insurance, a current asset, on the Company’s Consolidated Balance Sheet.

•		State unemployment taxes — We record our state unemployment (“SUI”) 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. Prior to the receipt of final tax rate notices, we estimate our expected SUI tax rate in those states for which tax rate notices have not yet been received.

		In December 2001, as a result of the 2001 corporate reorganization, we filed for a transfer of our reserve account with the Employment Development Department of the State of California (“EDD”). The EDD approved our request for transfer of our reserve account in May 2002, and notified us of our new contribution rates based upon the approved transfer. In December 2003, we received a Notice of Duplicate Accounts and Notification of Assessment (“Notice”) from the Employment Development Department of the State of California (“EDD”). The Notice stated that the EDD was collapsing the accounts of Administaff’s subsidiaries into the account of the entity with the highest unemployment tax rate. The Notice also retroactively imposed the higher unemployment insurance rate on all our California employees for 2003, resulting in an assessment of $5.6 million. In January 2004, we filed a petition with an administrative law judge of the California Unemployment Insurance Appeals Board (“ALJ”) to protest the Notice. Pending a resolution of our protest, in the fourth quarter of 2003 we accrued and recorded at the higher assessed rate for all of 2003.

		In June 2004, we agreed to settle our dispute with the EDD for $3.3 million (“Settlement”). Based upon receipt of written acknowledgement of this agreement, we reduced our accrued payroll tax liability and payroll tax expense by $2.3 million during the quarter ended June 30, 2004. The Settlement was subject to the final approval by EDD’s legal department, the California Attorney General’s office and the ALJ. In October 2004, the legal department of the EDD verbally indicated they considered the previously agreed-upon settlement amount to be insufficient and suggested a settlement amount of $5.2 million. We continued discussions with the State of California, but in February 2005, we were notified that the EDD had rejected our settlement offer and that the matter will proceed with the appeals process with

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		the ALJ. If the outcome of the appeals process is unfavorable and we are assessed additional interest and penalties, we may recognize an increase in our payroll tax expense in a future period. Conversely, if the outcome of the appeals process is favorable to us, we may recognize a decrease in our payroll tax expense in a future period.

•		Workers’ compensation costs — On September 1, 2003, we obtained an annual workers’ compensation policy with selected member insurance companies of American International Group, Inc. (“AIG”). This policy was subsequently renewed in September 2004 and September 2005. Under our arrangement with AIG, we bear the economic burden for the first $1 million layer of claims per occurrence. AIG bears the economic burden for all claims in excess of such first $1 million layer. The policies are fully insured whereby AIG has the responsibility to pay all claims incurred under the policies regardless of whether we satisfy our responsibilities.

		Because we bear the economic burden of the first $1 million layer of claims per occurrence, such claims, which are the primary component of our workers’ compensation costs, are recorded in the period incurred. Workers compensation insurance includes ongoing healthcare and indemnity coverage whereby claims are paid over numerous years following the date of injury. Accordingly, the accrual of related incurred costs in each reporting period includes estimates, which take into account the ongoing development of claims and therefore requires a significant level of judgment. Our management estimates our workers’ compensation costs by applying an aggregate loss development rate to worksite employee payroll levels.

		We employ a third party actuary to estimate our loss development rate, which is primarily based upon the nature of worksite employees’ job responsibilities, the location of worksite employees, the historical frequency and severity of workers compensation claims, and an estimate of future cost trends. Each reporting period, changes in the actuarial assumptions resulting from changes in actual claims experience and other trends are incorporated into the Company’s workers’ compensation claims cost estimates. During the nine months ended September 30, 2005, Administaff reduced accrued workers’ compensation costs by $3.7 million for changes in estimated losses related to prior reporting periods. Workers’ compensation cost estimates are discounted to present value at a rate based upon the U.S. Treasury rates that correspond with the weighted average estimated claim payout period (the average discount rate utilized in 2005 and 2004 was 3.7% and 2.7%, respectively) and are accreted over the estimated claim payment period and included as a component of direct costs in our Consolidated Statements of Operations.

•		Contingent liabilities — We accrue and disclose contingent liabilities in our consolidated financial statements in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 5, Accounting for Contingencies. SFAS No. 5 requires accrual of contingent liabilities that are considered probable to occur and can be reasonably estimated. For contingent liabilities that are considered reasonably possible to occur, financial statement disclosure is required, including the range of possible loss if it can be reasonably determined. We have disclosed in our financial statements several issues that we believe are reasonably

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		possible to occur, although we cannot determine the range of possible loss in all cases. As these issues develop, we will continue to evaluate the probability of future loss and the potential range of such losses. If such evaluation were to determine that a loss was probable and the loss could be reasonably estimated, we would be required to accrue our estimated loss, which would reduce net income in the period such determination was made.

•		Deferred taxes — We have recorded a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, our ability to realize our deferred tax assets could change from our current estimates. If we determine we will be able to realize our deferred tax assets in the future in excess of our net recorded amount, an adjustment to reduce the valuation allowance would increase net income in the period that such determination is made. Likewise, should we determine we will not be able to realize all or part of our net deferred tax assets in the future, an adjustment to increase the valuation allowance would reduce net income in the period such determination is made.

•		Allowance for doubtful accounts — We maintain an allowance for doubtful accounts for estimated losses resulting from the inability of our clients to pay our comprehensive service fees. We believe the success of our business is heavily dependent on our ability to collect these comprehensive service fees for several reasons, including:

	•		the fact that we are at risk for the payment of our direct costs and worksite employee payroll costs regardless of whether our clients pay their comprehensive service fees;

	•		the large volume and dollar amount of transactions we process; and

	•		the periodic and recurring nature of payroll, upon which the comprehensive service fees are based.

		To mitigate this risk, we have established very tight credit policies. We generally require our clients to pay their comprehensive service fees no later than one day prior to the applicable payroll date. In addition, we maintain the right to terminate our 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, losses related to client nonpayment have historically been low as a percentage of revenues. However, if our clients’ financial condition were to deteriorate rapidly, resulting in nonpayment, our accounts receivable balances could grow and we could be required to provide for additional allowances, which would decrease net income in the period that such determination was made.

•		Property and equipment — Our property and equipment relate primarily to our 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, our depreciation and amortization expense could be accelerated, which would decrease net income in the periods of such a determination. In

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addition, we periodically evaluate these costs for impairment in accordance with SFAS No. 144, Accounting for Impairment or Disposal of Long-Lived Assets. If events or circumstances were to indicate that any of our long-lived assets might be impaired, we would analyze the estimated undiscounted future cash flows to be generated from the applicable asset. In addition, we would record an impairment loss, which would reduce net income, to the extent the carrying value of the asset exceeded the fair value of the asset. Fair value is generally determined using an estimate of discounted future net cash flows from operating activities or upon disposal of the asset.

New Accounting Pronouncement

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Results of Operations

Three Months Ended September 30, 2005 Compared to Three Months Ended September 30, 2004.

The following table presents certain information related to Administaff’s results of operations for the three months ended September 30, 2005 and 2004.


	Three months ended
	September 30,
	2005		2004		% Change
	(in thousands, except per share and statistical data)
Revenues (gross billings of $1.622 billion and $1.323 billion, less worksite employee payroll cost of $1.337 billion and $1.087 billion, respectively)	$	285,202	$	235,865		20.9	%
Gross profit		58,171		47,672		22.0	%
Operating expenses		47,566		42,581		11.7	%
Operating income		10,605		5,091		108.3	%
Other income		967		52		1,759.6	%
Net income		7,183		3,612		98.9	%
Diluted net income per share of common stock		0.26		0.14		85.7	%

Statistical Data:
Average number of worksite employees paid per month		90,493		78,817		14.8	%
Revenues per worksite employee per month⁽¹⁾	$	1,051	$	998		5.3	%
Gross profit per worksite employee per month		214		202		5.9	%
Operating expenses per worksite employee per month		175		180		(2.8	%)
Operating income per worksite employee per month		39		22		77.3	%
Net income per worksite employee per month		26		15		73.3	%


⁽¹⁾		Gross billings of $5,976 and $5,596 per worksite employee per month less payroll cost of $4,926 and $4,598 per worksite employee per month, respectively.

Revenues

Our revenues for the third quarter of 2005 increased 20.9% over the 2004 period due to a 14.8% increase in the average number of worksite employees paid per month and a 5.3%, or $53, increase in revenues per worksite employee per month.

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By region, our revenue growth over the third quarter of 2004 and revenue distribution for the quarter ended September 30, 2005 were as follows:


	Three months ended September 30,							Three months ended September 30,
	2005		2004		% Change			2005			2004
	(in thousands)							(% of total revenues)
Northeast	$	43,532	$	33,009		31.9	%		15.2	%		14.0	%
Southeast		24,875		21,681		14.7	%		8.7	%		9.2	%
Central		37,835		32,918		14.9	%		13.3	%		13.9	%
Southwest		111,993		91,930		21.8	%		39.3	%		39.0	%
West		65,275		54,919		18.9	%		22.9	%		23.3	%
Other revenue		1,692		1,408		20.2	%		0.6	%		0.6	%

Total revenue	$	285,202	$	235,865		20.9	%		100.0	%		100.0	%

Our 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 third quarter of 2005, all three sources of unit growth improved over the 2004 period.

Gross Profit

Gross profit for the third quarter of 2005 increased 22.0% to $58.2 million compared to the third quarter of 2004. The average gross profit per worksite employee increased 5.9% to $214 per month in the 2005 period from $202 per month in the 2004 period. Our 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 primary direct costs and operating expenses.

Our primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 5.2% to $837 per worksite employee per month in the third quarter of 2005 versus $796 in the third quarter of 2004.

•		Payroll tax costs — Payroll taxes increased $22 per worksite employee per month compared to the third quarter of 2004. The overall cost of payroll taxes as a percentage of payroll cost decreased slightly to 6.87% in the 2005 period from 6.88% in the 2004 period. Please read “Critical Accounting Policies and Estimates — State Unemployment Taxes” on page 18 for a discussion of the Company’s accounting for state unemployment taxes.

•		Benefits costs — The cost of health insurance and related employee benefits increased $28 per worksite employee per month to $433 compared to the third quarter of 2004. This increase is due to a 5.5% increase in the cost per covered employee and an increase in the percentage of worksite employees covered under our health insurance plans to 72.0% in the 2005 period from 71.0% in the 2004 period. The increase in the 2005 period contains $1.1 million, or $4 per worksite employee, in state premium tax assessed to our insurance carrier and passed on to us during the third quarter. Please read “Critical Accounting Policies and Estimates — Benefits Costs” on page 17 for a discussion of our accounting for health insurance costs.

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•

Workers’ compensation costs — Workers’ compensation costs decreased $12 per worksite employee per month compared to the third quarter of 2004. As a percentage of non-bonus payroll cost, workers’ compensation costs decreased to 1.06% in the 2005 period from 1.41% in the 2004 period as a result of favorable trends in both the frequency and severity of workers’ compensation claims. Reductions in accrued workers’ compensation costs related to prior reporting periods were $1.9 million, or 0.15% of non-bonus payroll costs, in the 2005 period. Please read “Critical Accounting Policies and Estimates — Workers’ Compensation Costs” on page 19 for a discussion of our accounting for workers’ compensation costs.

Operating Expenses

The following table presents certain information related to the Administaff’s operating expenses for the three months ended September 30, 2005 and 2004.


	Three months ended September 30,							Three months ended September 30,
	2005		2004		% change			2005		2004		% change
	(in thousands)							(per worksite employee per month)
Salaries, wages and payroll taxes	$	25,471	$	21,779		17.0	%	$	94	$	92		2.2	%
Stock-based compensation		360		—		—			1		—		—
General and administrative expenses		12,476		12,322		1.2	%		46		52		(11.5	)%
Commissions		2,610		2,557		2.1	%		10		11		(9.1	)%
Advertising		2,956		1,547		91.1	%		11		7		57.1	%
Depreciation and amortization		3,693		4,376		(15.6	)%		13		18		(27.8	)%

Total operating expenses	$	47,566	$	42,581		11.7	%	$	175	$	180		(2.8	)%

Operating expenses increased 11.7% to $47.6 million compared to the third quarter of 2004. Operating expense per worksite employee decreased to $175 per month in the 2005 period from $180 in the 2004 period. The components of operating expenses changed as follows:

•		Salaries, wages and payroll taxes of corporate and sales staff increased 17.0%, or $2 per worksite employee per month, compared to the 2004 period. The increase was primarily due to a $2.1 million increase in incentive compensation expense based upon the current forecast of improved operating results for the year. Corporate headcount increased 3.6% as compared to 2004.

•		Stock-based compensation expense of $360,000 or $1 per worksite employee per month was related to the amortization of the compensation expense associated with the February 2005 restricted stock grant. Please read Note 3 to the consolidated financial statements on page 13 for additional information.

•		General and administrative expenses increased 1.2%, but decreased $6 per worksite employee per month, compared to the third quarter of 2004.

•		Commissions expense increased 2.1%, but decreased $1 per worksite employee per month compared to the 2004 period.

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•		Advertising costs increased 91.1%, or $4 per worksite employee per month, compared to the third quarter of 2004, due to the timing of marketing efforts associated with the 2005 fall sales campaign, which were initiated during the third quarter of 2005 as opposed to the fourth quarter in 2004.

•		Depreciation and amortization expense decreased 15.6%, or $5 per worksite employee per month, compared to the 2004 period as the effect of certain fixed assets becoming fully amortized more than offset the incremental depreciation and amortization expense related to the 2005 capital additions.

Other Income (Expense)

Other income (expense) increased from $52,000 in the third quarter of 2004 to $967,000 in the 2005 period. Interest income increased by $1.0 million, primarily as a result of an increase in cash balances, including cash held in our workers’ compensation program, and higher interest rates in the 2005 period.

Income Tax Expense

Our provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses.

Net Income

Operating and net income per worksite employee per month was $39 and $26 in the 2005 period, versus $22 and $15 in the 2004 period.

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Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004.

The following table presents certain information related to Administaff’s results of operations for the nine months ended September 30, 2005 and 2004.


	Nine months ended
	September 30,
	2005		2004		% Change
	(in thousands, except per share and statistical data)
Revenues (gross billings of $4.756 billion and $3.861 billion, less worksite employee payroll cost of $3.892 billion and $3.141 billion, respectively)	$	864,062	$	720,804		19.9	%
Gross profit		168,534		146,251		15.2	%
Operating expenses		140,194		129,495		8.3	%
Operating income		28,340		16,756		69.1	%
Other income		2,291		8,303		(72.4	)%
Net income		19,057		15,661		21.7	%
Diluted net income per share of common stock		0.72		0.58		24.1	%

Statistical Data:
Average number of worksite employees paid per month		87,030		76,940		13.1	%
Revenues per worksite employee per month⁽¹⁾	$	1,103	$	1,041		6.0	%
Gross profit per worksite employee per month		215		211		1.9	%
Operating expenses per worksite employee per month		179		187		(4.3	)%
Operating income per worksite employee per month		36		24		50.0	%
Net income per worksite employee per month		24		23		4.3	%


⁽¹⁾		Gross billings of $6,072 and $5,576 per worksite employee per month less payroll cost of $4,969 and $4,535 per worksite employee per month, respectively.

Revenues

Our revenues for the nine months ended September 30, 2005 increased 19.9% over the 2004 period due to a 13.1% increase in the average number of worksite employees paid per month and a 6.0%, or $62, increase in revenues per worksite employee per month.

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By region, our revenue growth over the first nine months of 2004 and revenue distribution for the nine months ended September 30, 2005 were as follows:


	Nine months ended September 30,							Nine months ended September 30,
	2005		2004		% Change			2005			2004
	(in thousands)							(% of total revenues)
Northeast	$	130,762	$	99,616		31.3	%		15.1	%		13.8	%
Southeast		74,932		67,755		10.6	%		8.7	%		9.4	%
Central		114,836		103,689		10.8	%		13.3	%		14.4	%
Southwest		337,326		281,214		20.0	%		39.0	%		39.0	%
West		201,021		164,175		22.4	%		23.3	%		22.8	%
Other revenue		5,185		4,355		19.1	%		0.6	%		0.6	%

Total revenue	$	864,062	$	720,804		19.9	%		100.0	%		100.0	%

Our 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 nine months ended September 30, 2005, all three sources of unit growth improved compared to the 2004 period.

Gross Profit

Gross profit for the first nine months of 2005 increased 15.2% to $168.5 million compared to the first nine months of 2004. The average gross profit per worksite employee increased 1.9% to $215 per month in the 2005 period from $211 per month in the 2004 period. Our 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 primary direct costs and operating expenses.

Our primary direct costs, which include payroll taxes, benefits and workers’ compensation expenses, increased 7.0% to $888 per worksite employee per month in the first nine months of 2005 versus $830 in the first nine months of 2004.

•		Payroll tax costs — Payroll taxes increased $36 per worksite employee per month compared to the first nine months of 2004. The overall cost of payroll taxes as a percentage of payroll cost increased in the 2005 period to 7.95% from 7.91% in the 2004 period. During the 2004 period, payroll tax expense included a $2.3 million credit, or 0.07% as a percentage of payroll costs, related to a state unemployment tax matter with the State of California. Please read “Critical Accounting Policies and Estimates — State Unemployment Taxes” on page 18 for a discussion of our accounting for state unemployment taxes.

•		Benefits costs — The cost of health insurance and related employee benefits increased $27 per worksite employee per month to $426 compared to 2004. This increase is due to a 4.7% increase in the cost per covered employee and an increase in the percentage of worksite employees covered under our health insurance plans to 72.3% in the 2005 period from 70.8% in the 2004 period. Please read “Critical Accounting Policies and Estimates — Benefits Costs” on page 17 for a discussion of our accounting for health insurance costs.

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•

Workers’ compensation costs — Workers’ compensation costs decreased $6 per worksite employee per month compared to the first nine months of 2004. As a percentage of non-bonus payroll cost, workers’ compensation costs decreased to 1.13% in the 2005 period from 1.37% in the 2004 period as a result of favorable trends in both the frequency and severity of workers’ compensation claims. Reductions in accrued workers’ compensation costs related to prior reporting periods were $3.7 million, or 0.10% of non-bonus payroll costs, in the 2005 period. Please read “Critical Accounting Policies and Estimates — Workers’ Compensation Costs” on page 19 for a discussion of our accounting for workers’ compensation costs.

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Operating Expenses

The following table presents certain information related to the Administaff’s operating expenses for the nine months ended September 30, 2005 and 2004.


	Nine months ended September 30,							Nine months ended September 30,
	2005		2004		% change			2005		2004		% change
	(in thousands)							(per worksite employee per month)
Salaries, wages and payroll taxes	$	73,436	$	65,161		12.7	%	$	94	$	94		—
Stock-based compensation		1,765		—		—			2		—		—
General and administrative expenses		39,077		37,003		5.6	%		50		53		(5.7	)%
Commissions		7,462		7,879		(5.3	)%		10		11		(9.1	)%
Advertising		7,355		5,955		23.5	%		9		9		—
Depreciation and amortization		11,099		13,497		(17.8	)%		14		20		(30.0	)%

Total operating expenses	$	140,194	$	129,495		8.3	%	$	179	$	187		(4.3	)%

Operating expenses increased 8.3% to $140.2 million compared to the first nine months of 2004. Operating expense per worksite employee decreased to $179 per month in the 2005 period from $187 in the 2004 period. The components of operating expenses changed as follows:

•		Salaries, wages and payroll taxes of corporate and sales staff increased 12.7%, but remained flat on a per worksite employee per month basis compared to the 2004 period. The increase in total dollars was primarily due to a $5.6 million increase in incentive compensation expense based upon the current forecast of improved operating results for the year. Corporate headcount increased 1.2% in the 2005 period as compared to 2004.

•		Stock-based compensation expense of $1.8 million or $2 per worksite employee per month was a result of: (i) $790,000 related to the acceleration of stock option vesting during the first quarter of 2005; and (ii) $975,000 related to the amortization of deferred compensation expense associated with the February 2005 restricted stock grant. Please read Note 3 to the consolidated financial statements on page 13 for additional information.

•		General and administrative expenses increased 5.6%, due primarily to increases in: (i) professional fees such as accounting, consulting and recruiting; and (ii) repairs and maintenance costs. General and administrative expenses decreased $3 per worksite employee per month compared to the first nine months of 2004.

•		Commissions expense decreased 5.3%, or $1 per worksite employee per month, compared to the 2004 period, due to the termination of the American Express Marketing Agreement at the end of 2004, partially offset by an increase in commissions paid to Administaff sales representatives.

•		Advertising costs increased 23.5%, due primarily to increases in radio and television advertising associated with the spring and fall 2005 sales campaigns, but remained flat on a per worksite employee per month basis compared to the first nine months of 2004.

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•

Depreciation and amortization expense decreased 17.8%, or $6 per worksite employee per month, compared to the 2004 period, as the effect of certain fixed assets becoming fully amortized more than offset the incremental depreciation and amortization expense related to the 2005 capital additions.

Other Income (Expense)

Other income (expense) decreased from $8.3 million in the first nine months of 2004 to $2.3 million in the 2005 period, primarily due to the $8.25 million settlement of our dispute with Aetna during the 2004 period. Interest income increased by $2.5 million, primarily as a result of an increase in cash balances, including cash held in our workers’ compensation program, and higher interest rates in the 2005 period.

Income Tax Expense

Our provision for income taxes differed from the U.S. statutory rate of 35% primarily due to state income taxes and non-deductible expenses.

Net Income

Operating and net income per worksite employee per month was $36 and $24 in the 2005 period, versus $24 and $23 in the 2004 period.

Non-GAAP Financial Measures

Non-bonus payroll cost is a non-GAAP financial measure that excludes the impact of bonus payrolls paid to our worksite employees. Bonus payroll cost varies from period to period, but has no direct impact to our ultimate workers’ compensation costs under the current program. As a result, our management refers to non-bonus payroll cost in analyzing, reporting and forecasting our workers’ compensation costs. Non-GAAP financial measures are not prepared in accordance with generally accepted accounting principles (“GAAP”) and may be different from non-GAAP financial measures used by other companies. Non-GAAP financial measures should not be considered as a substitute for, or superior to, measures of financial performance prepared in accordance with GAAP. We include these non-GAAP financial measures because we believe they are useful to investors in allowing for greater transparency related to the costs incurred under our current workers’ compensation program. Investors are encouraged to review the reconciliation of the non-GAAP financial measures used to their most directly comparable GAAP financial measures as provided in the table below.

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	Three months ended							Nine months ended
	September 30,							September 30,
	2005		2004		Change			2005		2004		Change
Payroll cost (GAAP)	$	1,337,230	$	1,087,311		23.0	%	$	3,891,756	$	3,140,597		23.9	%
Less: Bonus payroll cost		71,302		64,176		11.1	%		302,877		213,446		41.9	%

Non-bonus payroll cost	$	1,265,928	$	1,023,135		23.7	%	$	3,588,879	$	2,927,151		22.6	%


Payroll cost per worksite employee (GAAP)	$	4,926	$	4,598		7.1	%	$	4,969	$	4,535		9.6	%
Less: Bonus payroll cost per worksite employee		263		271		(3.0	)%		387		308		25.6	%

Non-bonus payroll cost per worksite employee	$	4,663	$	4,327		7.8	%	$	4,582	$	4,227		8.4	%

Liquidity and Capital Resources

We periodically evaluate our liquidity requirements, capital needs and availability of resources in view of, among other things, expansion plans, debt service requirements and other operating cash needs. To meet short and long-term liquidity requirements, including payment of direct costs, operating expenses and repaying debt, we rely primarily on cash from operations. However, we have in the past sought, and may in the future seek, to raise additional capital or take other steps to increase or manage our liquidity and capital resources. We had $155.7 million in cash and cash equivalents and marketable securities at September 30, 2005, including approximately $62.5 million for withheld federal and state income taxes, employment taxes and other payroll deductions and $5.8 million in customer prepayments that were payable in October 2005. At September 30, 2005, we had working capital of $97.9 million compared to $47.5 million at December 31, 2004. We currently believe that our cash on hand, marketable securities and cash flows from operations will be adequate to meet our liquidity requirements for the remainder of 2005. We will rely on these same sources, as well as public and private debt or equity financing, to meet our longer-term liquidity and capital needs.

Cash Flows From Operating Activities

Our cash flows from operating activities in 2005 increased $41.1 million from 2004 to $50.5 million. Our primary source of cash from operations is the comprehensive service fee and payroll funding we collect from our clients. The level of cash and cash equivalents, and thus our reported cash flows from operating activities are significantly impacted by various external and internal factors, which are reflected in part by the changes in our balance sheet accounts. These include the following:

•

Timing of customer payments / payrolls — We typically collect our comprehensive service fee, along with the client’s payroll funding, from clients at least one day prior to the payment of worksite employee payrolls. Therefore, the date of the last day of a reporting period has a substantial impact on our reporting of operating cash flows. For example,

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			many worksite employees are paid on Fridays; therefore, operating cash flows decline in the reporting periods that end on a Friday, such as in September 2005, when client prepayments were $5.8 million and accrued worksite employee payroll was $74.8 million. However, for those reporting periods that end on a Thursday, such as in June 2005, when customer prepayments were $51.7 million and accrued worksite employee payroll was $103.2 million, our cash flows are higher due to the collection of the comprehensive service fee and client’s payroll funding prior to processing the large number worksite employees’ payrolls one day subsequent to quarter-end.

	•		Medical plan funding — Our healthcare contract with United establishes participant cash funding rates 90 days in advance of the beginning of a reporting quarter. Therefore, changes in the participation level of the United Plan have a direct impact on our operating cash flows. In addition, changes to the funding rates, which are solely determined by United based primarily upon recent claim history and anticipated cost trends, also have a significant impact on our operating cash flows. Since inception of the United Plan in January 2002, cash funded to United has exceeded Plan Costs, resulting in a $21.1 million surplus, $10.1 million of which is reflected as a current asset, and $11.0 million of which is reflected as a long-term asset on our Consolidated Balance Sheet at September 30, 2005. Additionally, the $17.5 million included in long-term deposits on the Consolidated Balance Sheet at December 31, 2004, was returned to Administaff during the quarter ended June 30, 2005.

	•		Workers’ compensation plan funding — Under our arrangement with AIG, we make monthly payments to AIG comprised of premium costs and funds to be set aside for payment of future claims (“claim funds”). These pre-determined amounts are stipulated in our agreement with AIG, and are based primarily on anticipated worksite employee payroll levels and workers compensation loss rates during the policy year. Changes in payroll levels from that which was anticipated in the arrangement with AIG can result in changes in the amount of the cash payments to AIG, which will impact our reporting of operating cash flows. Our claim funds paid to AIG, based upon anticipated worksite employee payroll levels and workers’ compensation loss rates, were $38.4 million, less claims paid of $12.6 million in 2005, and $38.0 million, less claims paid of $6.7 million for the 2004 period. This compares to our estimate of workers’ compensation loss costs of $26.8 million and $29.1 million in 2005 and 2004, respectively. Additionally, during the nine months ended September 30, 2005, Administaff received $16.8 million for the return of excess funding related to the 2003-2004 policy and $6.0 million in return of buffer collateral.

	•		Operating results — Our net income has a significant impact on our operating cash flows. Our net income increased 21.7% to $19.1 million in 2005 compared to 2004. Please read Results of Operations — Nine Months Ended September 30, 2005 Compared to Nine Months Ended September 30, 2004 on page 26.

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Cash Flows Used in Investing Activities

Cash flows used in investing activities increased $18.1 million from 2004 to $26.5 million. We invested a net $19.2 million in marketable securities and approximately $6.9 million in capital expenditures during 2005.

Cash Flows Provided by Financing Activities

Cash flows provided by financing activities primarily related to $21.6 million in proceeds from the exercise of employee stock options, offset by the repurchase of $12.2 million in treasury stock and $5.5 million in dividends paid.

Other Matters

As previously disclosed, after capital constraints and downgrades from various rating agencies, our former workers’ compensation insurance carrier, Lumbermens Mutual Casualty Company, a unit of Kemper Insurance Companies (“Kemper”) has entered into a “run-off.” In June 2005, Kemper announced further negative developments with respect to its financial status. In August 2005, Kemper announced that it had filed its audited statutory financial statements for 2004. If the run-off process is not successful and Kemper is placed into a formal liquidation or a similar proceeding, most states have established guaranty associations to pay the remaining claims. However, the guaranty associations of certain states, including Texas, may attempt to return the liability for such remaining claims to Administaff, which may have a material adverse effect on net income in the reported period. For more information regarding Kemper as well as the effect on us of the bankruptcy of another former workers compensation insurance carrier, please read “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Factors That May Affect Future Results and the Market Price of Common Stock- Increases in Health Insurance Premiums and Workers’ Compensation Costs” on pages 41 and 42 of our Form 10-K for the year ended December 31, 2004 filed with the SEC. Our 2004 Form 10-K is also available on our web site at www.administaff.com.

Seasonality, Inflation and Quarterly Fluctuations

We believe the effects of inflation have not had a significant impact on our 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,” “objective,” “assume,” “outlook,” “guidance,” “predicts,” “appears,” “indicator” and similar expressions. Forward-looking statements involve a number of risks and uncertainties. In the normal course of business,

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Administaff, Inc., in an effort to help keep our stockholders and the public informed about our 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. We base the forward-looking statements on our current expectations, estimates and projections. These statements are not guarantees of future performance and involve risks and uncertainties that we cannot predict. In addition, we have 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 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 and possible adverse application of various federal, state and local regulations; (iii) changes in our direct costs and operating expenses including, but not limited to, increases in health insurance premiums and workers’ compensation rates and underlying claims trends, financial solvency of workers’ compensation carriers and other insurers, 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 our operations; (iv) our ability to effectively manage our retirement services operation; (v) the effectiveness of our sales and marketing efforts; (vi) changes in the competitive environment in the PEO industry, including the entrance of new competitors and our ability to renew or replace client companies; (vii) our liability for worksite employee payroll and benefits costs; and (viii) an adverse final judgment or settlement of claims against Administaff. These factors are discussed in detail in our 2004 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 our operations and whether forward-looking statements we make ultimately prove to be accurate.

ITEM 4. CONTROLS AND PROCEDURES.

In accordance with Exchange Act Rules 13a-15 and 15d-15, we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of September 30, 2005.

There has been no change in our internal controls over financial reporting that occurred during the three months ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.

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PART II

ITEM 1. LEGAL PROCEEDINGS.

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

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

The following table provides information about purchases by Administaff during the three months ended September 30, 2005, of equity securities that are registered by Administaff pursuant to Section 12 of the Exchange Act:


					Total Number
					of Shares
					Purchased as		Maximum Number
	Total Number				Part of Publicly		of Shares that May
	of Shares		Average Price Paid		Announced		Yet Be Purchased
Period	Purchased ⁽¹⁾		per Share		Program ⁽²⁾		Under the Program ⁽²⁾
07/01/2005-07/31/2005		—	$	—		7,310,823		689,177
08/01/2005-08/31/2005		90,800		32.21		7,401,623		598,377
09/01/2005-09/30/2005		—		—		7,401,623		598,377
Total		90,800	$	32.21		7,401,623		598,377


⁽¹⁾		Our board of directors has approved the repurchase of up to an aggregate amount of 8,000,000 shares of Administaff common stock, of which 7,401,623 had been repurchased as of September 30, 2005. During the three months ended September 30, 2005, we purchased 90,800 shares of our common stock.

⁽²⁾		Unless terminated earlier by resolution of the board of directors, the repurchase program will expire when we have repurchased all shares authorized for repurchase under the repurchase program.

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Part I

Item 1. Financial Statements			3

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			17

Item 4. Controls and Procedures			34

Part II

Item 1. Legal Proceedings			35

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			35

Item 6. Exhibits			36
Certification of CEO pursuant to Section 302
Certification of CFO pursuant to Section 302
Certification of CEO pursuant to Section 906
Certification of CFO pursuant to Section 906

	31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

	32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


	Administaff, Inc.

Date: November 1, 2005	By:	/s/ Douglas S. Sharp

	Douglas S. Sharp
	Vice President of Finance,
	Chief Financial Officer and Treasurer
	(Principal Financial and Duly Authorized Officer)

31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

	(a)		Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

	(b)		Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

	(c)		Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

	(d)		Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

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	1.		I have reviewed this quarterly report on Form 10-Q of Administaff, Inc.;

	2.		Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

	3.		Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

	4.		The registrant’s other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

	(a)		All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

	(b)		Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.


		/s/ Paul J. Sarvadi
		Paul J. Sarvadi
		Chairman of the Board and Chief Executive Officer


/s/ Douglas S. Sharp
Douglas S. Sharp
Vice President of Finance, Chief Financial Officer and Treasurer
November 1, 2005