Insperity, Inc. Annual Report 2003

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FY2003 Annual Report · Insperity, Inc.

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The business of employment...in ACTION.

2003 A n n u a l R e p o r t
2003 A n n u a l R e p o r t

F i n a n c i a l H i g h l i g h t s

(in thousands, except per share amounts and statistical data)

2003

2002

Year ended December 31,
2001

2000

1999

Income Statement Data:

Revenues(1)

Gross profit

Operating income

Net income (loss) from continuing operations

Net loss from discontinued operations

Net income (loss)

Diluted net income (loss) per share from

continuing operations(2)

Balance Sheet Data:

Working capital

Total assets

Total debt

Total stockholders’ equity

Statistical Data:

$891,721

$848,416

$720,219

$598,291

$373,512

197,967

165,790

165,015

138,534

24,274

14,985

(2,121)

12,864

(2,921)

(1,160)

(4,081)

18,539

10,357

–

22,234

16,900

–

89,528

10,559

9,358

–

10,357

16,900

9,358

0.55

(0.11)

0.36

0.58

0.34

$ 56,032

$ 41,238

$ 36,609

$ 51,179

$ 35,792

348,071

42,362

122,634

315,164

44,169

116,349

274,003

13,500

122,935

242,817

147,698

–

105,510

80,468

Average number of worksite employees paid

per month during period

Revenues per worksite employee per month(3)

Gross profit per worksite employee per month

Operating income per worksite employee per month

75,036

77,334

69,480

62,140

42,479

990

220

914

179

–

864

198

802

186

733

176

(1) Gross billings of $4.830 billion, $4.857 billion, $4.373 billion, $3.708 billion and $2.261 billion less worksite employee payroll cost of $3.938 billion,

$4.009 billion, $3.653 billion, $3.110 billion and $1.887 billion, respectively.

(2) Adjusted to reflect the two-for-one split of the common stock effected on October 16, 2000.

(3) Gross billings of $5,364, $5,234, $5,245, $4,973 and $4,435 per worksite employee per month less payroll cost of $4,374, $4,320, $4,381, $4,171 and

$3,702 per worksite employee per month, respectively.

This Annual Report includes forward-looking statements within the meaning of the federal securities laws. You can identify such forward-looking statements
by the words “are confident,” “expects,” “intends,” “plans,” “projects,” “believes,” “estimates,” “likely,” “goal,” “assume” and similar expressions. For information
concerning important factors that could cause actual results to differ materially from those in such statements, see “Management’s Discussion and Analysis of
Financial Condition and Results of Operations” in the Company’s Annual Report on Form 10-K.

C o m p a n y P r o f i l e

With 2003 revenues of $892 million, Administaff is the nation’s leading Professional Employer Organization (PEO),

serving as an outsourced human resources department for small and medium-sized businesses throughout the United States.

At year-end 2003, Administaff had more than 4,500 client companies, 73,000 worksite employees and 1,300 corporate employees.

The Company also had four client service centers and 38 sales offices in 21 major markets.

Administaff ’s common stock is listed on the New York Stock Exchange and traded under the symbol “ASF”. Headquartered

in Houston, Texas, the Company is accredited by the Employer Services Assurance Corporation and is an active member of the

National Association of Professional Employer Organizations.

L e t t e r t o S h a r e h o l d e r s

A dministaff experienced an extraordinary recovery

and return to profitability in 2003. While emerging
from one of the most challenging periods in our 17-year
history, we overcame significant obstacles, accomplished
major objectives and posted some of our best-ever financial
results. We also set the stage for a return to double-digit
unit growth by year-end 2004.

Leading Administaff’s financial performance in
2003 was record-setting operating income of $24.3 mil-
lion, compared to $67,000 in 2002. With this accom-
plishment, we successfully transitioned from our worst
year, to our best year, in one year. The Company also
achieved $27 in operating income per worksite employee
per month, which is at the upper end of our historical
range. Driving home the magnitude of our recovery
was a 36 percent increase in working capital to a record
$56.0 million.

Revenues for the year increased 5.1 percent to
$892 million, primarily due to an 8.3 percent increase
in monthly revenues per worksite employee. Although
our worksite employee base decreased 3.0 percent,
our monthly gross profit per worksite employee rose
22.9 percent, primarily as a result of improved pricing
and effective management of direct costs. The Company
also posted net income and diluted net earnings per share
from continuing operations of $15.0 million and $0.55,
versus a net loss of $2.9 million and diluted net loss
per share of $0.11 in 2002.

In addition to our financial results for 2003, we
made tremendous strides to strengthen our Company
and our product proposition by enhancing our service
model, improving processes, and settling legal and
regulatory matters:

Launch of Administaff Retirement Services. As
a result of 2002’s Internal Revenue Service Guidance,
we were able to expand our retirement savings offering
for clients and plan participants in 2003. In October,
Administaff became the recordkeeper for its existing
401(k) plan, then transitioned nearly 3,000 client
companies to the new Administaff Retirement Services

plans. This expanded offering
provides participants with more
investment options and greater
plan flexibility. As a result, we
expect to attract and retain
more clients and to benefit
from those who may use our
retirement services outside of
the co-employment relationship.

Paul J. Sarvadi
Chairman and
Chief Executive Officer

Advances in client service.
To help increase client retention, we
continued to refine our team-based
service model to help ensure every client receives
top-notch service from its team of specialists. We also
aligned the compensation of our service providers with
annual retention targets. A 2003 client survey revealed
a higher level of overall satisfaction with Administaff than
in 2002. Ninety-two percent of respondents said they are
“completely or mostly” satisfied with the professionalism
of our staff, and 95 percent indicated an intention to
renew with Administaff in 2004.

New benefits and services. Enhancing our eBusiness

initiative was the introduction of an improved online
training program and AVA, a virtual assistant that uses
conversational language to answer worksite employees’
basic questions about Administaff benefits and services.
We also launched a new commuter benefit that allows
worksite employees to designate pretax dollars to pay
for eligible commuting expenses, such as work-related
mass transit and parking.

Matching price with cost. The conversion of new
and renewing clients to our real-time pricing and billing
system was completed in 2003. The new system eliminates
the potential for revenue shortfall resulting from changes
in pay rates or benefit elections of worksite employees.
We also reorganized our management team to better align
the Company’s resources with our goals for matching
price with cost.

– 1 –

Improvements to direct cost items. By managing
and controlling our direct costs more effectively, we have
increased our competitive edge in several key areas:

• Health care benefits cost – Administaff’s security

deposit with UnitedHealthcare, our primary health
insurance carrier, was reduced from $25.0 million to
$17.5 million, with $7.5 million of the original deposit
refunded in early 2004. By incorporating risk factors
such as age, gender and COBRA ratings into our pricing
model, we improved alignment between client pricing
allocation and the marketplace. To improve client
selection and control plan costs, we tightened our risk
management standards, including client size, employer
contributions and COBRA takeovers. In addition, the
increased use of technology and a streamlining of admin-
istrative processes between the companies resulted in a
reduction of UnitedHealthcare’s administrative charges
to Administaff. This reduction equated to an estimated
savings of $5 per worksite employee per month begin-
ning in the fourth quarter of 2003.

• Workers’ compensation – In August, the Company

established a new workers’ compensation program with
members of A++ carrier American International Group,
Inc. This customized, loss-sensitive plan included the
formation of Administaff Captive Insurance Companies,
Ltd., a wholly owned Bermuda-based licensed subsidiary
of Administaff. This structure enables us to better manage
risk, control costs and maximize the return on the capital
invested to collateralize the program.

• Payroll taxes – Administaff received its final
2002 and 2003 unemployment tax rates from the Texas
Workforce Commission, resulting in a $5.1 million state
unemployment tax prepayment balance at year’s end.
This balance will be used to satisfy future unemployment
tax liabilities as incurred.

Progress on legal matters. Administaff received
a favorable jury verdict in its case against Aetna Life
Insurance Company, its former health insurance carrier
for its corporate and worksite employees. In October,
the jury found Aetna guilty on several breach-of-contract
matters, many of which had been major obstacles in
our efforts to match price with cost. The jury awarded
Administaff $15.5 million in damages – later reduced
to $10.6 million and subject to appeal – and also rejected
Aetna’s counterclaims. More importantly, the ruling

validated Administaff’s position in the matter and
mitigated a significant distraction for the Company.
Following Aetna’s appeal of the ruling, we finally settled
the matter for $8.25 million, thereby avoiding additional
legal expenses and the uncertainty of the appellate process.
In the fourth quarter, Administaff collected a $2.0 million
reimbursement for defense-related legal fees and costs
associated with the Aetna trial from National Union Fire
Insurance Company and American International Specialty
Lines Insurance Company. In addition, we paid $1.1 mil-
lion to Texas Property and Casualty Insurance Guaranty
Association to settle a $6.8 million dispute that arose
from the liquidation of Reliance National Indemnity Co.,
our former workers’ compensation carrier. We expect
the settlement to be fully covered by an insurance policy
specifically obtained for Reliance-related claims.

Our progress in 2003 was punctuated by a strong

fall selling season that marks the start of our renewed
sales momentum. Maintaining our year-end sales levels
and focusing on client retention will help us to accomplish
our goal of re-establishing double-digit unit growth in
the fourth quarter. Moreover, we expect to achieve a
healthy balance of growth and profitability by continuing
to leverage our infrastructure investments and control
operating costs.

Like 2003, our goals for this year will only be
achieved through the talent and commitment of our
corporate employees, along with valuable guidance from
our board of directors. Management extends its heartfelt
gratitude for the impressive individual and team efforts
delivered year after year.

We also express appreciation for our clients who
stayed the course while we turned our challenges into
opportunities to improve our Company. Entering 2004
with renewed sales momentum, a proven business model
and the best offering in the PEO industry, we have never
been in a better position to put our premium human
resource services into action for the best businesses
in America.

Sincerely,
Paul J. Sarvadi
Chairman and Chief Executive Officer
March 22, 2004

– 2 –

TEAM
MANAGER

CLIENT
LIAISON

BENEFITS
SPECIALIST

Client Company

AVA – ADMINISTAFF
VIRTUAL ASSISTANT

HUMAN RESOURCE
SPECIALIST

SAFETY
CONSULTANT

– 3 –

PAYROLL
SPECIALIST

RECRUITING
SPECIALIST

TRAINING
SPECIALIST

the

teamapproach to

service delivery.

Administaff is a human

resources department

for small and medium-

sized businesses. That

may not sound like very

much until you realize

that most small businesses

have never had a human

resources department.

And when you bring

high-performance human

resource practices to bear

in a small business for the

first time, it really makes

a difference in the success

equation for that business.

Will manages a wide range
of employee benefits.
BENEFITS SPECIALIST

Laura coordinates
the implementation
of client services.
CLIENT LIAISON

Colleen handles
the details of payroll
administration.
PAYROLL SPECIALIST

Sue orchestrates a
comprehensive team effort.
TEAM MANAGER

– 4 –

Susan plans
and implements
performance-
based training.
TRAINING SPECIALIST

Dean helps keep
client workplaces
safe and sound.
SAFETY CONSULTANT

Chris provides value-added
human resource services.
HUMAN RESOURCE SPECIALIST

AVA serves worksite
employees 24/7.
ADMINISTAFF VIRTUAL ASSISTANT

9Client Service

– 5 –

Professionals...in ACTION.

Administaff uses a team approach to deliver its comprehensive

Personnel Management SystemSM to clients throughout the country.

These teams are comprised of all the functions and disciplines

typically found in a Fortune 500-caliber human resources department.

Kristen helps
find and hire the
right employees.
RECRUITING SPECIALIST

O u r M i s s i o n

Administaff’s mission is to be the recognized
leader in the development, sale and delivery
of quality Professional Employer Organization
services to our strategically selected market of
small to medium-sized businesses. This mission
will be accomplished by a highly motivated
team of innovative people
dedicated to finding, attracting and satisfying
clients in a manner that will produce consistent
and superior productivity among clients,
employees and the Company.

– 6 –

Southeastern Lung Care

Treatment of Pulmonary Disease and Sleep Disorders

S e r v i c e I n A c t i o n | Helping

patients sleep better and breathe easier is

the focus of Southeastern Lung Care.

Practice Administrator Lynn Discordia

says this important undertaking is made

significantly easier by the support of their

Administaff service team. “Sue Napolitano,

our Administaff Team Manager, is constantly

working to ensure that her team members

always have what they need to meet our

human resource needs. This kind of

professional management is exactly what

we were looking for in a Professional

Employer Organization and found

only with Administaff”.

Sue Napolitano | Team Manager | Managerial oversight of Administaff
client service team members, including: Client Liaison, Payroll Specialist,

Recruiting Specialist, Benefits Specialist, Training Specialist, Safety
Consultant and Human Resource Specialist | Responsible for ensuring
service satisfaction for a targeted group of clients |

– 7 –

Entertainment Production Services

2Cinnabar

activities of Cinnabar’s Administaff service team.

S e r v i c e I n A c t i o n | From creative props, set design and construction

to special effects, digital graphics and project management, California-based

Cinnabar creates custom environments for its many clients. When Lateria Moch

became Cinnabar’s new Office Manager, she needed someone to create an instant

HR department for her. Administaff Client Liaison Laura Salinas quickly met

that need by introducing her Administaff service team and the wide range of

HR services at her beck and call. After a comprehensive needs analysis, Laura

created an HR implementation plan for Lateria and now coordinates the

Create a coordinated implementation plan for Administaff services |

– 8 –

WillMax Capital

Real Estate Property Management

S e r v i c e I n A c t i o n | With more than

75 employees spread across four states, WillMax

Capital knows what it is worth to have Administaff

Payroll Specialist Colleen Turner handle its personnel

paperwork. “We tried another PEO for six months

with disastrous results,” said Kelly Trowbridge, WillMax

Payroll Administrator. “By contrast, Colleen knows

what we need and when we need it, and she gets it

done. That includes handling new employee paper-

work, producing accurate and timely payrolls, and

communicating with our other Administaff service

team members on important issues.”

WebPayroll | Online Enrollment of Employees |

– 9 –

4Netflix

Online DVD Rentals

S e r v i c e I n A c t i o n | Netflix relies

on a dedicated national staff to serve a grow-

ing base of nearly 1.5 million DVD rental

customers. “Our rapid expansion requires

that we find and retain quality employees,”

said Greg Silva, HR Director for Netflix.

“Kristen, our Administaff Recruiting

Specialist, introduced us to the broad

scope of our Administaff recruiting services.

She quickly improved the quality of our

background checks and significantly reduced

the number of resumes our managers review.

As a result, we have better applicants and

more time to focus on business operations.”

Kristen Isotalo-Fennelly | Recruiting

Specialist | Resume Review & Interviewing |

Classified Advertising Coordination |

Background Checks | Pre-Employment

Testing | Outplacement |

S e r v i c e I n A c t i o n | Across the

country, Netflix managers use their online

Administaff Employee Service CenterSM to

submit payroll information, sort and export

employee data, formulate, store and generate

reports, and manage training curriculums.

Employees also have 24/7 access to their

employee benefits data, paystub histories

and a wide range of value-added services.

Locating information on the Employee

Service Center is even easier now with

AVA, the Administaff Virtual Assistant,

who uses conversational language to

answer common queries.

AVA | Administaff Virtual Assistant | Online
Information Assistance for the Employee Service

Center | Answers Questions in Chat-like Style |
Searches Administaff Database for Responses |

– 11 –

Burlington Engineering

Metal Surface Refinishing

S e r v i c e I n A c t i o n | Successful

organizations are learning organizations,

and California-based Burlington Engineering

has called on Administaff Training Specialist

Susan Inouye to help it improve performance

and leverage its 25-year history into the

future. “Susan has an amazing ability to

hear what is said and unsaid, to read people

and to relate to them as individuals,” said

Bill Welsh, Burlington President. “She then

translates those findings into ‘outside-the-box’

process improvements that positively impact

our bottom line. That ability is very rare

and very welcome.”

– 12 –

Susan Inouye | Training Specialist |

Performance Improvement | Training Needs

Analysis | Organizational Development |

Training & Development Programs

| Coaching | Training Consultations |

Core Systems

Integration of Audio, Lighting and Video Systems

S e r v i c e I n A c t i o n | An industry leader in creating innovative

audio, visual and lighting systems for both hospitality and corporate clients,

Core Systems has come to depend on the proactive recommendations of

Administaff Safety Consultant Dean Fisher. “Maintaining a safe working

environment is always a top priority at our company, and Dean plays a

key role in helping us accomplish that goal,” said Core Systems President

Doug Black. “He has been instrumental in promoting safety awareness

and helping us implement the right kinds of safety programs.”

– 13 –

eSchool Solutions

Education Management Software

S e r v i c e I n A c t i o n | eSchool

Solutions is focused on saving school districts

money while providing them with exceptional

efficiencies. “That is exactly what Administaff

Benefits Specialist Will Campbell does for

us regarding employee benefits,” said Julie

Wheeler, HR Manager for eSchool Solutions.

“Will’s experience enables him to answer

our questions about health care coverage

much more quickly than we could on our

own. He helps us maximize the value of our

Administaff employee benefits and has saved

our company and staff both time and money.”

Will Campbell | Benefits Specialist |

Health Care, Dental & Vision Plans |

Claims Resolution Assistance | Provider
Network Support | Employee Assistance
Program | Disability Coverage | Life

Insurance | Adoption Assistance |

Educational Assistance | Dependent

Care Spending Plan |

– 14 –

9East Valley Cardiology

Cardiology Clinic

S e r v i c e I n A c t i o n | As Practice Manager for East Valley Cardiology,

Linda Stephan has used HR outsourcing firms for nearly 20 years. When she met

Administaff HR specialist Chris Bethany, she realized she had found someone who

“knows my heart,” as she puts it. “Whether it is job descriptions, employee handbooks

or staffing matters, Chris is like my personal HR assistant. I would have to spend

my weekends doing what she now does for me.”

Terminations Support |

– 15 –

RECRUITING & SELECTION
Find and hire the highest-quality
employees possible.

•Job Descriptions
•Resume Review & Interviewing
•Salary Planning & Administration
•Classified Advertising Coordination
•Background Checks
•Pre-Employment Testing
•Drug Testing
•Outplacement

PERFORMANCE MANAGEMENT
Increase employee productivity
by improving individual and
group performance.

•Performance Measurement

& Review

•Compensation &
Incentive Plans

•Employee Relations
•Supervisor Training
•Conflict Resolution
•Job Design

BENEFITS MANAGEMENT
Gain one of the best benefits values in
the marketplace for employee retention.

•Health Care, Dental & Vision Plans
•Employee Assistance Program
•Retirement Services
•Basic & Voluntary Disability Coverage
•Basic & Voluntary Life Insurance
•Basic & Voluntary Personal

Accident Insurance
•Adoption Assistance
•Credit Union
•Educational Assistance
•Dependent Care Spending Plan

TRAINING & DEVELOPMENT
Become more productive
and profitable with a
professional development
program for employees.

•Needs Analysis
•Curriculum Development
•Training Programs
•Certified Provider of

Continuing Education Units

•Online Courses

EMPLOYER LIABILITY MANAGEMENT
Manage employer obligations more effectively
with lower risk and reduced liability.

•Workers’ Compensation Coverage

& Claims Resolution

•Employment Practices Liability Insurance
•Safety Review & Policy Development
•Unemployment Claims Management
•Conflict Resolution
•Employee Handbooks
•Personnel Guide, Forms & Policies
•Terminations Support

A team-based system that works!

Administaff ’s eight-point Personnel Management SystemSM provides a comprehensive human resources solution that
enables business owners to be more systematic and strategic about the role that people play in the success of a company.

With Administaff managing the “business of employment,” growth-minded entrepreneurs and employees are free to

focus on the “business of business.”

GOVERNMENT COMPLIANCE
Keep pace with changing regulations
to reduce or eliminate fines
and penalties.

•Government Reporting
& Agency Interface

•Unemployment Claims Management
•Wage Claims & Audits
•OSHA, EEOC, DOL, ADA,

FMLA, FLSA, Title VII & More

OWNER SUPPORT
Achieve a more secure future
through forward-focused resources
that help create value.

EMPLOYMENT ADMINISTRATION
Reduce the burden of
employee-related paperwork
by sharing it with Administaff.

•Payroll Processing
•Payroll Tax Filing
•FICA, FUTA, SUTA
•Garnishments
•Quarterly Reports
•Human Resources
•Management Reports
•Direct Deposit
•W-2s & W-4s
•Employment Verification

•Personnel Consulting
•Employee Communications
•Employee Service CenterSM
•My MarketPlaceSM
•Best2Best®Client Network

Through My MarketPlaceSM,
American Express offers:

•Business and/or Personal

Financial Planning
•Retirement Planning
•Business Transition &

Estate Planning

•Key Person Insurance Coverage
•Tax & Business Services

– 16 –

B o a r d o f D i r e c t o r s

Michael W. Brown | Independent Director
Mr. Brown joined the Company as a director in
November 1997, and he currently serves on the
Finance, Risk Management and Audit Committee
and on the Nominating and Corporate Governance

Committee. A certified public accountant, he is
the past Chairman of the NASDAQ Stock Market Board
of Directors and a past governor of the National Association of Securities
Dealers. Mr. Brown joined Microsoft Corporation in 1989 as its Treasurer
and became its Chief Financial Officer in 1993. He served in that capacity
until his retirement in 1997. Prior to joining Microsoft, Mr. Brown spent
18 years with Deloitte & Touche LLP. Mr. Brown also is a member of
the Thomas Weisel Partners Advisory Board.

Jack M. Fields, Jr. | Independent Director
Mr. Fields joined the Company as a director in
January 1997. He currently serves as Chairman
of the Compensation Committee and is also
a member of the Nominating and Corporate
Governance Committee. Mr. Fields served in the
United States House of Representatives for 16 years
prior to his retirement. During 1995 and 1996, he served as Chairman
of the House Telecommunications and Finance Subcommittee, which has
jurisdiction and oversight of the Federal Communications Commission
and the Securities and Exchange Commission. Mr. Fields is Chief
Executive Officer of Twenty-First Century Group in Washington, D.C.,
and also serves on the Board of Directors for AIM Mutual Funds
and the Discovery Channel – Global Education Fund.

Paul S. Lattanzio | Independent Director
Mr. Lattanzio has been a director of the
Company since 1995, and he currently serves
on the Finance, Risk Management and Audit
Committee and on the Nominating and Corporate

Governance Committee. He joined Bear Stearns,
Inc. in 2003 as a Senior Managing Director and head

of Bear Growth Capital Partners, a private equity group. Mr. Lattanzio
previously served as a Managing Director for TD Capital Communications
Partners (f/k/a Toronto Dominion Capital), a venture capital investment
firm from 1999 until 2002; and he was a co-founder and Senior
Managing Director of NMS Capital Management, LLC, a private equity
fund affiliated with NationsBanc Montgomery Securities. Mr. Lattanzio
also served in several positions with various affiliates of Bankers
Trust New York Corporation, lastly as a Managing Director of BT Capital
Partners, Inc. He also serves on the Board of Directors of Clintrak
Pharmaceutical Services, LLC.

Gregory E. Petsch | Independent Director
Mr. Petsch joined the Company as a director in
October 2002. He currently serves as Chairman
of the Nominating and Corporate Governance
Committee and also is a member of the Compensa-
tion Committee. He retired in 1999 from Compaq
Computer Corporation, where he had held various
positions since 1983, most recently as Senior Vice President of
Worldwide Manufacturing and Quality since 1991. Prior to joining
Compaq, he worked for 10 years at Texas Instruments. In 1992,
Mr. Petsch was voted Manufacturing Executive of the Year by Upside
magazine, and in 1993–1995 he was nominated Who’s Who of Global
Business Leaders. He is founder and President of Godsmoneyman
Ministries and also a Board member of Culture Shapers.

Richard G. Rawson | Management Director
Mr. Rawson is Administaff’s President. Prior to
his election as President in 2003, he served as
Executive Vice President of Administration, Chief
Financial Officer and Treasurer. He has served as
a director of the Company since April 1989. Mr.
Rawson has previously served the National Association
of Professional Employer Organizations (NAPEO) as President
(1999–2000), First Vice President, Second Vice President and Treasurer.
In addition, he served as Chairman of the Accounting Practices Committee
of NAPEO for five years.

Paul J. Sarvadi | Management Director
Mr. Sarvadi is Chairman of the Board, Chief Executive
Officer and a co-founder of Administaff. Prior to his
election as Chairman in 2003, he served as Chief
Executive Officer and President. He has served on
Administaff’s Board since the Company’s inception
in March 1986. Mr. Sarvadi has served as President
of the National Association of Professional Employer
Organizations (NAPEO) and was a member of its Board
of Directors for five years. Mr. Sarvadi serves on the Board of Trustees
of the DePelchin Children’s Center in Houston. In 2001, he was named
National Ernst & Young Entrepreneur Of The Year in the Service category.

Austin P. Young | Independent Director
Mr. Young became a director of the Company in
January 2003. He currently serves as Chairman
of the Finance, Risk Management and Audit Com-
mittee and also is a member of the Nominating and
Corporate Governance Committee. He is a certified
public accountant and served as Senior Vice President,
Chief Financial Officer and Treasurer of CellStar Corporation from 1999
until his retirement at year-end 2001. From 1996 to 1999, he served as
Executive Vice President – Finance and Administration of Metamor World-
wide, Inc. Mr. Young also has served as Senior Vice President and Chief
Financial Officer at American General Corporation, and he was a partner
in the Houston and New York offices of KPMG Peat Marwick. He currently
serves as Vice President, Treasurer and Director of The Park People;
Vice President and Director of the Houston Fire Museum; and Chairman
of the Houston Zoo Advisory Council.

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

(Mark One)

(cid:1) Annual Report Pursuant to Section 13 or 15(d) of the Securities

Exchange Act of 1934

(cid:2)(cid:3) Transition Report Pursuant to Section 13 or 15(d) of the Securities

For the fiscal year ended December 31, 2003.
or

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)

19001 Crescent Springs Drive

Kingwood, Texas
(Address of principal executive offices)

76-0479645
(I.R.S. Employer
Identification No.)

77339
(Zip Code)

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

Securities Registered Pursuant to Section 12(b) of the Act:

Common Stock, par value $0.01 per share
Rights to Purchase Series A Junior Participating Preferred Stock
(Title of class)

New York Stock Exchange
New York Stock Exchange

(Name of Exchange on Which Registered)

Securities Registered Pursuant to Section 12(g) of the Act: NONE

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 (cid:4) No

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not
contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).

Yes (cid:4) No

As of February 18, 2004, 26,543,619 shares of the registrant’s common stock, par value $0.01 per share, were
outstanding. As of the end of the registrant’s most recently completed second quarter, the aggregate market value of the
common stock held by non-affiliates (based upon the June 30, 2003 closing price of the common stock as reported by
the New York Stock Exchange) was approximately $229 million.

Part III information is incorporated by reference from the proxy statement for the annual meeting of
stockholders to be held May 6, 2004, which the registrant intends to file within 120 days of the end of the fiscal year.

TABLE OF CONTENTS

Part I

Item 1.

Item 2.

Item 3.

Item 4.

Business ......................................................................................................................... 2

Properties ....................................................................................................................... 15

Legal Proceedings.......................................................................................................... 16

Submission of Matters to a Vote of Security Holders.................................................... 18

Item S-K 401(b).

Executive Officers of the Registrant .............................................................................. 19

Part II

Item 5.

Market for the Registrant’s Common Equity and

Related Stockholder Matters ...................................................................................... 20

Item 6.

Item 7.

Selected Financial Data.................................................................................................. 21

Management’s Discussion and Analysis of Financial Condition

and Results of Operations........................................................................................... 22

Item 7A.

Qualitative and Quantitative Disclosures About Market Risk ....................................... 42

Item 8.

Item 9.

Financial Statements and Supplementary Data .............................................................. 43

Changes in and Disagreements with Accountants on Accounting

and Financial Disclosure ............................................................................................ 43

Item 9A.

Controls and Procedures ................................................................................................ 43

Item 10.

Item 11.

Item 12.

Item 13.

Item 14.

Part III

Directors and Executive Officers of the Registrant........................................................ 44

Executive Compensation................................................................................................ 44

Security Ownership of Certain Beneficial Owners and Management
and Related Stockholder Matters ............................................................................... 45

Certain Relationships and Related Transactions ............................................................ 45

Principal Accounting Fees and Services ........................................................................ 45

Item 15.

Exhibits, Financial Statement Schedules and Reports on Form 8-K.............................. 46

Part IV

PART I

This document contains forward-looking statements within the meaning of Section 27A of the Securities

Act of 1933 and Section 21E of the Securities Exchange Act of 1934. You can identify such forward-looking
statements by the words “expects”, “intends,” “plans,” “projects,” “believes,” “estimates,” “likely,” “goal,” “assume”
and similar expressions. In the normal course of business, Administaff, Inc. (“Administaff” or the “Company”), 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 or other aspects of operating results. Administaff bases the forward-looking
statements on its current expectations, estimates and projections. Administaff cautions you that these statements are
not guarantees of future performance and involve risks, uncertainties and assumptions 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 in this Annual Report, or elsewhere, could differ materially from those stated in such forward-
looking statements. Among the factors that could cause actual results to differ materially are the risks and
uncertainties discussed in this Annual Report, including, without limitation, factors discussed in Item 1, “Business”
and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” including
the factors discussed under the caption “Factors That May Affect Future Results and the Market Price of Common
Stock,” beginning on page 38.

ITEM 1. BUSINESS.

General

Administaff is a professional employer organization (“PEO”) that provides a comprehensive Personnel

Management SystemSM encompassing a broad range of services, including benefits and payroll administration, health
and workers’ compensation insurance programs, personnel records management, employer liability management,
employee recruiting and selection, employee performance management and employee training and development
services to small and medium-sized businesses in strategically selected markets. The Company was organized as a
corporation in 1986 and has provided PEO services since inception. In 2003, the Company formed Administaff
Retirement Services, LP, which currently performs recordkeeping services for defined contribution plans. In 2003,
those services were limited to the Company’s 401(k) plan.

The Company’s principal executive offices are located at 19001 Crescent Springs Drive, Kingwood, Texas
77339. The Company’s telephone number at that address is (281) 358-8986 and the Company’s website address is
http://www.administaff.com. The Company’s stock is traded on the New York Stock Exchange under the symbol
“ASF.” Periodic SEC filings, including the Company’s annual reports on Form 10-K, quarterly reports on Form
10-Q, current reports on Form 8-K, and if applicable, amendments to those reports filed or furnished pursuant to
Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available through the Company’s website free of
charge as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC.

The Company’s Personnel Management System is designed to improve the productivity and profitability of

small and medium-sized businesses. It relieves business owners and key executives of many employer-related
administrative and regulatory burdens, which enables them to focus on the core competencies of their businesses. It
also promotes employee performance through human resource management techniques that improve employee
satisfaction. The Company provides the Personnel Management System by entering into a Client Service Agreement
(“CSA”), which establishes a three-party relationship whereby the Company and client act as co-employers of the
employees who work at the client’s location (“worksite employees”). Under the CSA, Administaff assumes
responsibility for personnel administration and compliance with most employment-related governmental regulations,
while the client company retains the employees’ services in its business and remains the employer for various other
purposes. The Company charges a comprehensive service fee (“comprehensive service fee” or “gross billing”),
which is invoiced concurrently with the processing of payroll for the worksite employees of the client. The
comprehensive service fee consists of the payroll of its worksite employees and a markup computed as a percentage
of the payroll cost of the worksite employees.

- 2 -

The Company accomplishes the objectives of the Personnel Management System through a High

Touch/High Tech approach to service delivery. In advisory areas, such as recruiting, employee performance
management and employee training, the Company employs a high touch approach designed to ensure that its clients
receive the personal attention and expertise needed to create a customized human resources solution. For
transactional processing, the Company employs a high tech approach that provides secure, convenient information
exchange among the Company, its clients and its worksite employees, creating efficiencies for all parties. The
primary component of the high tech portion of the Company’s strategy is the Employee Service Center (“ESC”).
The ESC is the Company’s web-based interactive PEO service delivery platform, which is designed to provide
automated, personalized PEO services to the Company’s clients and worksite employees.

Administaff is a leading provider of PEO services, both in terms of the number of worksite employees and
in terms of revenues. The Company, which serves client companies with worksite employees located throughout the
United States, is currently executing a long-term national expansion strategy targeting approximately 90 sales offices
located in 40 strategically selected markets. While addressing a price and cost mismatch in the benefits component
of its business resulting from a breach of contract by a former health insurance carrier, the Company scaled back its
expansion efforts from five new sales office openings in 2001 to two new sales offices in two new markets during
2002 and no new offices in 2003. While the Company is currently planning no new sales offices in 2004, it intends to
resume its national expansion strategy in 2005, subsequent to the utilization of existing sales office capacity.

The Company’s national expansion strategy also includes regionalized data processing for payroll and
benefits transactions and localized face-to-face human resources service capacity. During 2003, the Company
continued to place human resources and client service personnel in its sales markets. As of December 31, 2003, the
Company had four service centers, which when fully staffed will provide the capacity to serve approximately
160,000 worksite employees. In addition, the Company has human resources and client service personnel located in
a majority of its 21 sales markets.

PEO Industry

The PEO industry began to evolve in the early 1980’s largely in response to the burdens placed on small

and medium-sized employers by an increasingly complex legal and regulatory environment. While various service
providers were available to assist these businesses with specific tasks, PEOs emerged as providers of a more
comprehensive range of services relating to the employer/employee relationship. In a PEO arrangement, the PEO
assumes broad aspects of the employer/employee relationship. Because PEOs provide employer-related services to a
large number of employees, they can achieve economies of scale that allow them to perform employment-related
functions more efficiently, provide a greater variety of employee benefits and devote more attention to human
resources management.

The Company believes that the key factors driving demand for PEO services include (i) trends relating to

the growth and productivity of the small and medium-sized business community in the United States, such as
outsourcing and a focus on core competencies; (ii) the need to provide competitive health care and related benefits to
attract and retain employees; (iii) the increasing costs associated with health and workers’ compensation insurance
coverage, workplace safety programs, employee-related complaints and litigation; and (iv) complex regulation of
labor and employment issues and the related costs of compliance, including the allocation of time and effort to such
functions by owners and key executives.

A significant factor in the development of the PEO industry has been increasing recognition and acceptance

of PEOs and the co-employer relationship by federal and state governmental authorities. The Company and other
industry leaders, in concert with the National Association of Professional Employer Organizations (“NAPEO”), have
worked with the relevant governmental entities for the establishment of a regulatory framework that protects clients
and employees, discourages unscrupulous and financially unsound companies, and promotes further development of
the industry. Currently, 24 states have legislation containing licensing, registration, or certification requirements and
several others are considering such regulation. Such laws vary from state to state but generally provide for
monitoring the fiscal responsibility of PEOs. State regulation assists in screening insufficiently capitalized PEO
operations and helps to resolve interpretive issues concerning employee status for specific purposes under applicable
state law. The Company has actively supported such regulatory efforts and is currently licensed or registered in 23

- 3 -

of these states, and anticipates completing registration in New York in 2004. The cost of compliance with these
regulations is not material to the Company’s financial position or results of operations.

PEO Services

The Company serves small and medium-sized business by providing its Personnel Management System,
which encompasses a broad range of services, including benefits and payroll administration, health and workers’
compensation insurance programs, personnel records management, employer liability management, employee
recruiting and selection, employee performance management and training and development services. The Personnel
Management System is designed to attract and retain high-quality employees, while relieving client owners and key
executives of many employer-related administrative and regulatory burdens. Among the employment-related laws
and regulations that may affect a client company are the following:

•
Internal Revenue Code (the “Code”)
• Federal Income Contribution Act (FICA)
• Federal Unemployment Tax Act (FUTA)
• Fair Labor Standards Act (FLSA)
• Employee Retirement Income Security Act,

as amended (ERISA)

• The Family and Medical Leave Act (FMLA)
• Health Insurance Portability and
Accountability Act (HIPAA)

• Drug-Free Workplace Act
• Occupational Safety and Health Act

(OSHA)

• Consolidated Omnibus Budget Reconcilia-

• Worker Adjustment and Retraining

•

tion Act of 1987 (COBRA)
Immigration Reform and Control Act
(IRCA)

• Title VII (Civil Rights Act of 1964)
• Americans with Disabilities Act (ADA)
• Age Discrimination in Employment Act

(ADEA)

Notification Act (WARN)

• Uniform Services Employment and

Reemployment Rights Act (USERRA)
• State unemployment and employment

security laws

• State workers’ compensation laws

While these regulations are complex, and in some instances overlapping, Administaff assists its client

companies in achieving compliance with these regulations by providing services in four primary categories:
administrative functions, benefit plans administration, personnel management and employer liability management.
All of the following services are included in the Personnel Management System and are available to all client
companies.

Administrative Functions. Administrative functions encompass a wide variety of processing and record

keeping tasks, mostly related to payroll administration and government compliance. Specific examples include
payroll processing, payroll tax deposits, quarterly payroll tax reporting, employee file maintenance, unemployment
claims processing and workers’ compensation claims reporting.

Benefit Plans Administration. The Company maintains several benefit plans including the following types
of coverage: group health coverage, a dependent care spending account plan, an educational assistance program, an
adoption assistance program, group term and universal life insurance coverage, accidental death and dismemberment
insurance coverage, short-term and long-term disability insurance coverage and a 401(k) plan. The group health
plan includes medical, dental, vision, a worklife program and a prescription drug program. All benefit plans are
provided to applicable employees based on eligibility provisions specific to those plans. The Company is
responsible for the costs and premiums associated with these plans, acts as plan sponsor and administrator of the
plans, negotiates the terms and costs of the plans, maintains the plans in accordance with applicable federal and
state regulations and serves as liaison for the delivery of such benefits to worksite employees. The Company
believes that this variety and quality of benefit plans are generally not available to employees in its small and
medium-sized business target market and are usually offered only by larger companies that can spread program costs
over a much larger group of employees. As a result, the Company believes that the availability of these benefit
plans provides its clients with a competitive advantage that small and medium-sized businesses are typically unable
to attain.

- 4 -

Personnel Management. The Company provides a wide variety of personnel management services that give
its client companies access to resources normally found only in the human resources departments of large companies.
All client companies have access to the Company’s comprehensive personnel guide, which sets forth a systematic
approach to administering personnel policies and practices, including recruiting, discipline and termination
procedures. Other human resources services provided by the Company include drafting and reviewing personnel
policies and employee handbooks, designing job descriptions, performing prospective employee screening and
background investigations, designing performance appraisal processes and forms, and providing professional
development and issues-oriented training, employee counseling, substance abuse awareness training, drug testing,
outplacement services and compensation guidance.

Employer Liability Management. Under the CSA, the Company assumes many of the employment-related
responsibilities associated with its administrative functions, benefit plans administration and personnel management
services. For those employment-related responsibilities that are the responsibility of the client or that Administaff
shares with its clients, the Company can assist its clients in managing and limiting exposure. This includes first time
and ongoing safety-related risk management reviews, as well as the implementation of safety programs designed to
reduce workers’ compensation claims. Administaff also provides guidance to clients for avoiding liability for claims
for discrimination, sexual harassment and civil rights violations, and participates in termination decisions to attempt
to minimize liability on those grounds. When a claim arises, the Company often assists in the client’s defense
regardless of whether the Company has been named directly. The Company employs in-house and external counsel
specializing in several areas of employment law who have broad experience in disputes concerning the
employer/employee relationship and who provide support to the Company’s human resources service specialists. As
part of its comprehensive service, the Company also maintains employment practice liability insurance coverage for
its clients, monitors changing government regulations and notifies clients of the potential effect of such changes on
employer liability.

Employee Service CenterSM. The Employee Service Center (“ESC”) is the Company’s web-based
interactive PEO service delivery platform, which is designed to provide automated, personalized PEO services to the
Company’s clients and worksite employees. The ESC provides a wide range of functionality, including:

• WebPayrollSM for the submission and approval of payroll data;
• Online new employee enrollment;
• Client-specific payroll information and reports;
• Employee information, including online check stubs and pay history reports;
• Online human resources forms;
• Best practices human resource management process maps and process overviews;
• An online personnel guide;
•
• Links to benefits providers and other key vendors; and
• Frequently asked questions.

e-Learning web-based training;

The ESC also contains My MarketPlaceSM, an eCommerce portal that brings a wide range of product and
service offerings from best-of-class providers to Administaff clients, worksite employees and their families. The
Company’s My Marketplace offerings include financial services, technology solutions, communications services,
travel services, leisure and entertainment services, retail services, gifts and rewards, insurance services, real estate
services, research and consulting services and other business and consumer products and services. My MarketPlace
also features the unique Best2Best® client network, where Administaff clients can offer their products and services to
one another.

Client Service Agreement

All clients enter into Administaff’s Client Service Agreement (“CSA”). The CSA generally provides for an

on-going relationship, subject to termination by the Company or the client upon 30 to 60 days written notice.

- 5 -

The CSA establishes the Company’s comprehensive service fee, which is subject to periodic adjustments to

account for changes in the composition of the client’s workforce, employee benefit election changes and statutory
changes that affect the Company’s costs. Prior to January 1, 2003, the Company’s comprehensive service fees were
typically determined at the outset of the CSA, and remained relatively static throughout the contract year. If
significant changes occurred during a contract year, the CSA specifically allows the Company to initiate a manual
process to review that specific client’s pricing and adjust it accordingly, based on the rates that had been in effect at
the date of the original contract.

As a result of modifications to the CSA, as described above, effective January 1, 2003, the Company

implemented a new pricing and billing system for new and renewing clients (“New System”). For clients active on
the New System in January of any year, the system includes a feature that accelerates invoicing of the estimated
payroll tax component of the comprehensive service fee to more closely reflect the pattern of estimated incurred
payroll tax costs. Accordingly, the impact of new and renewing clients invoiced on the New System in January
2003, which represented approximately 20% of the Company’s client base, has resulted in the partial offset in 2003
of the Company’s historical earnings pattern of losses in the first quarter, followed by improved profitability in
subsequent quarters throughout the year. Substantially all clients were billed using the New System in January 2004.
For those clients active on the New System in January 2004, a complete offset of the Company’s earnings pattern is
expected. However, new clients enrolling subsequent to January 2004 will be invoiced at a relatively constant rate
throughout the remaining portion of each year, resulting in improved profitability over the course of the year for
those clients.

The CSA also establishes the division of responsibilities between the Company and the client as co-

employers. Pursuant to the CSA, the Company is responsible for personnel administration and is liable for certain
employment-related government regulation. In addition, the Company assumes liability for payment of salaries and
wages (as well as related payroll taxes) of its worksite employees and responsibility for providing specified
employee benefits to such persons. These liabilities are not contingent on the prepayment by the client of the
associated comprehensive service fee and, as a result of the Company’s employment relationship with each of its
worksite employees, the Company is liable for payment of salary and wages of the worksite employees and is
responsible for providing specified employee benefits to such persons, regardless of whether the client company pays
the associated comprehensive service fee. The client retains the employees’ services and remains liable for the
purposes of certain government regulations, compliance with which requires control of the worksite or daily
supervisory responsibility or is otherwise beyond the Company’s ability to assume. A third group of responsibilities
and liabilities are shared by the Company and the client where such joint responsibility is appropriate. The specific
division of applicable responsibilities under the CSA is as follows:

Administaff

• Payment of wages and related tax reporting and remittance (local, state and federal withholding, FICA, FUTA, state

unemployment);

• Workers’ compensation compliance, procurement, management and reporting;
• Compliance with COBRA, HIPAA and ERISA (for employee benefit plans sponsored by Administaff only), as well
as monitoring changes in other governmental regulations governing the employer/employee relationship and
updating the client when necessary; and

• Employee benefits administration.

Client

• Payment, through Administaff, of commissions, bonuses, paid leaves of absence and severance payments;
• Payment and related tax reporting and remittance of non-qualified deferred compensation and equity-based

compensation;

• Assignment to, and ownership of, all client intellectual property rights;
• Compliance with OSHA regulations, EPA regulations, FLSA, WARN, USERRA and state and local equivalents and

compliance with government contracting provisions;

• Compliance with the National Labor Relations Act (“NLRA”), including all organizing efforts and expenses related

to a collective bargaining agreement and related benefits;

- 6 -

• Professional licensing requirements, fidelity bonding and professional liability insurance;
• Products produced and/or services provided; and
• HIPAA and ERISA compliance for client-sponsored benefit plans.

Joint

Implementation of policies and practices relating to the employee/employer relationship; and

•
• Compliance with all federal, state and local employment laws, including, but not limited to Title VII of the Civil
Rights Act of 1964, ADEA, Title I of ADA, FMLA, the Consumer Credit Protection Act, and immigration laws and
regulations.

Because the Company is a co-employer with the client company for some purposes, it is possible that the
Company could incur liability for violations of such laws, even if it is not responsible for the conduct giving rise to
such liability. The CSA addresses this issue by providing that the client will indemnify the Company for liability
incurred to the extent the liability is attributable to conduct by the client. Notwithstanding this contractual right to
indemnification, it is possible that the Company could be unable to collect on a claim for indemnification and may
therefore be ultimately responsible for satisfying the liability in question. The Company maintains certain general
insurance coverages (including coverages for its clients) to manage its exposure for these types of claims, and as a
result, the costs in excess of insurance premiums incurred by the Company with respect to this exposure have
historically been insignificant to the Company’s operating results.

Clients are required to remit their comprehensive service fees no later than one day prior to the applicable
payroll date by wire transfer or automated clearinghouse transaction. Although the Company is ultimately liable, as
the employer for payroll purposes, to pay employees for work previously performed, it retains the ability to terminate
the CSA and associated worksite employees or to require prepayment, letters of credit or other collateral upon
deterioration in a client’s financial condition or upon non-payment by a client. These rights, the periodic nature of
payroll and the overall quality of the Company’s client base have resulted in an excellent overall collections history.

Customers

Administaff provides a value-added, full-service human resources solution that it believes is most suitable

to a specific segment of the small and medium-sized business community. The Company targets successful small
businesses with five to 500 employees, who perceive an advantage in the strategic use of high-performance human
resource practices. The Company has set a long-term goal to serve approximately 10% of the overall small and
medium sized business community. Administaff serves client companies and worksite employees located throughout
the United States. For the year ended December 31, 2003, Houston, the Company’s original market, accounted for
approximately 22% of the Company’s revenues with other Texas markets contributing an additional 18%. By
region, the Company’s revenue growth over 2002 and revenue distribution for the year ended December 31, 2003
were as follows:

Northeast .......................................................
Southeast .......................................................
Central ...........................................................
Southwest ......................................................
West...............................................................
Other revenue ................................................

% of
Total
Revenues

13.0%
10.7%
14.7%
39.8%
21.1%
0.7%

Revenue
Growth

14.6%
3.0%
6.1%
(1.5)%
14.5%
(3.8)%

- 7 -

As part of its client selection strategy, the Company does not offer its services to businesses falling within

certain specified NAICS (North American Industry Classification System) codes, formerly known as Standard
Industrial Classification codes, essentially eliminating certain industries that it believes present a higher employer
risk such as employee injury, high turnover or litigation. All prospective clients are evaluated individually on the
basis of workers’ compensation risk, group medical history (where permitted by law), unemployment history,
operating stability and human resource practices. The Company’s client base is broadly distributed throughout a
wide variety of industries including:

• Finance, insurance and real estate – 16%;
• Computer and information services – 13%;
• Management, administration and consulting services – 12%;
• Medical services – 10%;
• Manufacturing – 9%;
• Construction – 9%;
• Wholesale trade – 8%;
• Engineering, accounting and legal services – 7%;
• Retail trade – 4%;
• Transportation – 2%; and
• Other – 10%.

This diverse client base lowers the Company’s exposure to downturns or volatility in any particular

industry. However, the Company’s performance could be affected by a downturn in one of these industries or by
general economic conditions within the small and medium-sized business community.

The Company focuses heavily on client retention. Administaff’s client retention record over the last five

years reflects that approximately 70% of Administaff’s clients remain for more than one year, and that the retention
rate improves for clients who remain with Administaff for longer periods, up to approximately 81% for clients in
their fifth year with Administaff. The resulting average retention rate over the last five years was 75%. During
2003, the Company’s retention rate declined to 70% due primarily to price increases charged to clients to offset
higher benefits costs. See Item 7. “– Management’s Discussion and Analysis of Financial Condition and Results of
Operations” on page 22. Client attrition is attributable to a variety of factors, including (i) client non-renewal due to
price factors; (ii) termination of the CSA by Administaff resulting from the client’s non-compliance or inability to
make timely payments; (iii) competition from other PEOs or business services firms; and (iv) client business failure,
sale, merger, or disposition.

- 8 -

Marketing and Sales

As of December 31, 2003, the Company had 38 sales offices located in 21 markets. The Company’s long-

term national expansion strategy targets approximately 90 sales offices in 40 strategically selected markets. The
Company’s sales offices typically consist of six to eight sales representatives, a district sales manager and an office
administrator. To take advantage of economic efficiencies, multiple sales offices may share a physical location. The
Company’s markets and their respective year of entry are as follows:

Market

Sales Offices

Initial
Entry Date

Houston
San Antonio
Austin
Orlando
Dallas/Fort Worth
Atlanta
Phoenix
Chicago
Washington D.C.
Denver
Los Angeles
Charlotte
St. Louis
San Francisco
New York
Baltimore
New Jersey
San Diego
Boston
Minneapolis
Cleveland

4
1
1
1
3
3
1
3
2
1
3
1
1
4
2
1
1
1
2
1
1

1986
1989
1989
1989
1993
1994
1995
1995
1995
1996
1997
1997
1998
1998
1999
2000
2000
2001
2001
2002
2002

The 40 markets included in the national expansion plan were identified using a systematic market

evaluation and selection process. The Company continues to evaluate a broad range of factors in the selection
process, using a market selection model that weights various criteria that the Company believes are reliable
predictors of successful penetration based on its experience. Among the factors considered are (i) market size, in
terms of small and medium-sized businesses engaged in selected industries that meet the Company’s risk profile; (ii)
market receptivity to PEO services, including the regulatory environment and relevant history with other PEO
providers; (iii) existing relationships within a given market, such as vendor or client relationships; (iv) expansion
cost issues, such as advertising and overhead costs; (v) direct cost issues that bear on the Company’s effectiveness in
controlling and managing the cost of its services, such as workers’ compensation and health insurance costs,
unemployment risks and various legal and other factors; (vi) a comparison of the services offered by Administaff to
alternatives available to small and medium-sized businesses in the relevant market, such as the cost to the target
clients of procuring services directly or through other PEOs; and (vii) long-term strategy issues, such as the general
perception of markets and the Company’s estimate of the long-term revenue growth potential of the market. Each of
the Company’s expansion markets, beginning with Dallas in 1993, was selected in this manner. The Company does
not expect to open any additional sales offices in new or existing markets during 2004 and intends to resume its
national expansion strategy in 2005.

The Company’s marketing strategy is based on the application of techniques that have produced consistent

and predictable results in the past. The Company develops a mix of advertising media and a placement strategy
tailored to each individual market. After selecting a market and developing its marketing mix, but prior to entering
the market, the Company engages in an organized media and public relations campaign to prepare the market for the
Company’s entry and to begin the process of generating sales leads. The Company markets its services through a

- 9 -

broad range of media outlets, including radio, newspapers, periodicals, direct mail and the Internet. The Company
employs a public relations firm in most of its markets as well as advertising consultants to coordinate and implement
its marketing campaigns. The Company has developed an inventory of proven, successful radio and newsprint
advertisements, which are utilized in this effort.

The Company’s organic growth model generates sales leads from five primary sources: direct sales efforts,
advertising, referrals, marketing alliances and the Internet. These leads result in initial presentations to prospective
clients, and, ultimately, a predictable number of client census reports. A prospective client’s census report reflects
information gathered by the sales representative about the prospect’s employees, including job classification, state of
employment, workers’ compensation claims history, group medical information (where permitted by law), salary and
desired level of benefits. This information is entered into the Company’s customized bid system, which applies
Administaff’s proprietary pricing model to the census data, leading to the preparation of a bid. Concurrent with this
process, the prospective client’s workers’ compensation, health insurance, employer practices and financial stability
are evaluated from a risk management perspective. Upon completion of a favorable risk evaluation, the sales
representative presents the Company’s bid and attempts to enroll the prospect. The Company’s selling process
typically takes approximately 90 days.

The Company has entered into a Marketing Agreement with American Express, under which American

Express is utilizing its resources and working jointly with the Company to generate appointments with prospects for
the Company’s services from the American Express customer base in certain markets. In addition, certain American
Express services are included in the Company’s My MarketPlace offerings. The Company pays a commission to
American Express based upon the number of worksite employees paid after being referred to the Company pursuant
to the Marketing Agreement and the total number of worksite employees paid by the Company. In 2003, the
Marketing Agreement produced 13.2% of the Company’s sales leads and 7.9% of new worksite employees sold.
The Marketing Agreement expires at the end of 2005 for existing markets, but was extended until the end of 2006 for
new markets opened after 2002 through 2005. The Company has also entered into marketing alliances with other
companies that target small businesses, such as Pitney Bowes, MassMutual and Avaya.

Competition

Administaff provides a value-added, full-service human resources solution that it believes is most suitable
to a specific segment of the small and medium-sized business community. This full-service approach is exemplified
by the Company’s commitment to service and technology personnel and tools, which has produced a ratio of
corporate staff to worksite employees (the “staff support ratio”) that is higher than average for the PEO industry.
Based on an analysis of the 2000 through 2002 annual NAPEO surveys of the PEO industry, the Company has
successfully leveraged its full-service approach into significantly higher returns for the Company on a per worksite
employee per month basis. During the three year period from 2000 through 2002, the Company’s staff support ratio
averaged 47% higher than the PEO industry average, while gross profit per worksite employee and operating income
per worksite employee both exceeded industry averages by 126%.

Competition in the PEO industry revolves primarily around quality of services, scope of services, choice
and quality of benefits packages, reputation and price. The Company believes that reputation, national presence,
regulatory expertise, financial resources, risk management and information technology capabilities distinguish
leading PEOs from the rest of the industry. The Company also believes that it competes favorably in these areas.

Due to the differing geographic regions and market segments in which most PEOs operate, and the
relatively low level of market penetration by the industry, the Company considers its primary competition to be the
traditional in-house provision of human resource services. The PEO industry is highly fragmented, and the Company
believes that it is one of the largest PEOs in the United States. The Company’s largest national competitors include
Gevity HR and PEO divisions of large business services companies such as Automatic Data Processing, Inc. and
Paychex, Inc. In addition, the Company competes to some extent with fee-for-service providers such as payroll
processors and human resource consultants and faces competition from large regional PEOs in certain areas of the
country. As the Company and other large PEOs expand nationally, the Company expects that competition may
intensify among larger PEOs.

- 10 -

Vendor Relationships

Administaff provides benefits to its worksite employees under arrangements with a variety of vendors.

Although the Company believes that any of its benefit contracts could be replaced if necessary, the Company
considers two such contracts to be the most significant elements of the package of benefits provided to employees
and the most difficult to replace.

The Company provides health insurance coverage to its worksite employees through a national network of

The Company’s workers’ compensation policy (the “2004 Policy”) is currently provided through selected
member insurance companies of American International Group, Inc. (“AIG”). Under its arrangement with AIG, 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 2004 Policy is a fully insured policy
whereby AIG has the responsibility to pay all claims incurred under the policy regardless of whether the Company
satisfies its responsibilities. For additional discussion of the Company’s policy with AIG, see Item 7. “Critical
Accounting Policies and Estimates – Workers’ Compensation Costs” on page 26.

Information Technology

The Company has developed customized information technology capable of meeting the demands of payroll

and related processing for the Company’s worksite employees, satisfying the Company’s administrative and
management information needs, providing productivity enhancement tools to the Company’s corporate staff and
providing web-based access to certain tools and data. While the Company utilizes commercially available software
for standard business functions such as finance and accounting, it has developed a proprietary professional employer
information system for the delivery of its primary services.

Administaff Information Management System (“AIMS”), is the Company’s proprietary PEO information
system and is in its fifth generation. This system manages data relating to worksite employee enrollment, human
resource management, benefits administration, payroll processing, client billing and collection, management
information, and sales bid calculations that are unique to the PEO industry and to Administaff. Central to the system
is a payroll processing system that allows the Company to process a high volume of payroll transactions that meet the
specific needs of its client companies.

The Employee Service Center is the Company’s web-based PEO service delivery platform. With its

integration into AIMS, the ESC is designed to provide automated, personalized PEO services to the Company’s
clients and worksite employees. For a description of the functionality provided through the ESC, see “PEO Services
– Employee Service Center” on page 5.

The Company’s primary information processing facility is located at the Company’s corporate headquarters

in Kingwood, Texas (a suburb of Houston) with secondary processing facilities located at the Company’s service
centers in Atlanta, Dallas, Houston and Los Angeles. The Dallas facility acts as a disaster recovery facility for the
Company, capable of handling all of the Company’s operations for short periods of time.

The Company has invested substantially in its technology and network infrastructure. Service centers,

district sales offices and corporate offices are connected to the corporate data center by high-speed frame-relay and
point-to-point network services provided by AT&T and MCI.

- 11 -

Industry Regulation

The Company’s operations are affected by numerous federal and state laws relating to tax and employment

matters. By entering into a co-employer relationship with its worksite employees, the Company assumes certain
obligations and responsibilities of an employer under these federal and state laws. Because many of these federal
and state laws were enacted prior to the development of nontraditional employment relationships, such as PEOs,
temporary employment and outsourcing arrangements, many of these laws do not specifically address the obligations
and responsibilities of nontraditional employers. Currently, 24 states have passed laws that have licensing,
registration or certification requirements for PEOs, and several others are considering such regulation.

Certain federal and state statutes and regulations use the terms “employee leasing” or “staff leasing” to
describe the arrangement among a PEO and its clients and worksite employees. The terms “employee leasing,”
“staff leasing” and “professional employer arrangements” are generally synonymous in such contexts and describe
the arrangements entered into by the Company, its clients and worksite employees.

As an employer, the Company is subject to all federal statutes and regulations governing the

employer/employee relationship. Subject to the issues discussed below, the Company believes that its operations are
in compliance in all material respects with all applicable federal statutes and regulations.

Employee Benefit Plans

The Company offers various employee benefits plans to eligible employees, including its worksite
employees. These plans include the 401(k) Plan (a profit-sharing plan with a cash or deferred arrangement
(“CODA”) under Code Section 401(k) and an employer matching contribution feature under Code Section 401(m))
maintained in compliance with Revenue Procedure 2002-21 and 2003-86 (each of which is explained in more detail
below); a cafeteria plan under Code Section 125; a group health plan which includes medical, dental, vision and
worklife programs; a welfare benefits plan which includes life insurance and disability programs; a dependent care
spending plan; an educational assistance program; and an adoption assistance program. Generally, employee benefit
plans are subject to provisions of both the Code and ERISA.

Employer Status. In order to qualify for favorable tax treatment under the Code, the plans must be

established and maintained by an employer for the exclusive benefit of its employees. Generally, an entity is an
“employer” of individuals for federal employment tax purposes if an employment relationship exists between the
entity and the individuals under the common law test of employment. In addition, the officers of a corporation are
deemed to be employees of that corporation for federal employment tax purposes. The common law test of
employment, as applied by the IRS, involves an examination of approximately 20 factors to ascertain whether an
employment relationship exists between a worker and a purported employer. Generally, the test is applied to
determine whether an individual is an independent contractor or an employee for federal employment tax purposes
and not to determine whether each of two or more companies is a “co-employer.” Substantial weight is typically
given to the question of whether the purported employer has the right to direct and control the details of an
individual’s work. Among the factors which appear to have been considered more important by the IRS are (i) the
employer’s degree of behavioral control (the extent of instructions, training and the nature of the work); (ii) the
financial control or the economic aspects of the relationship; and (iii) the intended relationship of the parties
(whether employee benefits are provided, whether any contracts exist, whether services are ongoing or for a project,
whether there are any penalties for discharge/termination, and the frequency of the business activity).

ERISA Requirements. Employee pension and welfare benefit plans are also governed by ERISA. ERISA

defines “employer” as “any person acting directly as an employer, or indirectly in the interest of an employer, in
relation to an employee benefit plan.” ERISA defines the term “employee” as “any individual employed by an
employer.” The United States Supreme Court has held that the common law test of employment must be applied to
determine whether an individual is an employee or an independent contractor under ERISA. A definitive judicial
interpretation of “employer” in the context of a PEO or employee leasing arrangement has not been established.

If the Company were found not to be an employer with respect to worksite employees for ERISA purposes,

its plans would not comply with ERISA. Further, as a result of such finding the Company and its plans would not

- 12 -

enjoy, with respect to worksite employees, the preemption of state laws provided by ERISA and could be subject to
varying state laws and regulations, as well as to claims based upon state common laws. Even if such a finding were
made, the Company believes it would not be materially adversely affected because it could continue to make
available similar benefits at comparable costs.

In addition to ERISA and the Code provisions discussed herein, issues related to the relationship between

the Company and its worksite employees may also arise under other federal laws, including other federal income tax
laws.

401(k) Plan. On April 24, 2002, the Internal Revenue Service (“IRS”) issued Revenue Procedure 2002-21,
and on November 11, 2003, issued Revenue Procedure 2003-86, each of which provided guidance for the operation
of defined contribution plans maintained by PEOs that benefit worksite employees. Each applies to plans in
existence on May 12, 2002 and their operation in plan years beginning after December 31, 2003.

The Company elected to comply with the guidance by amending the terms of the Administaff 401(k) Plan to

observe the qualification requirements of Code Section 413(c) for plan years beginning after December 31, 2003.
Accordingly, beginning January 1, 2004, electing client companies shall be treated as adopting employers for plan
qualification purposes under the Code. On December 31, 2003, participant account balances attributable to worksite
employees associated with client companies who failed to: (i) agree to be treated as an adopting employer; or (ii)
make another valid election in a timely manner, were transferred to the newly established Administaff Spinoff 401(k)
Plan. Additionally, a small number of client companies chose to transfer attributable participant account balances to
other 401(k) plans separately maintained by the clients companies pursuant to the guidance. The Administaff
Spinoff 401(k) Plan was also terminated effective December 31, 2003 subject to IRS approval. Upon receipt of IRS
approval, all remaining participant account balances in such plan will be distributed to the participants pursuant to
the guidance. Compliance with Revenue Procedures 2002-21 and 2003-86 will require additional administrative
compliance efforts, the cost of which is expected to be born by the plan and therefore is not expected to have a
material adverse impact on the Company’s financial condition or results of operations.

Federal Employment Taxes

As a co-employer, the Company assumes responsibility and liability for the payment of federal and state

employment taxes with respect to wages and salaries paid to worksite employees. There are essentially three types of
federal employment tax obligations: (i) withholding of income tax requirements governed by Code Section 3401, et
seq.; (ii) obligations under FICA, governed by Code Section 3101, et seq.; and (iii) obligations under FUTA,
governed by Code Section 3301, et seq. Under these Code sections, employers have the obligation to withhold and
remit the employer portion and, where applicable, the employee portion of these taxes.

Code Section 3401, which applies to federal income tax withholding requirements, contains an exception to
the general common law test applied to determine whether an entity is an “employer” for purposes of federal income
tax withholding. Section 3401(d)(1) states that if the person for whom services are rendered does not have control of
the payment of wages, the “employer” for this purpose is the person having control of the payment of wages. The
Treasury regulations issued under Section 3401(d)(1) state that a third party can be deemed to be the employer of
workers under this section for income tax withholding purposes where the person for whom services are rendered
does not have legal control of the payment of wages. While Section 3401(d)(1) has been examined by several
courts, its ultimate scope has not been delineated. Moreover, the IRS has to date relied extensively on the common
law test of employment in determining liability for failure to comply with federal income tax withholding
requirements.

Accordingly, while the Company believes that it can assume the withholding obligations for worksite

employees, in the event the Company fails to meet these obligations the client company may be held jointly and
severally liable therefor. While this interpretive issue has not to the Company’s knowledge discouraged clients from
enrolling with the Company, there can be no assurance that a definitive adverse resolution of this issue would not do
so in the future. These interpretive uncertainties may also impact the Company’s ability to report employment taxes
on its own account rather than for the accounts of its clients.

- 13 -

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 January 2002, as a result of a 2001 corporate restructuring plan, the Company filed for a partial transfer

of compensation experience 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 in 2002, the Company paid its unemployment taxes to
the state of Texas at the higher new employer rate as required by state law. In September 2003, the Company
received its final 2002 and 2003 unemployment tax rates from the TWC. The impact of these lower final rates
resulted in a $3.9 million reduction in payroll tax expense in the third quarter of 2003 and a state unemployment tax
prepayment which the Company is utilizing to offset its future unemployment tax liabilities as incurred. The
prepayment balance at December 31, 2003 was $5.1 million and is included as a component of other current assets in
the Company’s Consolidated Balance Sheet.

As a result of the 2001 corporate restructuring plan, 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 from the EDD (the “Notice”). 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 of 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
to protest the Notice. Pending a resolution of its protest, the Company has accrued and recorded at the higher
assessed rate for all of 2003. If the amount finally determined to be owed is higher or lower than the Company’s
estimate, the Company would be required to recognize a corresponding reduction or increase in the accrued payroll
tax liability as additional payroll tax expense or benefit in the period of such determination. For a discussion of the
impact of rising unemployment tax rates on the Company, see “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 Unemployment Tax Rates” on page 40.

State Regulation

While many states do not explicitly regulate PEOs, 24 states have regulations containing licensing,

registration or certification requirements for PEOs, and several others are considering such regulation. Such laws
vary from state to state but generally provide for monitoring the fiscal responsibility of PEOs, and in some cases
codify and clarify the co-employment relationship for unemployment, workers’ compensation and other purposes
under state law. The Company holds licenses in Arkansas, Florida, Montana, New Hampshire, New Mexico,
Oklahoma, Oregon, South Carolina, Tennessee, Texas and Vermont. The Company is registered or certified in
Colorado, Illinois, Kentucky, Louisiana, Maine, Minnesota, Nevada, New Jersey, North Carolina, Rhode Island,
Utah and Virginia. The Company is applying for registration pursuant to a recently enacted registration statute in
New York. Regardless of whether a state has licensing, registration or certification requirements, the Company must
comply with a number of other state and local regulations that could impact its operations. In 1993, the Company
was instrumental in obtaining enactment of PEO legislation in Texas, where it faced a number of challenges under
state law, and believes that its prior experience with Texas regulatory authorities will be valuable in surmounting
regulatory obstacles or challenges it may face in the future.

- 14 -

Corporate Office Employees

The Company had approximately 1,350 corporate office and sales employees as of December 31, 2003.

The Company believes that its relations with its corporate office and sales employees are good. None of the
Company’s corporate office and sales employees are covered by a collective bargaining agreement.

Intellectual Property

The Company currently has registered trademarks and pending applications for registration. Although the
Administaff mark is the most material trademark to the Company’s business, the Company’s trademarks as a whole
are also of considerable importance to the Company. Additionally, the Company has a pending patent application
for its WebPayroll software application.

ITEM 2. PROPERTIES.

The Company believes that its current facilities are adequate for the purposes for which they are intended

and that they provide sufficient capacity to accommodate the Company’s expansion plan. The Company will
continue to evaluate the need for additional facilities based on the rate of growth in worksite employees, the
geographic distribution of the worksite employee base and the Company’s long-term service delivery requirements.

Corporate Headquarters

The Company’s corporate headquarters is located in Kingwood, Texas, in a 327,000 square foot office

campus-style facility. This 28-acre Company-owned office campus includes approximately nine acres of
undeveloped land for future expansion. All development and support operations are located in the Kingwood
facility, along with the Company’s record retention center and primary data processing center. The Company’s
corporate headquarters secures a $36 million mortgage on the property. For more information regarding the
mortgage, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Liquidity
and Capital Resources” on page 36.

Service Centers

The Company currently has four service centers located in Atlanta, Dallas, Houston, and Los Angeles.

The Atlanta service center, which currently services approximately 21% of the Company’s worksite

employee base, is located in a 40,000 square foot leased facility. This facility, which is under lease until 2009, is
designed to service approximately 40,000 worksite employees at full capacity.

The Dallas service center, which currently services approximately 23% of the Company’s worksite

employee base, is located in a 40,000 square foot leased facility, which also serves as the Company’s backup data
processing center and disaster recovery center. This facility, which is under lease until 2008, is designed to service
approximately 40,000 worksite employees at full capacity.

The Houston service center, which services approximately 29% of the Company’s worksite employee base,
is located in a 40,000 square foot leased facility. This facility, which is under lease until 2010, is designed to service
approximately 40,000 worksite employees at full capacity.

The Los Angeles service center, which currently services approximately 27% of the Company’s worksite
employee base, is located in a 45,000 square foot leased facility. This facility, which is under lease until 2012, is
designed to service approximately 40,000 worksite employees at full capacity.

Sales Offices

As of December 31, 2003, the Company had sales and service personnel in 28 facilities located in its 21

sales markets throughout the United States. All of the facilities are leased facilities, and some of these facilities are

- 15 -

shared by multiple sales offices and/or client service personnel. As of December 31, 2003, the Company had 38
sales offices in these 21 markets. To take advantage of economic efficiencies, multiple sales offices may share a
physical location. Each sales office is typically staffed by six to eight sales representatives, a district sales manager
and an office administrator. In addition, the Company has placed certain client service personnel in a majority of its
sales markets to provide high-quality, localized service to its clients in those major markets. The Company expects
to continue placing various client service personnel in its sales markets as a critical mass of clients is attained in each
market.

ITEM 3. LEGAL PROCEEDINGS.

Other than as set forth below, the Company is not a party to any material pending legal proceedings other

than ordinary routine litigation incidental to its business that the Company believes would not have a material
adverse effect on its financial condition or results of operations.

Aetna Healthcare Litigation

On November 5, 2001, the Company filed a lawsuit in the United States District Court for the Southern

District of Texas against Aetna Life Insurance Company (“Aetna”). The Company alleged, among other things, that
during the third quarter of 2001, Aetna breached its contract with the Company 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,
and 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. Aetna filed a counterclaim alleging, among other things, that the
Company 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. Certain other claims made by the parties were dismissed on
motions for summary judgment prior to the trial.

On October 30, 2003, a jury returned a verdict in favor of the Company, awarding the Company $15.5

million in compensatory damages. The following findings were included in the jury’s verdict:

1. Aetna breached an agreement with Administaff by failing to use the care and diligence of a reasonably
prudent financial accounting manager when providing Administaff financial reports concerning the
Administaff health plan.

2. Aetna breached an agreement with Administaff by imposing rate increases contrary to the agreed upon two-

quarter waiting period.

3. Aetna breached an agreement with Administaff in September of 2001 by threatening to terminate

Administaff’s health insurance coverage unless Administaff agreed to pay retroactive and immediate rate
increases.

4. Administaff did not make a negligent misrepresentation to Aetna.

5. Administaff did not orally agree to pay Aetna the accumulated health plan deficit, if any.

On November 7, 2003, the court entered a final judgment in favor of Administaff in the amount of $15.5

million, with post judgment interest at a rate of 1.3% per annum. On December 10, 2003, the court granted Aetna’s
motion to reduce the judgment to $10.6 million. The judgment is subject to post-judgment motions and appeal;
therefore, the damages awarded to the Company have not been recorded in the Company’s consolidated balance
sheet or statement of operations. Aetna has filed a notice of appeal, and the Company has filed the notice of cross-
appeal. While the Company cannot predict the ultimate outcome or the timing of a resolution of this lawsuit or the
appeal, the Company plans to continue to vigorously pursue its case and defend the counterclaims. However, an
adverse ultimate outcome in this dispute could have a material adverse effect on the Company’s results of operations
or financial condition.

- 16 -

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. Through September
30, 2003, the Company had submitted claims for approximately $4.2 million in defense costs to National Union for
reimbursement, of which National Union had reimbursed the Company only $200,000. As a result, the Company
filed a lawsuit in the United States District Court for the Southern District of Texas against National Union
requesting the court to determine National Union’s obligations to reimburse the Company for defense costs. During
the fourth quarter of 2003, the Company settled its claims against National Union and another insurance carrier for
reimbursement of defense-related legal fees and costs associated with the Aetna counterclaim. Pursuant to the
settlement, the insurers paid Administaff an additional $2 million, which was recorded as an offset to general and
administrative expense in 2003.

Reliance National Indemnity Co. Bankruptcy Liquidation and Related Litigation

In October 2001, Reliance National Indemnity Co. (“Reliance”), a former workers’ compensation insurance
carrier of the Company, was forced into bankruptcy liquidation. 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 disputed the right of the guaranty association to be reimbursed for such claims.

On August 1, 2003, the Company filed a lawsuit in the 126th District Court of Travis County Texas against
the Texas Property and Casualty Insurance Guaranty Association (“TPCIGA”) seeking a declaratory judgment that
the Company is not required to reimburse TPCIGA for workers’ compensation benefits paid or to be paid by
TPCIGA under the Company’s workers’ compensation policies with Reliance. On August 15, 2003, TPCIGA filed
its answer, denying the claims asserted by the Company as well as filing a counterclaim that TPCIGA is entitled to
full reimbursement from the Company for workers’ compensation benefits paid or to be paid by TPCIGA under the
Company’s workers’ compensation policies with Reliance. Administaff estimated that TPCIGA’s claim for
reimbursement was approximately $6.8 million. During the fourth quarter of 2003, the Company paid $1.1 million
to settle the lawsuit, including TPCIGA’s claim for reimbursement. The cost of the settlement has been reported as a
component of workers’ compensation expense in the Company’s 2003 Consolidated Statements of Operations.

The Company initially secured $1.8 million in insurance coverage to cover potential claims returned to the

Company related to its Reliance policies. Administaff has submitted the TPCIGA settlement as a claim under the
policy. Although the settlement is expected to be fully covered by its insurance policy, the Company has deferred
recording the reimbursement until such reimbursement takes place. As of December 31, 2003, after deducting the
TPCIGA settlement from the policy limits, there was $208,000 in coverage remaining on the policy. At December
31, 2003, the estimated outstanding claims under the Company’s former policies with Reliance totaled approximately
$329,000, which excludes the Texas claims resolved in the TPCIGA settlement. The Company has accrued and
recorded its estimate of the outstanding claims in excess of the remaining insurance coverage as of December 31,
2003. 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.

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 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 seek unspecified damages, among
other remedies. The Company believes these claims are without merit and intends to vigorously defend this

- 17 -

litigation, which is in its preliminary stages. A motion has been filed to consolidate the seven lawsuits into one
action and for the appointment of lead plaintiff and lead counsel. The court has not yet ruled on the pending motion.

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

No matters were submitted to a vote of security holders of the Company, through solicitation of proxies or

otherwise, during the quarter ended December 31, 2003.

- 18 -

ITEM S-K 401 (b). EXECUTIVE OFFICERS OF THE REGISTRANT.

The following table sets forth the names, ages (as of February 25, 2004) and positions of the Company’s

executive officers:

Name

Age

Position

Paul J. Sarvadi ....................................... 47 Chairman of the Board and Chief Executive Officer
Richard G. Rawson ................................ 55
A. Steve Arizpe...................................... 46

Jay E. Mincks ........................................ 50
John H. Spurgin, II ................................ 57
Douglas S. Sharp ................................... 42 Vice President, Finance, Chief Financial Officer and Treasurer

President
Executive Vice President, Client Services and Chief Operating
Officer
Executive Vice President, Sales and Marketing
Senior Vice President, Legal, General Counsel and Secretary

Paul J. Sarvadi has served as Chairman of the Board and Chief Executive Officer since August 2003. Mr.

Sarvadi co-founded Administaff in 1986 and served as Vice President and Treasurer of the Company from its
inception in 1986 through April 1987, as Vice President from April 1987 through 1989 and as President and Chief
Executive Officer from 1989 to August 2003. Prior to founding Administaff, Mr. Sarvadi started and operated
several small businesses. Mr. Sarvadi has served as President of NAPEO and was a member of its Board of
Directors for five years. He also served as President of the Texas Chapter of NAPEO for three of the first four years
of its existence. Mr. Sarvadi was selected as the 2001 National Ernst & Young Entrepreneur Of The Year® for
service industries.

Richard G. Rawson has served as President since August 2003. He served as Executive Vice President,

Administration, Chief Financial Officer and Treasurer from February 1997 to August 2003. He joined Administaff
in 1989 as Senior Vice President, Chief Financial Officer, and Treasurer. He previously served as a Senior Financial
Officer and Controller for several companies in the manufacturing and seismic data processing industries. Mr.
Rawson has served as President, First Vice President, Second Vice President and Treasurer of NAPEO as well as
Chairman of the NAPEO Accounting Practices Committee.

A. Steve Arizpe has served as Executive Vice President, Client Services and Chief Operating Officer since
August 2003. He joined Administaff in 1989 and has served in a variety of roles, including Houston Sales Manager,
Regional Sales Manager, Vice President of Sales and Executive Vice President, Client Services. Prior to joining
Administaff, Mr. Arizpe served in sales and sales management roles for two large corporations.

Jay E. Mincks has served as Executive Vice President, Sales and Marketing since January 1999. Mr.
Mincks served as Vice President, Sales and Marketing from February 1997 through January 1999. He joined
Administaff in 1990 and has served in a variety of other roles, including Houston Sales Manager and Regional Sales
Manager for the Western United States. Prior to joining Administaff, Mr. Mincks served in a variety of positions,
including management positions, in the sales and sales training fields with various large companies.

John H. Spurgin, II has served as Senior Vice President, Legal, General Counsel and Secretary since August
2003. He joined Administaff in January 1997 as Vice President, Legal, General Counsel and Secretary. Prior to joining
Administaff, Mr. Spurgin was a partner with the Austin office of McGinnis, Lochridge & Kilgore, L.L.P., where he
served as Administaff’s outside counsel for nine years.

Douglas S. Sharp has served as Vice President, Finance, Chief Financial Officer and Treasurer since August

2003. He joined Administaff in January 2000 as Vice President, Finance and Controller. From July 1994 until he
joined Administaff, Mr. Sharp served as Chief Financial Officer for Rimkus Consulting Group, Inc. Prior to that, he
served as Controller for a small publicly held company; as Controller for a large software company; and as an Audit
Manager for Ernst & Young LLP. Mr. Sharp has served as a member of the Accounting Practices Committee of
NAPEO since January 2002.

- 19 -

PART II

ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.

Price Range of Common Stock

The Company’s common stock is traded on the New York Stock Exchange under the symbol “ASF”. As of

February 18, 2004, there were 195 holders of record of the common stock. This number does not include
stockholders for whom shares were held in “nominee” or “street name.” The following table sets forth the high and
low sales prices for the common stock as reported on the New York Stock Exchange composite transactional tape.

2003

First Quarter ................................................................
Second Quarter ............................................................
Third Quarter...............................................................
Fourth Quarter .............................................................

2002

High

$ 7.50
10.57
13.31
18.10

$ 28.40
28.15
10.51
7.90

Low

$ 4.42
5.10
8.53
8.80

$ 20.40
8.30
1.99
3.85

Dividend Policy

The Company has not paid cash dividends on its common stock since its formation and does not anticipate

declaring or paying dividends on its common stock in the foreseeable future. Any future determination as to the
payment of dividends will be made at the discretion of the Board of Directors of the Company and will depend upon
the Company’s operating results, financial condition, capital requirements, general business conditions and such
other factors as the Board of Directors deems relevant.

- 20 -

ITEM 6. SELECTED FINANCIAL DATA.

The selected consolidated financial data set forth below should be read in conjunction with the

Consolidated Financial Statements and accompanying Notes and Item 7, “Management’s Discussion and Analysis of
Financial Condition and Results of Operations,” on page 22.

Income Statement Data:

Revenues(1) .............................................
Gross profit ............................................
Operating income ...................................
Net income (loss) from
continuing operations .........................
Net loss from discontinued operations ...
Net income (loss) ...................................
Diluted net income (loss) per share

from continuing operations (2) .............

2003

Year ended December 31,
2001
(in thousands, except per share and statistical data)

2000

2002

1999

$ 891,721
197,967
24,274

$ 848,416
165,790
67

$ 720,219
165,015
18,539

$ 598,291
138,534
22,234

$ 373,512
89,528
10,559

14,985
(2,121)
12,864

(2,921)
(1,160)
(4,081)

10,357
—
10,357

16,900
—
16,900

9,358
—
9,358

0.55

(0.11)

0.36

0.58

0.34

Balance Sheet Data:

Working capital......................................
Total assets.............................................
Total debt ..............................................
Total stockholders’ equity......................

$ 56,032
348,071
42,362
122,634

$ 41,238
315,164
44,169
116,349

$ 36,609
274,003
13,500
122,935

$ 51,179
242,817
—
105,510

$ 35,792
147,698
—
80,468

Statistical Data:

Average number of worksite employees
paid per month during period .............
Revenues per worksite
employee per month (3) .......................
Gross profit per worksite
employee per month ...........................
Operating income per worksite
employee per month ...........................

_________________

75,036

77,334

69,480

62,140

42,479

990

220

914

179

—

864

198

802

186

733

176

(1)

(2)

(3)

Gross billings of $4.830 billion, $4.857 billion, $4.373 billion, $3.708 billion and $2.261 billion less worksite
employee payroll cost of $3.938 billion, $4.009 billion, $3.653 billion, $3.110 billion and $1.887 billion,
respectively.
Adjusted to reflect the two-for-one split of the common stock effected on October 16, 2000.
Gross billings of $5,364, $5,234, $5,245, $4,973 and $4,435 per worksite employee per month less payroll
cost of $4,374, $4,320, $4,381, $4,171 and $3,702 per worksite employee per month, respectively.

- 21 -

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.

The following discussion should be read in conjunction with, and is qualified in its entirety by, the
Company’s Consolidated Financial Statements and Notes thereto included elsewhere in this Annual Report.
Historical results are not necessarily indicative of trends in operating results for any future period.

The statements contained in this Annual Report that are not historical facts are forward-looking statements

that involve a number of risks and uncertainties. The actual results of the future events described in such forward-
looking statements in this Annual Report could differ materially from those stated in such forward-looking
statements. Among the factors that could cause actual results to differ materially are the risks and uncertainties
discussed in this Item 7 under “Factors that May Affect Future Results and the Market Price of Common Stock” on
page 38 and the uncertainties set forth from time to time in the Company’s other public reports and filings and public
statements.

Overview

Administaff provides a comprehensive Personnel Management SystemSM that encompasses a broad range of

services, including benefits and payroll administration, health and workers’ compensation insurance programs,
personnel records management, employer liability management, employee recruiting and selection, employee
performance management, and employee training and development services. The Company’s overall operating
results are largely dependent on the number of worksite employees paid, and can be measured in terms of revenues,
payroll costs, or gross profit per worksite employee per month. As a result, the Company often uses this unit of
measurement in analyzing and discussing its results of operations.

Administaff experienced a significant improvement in profitability in 2003 from just $67,000 of operating
income in 2002 to over $24 million in 2003. The Company’s objective for 2003 was to return to a $20 to $30 range
for operating income per worksite employee per month. Administaff’s 2003 results reflected $27 of operating
income per worksite employee per month, at the high end of the Company’s targeted range. The Company also
experienced a significant improvement in liquidity, ending 2003 with $56 million of working capital, a 36% increase
over December 2002.

During 2003, the Company achieved $220 in gross profit per worksite employee per month, a 23% increase
over 2002, and resolved several significant issues resulting in improvement in managing its pricing and direct costs.

• Administaff experienced a significant price and cost mismatch in the benefits component of its business in
2002 due to a sudden, significant step up in healthcare costs resulting from the breach of contract by the
Company’s former health insurance carrier, Aetna Life Insurance Company. Not only did this have a
significant negative impact on 2002 earnings, but was also the primary driver in the decline in paid worksite
employees during the 2003 period, as the increased healthcare costs were passed on to renewing clients.
These price increases, when combined with effective benefit plan design and client selection changes,
resulted in the significant improvement in gross profit during 2003. Any price increases in the healthcare
component of its business during 2004 are expected to be in line with, or slightly below the average national
trend, which should improve the Company’s competitiveness in the marketplace.

• The structural changes in the Company’s workers’ compensation program in 2003 included the formation of
a captive insurance company and a $1 million per occurrence retention level. Under this program, actual
workers’ compensation claim experience is the primary driver in reported costs. Accordingly, this allows
for the recognition of favorable claim experience in the Company’s financial results as incurred. Under the
Company’s previous fixed premium policy, Administaff earned dividends of $2.5 million in 2002 resulting
from favorable claims experience. However, due to the financial instability of the previous carrier, the
earned dividends were written off in 2003.

• Administaff resolved its dispute with the Texas Workforce Commission concerning state unemployment

taxes resulting in a $3.9 million reduction in payroll tax expense in 2003. Looking forward into 2004, as a

- 22 -

result of deficiencies in various state unemployment funds, Administaff expects significant increases in state
unemployment tax costs and has adjusted the Company’s pricing accordingly. If states were to implement
retroactive cost increases, the Company’s financial results could be negatively impacted.

Operating expenses increased by 4.8% in 2003 to $174 million and are expected to increase only slightly in

2004 over 2003, as Administaff plans to achieve unit growth with the Company’s existing infrastructure and
operating expense levels. Capital expenditures in 2003 totaled $8.7 million, down from over $36 million in each of
the two previous years when Administaff was investing heavily in the Company’s facility and technology
infrastructure. Capital expenditures are expected to remain below $10 million in 2004.

The Company experienced an improvement in sales and retention during the latter half of 2003, compared
to that experienced earlier in the year, and expects continued improvement throughout 2004 based on its view of an
improving economy and labor market.

While Administaff has taken measures to mitigate risks in the Company’s benefits and workers’
compensation programs, including client risk assessment, safety management and claims management, a sudden and
unexpected significant increase in claims could negatively impact the Company’s financial results, including sales
and client retention levels and gross profit levels. As for execution risks for a service company, the challenge
remains staffing appropriately to balance meeting and exceeding client expectations and controlling costs.

Administaff’s long-term strategy continues to be aggregating the best small businesses in the United States
on the common platform of the Company’s unique human resource service offering, and leverage the buying power
to provide additional valuable services to clients and new income streams to Administaff.

Revenues

The Company accounts for its revenues in accordance with Emerging Issues Task Force (“EITF”) 99-19,
Reporting Revenues Gross as a Principal Versus Net as an Agent. The Company’s revenues are derived from its
gross billings, which are based on (i) the payroll cost of its worksite employees; and (ii) a markup computed as a
percentage of the payroll cost. In determining the pricing of the markup component of the gross billings, the
Company takes into consideration its estimates of the costs directly associated with its worksite employees, including
payroll taxes, benefits and workers’ compensation costs, plus an acceptable gross profit margin. The gross billings
are invoiced concurrently with each periodic payroll of its worksite employees. Revenues, which exclude the payroll
cost component of gross billings, are recognized ratably over the payroll period as worksite employees perform their
service at the client worksite. Revenues that have been recognized but not invoiced are included in unbilled accounts
receivable on the Company’s Consolidated Balance Sheets.

The Company’s revenues are primarily dependent on the number of clients enrolled, the resulting number of

worksite employees paid each period and the number of worksite employees enrolled in the Company’s benefit
plans. Because the Company’s markup is computed as a percentage of payroll cost, revenues are also affected by the
payroll cost of worksite employees, which can fluctuate based on the composition of the worksite employee base,
inflationary effects on wage levels and differences in the local economies of the Company’s markets.

Direct Costs

The Company’s primary direct costs associated with its revenue generating activities are (i) employment-

related taxes (“payroll taxes”); (ii) costs of employee benefit plans; and (iii) workers’ compensation insurance
premiums.

Payroll taxes consist of the employer’s portion of Social Security and Medicare taxes under FICA, federal

unemployment taxes and state unemployment taxes. Payroll taxes are generally paid as a percentage of payroll cost.

- 23 -

The federal tax rates are defined by federal regulations. State unemployment tax rates are subject to claims histories
and vary from state to state.

Employee benefits costs are comprised primarily of health insurance costs (including dental and pharmacy

costs), but also include costs of other employee benefits such as life insurance, vision care, disability insurance,
education assistance, adoption assistance, a dependent care spending account and a worklife program.

The Company’s gross profit per worksite employee is determined in part by its ability to accurately estimate
and control direct costs and its ability to incorporate changes in these costs into the gross billings charged to clients,
which are subject to contractual arrangements that are typically renewed annually. Gross profit, measured as a
percentage of revenues, is also affected by the markup portion of its gross billings, which is calculated based on a
percentage of worksite employee payroll cost, and the Company’s direct cost structure. The Company uses gross
profit per worksite employee per month as its principal measurement of relative performance at the gross profit level.

Operating Expenses

• Salaries, wages and payroll taxes – Salaries, wages and payroll taxes are primarily a function of the number of

corporate employees and their associated average pay and any additional incentive compensation. The
Company’s corporate employees primarily include sales and marketing, client services, benefits, legal, finance,
technology development and administrative support personnel.

• General and administrative expenses – The Company’s general and administrative expenses primarily include (i)
rent expenses related to the Company’s service centers and sales offices; (ii) outside professional service fees
related to legal, consulting and accounting services; (iii) administrative costs, such as postage and supplies; (iv)
employee travel expenses; and (v) repairs and maintenance costs associated with the Company’s facilities and
technology infrastructure.

• Commissions – Commission expense primarily consists of amounts paid to sales personnel and to American

Express. Commissions for sales personnel are based on a percentage of revenue generated by such personnel,
while commissions are paid to American Express in accordance with its Marketing Agreement with the Company.

• Advertising – Advertising expense primarily consists of media advertising and other business promotions in the
Company’s current and anticipated sales markets. This expense is impacted to some degree by the number of
new markets included in each year’s expansion plan.

• Depreciation and amortization–- Depreciation and amortization expense is primarily a function of the

Company’s capital investments in corporate facilities, service centers, sales offices and technology infrastructure.

Income Taxes

The Company’s provision for income taxes typically differs from the U.S. statutory rate of 35%, due
primarily to state income taxes and non-deductible expenses. During 2002 and 2001, the Company also experienced
an increase in its effective tax rate due to the write-offs associated with its investments in other companies. Deferred
income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and
liabilities used for financial reporting purposes and the amounts used for income tax purposes. Significant items
resulting in deferred income taxes include depreciation, software development costs and the Company’s workers’
compensation accruals. Changes in these items are reflected in the Company’s financial statements through the
Company’s deferred income tax provision.

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

- 24 -

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, state unemployment taxes, client bad debts, 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:

• Revenue and direct cost recognition – The Company accounts for its revenues in accordance with EITF 99-19.
The Company’s revenues are derived from its gross billings, which are based on (i) the payroll cost of its
worksite employees; and (ii) a markup computed as a percentage of the payroll cost. The gross billings are
invoiced concurrently with each periodic payroll of its worksite employees. Revenues, which exclude the
payroll cost component of gross billings, are recognized ratably over the payroll period as worksite employees
perform their service at the client worksite. Revenues that have been recognized but not invoiced are included
in unbilled accounts receivable on the Company’s consolidated balance sheets.

In determining the pricing of the markup component of the gross billings, the Company takes into consideration
its estimates of the costs directly associated with its worksite employees, including payroll taxes, benefits and
workers’ compensation costs, plus an acceptable gross profit margin. As a result, the Company’s operating
results are significantly impacted by the Company’s ability to accurately estimate, control and manage its direct
costs relative to the revenues derived from the markup component of the Company’s gross billings.

Consistent with its revenue recognition policy, the Company’s direct costs do not include the payroll cost of its
worksite employees. The Company’s direct costs associated with its revenue generating activities are comprised
of all other costs related to its worksite employees, such as the employer portion of payroll-related taxes,
employee benefit plan premiums and workers’ compensation insurance costs.

• Benefits 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
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 plan, up to the amount of the Company’s then-outstanding security deposit with
United. As a result of these contractual terms, the Company accounts for this plan using a partially self-funded
insurance accounting model.

Each reporting period, the Company records the costs of the United Plan, including paid claims, an estimate of
the change in incurred but not reported (“IBNR”) claims, taxes and administrative fees (collectively the “Plan
Costs”) as benefits expense in the Consolidated Statements of Operations. The estimated IBNR claims are
based upon both (i) a recent average level of paid claims under the plan; and (ii) an estimated lag factor, to
provide for those claims which have been incurred but not yet paid.

Under the terms of the contract, United establishes plan participant 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 current 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 a current
asset for the excess premiums on its Consolidated Balance Sheet. During the year ended December 31, 2003,
the cash funded to United exceeded the Plan Costs by approximately $12.3 million, resulting in an accumulated

- 25 -

cash surplus from the inception of the plan of approximately $10.0 million, which is recorded as prepaid
insurance on the Company’s Consolidated Balance Sheet.

As of December 31, 2003, the Company’s security deposit with United totaled $25 million. In January 2004,
the security deposit was reduced to $17.5 million, at which time the $7.5 million security deposit reduction plus
accrued interest was returned to the Company. Accordingly, as of December 31, 2003, the Company has
recorded, on its Consolidated Balance Sheet, a long-term deposit of $17.5 million and prepaid insurance of $7.5
million relating to the portion returned to the Company in January 2004.

•

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. The Company must estimate its expected SUI
tax rate in those states for which tax rate notices have not yet been received. In determining these estimates, the
Company takes into account the expected payroll levels and unemployment claim history for such states.

In January 2002, as a result of a 2001 corporate restructuring plan, the Company filed for a partial transfer of
compensation experience 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 in 2002, the Company paid its unemployment
taxes to the state of Texas at the higher new employer rate as required by state law. In September 2003, the
Company received its final 2002 and 2003 unemployment tax rates from the TWC. The impact of these lower
final rates resulted in a $3.9 million reduction in payroll tax expense in the third quarter of 2003 and a state
unemployment tax prepayment balance, which the Company is utilizing to offset its future unemployment tax
liabilities as incurred. The prepayment balance at December 31, 2003 was $5.1 million.

As a result of the 2001 corporate restructuring, 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 from the EDD (“the Notice”). 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 to protest the Notice. Pending a resolution of its protest, the Company has accrued and recorded at the
higher assessed rate for all of 2003. If the amount finally determined to be owed is higher or lower than the
Company’s estimate, the Company would be required to recognize a corresponding reduction or increase in the
accrued payroll tax liability as additional payroll tax expense or benefit in the period of such determination.

• Workers’ compensation costs – The Company’s workers’ compensation insurance policy for the two-year period
ending September 30, 2003 (“2003 Policy”) was a guaranteed-cost policy under which premiums were paid for
full-insurance coverage of all claims incurred during the policy period. This policy also contained a dividend
feature for each policy year, under which the Company was entitled to a refund of a portion of its premiums if,
four years after the end of the policy year, claims paid by the insurance carrier for the policy year were 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 estimated the amount of refund, if any, that had been earned under the dividend feature, based on the
actual claims incurred to date and a factor used to develop those claims to an estimate of the ultimate cost of the
incurred claims during that policy year. If the Company’s estimates were to indicate that an additional dividend
had been earned, the Company would record a receivable for the amount of that dividend and decrease its
workers’ compensation insurance expense, which would increase net income in the period that such
determination was made. On the other hand, if the Company’s estimates were to indicate that the amount of any
recorded dividend receivable had been reduced due to greater than anticipated claim developments, the
Company would reduce its receivable and increase its workers’ compensation insurance expense, which would
reduce net income in the period that such determination was made. In May 2003, the Company’s workers’
- 26 -

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. 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.

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. As of December 31, 2003, the Company has estimated and accrued $12.0
million in incurred but not reported workers’ compensation claims, net of paid claims, which is included in
accrued workers’ compensation costs in the Company’s Consolidated Balance Sheets. Workers’ compensation
cost estimates are discounted to present value at 2%, are accreted over the estimated claim payment period and
are included as a component of workers’ compensation costs in the Company’s Consolidated Statements of
Operations.

• Contingent liabilities – The Company accrues and discloses contingent liabilities in its 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
that 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.
The Company has disclosed in its audited financial statements several issues that it believes are reasonably
possible to occur, although it cannot determine the range of possible loss in all cases. As these issues develop,
the Company will continue to evaluate the probability of future loss and the potential range of such losses. If
such evaluation were to determine that a loss was probable and the loss could be reasonably estimated, the
Company would be required to accrue its estimated loss, which would reduce net income in the period that such
determination was made.

• Deferred taxes – The Company has recorded a valuation allowance to reduce its deferred tax assets to the

amount that is more likely than not to be realized. While the Company has considered future taxable income
and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, the
Company’s ability to realize its deferred tax assets could change from its current estimates. If the Company
determines that it would be able to realize its deferred tax assets in the future in excess of its net recorded
amount, an adjustment to reduce the valuation allowance would increase net income in the period that such
determination is made. Likewise, should the Company determine that it will not be able to realize all or part of
its net deferred tax assets in the future, an adjustment to increase the valuation allowance would reduce net
income in the period such determination is made.

• Allowance for doubtful accounts – The Company maintains an allowance for doubtful accounts for estimated

losses resulting from the inability of its customers to pay its comprehensive service fees. The Company believes
that the success of its business is heavily dependent on its ability to collect these comprehensive service fees for
several reasons, including: (i) the fact that the Company is at risk for the payment of its direct costs and worksite
employee payroll costs regardless of whether its clients pay their comprehensive service fees; (ii) the large
volume and dollar amount of transactions processed by the Company; and (iii) the periodic and recurring nature
of payroll, upon which the comprehensive service fees are based. To mitigate this risk, the Company has

- 27 -

established very tight credit policies. The Company generally requires its clients to pay their comprehensive
service fees no later than one day prior to the applicable payroll date. In addition, the Company maintains the
right to terminate its Client Service Agreement and associated worksite employees or to require prepayment,
letters of credit or other collateral upon deterioration in a client’s financial position or upon nonpayment by a
client. As a result of these efforts, losses related to customer nonpayment have historically been low as a
percentage of revenues. However, if the financial condition of the Company’s customers were to deteriorate
rapidly, resulting in nonpayment, the Company’s accounts receivable balances could grow and the Company
could be required to provide for additional allowances, which would decrease net income in the period that such
determination was made.

• Property and equipment – The Company’s property and equipment relate primarily to its facilities and related
improvements, furniture and fixtures, computer hardware and software and capitalized software development
costs. These costs are depreciated or amortized over the estimated useful lives of the assets. If the useful lives
of these assets were determined to be shorter than their current estimates, the Company’s depreciation and
amortization expense could be accelerated, which would decrease net income in the periods of such a
determination. In addition, the Company periodically evaluates 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 the Company’s long-lived assets might be impaired, the Company would analyze the
estimated undiscounted future cash flows to be generated from the applicable asset. In addition, the Company
would record an impairment loss, which would reduce net income, to the extent that the carrying value of the
asset exceeded the fair value of the asset. Fair value is generally determined using an estimate of discounted
future net cash flows from operating activities or upon disposal of the asset. During 2003 the Company ceased
operations of Administaff Financial Management Services, Inc. (“FMS”) and recorded an after-tax impairment
charge of approximately $800,000 related to the write down of assets of FMS. As a result, FMS is being
reported as a discontinued operation in accordance with SFAS No. 144.

New Accounting Pronouncements

In July 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial
Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities ("SFAS 146").
SFAS 146 addresses accounting and reporting for costs associated with exit or disposal activities, such as
restructurings, involuntary termination of employees, and consolidating facilities initiated after December 31, 2002.
SFAS 146, which requires that costs related to exiting an activity or to a restructuring not be recognized until the
liability is incurred, was effective for the Company beginning January 1, 2003. The adoption of SFAS 146 did not
have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities
(“FIN 46”). This interpretation explains how to identify variable interest entities and how an enterprise assesses its
interest in a variable interest entity to decide whether to consolidate that entity. This interpretation requires existing
unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not
effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be
consolidated unless a single party holds an interest or combination of interest that effectively recombines risks that
were previously dispersed. This interpretation applies immediately to variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the
first fiscal year or interim period beginning after March 15, 2004, to variable interest entities in which an enterprise
holds a variable interest that it acquired before February 1, 2003. Because the Company does not have any variable
interest entities, the adoption of FIN 46 did not have a material impact on the Company’s consolidated financial
position, results of operations or cash flows.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150 , Accounting for

- 28 -

entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period
beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on the Company’s
consolidated financial position, results of operations or cash flows.

Transactions with Related and Other Certain Parties

The Company does not have any transactions with related parties that are considered material to the

Company’s results of operations and/or financial condition.

During 2001 and 2002, American Express exercised common stock purchase warrants for 1,073,729 shares

and 526,271 shares, respectively, of the Company’s common stock at exercise prices ranging from $20 to $25 per
share. During 2003, the Company repurchased 1,286,252 shares of common stock from American Express in a
private transaction for $7.7 million or $6.00 per share. As of December 31, 2003 the Company has repurchased
2,612,523 shares from American Express in private transactions at prices ranging from $6.00 to $27.02 per share.

- 29 -

Results of Operations

Year Ended December 31, 2003 Compared to Year Ended December 31, 2002.

The following table presents certain information related to the Company’s results of operations for the years

ended December 31, 2003 and 2002.

Year ended December 31,
2002

% change

2003

(in thousands, except per share and statistical data)

Revenues (gross billings of $4.830 billion and
$4.857 billion less worksite employee payroll cost of
$3.938 billion and $4.009 billion, respectively)..............
Gross profit.........................................................................
Operating expenses.............................................................
Operating income................................................................
Other income (expense) ......................................................
Net income (loss) from continuing operations....................
Diluted net income (loss) from continuing operations
per share of common stock..............................................

Statistical Data:
Average number of worksite employees paid per month ....
Revenues per worksite employee per month (1)...................
Gross profit per worksite employee per month...................
Operating expenses per worksite employee per month.......
Operating income per worksite employee per month..........
Net income (loss) from continuing operations
per worksite employee per month ...................................
_______________

$ 891,721
197,967
173,693
24,274
196
14,985

$ 848,416
165,790
165,723
67
(1,747)
(2,921)

5.1%
19.4%
4.8%
36,129.9%
111.2%
613.0%

0.55

(0.11)

600.0%

75,036
990
220
193
27

77,334
914
179
179
—

(3.0)%
8.3%
22.9%
7.8%
—

(3)

666.7%

(1) Gross billings of $5,364 and $5,234 per worksite employee per month less payroll cost of $4,374 and $4,320 per

worksite employee per month, respectively.

Revenues

The Company’s revenues, which represent gross billings net of worksite employee payroll cost, increased

5.1% over 2002 due to an 8.3% increase in revenues per worksite employee per month partially offset by a 3.0%
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. The 3.0% decrease in the
average number of worksite employees paid per month during 2003 was primarily related to a decline in worksite
employees from new client sales and lower levels of client retention.

The 8.3% increase in revenues per worksite employee per month was primarily due to pricing increases in
the markup portion of the Company’s gross billings and a 1.3% increase in the average worksite employee payroll
cost per month. In 2003, worksite employee payroll cost per month increased as compared to the decrease
experienced in 2002.

- 30 -

The following table presents certain information related to the Company’s revenues by region for the years

ended December 31, 2003 and 2002.

Year ended December 31,

2003

2002 % change

(in thousands)

2002
2003
(% of total revenue)

Northeast......................................
Southeast......................................
Central .........................................
Southwest.....................................
West.............................................
Other revenues .............................
Total revenues.....................

$ 115,872
95,293
131,416
355,283
187,996
5,861
$ 891,721

$ 101,097
92,480
123,901
360,622
164,221
6,095
$ 848,416

14.6%
3.0%
6.1%
(1.5)%
14.5%
(3.8)%
5.1%

13.0%
10.7%
14.7%
39.8%
21.1%
0.7%
100.0%

11.9%
10.9%
14.6%
42.5%
19.3%
0.8%
100.0%

Gross Profit

Gross profit increased 19.4% to $198 million compared to 2002. Gross profit per worksite employee

increased 22.9% to $220 per month in 2003 versus $179 in 2002. This increase was primarily the result of pricing
increases exceeding increases in direct costs. 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 8.3%, the Company’s direct

costs, which primarily include payroll taxes, benefits and workers’ compensation expenses, increased 4.6% to $770
per worksite employee per month in 2003 versus $736 in 2002. The primary direct cost components changed as
follows:

• Payroll tax costs – Payroll taxes increased $3 per worksite employee per month. Payroll taxes as a percentage
of payroll cost decreased to 7.23% in 2003 from 7.25% in 2002. During 2003, the Company recorded a $3.9
million reduction in payroll taxes due to the receipt of the Company’s final 2002 and 2003 unemployment tax
rates from the Texas Workforce Commission. In addition, the Company accrued $5.6 million in additional
payroll taxes in 2003 related to an unemployment tax assessment from the Employment Development
Department of the State of California. See “Critical Accounting Policies and Estimates – State Unemployment
Taxes” on page 26 for a detailed discussion of the Company’s accounting for payroll taxes.

• Benefits costs – The cost of health insurance and related employee benefits increased $17 per worksite employee
per month over 2002, due to a 8.1% increase in the cost per covered employee and a decrease in the percentage
of worksite employees covered under the Company’s health insurance plan to 70.7% in 2003 versus 73.0% in
2002. See “Critical Accounting Policies and Estimates – Benefits Costs” on page 25 for a discussion of the
Company’s accounting for health insurance costs.

• Workers’ compensation costs – Workers’ compensation costs increased $14 per worksite employee per month,
and increased to 1.43% of payroll cost in 2003 from 1.12% in 2002. The primary cause of the increase was a
$2.5 million charge in 2003 related to the write-off of the workers’ compensation dividend, earned and initially
recorded in 2002, as a result of the workers’ compensation carrier’s rating downgrades. Additionally, during
2003 the Company incurred approximately $2.0 million in workers’ compensation costs related to contract
termination costs associated with the Company’s former policy and state surcharges relating to policies dating
back to 1999, which were assessed by various states and passed through to the Company through its previous
carrier. See “Critical Accounting Policies and Estimates – Workers’ Compensation Costs” on page 26 for a
discussion of the Company’s accounting for workers’ compensation costs.

Gross profit, measured as a percentage of revenues, increased to 22.2% in 2003 from 19.5% in 2002.

- 31 -

Operating Expenses

The following table presents certain information related to the Company’s operating expenses for the years

ended December 31, 2003 and 2002.

Year ended December 31,

2003

2002 % change

(in thousands)

Year ended December 31,
2003

2002 % change
(per worksite employee per month)

Salaries, wages and payroll taxes
General and administrative expenses
Commissions
Advertising
Depreciation and amortization
Total operating expenses

$ 83,195
50,502
10,656
8,581
20,759
$ 173,693

$ 74,989
50,172
12,127
7,138
21,297
$ 165,723

10.9%
0.7%
(12.1)%
20.2%
(2.5)%
4.8%

92
56
12
10
23
193

81
54
13
8
23
179

13.6%
3.7%
(7.7)%
25.0%
—
7.8%

Operating expenses increased 4.8% to $173.7 million. Operating expenses per worksite employee per
month increased 7.8% to $193 in 2003 versus $179 in 2002. The components of operating expenses changed as
follows:

• Salaries, wages and payroll taxes of corporate and sales staff increased 10.9%, or $11 per worksite employee per
month. The increase is primarily due to an accrual related to the Company’s 2003 incentive compensation plan
and the increased compensation costs to staff the new retirement services business. The average number of
corporate employees during 2003 remained flat as compared to the 2002 average. The average base pay of
corporate employees during 2003 increased 3.2%.

• General and administrative expenses increased 0.7%, or $2 per worksite employee per month compared to 2002.

• Commissions expense decreased 12.1% or $1 per worksite employee per month compared to 2002 due to the

decline in paid worksite employees in 2003 as compared to 2002.

• Advertising costs increased 20.2% or $2 per worksite employee as compared to 2002 due to increased

marketing efforts focused on lead generation.

• Depreciation and amortization expense decreased 2.5% and remained constant on a per worksite employee basis
versus 2002 as the effect of certain fixed assets becoming fully amortized more than offset the incremental
depreciation and amortization expense related to the 2003 capital additions.

Other Income (Expense)

Other income (expense) improved from net expense of $1.7 million in 2002 to net other income of
$196,000 in 2003, primarily due to the Company recording a write-off of its investment in eProsper of $3.1 million
in 2002.

Income Tax Expense

During 2003, the Company incurred federal and state income tax expense from continuing operations of

$9.5 million on pre-tax income of $24.5 million. The Company’s effective income tax provision differed from the
US statutory rate of 35% primarily due to state income taxes and non-deductible expenses.

- 32 -

Net Income (Loss) From Continuing Operations

Net income from continuing operations for 2003 was $15.0 million, or $0.55 per diluted share, compared to

a net loss of $2.9 million, or $0.11 per diluted share in 2002. On a per worksite employee per month basis, net
income increased 666.7% to $17 in 2003 versus a net loss of $3 in 2002.

Discontinued Operations

During 2003 the Company incurred a net loss from its discontinued operations, Administaff Financial

Management Services, of $2.1 million versus $1.2 million in 2002. During 2003, the Company ceased operations of
FMS and incurred after-tax impairment charges of $800,000 related to the write-off of the assets of FMS.

Year Ended December 31, 2002 Compared to Year Ended December 31, 2001.

The following table presents certain information related to the Company’s results of operations for the years

ended December 31, 2002 and 2001.

Year ended December 31,
2001

% change

2002

(in thousands, except per share and statistical data)

Revenues (gross billings of $4.857 billion and
$4.373 billion less worksite employee payroll cost of
$4.009 billion and $3.653 billion, respectively)..............
Gross profit.........................................................................
Operating expenses.............................................................
Operating income................................................................
Other income (expense) ......................................................
Net income (loss)................................................................
Diluted net income (loss) from continuing operations
per share of common stock..............................................

$ 848,416
165,790
165,723
67
(1,747)
(2,921)

$ 720,219
165,015
146,476
18,539
848
10,357

17.8%
0.5%
13.1%
(99.6)%
(306.0)%
(128.2)%

(0.11)

0.36

(130.6)%

77,334
914
179
179
—

69,480
864
198
176
22

11.3%
5.8%
(9.6)%
1.7%
—

(3)

(125.0)%

(1) Gross billings of $5,234 and $5,245 per worksite employee per month less payroll cost of $4,320 and $4,381 per

worksite employee per month, respectively.

Revenues

The Company’s revenues, which represent gross billings net of worksite employee payroll cost, increased
17.8% over 2001 due to a 11.3% increase in the average number of worksite employees paid per month combined
with a 5.8% increase in revenues per worksite employee per month.

The 11.3% increase in the average number of worksite employees paid per month during 2002 was directly
related to improvements in all three of the Company’s sources of paid worksite employees as compared to 2001- new
client sales, client retention, and net change in existing clients through new hires and terminations. New client sales
improved over 2001 as the average number of trained sales representatives increased during 2002. While client

- 33 -

retention percentages remained relatively constant during 2001 and 2002, there were fewer worksite employees
associated with terminated clients during 2002 as compared to 2001. The net change in existing clients was
impacted as terminations in the existing client base exceeded new hires during 2002; however, at levels lower than
those experienced during 2001.The 5.8% increase in revenues per worksite employee per month was primarily due to
pricing increases in the markup portion of the Company’s gross billings, partially offset by a 1.4% decrease in the
average worksite employee payroll cost per month. In 2002, worksite employee payroll cost per month decreased as
compared to the increase experienced in 2001. This decrease was primarily due to weakness in U.S. economic
conditions which resulted in lower compensation increases and a reduction in the payroll cost for new and
replacement worksite employees within the Company’s existing client base.

The following table presents certain information related to the Company’s revenues by region for the years

ended December 31, 2002 and 2001.

Year ended December 31,

2002

2001 % change

(in thousands)

2002
2001
(% of total revenue)

$ 101,097
92,480
123,901
360,622
164,221
6,095
$ 848,416

$ 74,900
73,267
96,528
337,725
130,958
6,841
$ 720,219

35.0%
26.2%
28.4%
6.8%
25.4%
(10.9)%
17.8%

11.9%
10.9%
14.6%
42.5%
19.3%
0.8%
100.0%

10.4%
10.2%
13.4%
46.9%
18.2%
0.9%
100.0%

Gross Profit

Gross profit increased 0.5% to $165.8 million compared to 2001. Gross profit per worksite employee

decreased 9.6% to $179 per month in 2002 versus $198 in 2001. This decline was primarily the result of an increase
of $67 in benefits cost per worksite employee per month, partially offset by a $50 increase in revenue 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. The Company has implemented pricing increases designed to match the anticipated health insurance
costs increases. However, during 2002, the Company was unable to immediately pass certain benefit cost increases
through to most of its clients due to annual contract commitments. See Item 3. Legal Proceedings on page 16 for a
discussion of the health insurance rate increase dispute.

While the Company’s revenues per worksite employee per month increased 5.8%, the Company’s direct

costs, which primarily include payroll taxes, benefits and workers’ compensation expenses, increased 10.5% to $736
per worksite employee per month in 2002 versus $666 in 2001. The primary components changed as follows:

• Payroll tax costs – Payroll taxes decreased $3 per worksite employee per month, primarily due to the decreased
average payroll cost per worksite employee. Payroll taxes as a percentage of payroll cost increased to 7.25% in
2002 from 7.20% in 2001. The Company estimated and recorded its state unemployment tax expense during
2002 using tax rates in certain states, including Texas, that were based on its expectation that its application for
a partial transfer of compensation experience resulting from its corporate restructuring would be approved. In
2002 the Company received a determination from the TWC that its partial transfer application was approved.
However, the Company did not receive its final official tax rates, as determined by the TWC, until 2003. See
“Critical Accounting Policies and Estimates – State Unemployment Taxes” on page 26 for a detailed discussion
of this matter.

• Benefits costs – The cost of health insurance and related employee benefits increased $67 per worksite employee
per month over 2001, due to a 20.8% increase in the cost per covered employee and a slight increase in the
percentage of worksite employees covered under the Company’s health insurance plan to 73.0% in 2002 versus

- 34 -

72.0% in 2001. See “Critical Accounting Policies and Estimates – Benefits Costs” on page 25 for a discussion
of the Company’s accounting for health insurance costs. The 2001 benefits expense includes the impact of the
disputed health insurance rate increases by Aetna of approximately $12.7 million. See Item 3. Legal
Proceedings on page 16 for a discussion of the health insurance rate increase dispute.

• Workers’ compensation costs – Workers’ compensation costs increased $6 per worksite employee per month,

and increased to 1.12% of payroll cost in 2002 from 0.98% in 2001. The Company’s 2001 workers’
compensation costs included the receipt of a $6.6 million credit related to the policy ended September 30, 2001.
During 2002, the Company recorded an estimated dividend receivable of $2.5 million under the policy’s
dividend feature. See “Critical Accounting Policies and Estimates – Workers’ Compensation Costs” on page 26
for a discussion of the Company’s accounting for workers’ compensation costs.

Gross profit, measured as a percentage of revenues, decreased to 19.5% in 2002 from 22.9% in 2001.

Operating Expenses

The following table presents certain information related to the Company’s operating expenses for the years

ended December 31, 2002 and 2001.

Year ended December 31,

2002

2001 % change

(in thousands)

Year ended December 31,
2002

2001 % change
(per worksite employee per month)

Salaries, wages and payroll taxes
General and administrative expenses
Commissions
Advertising
Depreciation and amortization
Total operating expenses

$ 74,989
50,172
12,127
7,138
21,297
$ 165,723

$ 67,761
44,569
11,173
6,092
16,881
$ 146,476

10.7%
12.6%
8.5%
17.2%
26.2%
13.1%

$ 81
54
13
8
23
$ 179

$ 81
54
14
7
20
$ 176

—
—
(7.1)%
14.3%
15.0%
1.7%

Operating expenses increased 13.1% to $165.7 million. Operating expenses per worksite employee per
month increased 1.7% to $179 in 2002 versus $176 in 2001. The components of operating expenses changed as
follows:

• Salaries, wages and payroll taxes of corporate and sales staff increased 10.7% and remained constant on a per
worksite employee basis, primarily due to an 8.3% increase in corporate personnel and a 4.3% increase in the
average base pay per corporate employee. The increase in corporate personnel was primarily composed of a
7.9% increase in sales personnel, a 2.8% increase in service personnel, a 36.2% increase in benefits personnel
and a 6.7% increase in other corporate personnel.

• General and administrative expenses increased 12.6% and remained constant on a per worksite employee basis
compared to 2001. The increase resulted primarily from the increased legal expenses associated with the
Company’s litigation with Aetna. See Item 3. Legal Proceedings on page 16.

• Commissions expense increased 8.5%, but decreased $1 per worksite employee per month compared to 2001.

• Advertising costs increased 17.2%, or $1 on a per worksite employee basis versus 2001.

• Depreciation and amortization expense increased 26.2%, or $3 per worksite employee per month, over 2001 as a
result of the increased capital assets placed into service in late 2001 and 2002. These capital assets included (i)
the new corporate headquarters facilities, the Los Angeles Service Center and new sales offices; (ii) software
development costs related to online enrollment, AIMS, the Company’s proprietary PEO information system, and
the Employee Service Center, the Company’s web-based service delivery platform; (iii) computer software for
various corporate needs; (iv) computer hardware to expand the Company’s existing information technology

- 35 -

infrastructure; (v) an aircraft; and (vi) the purchase of assets from Virtual Growth, Inc. (“VGI”) through
bankruptcy proceedings.

Other Income (Expense)

Other income (expense) decreased from income of $848,000 in 2001 to a net expense of $1.7 million in

2002. This decrease was primarily due to a decline in interest income from the lower levels of cash and marketable
securities, which resulted primarily from the Company’s capital expenditures and reduced operating income in 2002.
During 2002 and 2001, the Company wrote-off investments in other companies totaling $3.1 million and $3.8
million, respectively.

Income Tax Expense

During 2002, the Company incurred federal and state income tax expense from continuing operations of

$1.2 million on a pre-tax loss of $1.7 million. The Company’s effective income tax provision differed from US
statutory rate of 35% primarily due to the valuation allowance for deferred tax assets related to the write-off of its
investment in eProsper, Inc., the realizability of which is uncertain, state income tax expense incurred by certain of
the Company’s subsidiaries, and non-deductible expenses.

Net Income (Loss) from Continuing Operations

Net loss for 2002 from continuing operations was $2.9 million, or $0.11 per diluted share, compared to net

income of $10.4 million, or $0.36 per diluted share in 2001. On a per worksite employee per month basis, net
income decreased 125.0% to a net loss of $3 in 2002 versus net income of $12 in 2001.

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 will be adequate to meet its liquidity requirements for the
remainder of 2004. 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.

On December 20, 2002, the Company entered into a $36 million mortgage agreement (“Mortgage”) that

matures in January 2008. The proceeds were used to repay the Company’s outstanding balance under its revolving
credit agreement, which expired in December 2002. The Mortgage bears interest at a variable rate equal to the
greater of (a) 4.5%; or (b) the 30-day LIBOR rate (1.1% at December 31, 2003) plus 2.9%. The Mortgage is
secured by the Company’s real estate and related fixtures located at Administaff’s headquarters in Kingwood, Texas.
Monthly principal and interest payments are approximately $230,000, with the remaining balance due upon maturity.
The Mortgage provides for prepayment penalties, as a percentage of the outstanding principal balance, ranging from
5% down to 1% during the first four years of the term. There is no prepayment premium during the final year of the
Mortgage.

In October 2002, the Company entered into a $3.8 million capital lease arrangement to finance the purchase

of office furniture. The assets under capital lease were capitalized using an effective interest rate of 7.5%. The
current monthly lease payments are $58,000 per month over the seven-year lease term.

In October 2002, the Company obtained a $4.5 million term loan that matures in October 2012 and bears

interest at the one-month commercial paper rate plus 3.1% (4.1% at December 31, 2003). The loan is secured by the
Company’s aircraft and is payable in monthly installments of $36,000, with the remaining outstanding principal
balance due at maturity.

- 36 -

The Company had $128.7 million in cash and cash equivalents and marketable securities at December 31,

2003, of which approximately $57.5 million was payable in early January 2004 for withheld federal and state income
taxes, employment taxes and other payroll deductions. At December 31, 2003, the Company had working capital of
$56.0 million compared to $41.2 million at December 31, 2002.

Cash Flows From Operating Activities

The Company’s cash flows from operating activities in 2003 increased $52.8 million to $55.9 million. The

increase in operating cash flows is primarily due to changes in the Company’s operating balance sheet accounts.
Cash flows generated by changes in the Company’s operating balance sheet accounts were $23.8 million in 2003
versus $(19.0) million in 2002. In addition, net income increased to $12.9 million in 2003 from a $4.1 million loss
in 2002. The increase in net income is primarily the result of the Company’s pricing increases exceeding direct cost
increases.

Cash Flows From Investing Activities

Capital expenditures totaled $8.7 million in 2003 and consisted primarily of computer hardware, software

and software development costs. Capital expenditures for computer hardware and software included costs associated
with purchasing and renewing software licenses and computer hardware to enhance the performance and stability of
the Company’s technology infrastructure.

The Company expects a consistent level of capital expenditures in 2004 and therefore has budgeted

approximately $10 million.

Cash Flows Used In Financing Activities

Cash flows used in financing activities were $8.5 million during 2003. These cash flows were primarily
related to $8.2 million of treasury stock purchases and the repayment of $1.8 million of its term notes and capital
lease obligations. Additionally, in February 2004 the Company repurchased 205,000 shares at an average price per
share of $15 for a total cost of $3.1 million.

Contractual Obligations and Commercial Commitments

The following table summarizes the Company’s contractual obligations and commercial commitments as of

December 31, 2003 and the effect they are expected to have on its liquidity and capital resources (in thousands):

Total

Less than
1 Year

1-3 Years

3-5 Years

More than
5 Years

Contractual obligations:
Mortgage
Term loan
Capital lease obligations
Non-cancelable operating leases
Purchase obligations
Other long-term liabilities
Total contractual cash obligations

$ 2,680
$ 40,641
430
5,302
695
4,029
8,473
42,906
2,841
7,002
12,844
4,584
$112,724 $ 19,703

$ 5,243
859
1,390
15,558
3,170
3,078
$ 29,298

$ 32,718
859
1,390
11,798
421
2,111
$ 49,297

$ —
3,154
554
7,077
570
3,071
$ 14,426

Seasonality, Inflation and Quarterly Fluctuations

Historically, the Company’s earnings pattern has included losses in the first quarter followed by improved

profitability in subsequent quarters throughout the year. This pattern is due to the effects of employment-related
taxes, which are based on each employee’s cumulative earnings up to specified wage levels, causing employment-
related taxes to be highest in the first quarter and then decline over the course of the year. Because the Company’s

- 37 -

revenues related to each employee are generally earned and collected at a relatively constant rate throughout each
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.

As a result of modifications to the CSA, effective January 1, 2003, the Company implemented a new pricing

and billing system for new and renewing clients (“New System”). For clients active on the New System in January
of any year, the system includes a feature that accelerates invoicing of the estimated payroll tax component of the
comprehensive service fee to more closely reflect the pattern of estimated incurred payroll tax costs. Accordingly,
the impact of new and renewing clients invoiced on the New 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 2003. Substantially all clients were billed using the New System in January 2004. For those
clients active on the New System in January 2004, a complete offset of the Company’s earnings pattern is expected.
However, new clients enrolling subsequent to January 2004 will be invoiced at a relatively constant rate throughout
the remaining portion of each year, resulting in improved profitability over the course of the year for those clients.

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

Liability for Worksite Employee Payroll and Benefits Costs

Under the CSA, the Company becomes a co-employer of worksite employees and assumes the obligations

to pay the salaries, wages and related benefits costs and payroll taxes of such worksite employees. The Company
assumes such obligations as a principal, not as an agent of the client company. The Company’s obligations include
responsibility for (i) payment of the salaries and wages for work performed by worksite employees, regardless of
whether the client company makes timely payment to the Company of the associated service fee; and (ii) providing
benefits to worksite employees even if the costs incurred by Administaff to provide such benefits exceed the fees
paid by the client company. If a client company does not pay the Company or if the costs of benefits provided to
worksite employees exceed the fees paid by a client company, the Company’s ultimate liability for worksite
employee payroll and benefits costs could have a material adverse effect on its financial condition or results of
operations.

Increases in Health Insurance Premiums and Workers’ Compensation Costs

The maintenance of health and workers’ compensation insurance plans that cover worksite employees is a

significant part of the Company’s business. The Company’s primary health insurance contract expires on December
31, 2004, and automatically renews each year, subject to cancellation by either party upon 180 days notice. The
current workers’ compensation contract expires on September 16, 2004. The Company’s inability to secure
replacement contracts on competitive terms could cause significant disruption to the Company’s business.

Health insurance premiums and workers’ compensation costs are in part determined by the Company’s

claims experience and comprise a significant portion of the Company’s direct costs. The Company employs
extensive risk management procedures in an attempt to control its claims incidence and structures its benefits
contracts to provide as much cost stability as possible. However, should the Company experience a sudden and
unexpected large increase in claim activity, its health insurance costs or workers’ compensation insurance costs could
increase. The Company’s ability to incorporate such increases into service fees to clients is constrained by
contractual arrangements with clients, which could result in a delay before such increases could be reflected in
service fees. As a result, such increases could have a material adverse effect on the Company’s financial condition
or results of operations.

The Company experienced an 8% increase in benefits costs per covered employee during 2003 and expects

an 8% to 10% increase in 2004. While the Company’s results of operations may be impacted to some degree in

- 38 -

future periods by the healthcare cost increase and its contractual pricing constraints, the Company does not expect
this situation to have a material adverse effect on its financial position.

The Company is currently in a dispute with Aetna, its former health insurance carrier, relating to health

insurance costs increases during 2001 and Aetna’s administration of its health plan prior to 2002. For a discussion of
the Company’s dispute with Aetna, see Item 3. Legal Proceedings on page 16. An unfavorable outcome in this
dispute could have a material adverse effect on the Company’s financial position or results of operations.

In 2003, facing continued capital constraints and a series of downgrades from various rating agencies, the

Company’s former workers’ compensation insurance carrier for the two-year period ending September 2003,
Lumbermens Mutual Casualty Company, a unit of Kemper Insurance Companies (“Kemper”), made the decision to
substantially cease underwriting operations and voluntarily entered into “run-off.” A “run-off” is the professional
management of an insurance company’s discontinued, distressed or nonrenewed lines of insurance and associated
liabilities outside of a judicial proceeding. The Company expects that Kemper will pay all open workers’
compensation claims through this run-off process. In the event the run-off process is not successful and Kemper is
forced into bankruptcy or a similar proceeding, most states have established guaranty funds to pay remaining claims.
However, the guarantee associations in some states, including Texas, have asserted that state law returns the liability
for open claims under such policies to the insured, as the Company experienced with another former insurance
carrier, Reliance National Indemnity Co. See Item 3. Legal Proceedings on page 16. If one or more states were to
assert that liability for open claims with Kemper should be returned to the Company, the Company may be required
to make a payment to the state covering estimated claims attributable to the Company. Any such payment would
reduce net income, which may have a material adverse effect on net income in the reported period.

On September 1, 2003, the Company obtained a workers’ compensation policy commencing on September
1, 2003 and ending on September 16, 2004 (“2004 Policy”) with selected member insurance companies of American
International Group, Inc. (“AIG”). Under its arrangement with AIG, 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 2004 Policy is a fully insured policy whereby AIG has the responsibility to pay all claims
incurred under the policy regardless of whether the Company satisfies its responsibilities. Accordingly, the
arrangement stipulates that the Company provide initial collateral of $10 million at the policy inception and an
additional $3.03 million to be paid in three equal installments of $839,000 in December 2003, March 2004 and June
2004 with a final installment of $513,197, which is to be paid in September 2004. As of December 31, 2003, the
total collateral held by AIG was $10.8 million, which is included in deposits in the Company’s Consolidated Balance
Sheets. Under its arrangement with AIG, the Company makes monthly premium payments and claim deposits with
AIG. The claim deposits are retained and held by AIG in an escrow account under AIG’s Reinsurance Captive Asset
Management Program (“RCAMP”), which is used to fund workers’ compensation claims as the claims are processed.
As of December 31, 2003, the total claim deposits held in the RCAMP by AIG was $15.1 million, of which $4.6
million is included in restricted cash and $10.5 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. As of December 31, 2003, the Company has estimated and accrued $12.0
million in incurred but not reported workers’ compensation claims, net of paid claims, which is included in accrued
workers’ compensation costs in the Company’s Consolidated Balance Sheets. Workers’ compensation cost estimates
are discounted to present value at 2%, are accreted over the estimated claim payment period and are included as a
component of workers’ compensation costs in the Company’s Consolidated Statements of Operations.

In conjunction with entering into the 2004 Policy, the Company formed a wholly owned captive insurance
subsidiary (the “Captive”). The Company recognizes the Captive as an insurance company for federal income tax
purposes, including the preparing and filing of the Company’s consolidated federal income tax return. In the event
the Internal Revenue Service (“IRS”) were to determine that the Captive does not qualify as an insurance company,
the Company could be required to make accelerated income tax payments to the IRS that otherwise would have been
deferred until future periods. Such a determination would have no effect on the Company’s effective income tax
rate.

- 39 -

Increases in Unemployment Tax Rates

The Company records its state unemployment tax expense based on taxable wages and tax rates assigned by

each state. State unemployment tax rates vary by state and are determined, in part, based on prior years’
compensation experience in each state. Should the Company’s claim experience increase, its unemployment tax
rates could increase. In addition, states have the ability under law to increase unemployment tax rates to cover
deficiencies in the unemployment tax fund. Many states have experienced and are experiencing significant increases
in unemployment claims due to depressed economic conditions over the last few years. As a result, unemployment
tax rates for the Company have increased over the last several years and are expected to continue to increase. Some
states have implemented retroactive cost increases. The Company’s ability to incorporate such increases into service
fees to clients is constrained by contractual arrangements with clients, which could result in a delay before such
increases could be reflected in service fees. As a result, such increases could have a material adverse effect on the
Company’s financial condition or results of operations.

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 from the EDD (the “Notice”). 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 of 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 to protest the Notice.
Pending a resolution of its protest, the Company has accrued and recorded at the higher assessed rate for all of 2003.
If the amount finally determined to be owed is higher or lower than the Company’s estimate, the Company would be
required to recognize a corresponding reduction or increase in the accrued payroll tax liability as additional payroll
tax expense or benefit in the period of such determination.

Need to Renew or Replace Client Companies

The Company’s standard CSA is subject to cancellation on 30 to 60 days notice by either the Company or
the client. Accordingly, the short-term nature of the CSA makes the Company vulnerable to potential cancellations
by existing clients, which could materially and adversely affect the Company’s financial condition and results of
operations. In addition, the Company’s results of operations are dependent in part upon the Company’s ability to
retain or replace its client companies upon the termination or cancellation of the CSA. Prior to 2003, the Company’s
average client attrition rate had ranged from approximately 20% to 25%. During 2003, the Company’s client
attrition ratio increased to approximately 30%, primarily as a result of significant price increases necessary to match
price and cost of the healthcare component of its business. There can be no assurance that the number of contract
cancellations will not continue at these levels or increase in the future.

Competition and New Market Entrants

The PEO industry is highly fragmented. Many PEOs have limited operations and fewer than 1,000 worksite

employees, but there are several industry participants that are comparable in size to the Company. The Company
also encounters competition from “fee for service” companies such as payroll processing firms, insurance companies
and human resource consultants. Several of the Company’s competitors are PEO divisions of large business services
companies, such as Automatic Data Processing, Inc. and Paychex, Inc. Such companies have substantially greater
resources than the Company. Accordingly, the PEO divisions of such companies may be able to provide their PEO
services at more competitive prices than may be offered by the Company. Moreover, the Company expects that as
the PEO industry grows and its regulatory framework becomes better established, well-organized competition with
greater resources than the Company may enter the PEO market, possibly including large “fee for service” companies
currently providing a more limited range of services.

- 40 -

Liabilities for Client and Employee Actions

A number of legal issues remain unresolved with respect to the co-employment arrangement between a PEO

and its worksite employees, including questions concerning the ultimate liability for violations of employment and
discrimination laws. The Administaff CSA establishes the contractual division of responsibilities between the
Company and its clients for various personnel management matters, including compliance with and liability under
various governmental regulations. However, because the Company acts as a co-employer, the Company may be
subject to liability for violations of these or other laws despite these contractual provisions, even if it does not
participate in such violations. Although the CSA provides that the client is to indemnify the Company for any
liability attributable to the conduct of the client, the Company may not be able to collect on such a contractual
indemnification claim and thus may be responsible for satisfying such liabilities. In addition, worksite employees
may be deemed to be agents of the Company, subjecting the Company to liability for the actions of such worksite
employees.

Federal, State and Local Regulation

As a major employer, the Company’s operations are affected by numerous federal, state and local laws and

regulations relating to labor, tax and employment matters. By entering into a co-employer relationship with
employees assigned to work at client company locations, the Company assumes certain obligations and
responsibilities of an employer under these laws. However, many of these laws (such as ERISA and federal and state
employment tax laws) do not specifically address the obligations and responsibilities of non-traditional employers
such as PEOs, and the definition of “employer” under these laws is not uniform. In addition, many of the states in
which the Company operates have not addressed the PEO relationship for purposes of compliance with applicable
state laws governing the employer/employee relationship. If these other federal or state laws are ultimately applied
to the Company’s PEO relationship with its worksite employees in a manner adverse to the Company, such an
application could have a material adverse effect on the Company’s results of operations or financial condition.

While many states do not explicitly regulate PEOs, 24 states have passed laws that have licensing or

registration requirements for PEOs, and several other states are considering such regulation. Such laws vary from
state to state, but generally provide for monitoring the fiscal responsibility of PEOs, and in some cases codify and
clarify the co-employment relationship for unemployment, workers’ compensation and other purposes under state
law. While the Company generally supports licensing regulation because it serves to validate the PEO relationship,
there can be no assurance that the Company will be able to satisfy licensing requirements or other applicable
regulations for all states. In addition, there can be no assurance that the Company will be able to renew its licenses
in all states.

401(k) Recordkeeping Services

On October 1, 2003, the Company began performing recordkeeping services for the Administaff 401(k)

Plan (“Plan”), and on December 31, 2003, began performing such services for the Administaff Spinoff 401(k) Plan
and Administaff Corporate 401(k) Plan. In addition, the Company began to offer such services to certain other
defined contribution plans, which are sponsored and maintained by PEO and non-PEO clients (“Other Plans”).
Historically, the Company has contracted with a third party administrator to provide a majority of the recordkeeping
functions associated with the Plan and has not offered any significant services with respect to Other Plans. Failure to
manage this new service effectively could have a material adverse effect on the Company’s financial condition and
results of operations.

Geographic Market Concentration

While the Company has sales offices in 21 markets, the Company’s Houston and Texas (including Houston)

markets accounted for approximately 22% and 40%, respectively, of the Company’s revenues for the year ended
December 31, 2003. Accordingly, while a primary aspect of the Company’s strategy is expansion in its current and
future markets outside of Texas, for the foreseeable future, a significant portion of the Company’s revenues may be
subject to economic factors specific to Texas (including Houston).

- 41 -

Potential Client Liability for Employment Taxes

Pursuant to the CSA, the Company assumes sole responsibility and liability for the payment of federal

employment taxes imposed under the Code with respect to wages and salaries paid to its worksite employees. There
are essentially three types of federal employment tax obligations: (i) income tax withholding requirements; (ii)
obligations under the Federal Income Contribution Act (“FICA”); and (iii) obligations under the Federal
Unemployment Tax Act (“FUTA”). Under the Code, employers have the obligation to withhold and remit the
employer portion and, where applicable, the employee portion of these taxes. Most states impose similar
employment tax obligations on the employer. While the CSA provides that the Company has sole legal
responsibility for making these tax contributions, the IRS or applicable state taxing authority could conclude that
such liability cannot be completely transferred to the Company. Accordingly, in the event the Company fails to meet
its tax withholding and payment obligations, the client company may be held jointly and severally liable therefor.
While this interpretive issue has not, to the Company’s knowledge, discouraged clients from enrolling with the
Company, there can be no assurance that a definitive adverse resolution of this issue would not do so in the future.

ITEM 7A. QUALITATIVE AND QUANTITATIVE DISCLOSURES ABOUT MARKET RISK.

The Company is primarily exposed to market risks from fluctuations in interest rates and the effects of those

fluctuations on the market values of its cash equivalent short-term investments, its available-for-sale marketable
securities, and its credit facilities. The cash equivalent short-term investments consist primarily of overnight
investments, which are not significantly exposed to interest rate risk, except to the extent that changes in interest
rates will ultimately affect the amount of interest income earned on these investments. The available-for-sale
marketable securities are subject to interest rate risk because these securities generally include a fixed interest rate.
As a result, the market values of these securities are affected by changes in prevailing interest rates.

The Company attempts to limit its exposure to interest rate risk primarily through diversification and low
investment turnover. The Company’s marketable securities are currently managed by two professional investment
management companies, each of which is guided by the Company’s investment policy. The Company’s investment
policy is designed to maximize after-tax interest income while preserving its principal investment. As a result, the
Company’s marketable securities consist primarily of short and intermediate-term debt securities.

As of December 31, 2003, the Company’s available-for-sale marketable securities included an investment in

a mutual fund that holds corporate debt securities with maturities up to 18 months. The amortized cost basis, fair
market value and 30-day yield of this investment was $11.1 million, $11.1 million and 2.05% at December 31, 2003.
The following table presents information about the Company’s available-for-sale marketable securities, excluding the
mutual fund investment, as of December 31, 2003 (dollars in thousands):

Principal
Maturities

Average
Interest Rate

2004
2005
2006
2007
2008
2009
Total
Fair Market Value

$
$

1,382
6,775
3,028
307
955
350
12,797
12,912

4.8%
2.1%
2.2%
3.0%
1.8%
2.2%
2.4%

- 42 -

The Company’s mortgage and term loan include variable interest rates, and as a result, the Company’s total

cost of borrowing under these agreements is also subject to interest rate risk. As of December 31, 2003 the
Company had borrowed $39.1 million under these agreements with a weighted average interest rate of 4.5%. At
December 31, 2003, the fair market value of the Company’s variable rate borrowings approximated their carrying
value. The following table presents information about the Company’s variable interest rate borrowings as of
December 31, 2003 (dollars in thousands):

2004
2005
2006
2007
2008
Thereafter

Principal
Maturities

1,394
1,417
1,440
1,364
30,677
2,809
39,101

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.

The information required by this Item 8 is contained in a separate section of this Annual Report. See

“Index to Consolidated Financial Statements” on page F-1.

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.

None.

ITEM 9A. CONTROLS AND PROCEDURES

In accordance with Exchange Act Rules 13a-15 and 15a-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 December 31, 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 December 31, 2003 that has materially affected, or is reasonably likely to materially affect,
the Company’s internal controls over financial reporting.

- 43 -

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.

Some of the information required by this item is incorporated by reference to the information set forth

under the captions “Proposal Number 1: Election of Directors – Nominees – Class III Directors (For Terms Expiring
at the 2007 Annual Meeting),” “– Directors Remaining in Office,” and “– Section 16(a) Beneficial Ownership
Reporting Compliance” in the Company’s definitive Proxy Statement to be filed with the Securities and Exchange
Commission pursuant to Regulation 14A within 120 days after the end of the fiscal year covered by this report (the
“Administaff Proxy Statement”).

Code of Business Conduct and Ethics

Pursuant to Rule 303A.10 of the NYSE Manual, the Company is required to adopt a code of business

conduct and ethics for directors, officers and employees of the Company. In January 2004, the Board of Directors
adopted the Code of Business Conduct and Ethics (the “Code of Ethics”), which also meets the requirements of a
code of ethics under Item 406 of Regulation S-K. You can access the Company’s Code of Ethics on the Investor
Relations page of the Company’s website at www.administaff.com. Any stockholder who so requests may obtain a
printed copy of the Code of Ethics from the Company. Changes in and waivers to the Code of Ethics for the
Company’s directors, executive officers and certain senior financial officers will be posted on the Company’s
Internet website within five business days and maintained for at least twelve months.

ITEM 11. EXECUTIVE COMPENSATION.

The information required by this item is incorporated by reference to the information set forth under the

captions “Proposal Number 1: Election of Directors – Director Compensation” and “—Executive Compensation” in
the Administaff Proxy Statement.

- 44 -

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS.

Equity Compensation Plan Information

The following table sets forth information about Administaff's common stock that may be issued under all

of the Company’s existing equity compensation plans as of December 31, 2003 (in thousands, except price per share
amounts):

Plan category

Equity compensation plans approved by
security holders (1)

Equity compensation plan not approved by
security holders (3)

Total

Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights

Weighted average
exercise price of
outstanding
options, warrants
and rights

Number of securities
remaining available
for future issuance

2,344

17.14

2,695

5,039

19.79

18.56

997 (2)

563 (4)

1,560

(1) The 1997 Incentive Plan and the 2001 Incentive Plan have been approved by the Company’s stockholders.
(2) The securities remaining available for issuance may be issued in the form of stock options, performance awards,

stock awards, stock appreciation rights, bonus stock and other stock-based awards.

(3) The Administaff Nonqualified Stock Option Plan was not approved by stockholders. For a description of the

material features of the Nonqualified Stock Option Plan, see the Employee Incentive Plan footnote in Note 9 in
the Notes to Consolidated Financial Statements included in this report.

(4) Shares of common stock may be issued pursuant to the 1997 Employee Stock Purchase Plan (“ESPP”), which
enables employees of the Company to purchase Administaff common stock through payroll deductions each
calendar month. After the end of each calendar month, shares of common stock are purchased by the ESPP.
Participants may enroll, change or discontinue payroll deductions at any time. The Company pays all expenses of
the ESPP other than brokerage commissions for sales. The ESPP was not approved by stockholders, and does
not include a limitation on the number of shares that may be issued thereunder.

Additional information required by this item is incorporated by reference to the information set forth under

the caption “Security Ownership of Certain Beneficial Owners and Management” in the Administaff Proxy
Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.

The information required by this item is incorporated by reference to the information set forth under the

caption “Proposal Number 1: Election of Directors – Certain Relationships and Related Transactions” in the
Administaff Proxy Statement.

ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES

The information required by this item is incorporated by reference to the information set forth under the

caption “Proposal Number 2: Ratification and Appointment of Independent Public Accountants – Fees of Ernst &
Young LLP” and “—Finance, Risk Management and Audit Committee Pre-Approval Policy for Audit and Non-
Audit Services” in the Administaff Proxy Statement.

- 45 -

PART IV

ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.

(a)

Financial Statements of the Company

The Consolidated Financial Statements listed by the Registrant on the accompanying Index to
Consolidated Financial Statements (see page F-1) are filed as part of this Annual Report.

(a)

Financial Statement Schedules

The required information is included in the Consolidated Financial Statements or Notes thereto.

(a)

List of Exhibits

3.1 Certificate of Incorporation (incorporated by reference to Exhibit 3.1 to the Registrant’s

Registration Statement on Form S-1 (No. 33-96952)).

3.2 Bylaws, as amended on March 7, 2001 (incorporated by reference to Exhibit 3.2 to the

Registrant’s Form 10-K filed for the year ended December 31, 2000).
3.3 Certificate of Designations of Series A Junior Participating Preferred Stock of

Administaff, Inc. Dated February 4, 1998 (incorporated by reference to Exhibit 2 to the
Registrant’s Form 8-A filed on February 4, 1998).
Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the
Registrant’s Registration Statement on Form S-1 (No. 33-96952)).

4.1

4.2 Rights Agreement dated as of February 4, 1998, between Administaff, Inc. and Harris
Trust and Savings Bank, as Rights Agent (incorporated by reference to Exhibit 1 to the
Registrant’s Form 8-A filed on February 4, 1998).

4.3 Amendment No. 1 to Rights Agreement dated as of March 9, 1998 between Administaff,

Inc. and Harris Trust and Savings Bank, as Rights Agent (incorporated by reference to
Exhibit 4.3 to the Registrant’s Form 10-K for the year ended December 31, 1999).
4.4 Amendment No. 2 to Rights Agreement dated as of May 14, 1999 between Administaff,

Inc. and Harris Trust and Savings Bank, as Rights Agent (incorporated by reference to
Exhibit 2 to the Registrant’s Form 8-A/A filed on May 19, 1999).

4.5 Amendment No. 3 to Rights Agreement dated as of July 22, 1999 between Administaff,
Inc. and Harris Trust and Savings Bank, as Rights Agent (incorporated by reference to
Exhibit 1 to the Registrant’s Form 8-A/A filed on August 9, 1999).

4.6 Amendment No. 4 to Rights Agreement dated as of August 2, 1999 between Administaff,

Inc. and Harris Trust and Savings Bank, as Rights Agent (incorporated by reference to
Exhibit 2 to the Registrant’s form 8-A/A filed on August 9, 1999).

4.7 Form of Rights Certificate (incorporated by reference to Exhibit 3 to the Registrant’s

Form 8-A filed on February 4, 1998).

4.8 Amended and Restated Rights Agreement effective as of April 19, 2003 between

Administaff, Inc. and Mellon Investor Services LLC, as Rights Agent (incorporated by
reference to Exhibit 1 to the Registrant’s Form 8-A/A filed on May 16, 2003).
4.9 Amendment No. 1 to Amended and Restated Rights Agreement dated as of August 21,

2003 between Administaff, Inc. and Mellon Investor Services LLC, as Rights Agent
(incorporated by reference to Exhibit 1 to the Registrant’s Form 8A/A filed on August 22,
2003).

4.10* Amendment No. 2 to Amended and Restated Rights Agreement dated as of February 24,

2004 between Administaff, Inc. and Mellon Investor Services LLC, as Rights Agent.

- 46 -

4.11 Securities Purchase Agreement between Administaff, Inc. and American Express Travel
Related Services Company, Inc., dated January 27, 1998 and the Letter Agreement
between Administaff, Inc. and American Express Travel Related Services Company, Inc.,
dated March 10, 1998 amending the Securities Purchase Agreement (incorporated by
reference to Exhibit 4.2 to the Registrant’s Form 10-Q for the quarter ended March 31,
1998).

4.12 Registration Rights Agreement between Administaff, Inc. and American Express Travel

Related Services Company, Inc., dated March 10, 1998 (incorporated by reference to
Exhibit 4.3 to the Registrant’s Form 10-Q for the quarter ended March 31, 1998).

4.13 Warrant Agreement between Administaff, Inc. and American Express Travel Related

Services Company, Inc., dated March 10, 1998 (incorporated by reference to Exhibit 4.4
to the Registrant’s Form 10-Q for the quarter ended March 31, 1998).

4.14 Warrant Certificate No. 4 for American Express Travel Related Services Company, Inc.

(incorporated by reference to Exhibit 4.8 to the Registrant’s Form 10-Q for the quarter
ended March 31, 1998).

4.15 Warrant Certificate No. 5 for American Express Travel Related Services Company, Inc.

(incorporated by reference to Exhibit 4.9 to the Registrant’s Form 10-Q filed for the
quarter ended March 31, 1998).

10.1** Administaff, Inc. 1997 Incentive Plan (incorporated by reference to Exhibit 99.1 to the

Registrant’s Registration Statement on Form S-8 (No. 333-85151)).

10.2** First Amendment to the Administaff, Inc. 1997 Incentive Plan (incorporated by reference
to Exhibit 99.2 to the Registrant’s Registration Statement on Form S-8 (No. 333-85151)).

10.3** Second Amendment to the Administaff, Inc. 1997 Incentive Plan (incorporated by

reference to Exhibit 99.3 to the Registrant’s Registration Statement on Form S-8 (No.
333-85151)).

10.4** Third Amendment to the Administaff, Inc. 1997 Incentive Plan (incorporated by reference
to Exhibit 99.4 to the Registrant’s Registration Statement on Form S-8 (No. 333-85151)).

10.5** Fourth Amendment to the Administaff, Inc. 1997 Incentive Plan (incorporated by

reference to Exhibit 99.5 to the Registrant’s Registration Statement on Form S-8 (No.
333-85151)).

10.6** Administaff, Inc. 2001 Incentive Plan (incorporated by reference to Exhibit 10.1 to the

Registrant’s Form 10-Q filed for the quarter ended March 31, 2001).

10.8

10.7 Administaff, Inc. Nonqualified Stock Option Plan (incorporated by reference to Exhibit
99.6 to the Registrant’s Registration Statement on Form S-8 (No. 333-85151)).
First Amendment to Administaff, Inc. Nonqualified Stock Option Plan, effective August
7, 2001 (incorporated by reference to Exhibit 10.8 to the Registrant’s Form 10-K for the
year ended December 31, 2002).
Second Amendment to Administaff, Inc. Nonqualified Stock Option Plan, effective
January 28, 2003 (incorporated by reference to Exhibit 10.9 to the Registrant’s Form 10-
K for the year ended December 31, 2002).

10.9

10.10 Administaff, Inc. Amended and Restated Employee Stock Purchase Plan effective April

1, 2002 (incorporated by reference to Exhibit 10.10 to the Registrant’s Form 10-K for the
year ended December 31, 2002).

10.11 First Amendment to Administaff, Inc. Amended and Restated Employee Stock Purchase
Plan, effective July 31, 2002 (incorporated by reference to Exhibit 10.11 to the
Registrant’s Form 10-K for the year ended December 31, 2002).

10.12* Second Amendment to Administaff, Inc. Amended and Restated Employee Stock

Purchase Plan, effective August 15, 2003.

10.13 Marketing Agreement between American Express Travel Related Services Company,

Inc., Administaff, Inc., Administaff Companies, Inc. and Administaff of Texas, Inc. dated
March 10, 1998 (incorporated by reference to Exhibit 10.1 to the Registrant’s Form 10-Q
for the quarter ended March 31, 1998).

- 47 -

10.14 First Amendment to the Marketing Agreement between American Express Travel Related
Services Company, Inc., Administaff, Inc., Administaff Companies, Inc. and Administaff
of Texas, Inc., dated November 17, 1998 (incorporated by reference to Exhibit 10.12 to
the Registrant’s Form 10-K for the year ended December 31, 1998)).

10.15 Second Amendment to the Marketing Agreement between American Express Travel

Related Services Company, Inc. and Administaff, Inc., Administaff Companies, Inc. and
Administaff of Texas, Inc., dated April 11, 2000 (incorporated by reference to Exhibit
10.1 to the Registrant’s Form 10-Q for the quarter ended June 30, 2000).
10.16 Letter Agreement between Administaff, Inc. and American Express Travel Related

Services Company, Inc., dated February 16, 2001 (incorporated by reference to Exhibit
10.1 to the Registrant’s form 10-Q for the quarter ended March 31, 2001).

10.17 Letter Agreement between Administaff, Inc. and American Express Foundation, dated

February 16, 2001 (incorporated by reference to Exhibit 10.2 to the Registrant’s Form 10-
Q for the quarter ended March 31, 2001).

10.18 Third Amendment to the Marketing Agreement between American Express Travel

Related Services Company, Inc., Administaff, Inc., Administaff Companies, Inc. and
Administaff of Texas, Inc., dated June 21, 2002 (incorporated by reference to Exhibit
10.2 to the Registrant’s Form 10-Q for the quarter ended June 30, 2002).
10.19 Promissory Note dated December 20, 2002 executed by Administaff Services, L.P,

payable to General Electric Capital Business Asset Funding Corporation (incorporated by
reference to Exhibit 10.18 to the Registrant’s Form 10-K for the year ended December
31, 2002).

10.20 Guaranty dated December 20, 2002 by Administaff, Inc. in favor of General Electric

Capital Business Asset Funding Corporation (incorporated by reference to Exhibit 10.19
to the Registrant’s Form 10-K for the year ended December 31, 2002).

10.21 Commercial Deed of Trust, Security Agreement, Assignment of Leases and Rents, and

Fixture Filing, dated December 20, 2002, executed by Administaff Services, L.P. in favor
of General Electric Capital Business Asset Funding Corporation (incorporated by
reference to Exhibit 10.20 to the Registrant’s Form 10-K for the year ended December
31, 2002).

10.22 Minimum Premium Financial Agreement by and between Administaff of Texas, Inc. and
United Healthcare Insurance Company, Hartford, Connecticut (incorporated by reference
to Exhibit 10.3 to the Registrant’s Form 10-Q for the quarter ended June 30, 2002).

10.23 Minimum Premium Administrative Services Agreement by and between Administaff of
Texas, Inc. and United Healthcare Insurance Company, Hartford, Connecticut
(incorporated by reference to Exhibit 10.4 to the Registrant’s Form 10-Q for the quarter
ended June 30, 2002).

10.24 Amended and Restated Security Deposit Agreement by and between Administaff of
Texas, Inc. and UnitedHealthcare Insurance Company, Hartford, Connecticut
(incorporated by reference to Exhibit 10.5 to the Registrant’s Form 10-Q for the quarter
ended June 30, 2002).

21.1* Subsidiaries of Administaff, Inc.
23.1* Consent of Independent Auditors.
24.1* Powers of Attorney.
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.

- 48 -

32.2* Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley

Act of 2002.
_____________________

*
**

Filed herewith.
Management contract or compensatory plan or arrangement required to be filed as an
exhibit to this Form 10-K.

(b)

Reports on Form 8-K

Current Report on Form 8-K filed on November 3, 2003, furnishing Items 7 and 12 for a press
release announcing 2003 third quarter results.

Current Report on Form 8-K filed on December 10, 2003, filing Items 5 and 7 for a press release
announcing modification of Mr. Sarvadi’s Rule 10b5-1 trading plan.

- 49 -

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, Administaff, Inc.

has duly caused this report to be signed in its behalf by the undersigned, thereunto duly authorized, on February 25,
2004.

ADMINISTAFF, INC.

By: /s/ DOUGLAS S. SHARP

Douglas S. Sharp
Vice President, Finance
Chief Financial Officer and Treasurer

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the

following persons on behalf of the registrant in the capacities indicated on February 25, 2004:

Title

Chairman of the Board, Chief Executive Officer
and Director
(Principal Executive Officer)

President and Director

Vice President, Finance
Chief Financial Officer and Treasurer
(Principal Financial Officer)

Director

Signature

/s/ Paul J. Sarvadi
Paul J. Sarvadi

/s/ Richard G. Rawson
Richard G. Rawson

/s/ Douglas S. Sharp
Douglas S. Sharp

*
Michael W. Brown

*
Jack M. Fields, Jr.

*
Paul S. Lattanzio

*
Gregory E. Petsch

*
Austin P. Young

* By: /s/ John H. Spurgin, II
John H. Spurgin, II, attorney-in-fact

- 50 -

ADMINISTAFF, INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

Report of Independent Auditors ................................................................................................................................. F-2

Consolidated Balance Sheets as of December 31, 2003 and 2002 ............................................................................. F-3

Consolidated Statements of Operations for the years ended

December 31, 2003, 2002 and 2001 ....................................................................................................................... F-5

Consolidated Statements of Stockholders’ Equity for the years ended

December 31, 2003, 2002 and 2001 ....................................................................................................................... F-6

Consolidated Statements of Cash Flows for the years ended

December 31, 2003, 2002 and 2001 ....................................................................................................................... F-7

Notes to Consolidated Financial Statements .............................................................................................................. F-9

F-1

THIS PAGE INTENTIONALLY LEFT BLANK

REPORT OF INDEPENDENT AUDITORS

Board of Directors and Stockholders
Administaff, Inc.

We have audited the accompanying consolidated balance sheets of Administaff, Inc. as of December 31, 2003
and 2002, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three
years in the period ended December 31, 2003. These financial statements are the responsibility of the Company’s
management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those
standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe
that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the
consolidated financial position of Administaff, Inc. at December 31, 2003 and 2002, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended December 31, 2003, in conformity with
accounting principles generally accepted in the United States.

ERNST & YOUNG LLP

Houston, Texas
February 5, 2004

F-2

ADMINISTAFF, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands)

ASSETS

December 31,

2003

2002

Current assets:

Cash and cash equivalents ........................................................................................ $ 104,728
4,584
Restricted cash..........................................................................................................
Marketable securities................................................................................................
23,989
Accounts receivable:

Trade ...................................................................................................................
Unbilled...............................................................................................................
Other ...................................................................................................................
Prepaid insurance......................................................................................................
Other current assets ..................................................................................................
Deferred income taxes ..............................................................................................
Total current assets..............................................................................................

5,752
53,033
2,959
22,554
7,468
3,423
228,490

Property and equipment:

Land..........................................................................................................................
Buildings and improvements ....................................................................................
Computer hardware and software .............................................................................
Software development costs .....................................................................................
Furniture and fixtures ...............................................................................................
Vehicles and aircraft.................................................................................................

Accumulated depreciation ........................................................................................
Total property and equipment .............................................................................

2,920
55,465
49,822
18,699
27,997
6,090
160,993
(82,224)
78,769

$ 71,799
—
14,714

5,161
74,358
2,956
10,409
12,126
641
192,164

2,920
53,899
46,972
16,820
27,491
6,692
154,794
(62,417)
92,377

Other assets:

Deposits ....................................................................................................................
39,909
Other assets...............................................................................................................
903
40,812
Total other assets.................................................................................................
Total assets.......................................................................................................... $ 348,071

26,552
4,071
30,623
$ 315,164

F-3

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

LIABILITIES AND STOCKHOLDERS’ EQUITY

December 31,

2003

2002

Current liabilities:

Accounts payable ..................................................................................................... $
Payroll taxes and other payroll deductions payable..................................................
Accrued worksite employee payroll cost..................................................................
Accrued health insurance costs.................................................................................
Accrued workers’ compensation costs .....................................................................
Other accrued liabilities............................................................................................
Income taxes payable................................................................................................
Current portion of long-term debt.............................................................................
Total current liabilities...................................................................................

4,319
65,310
65,503
6,559
5,489
15,898
7,520
1,860
172,458

3,069
57,228
69,676
5,815
95
13,019
348
1,676
150,926

Noncurrent liabilities:

Long-term debt .........................................................................................................
Accrued workers’ compensation costs .....................................................................
Deferred income taxes ..............................................................................................
Total noncurrent liabilities.............................................................................

40,502
7,417
5,060
52,979

42,493
—
5,396
47,889

Commitments and contingencies

Stockholders’ equity:

Preferred stock, par value $0.01 per share:

Shares authorized – 20,000
Shares issued and outstanding - none..................................................................

—

Common stock, par value $0.01 per share:

Shares authorized – 60,000
Shares issued – 30,839 and 30,839

at December 31, 2003 and 2002, respectively ...............................................
Additional paid-in capital .........................................................................................
Treasury stock, at cost – 4,120 and 2,946 shares

309
101,681

309
102,315

at December 31, 2003 and 2002, respectively ...............................................
—
Accumulated other comprehensive income, net of tax .............................................
69,439
Retained earnings .....................................................................................................
Total stockholders’ equity..............................................................................
122,634
Total liabilities and stockholders’ equity ....................................................... $ 348,071

(48,795)

(43,003)
153
56,575
116,349
$ 315,164

See accompanying notes.

F-4

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

Year ended December 31,

2003

2002

2001

Revenues (gross billings of $4.830 billion, $4.857 billion and

$4.373 billion less worksite employee payroll cost of
$3.938 billion, $4.009 billion, and $3.653 billion, respectively)

$ 891,721

$ 848,416

$ 720,219

Direct costs:

Payroll taxes, benefits and workers’ compensation costs ......

693,754

682,626

555,204

Gross profit .................................................................................

197,967

165,790

165,015

Operating expenses:

Salaries, wages and payroll taxes...........................................
General and administrative expenses.....................................
Commissions..........................................................................
Advertising ............................................................................
Depreciation and amortization ...............................................

Operating income ........................................................................

Other income (expense):

Interest income.......................................................................
Interest expense .....................................................................
Write-off of investments ........................................................
Other, net ...............................................................................

Income (loss) before income tax expense ...................................
Income tax expense .....................................................................
Net income (loss) from continuing operations ............................

Discontinued operations:

Loss from discontinued operations ........................................
Income tax expense (benefit) .................................................
Net loss from discontinued operations...................................

83,195
50,502
10,656
8,581
20,759
173,693
24,274

1,910
(2,176)
—
462
196
24,470
9,485
14,985

(3,264)
(1,143)
(2,121)

74,989
50,172
12,127
7,138
21,297
165,723
67

1,772
(437)
(3,354)
272
(1,747)
(1,680)
1,241
(2,921)

(1,917)
(757)
(1,160)

67,761
44,569
11,173
6,092
16,881
146,476
18,539

4,128
—

(3,786)
506
848
19,387
9,030
10,357

—
—
—

Net income (loss) ........................................................................

12,864

(4,081)

10,357

Basic net income (loss) per share of common stock:

Income (loss) from continuing operations .............................
Loss from discontinued operations ........................................
Basic net income (loss) per share of common stock....................

Diluted net income (loss) per share of common stock:

Income (loss) from continuing operations .............................
Loss from discontinued operations ........................................
Diluted net income (loss) per share of common stock ................

0.56
(0.08)
0.48

0.55
(0.08)
0.47

(0.11)
(0.04)
(0.15)

0.38
—
0.38

0.36
—
0.36

See accompanying notes.

F-5

ADMINISTAFF, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands)

Common Stock
Issued
Shares Amount

Additional

Accumulated
Other

Paid-In Treasury Comprehensive Retained
Earnings
Capital

Income (Loss)

Stock

Total

Balance at December 31, 2000

Purchase of treasury stock, at cost
Exercise of common stock
purchase warrant
Exercise of stock options
Income tax benefit from

exercise of stock options

Other
Change in unrealized gain on

marketable securities (net of tax):
Unrealized gain
Realized gain

Net income
Comprehensive income
Balance at December 31, 2001

Purchase of treasury stock, at cost
Exercise of common stock
purchase warrant
Sale of common stock to Administaff
Employee Stock Purchase Plan
Sale of treasury stock to Administaff
Employee Stock Purchase Plan

Exercise of stock options
Income tax benefit from

exercise of stock options

Other
Change in unrealized gain on

marketable securities (net of tax):
Unrealized gain
Realized gain

Net loss
Comprehensive loss

Balance at December 31, 2002

Purchase of treasury stock, at cost
Sale of treasury stock to Administaff
Employee Stock Purchase Plan

Exercise of stock options
Income tax benefit from

exercise of stock options

Other
Change in unrealized gain (loss) on
marketable securities (net of tax):
Unrealized loss
Realized gain

Net income
Comprehensive income
Balance at December 31, 2003

172
—

—
—

185
(33)
—

324
—

—

—
—

30,435
—

—
341

—
—

—
—
—

30,776
—

304
—

75,378

(20,643)
— (21,566)

—
4

—
—

—
—
—

14,136
3,620

1,957
23

—
—
—

8,707
—

—
35

—
—
—

308
—

95,114

(33,467)
— (17,088)

6,952

6,205

—

—
59

—
—

—
—
—

—

—
1

—
—

—
—
—

—

1,185
—

—
162

109

(724)
742

203
(81)

—
—
—

23
(194)
—

30,839
—

$ 309
—

$102,315
—

$(43,003)
(8,233)

$ 153
—

—
—

(322)
(466)

249
(95)

848
1,343

—
250

—
—
—
—
30,839

—
—
—
—
$ 309

—
—
—
—

—
—
—
—
$101,681 $ (48,795)

See accompanying notes.

—
—

(109)
(44)
—
—
—

F-6

50,299

105,510
— (21,566)

—
—

22,843
3,624

1,957
58

—
—
10,357

185
(33)
10,357
10,509
122,935
— (17,088)

60,656

—

—
—

13,157

109

461
743

203
81

—
—
(4,081)

$56,575
—

23
(194)
(4,081)
(4,252)
$116,349
(8,233)

—
—

526
877

249
155

—
—
12,864
—
$69,439

(109)
(44)
12,864
12,711
$122,634

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

Year ended December 31,
2002

2003

2001

Cash flows from operating activities:

Net income (loss).....................................................................
Adjustments to reconcile net income (loss) to
net cash provided by operating activities:
Depreciation and amortization ...........................................
Write-off of investments ....................................................
Deferred income taxes........................................................
Bad debt expense ...............................................................
Gain on disposition of assets..............................................
Changes in operating assets and liabilities:
Restricted cash ..............................................................
Accounts receivable......................................................
Prepaid insurance..........................................................
Other current assets.......................................................
Other assets...................................................................
Accounts payable..........................................................
Payroll taxes and other payroll deductions payable ......
Accrued worksite employee payroll expense................
Accrued health insurance costs.....................................
Accrued workers’ compensations costs ........................
Other accrued liabilities ................................................
Income taxes payable/receivable .................................
Total adjustments.......................................................
Net cash provided by operating activities ..................

Cash flows from investing activities:

Marketable securities:

Purchases............................................................................
Proceeds from maturities....................................................
Proceeds from dispositions.................................................
Cash received (exchanged) for note receivable .......................
Property and equipment:

Purchases............................................................................
Investment in software development costs.........................
Proceeds from dispositions.................................................
Proceeds from the sale of / (investments in) other companies .
Net cash used in investing activities..........................

$ 12,864

$ (4,081)

$ 10,357

22,185
—
(3,018)
494
(467)

(4,584)
20,237
(4,645)
1,949
(17,886)
1,250
8,082
(4,173)
744
12,811
2,879
7,172
43,030
55,894

(25,779)
6,645
9,612
2,958

(6,771)
(1,880)
275
457

(14,483)

21,857
3,354
77
1,139
(268)

—
(7,654)
(10,165)
(5,948)
(12,623)
(1,263)
7,420
6,826
4,489
(2,114)
2,067
16
7,210
3,129

(15,499)
23,436
25,130
(2,983)

(36,677)
(1,748)
148
(500)
(8,693)

17,075
3,786
(1,834)
1,783
(82)

—
(12,528)
3,509
(463)
(14,833)
2,836
(14,225)
11,610
1,326
2,129
213
(121)
181
10,538

(56,604)
39,005
8,817
—

(33,232)
(3,516)
431
(931)
(46,030)

F-7

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

Cash flows from financing activities:

Purchase of treasury stock .......................................................
Proceeds from the exercise of common
stock purchase warrants........................................................
Proceeds from sale of common stock to the
employee stock purchase plan..............................................
Proceeds from the exercise of stock options............................
Long-term debt and short-term borrowings:

Borrowings under long-term debt agreements .....................
Net borrowings under revolving line of credit .....................
Deferred financing costs ......................................................
Principal repayments on long-term debt

and capital lease obligations.............................................
Loans to employees .................................................................
Other........................................................................................
Net cash provided by (used in) financing activities ......

Year ended December 31,
2002

2001

2003

(8,233)

$ (17,088)

$ (21,566)

—

526
877

—
—
—

(1,807)
—
155
(8,482)

13,157

22,843

570
743

40,500
(13,500)
(689)

(105)
694
81
24,363

—
3,624

—
13,500
—

—
300
58
18,759

Net increase (decrease) in cash and cash equivalents .................
Cash and cash equivalents at beginning of year..........................
Cash and cash equivalents at end of year ....................................

32,929
71,799
$ 104,728

18,799
53,000
$ 71,799

(16,733)
69,733
$ 53,000

Supplemental disclosures:

Cash paid for income taxes......................................................
Cash paid for interest...............................................................

$
$

5,072
2,053

$
$

663
209

$ 11,259
—
$

Noncash Investing and Financing Activities:

During 2002, the Company entered into a long-term capital lease agreement to finance the purchase of office
furniture with a purchase price of $3.8 million.

See accompanying notes.

F-8

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2003

1. Accounting Policies

Description of Business

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.

The Company provides its comprehensive service by entering into a co-employment relationship with its

clients, under which the Company and its clients each take responsibility for certain portions of the employer-
employee relationship. The Company and its clients designate each party’s responsibilities through its Client
Services Agreement (“CSA”), under which the Company becomes the employer of its worksite employees for most
administrative and regulatory purposes.

As a co-employer of its worksite employees, the Company assumes most of the rights and obligations

associated with being an employer. The Company enters into an employment agreement with each worksite
employee, thereby maintaining a variety of employer rights, including the right to hire or terminate employees, the
right to evaluate employee qualifications or performance, and the right to establish employee compensation levels.
Typically, the Company only exercises these rights in consultation with its clients or when necessary to ensure
regulatory compliance. The responsibilities associated with the Company’s role as employer include the following
obligations with regard to its worksite employees: (i) to compensate its worksite employees through wages and
salaries; (ii) to pay the employer portion of payroll-related taxes; (iii) to withhold and remit (where applicable) the
employee portion of payroll-related taxes; (iv) to provide employee benefit programs; and (v) to provide workers’
compensation insurance coverage.

In addition to its assumption of employer status for its worksite employees, the Company’s comprehensive

service also includes other human resource functions for its clients to support the effective and efficient use of
personnel in their business operations. To provide these functions, the Company maintains a significant staff of
professionals trained in a wide variety of human resource functions, including employee training, employee
recruiting, employee performance management, employee compensation, and employer liability management. These
professionals interact and consult with clients on a daily basis to help identify each client’s service requirements and
to ensure that the Company is providing appropriate and timely personnel management services.

The Company provides its comprehensive service to small and medium-sized businesses in strategically

selected markets throughout the United States. During 2003, 2002 and 2001, revenues from the Company’s Texas
markets represented 40%, 43% and 47% of the Company’s total revenues, respectively.

Revenue and Direct Cost Recognition

The Company accounts for its revenues in accordance with EITF 99-19, Reporting Revenues Gross as a

Principal Versus Net as an Agent. The Company’s revenues are derived from its gross billings, which are based on
(i) the payroll cost of its worksite employees; and (ii) a markup computed as a percentage of the payroll cost. The
gross billings are invoiced concurrently with each periodic payroll of its worksite employees. Revenues are

F-9

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

recognized ratably over the payroll period as worksite employees perform their service at the client worksite.
Revenues that have been recognized but not invoiced are included in unbilled accounts receivable on the Company’s
Consolidated Balance Sheets.

In determining the pricing of the markup component of the gross billings, the Company takes into

consideration its estimates of the costs directly associated with its worksite employees, including payroll taxes,
benefits and workers’ compensation costs, plus an acceptable gross profit margin. As a result, the Company’s
operating results are significantly impacted by the Company’s ability to accurately estimate, control and manage its
direct costs relative to the revenues derived from the markup component of the Company’s gross billings.

Consistent with its revenue recognition policy, the Company’s direct costs do not include the payroll cost of

its worksite employees. The Company’s direct costs associated with its revenue generating activities are comprised
of all other costs related to its worksite employees, such as the employer portion of payroll-related taxes, employee
benefit plan premiums and workers’ compensation insurance costs.

Segment Reporting

The Company operates in one reportable segment under the Statement of Financial Accounting Standards

(“SFAS”) No. 131, Disclosures about Segments of an Enterprise and Related Information.

Principles of Consolidation

The consolidated financial statements include the accounts of Administaff, Inc. and its wholly owned

subsidiaries. Intercompany accounts and transactions have been eliminated in consolidation.

Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted 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.

Concentrations of Credit Risk

Financial instruments that could potentially subject the Company to concentration of credit risk include

accounts receivable.

Cash and Cash Equivalents

Cash and cash equivalents include bank deposits and short-term investments with original maturities of

three months or less at the date of purchase.

Marketable Securities

The Company accounts for marketable securities in accordance with SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities. The Company determines the appropriate classification of all marketable
securities as held-to-maturity, available-for-sale or trading at the time of purchase, and re-evaluates such
classification as of each balance sheet date. At December 31, 2003 and 2002, all of the Company’s investments in
marketable securities were classified as available-for-sale, and as a result, were reported at fair value. Unrealized
gains and losses are reported as a component of accumulated other comprehensive income (loss) in stockholders’
equity. The amortized cost of debt securities is adjusted for amortization of premiums and accretion of discounts
from the date of purchase to maturity. Such amortization is included in interest income as an addition to or

F-10

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

deduction from the coupon interest earned on the investments. The Company follows its investment managers’
methods of determining the cost basis in computing realized gains and losses on the sale of its available-for-sale
securities, which includes both the specific identification and average cost methods. Realized gains and losses are
included in other income (expense).

Property and Equipment

Property and equipment is recorded at cost and is depreciated over the estimated useful lives of the related

assets using the straight-line method. The estimated useful lives of property and equipment for purposes of
computing depreciation are as follows:

Buildings and improvements...................................................................................... 5-30 years
Computer hardware and software............................................................................... 2-5 years
Software development costs ....................................................................................... 3-5 years
Furniture and fixtures ................................................................................................. 5-7 years
Aircraft ....................................................................................................................... 10 years
5 years
Vehicles......................................................................................................................

Software development costs relate primarily to the Company’s proprietary professional employer
information system and its Internet-based service delivery platform, the Employee Service Center, and are accounted
for in accordance with Statement of Position (“SOP”) 98-1, Accounting for the Costs of Computer Software

Developed or Obtained for Internal Use.

The Company periodically evaluates its long-lived assets for impairment in accordance with SFAS No. 144,
Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 requires that an impairment loss be
recognized for assets to be disposed of or held-for-use when the carrying amount of an asset is deemed to not be
recoverable. If events or circumstances were to indicate that any of the Company’s long-lived assets might be
impaired, the Company would analyze the estimated undiscounted future cash flows to be generated from the
applicable asset. In addition, the Company would record an impairment loss to the extent that 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.

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 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 plan, up to the
amount of the Company’s then-outstanding security deposit with United. As a result of these contractual terms, the
Company accounts for this plan using a partially self-funded insurance accounting model.

Each reporting period, the Company records the costs of the United Plan, including paid claims, an estimate

of the change in incurred but not reported (“IBNR”) claims, taxes and administrative fees (collectively the “Plan
Costs”) as benefits expense in the Consolidated Statements of Operations. The estimated IBNR claims are based
upon both (i) a recent average level of paid claims under the plan; and (ii) an estimated lag factor, to provide for
those claims which have been incurred but not yet paid.

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 current liability for the excess costs on its Consolidated

F-11

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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 a current asset for the excess premiums on its
Consolidated Balance Sheet. During the year ended December 31, 2003, the cash funded to United exceeded the
Plan Costs by approximately $12.3 million, resulting in an accumulated cash surplus from the inception of the plan
of approximately $10.0 million, which is recorded as prepaid insurance on the Company’s Consolidated Balance
Sheet.

As of December 31, 2003, the Company’s security deposit with United totaled $25 million. In January
2004, the security deposit was reduced to $17.5 million, at which time the $7.5 million security deposit reduction
plus accrued interest was returned to the Company. Accordingly, as of December 31, 2003, the Company has
recorded, on its Consolidated Balance Sheet, a long-term deposit of $17.5 million and prepaid insurance of $7.5
million relating to the portion returned to the Company in January 2004.

Workers’ Compensation Costs

The Company’s workers’ compensation insurance policy for the two-year period ending September 30,

2003 was a guaranteed-cost policy (“2003 Policy”) under which premiums were paid for full-insurance coverage of
all claims incurred during the policy period. This policy also contained a dividend feature for each policy year,
under which the Company was 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 were 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 estimated the amount of
refund, if any, that had 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. In addition, the Company recorded a
charge of $2.5 million in 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.

Under its arrangement with AIG, the Company makes monthly premium payments and claim deposits with

AIG. The claim deposits are retained and held by AIG in an escrow account under AIG’s Reinsurance Captive
Asset Management Program (“RCAMP”), which is used to fund workers’ compensation claims as the claims are
processed. As of December 31, 2003, the total claim deposits held in the RCAMP by AIG was $15.1 million, of
which $4.6 million is included in restricted cash and $10.5 million is included in deposits in the Company’s
Consolidated Balance Sheets.

F-12

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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. As of December 31, 2003, the Company has estimated and accrued $12.0
million in incurred but not reported workers’ compensation claims, net of paid claims, which is included in accrued
workers’ compensation costs in the Company’s Consolidated Balance Sheets. Workers’ compensation cost
estimates are discounted to present value at 2%, are accreted over the estimated claim payment period and are
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 incurred but not reported workers’

compensation claims for the year ended December 31, 2003 (in thousands):

Beginning balance
Accrued claims
Present value discount
Paid claims
Ending balance

Current portion of accrued claims
Long-term portion of accrued claims

—
13,529
(844)
(685)
12,000

4,583
7,417
12,000

Fair Value of Financial Instruments

The carrying amounts of cash, cash equivalents, accounts receivable and accounts payable approximate

their fair values due to the short-term maturities of these instruments. The carrying amount of the Company’s long-
term debt approximates its fair value due to the stated interest rates approximating market rates.

Stock-Based Compensation

At December 31, 2003, the Company has three stock-based employee compensation plans, which are
described more fully in Note 9. 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 income (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 on net income (loss) and earnings 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.

Net income (loss), as reported..................................................................
Deduct: Total stock-based employee compensation expense

determined under fair value based methods for all awards,
net of related tax effects ....................................................................
Pro forma net income (loss) .....................................................................

Year ended December 31,
2001
2002
2003
(in thousands)

$ 12,864

$ (4,081) $ 10,357

(5,800)
$ 7,064

(9,253)
$ (13,334) $

(9,610)
747

Net income (loss) per share:

Basic – as reported ............................................................................
Basic – pro forma..............................................................................
Diluted – as reported.........................................................................
Diluted – pro forma...........................................................................

$
$
$
$

0.48
0.26
0.47
0.26

$ (0.15) $
$ (0.48) $
$ (0.15) $
$ (0.48) $

0.38
0.03
0.36
0.03

F-13

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The fair value for these options was estimated at the date of grant using a Black-Scholes option pricing

model with the following assumptions:

Risk-free interest rate ...............................................................................
Expected dividend yield...........................................................................
Expected volatility ...................................................................................
Weighted average expected life (in years) ...............................................

Year ended December 31,
2001
2002
2003

3.0%
0.0%
0.92
5.0

3.8%
0.0%
0.86
5.0

4.6%
0.0%
0.69
5.0

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.

Employee Savings Plan

The Company matches 50% of an eligible worksite employee’s eligible contributions and 100% of eligible
corporate employees’ contributions, both up to 6% of the employee’s eligible compensation with immediate vesting.
During 2003, 2002 and 2001, the Company made employer-matching contributions of $10,854,000, $11,434,000 and
$8,847,000, respectively. Of these contributions, $8,494,000, $9,244,000 and $6,831,000 were made on behalf of
worksite employees. The remainder represents employer contributions made on behalf of corporate employees.

Advertising

The Company expenses all advertising costs as incurred.

Income Taxes

The Company uses the liability method in accounting for income taxes. Under this method, deferred tax

assets and liabilities are determined based on differences between financial reporting and income tax carrying
amounts of assets and liabilities and are measured using the enacted tax rates and laws that will be in effect when the
differences are expected to reverse.

Reclassifications

Certain prior year amounts have been reclassified to conform to the 2003 presentation.

New Accounting Pronouncements

In July 2002, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial

Accounting Standards No. 146, Accounting for Costs Associated with Exit or Disposal Activities (“SFAS 146”).
SFAS 146 addresses accounting and reporting for costs associated with exit or disposal activities, such as
restructurings, involuntary terminating employees, and consolidating facilities initiated after December 31, 2002.
SFAS 146, which requires that costs related to exiting an activity or to a restructuring not be recognized until the
liability is incurred, was effective for the Company beginning January 1, 2003. The adoption of SFAS 146 did not
have a material impact on the Company’s consolidated financial position, results of operations or cash flows.

F-14

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

In January 2003, the FASB issued FASB Interpretation No. 46, Consolidation of Variable Interest Entities
(“FIN 46”). This interpretation explains how to identify variable interest entities and how an enterprise assesses its
interest in a variable interest entity to decide whether to consolidate that entity. This interpretation requires existing
unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not
effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be
consolidated unless a single party holds an interest or combination of interest that effectively recombines risks that
were previously dispersed. This interpretation applies immediately to variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the
first fiscal year or interim period beginning after March 15, 2004, to variable interest entities in which an enterprise
holds a variable interest that it acquired before February 1, 2003. The adoption of FIN 46 is not expected to have a
material impact on the Company’s consolidated financial position, results of operations or cash flows.

In May 2003, the FASB issued Statement of Financial Accounting Standards No. 150, Accounting for

Certain Financial Instruments with Characteristics of Both Liabilities and Equity (“SFAS 150”). SFAS 150
requires that certain financial instruments, which under previous guidance were accounted for as equity, must now
be accounted for as liabilities. The financial instruments affected include mandatory redeemable stock, certain
financial instruments that require or may require the issuer to buy back some of its shares in exchange for cash or
other assets and certain obligations that can be settled with shares of stock. SFAS 150 is effective for all financial
instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first
interim period beginning after June 15, 2003. The adoption of SFAS 150 did not have a material impact on the
Company’s consolidated financial position, results of operations or cash flows.

2. Accounts Receivable

The Company’s accounts receivable is primarily composed of trade receivables and unbilled receivables.

The Company’s trade receivables, which represent outstanding gross billings to clients, are reported net of allowance
for doubtful accounts of $647,000 and $734,000 as of December 31, 2003 and 2002, respectively. The Company
establishes an allowance for doubtful accounts based on management’s assessment of the collectibility of specific
accounts and by making a general provision for other potentially uncollectible amounts.

The Company makes an accrual at the end of each accounting period for its obligations associated with the

earned but unpaid wages of its worksite employees and for the accrued gross billings associated with such wages.
These accruals are included in accrued worksite employee payroll cost and unbilled accounts receivable; however,
these amounts are presented net in the Consolidated Statements of Operations. The Company generally requires that
clients pay invoices for service fees no later than one day prior to the applicable payroll date. As such, the Company
generally does not require collateral. Customer prepayments directly attributable to unbilled accounts receivable
have been netted against such receivables as the gross billings have been earned and the payroll cost has been
incurred, thus the Company has the legal right of offset for these amounts. As of December 31, 2003 and 2002,
unbilled accounts receivable consisted of the following:

2003

2002

(in thousands)

Accrued worksite employee payroll cost ..............
Unbilled revenues .................................................
Customer prepayments..........................................
Unbilled accounts receivable ................................

$ 65,503
19,324
(31,794)
$ 53,033

$ 69,676
17,710
(13,028)
$ 74,358

F-15

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

3. Marketable Securities

The following is a summary of the Company’s available-for-sale marketable securities as of December 31,

2003 and 2002:

Gross
Amortized Unrealized Unrealized
Gains

Losses

Gross

Cost

Estimated
Fair Value

December 31, 2003:

Fixed income mutual funds ...............................
U.S. Treasury securities and obligations

of U.S. government agencies .......................
U.S. corporate debt securities............................
Foreign corporate debt securities ......................

December 31, 2002:

U.S. Treasury securities and obligations

of U.S. government agencies .......................
Foreign corporate debt securities ......................
U.S. corporate debt securities............................
Fixed income mutual funds ...............................

(in thousands)

$ 11,132

$ —

(54)

$ 11,078

8,266
4,253
338
$ 23,989

62
5
1
$ 68

(12)
(1)
(1)
(68)

8,316
4,257
338
$ 23,989

$ 11,095
2,009
1,352
4
$ 14,460

$ 228
7
19
—
$ 254

$ —
—
—
—
$ —

$ 11,323
2,016
1,371
4
$ 14,714

For the years ended December 31, 2003, 2002 and 2001, the Company’s realized gains and losses

recognized on sales of available-for-sales marketable securities are as follows:

Net
Realized

Realized
Gains

Realized Gains
(Losses)
Losses
(in thousands)

2003 ....................................................
2002 ....................................................
2001 ....................................................

$ 78
354
56

(7)
(33)
—

$ 71
321
56

As of December 31, 2003, the contractual maturities of the Company’s marketable securities were as

follows:

Amortized
Cost

Estimated
Fair Value

(in thousands)

Less than one year ..........................
One to five years.............................
Total................................................

$ 12,512
11,477
$ 23,989

$ 12,501
11,488
$ 23,989

F-16

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

4. Deposits

In December 2001, the Company made a cash security deposit of $15.0 million with its primary health

insurance carrier, United. During 2002, the Company made two additional deposits of $5.0 million each with
United. In January 2004, $7.5 million of the security deposit plus accrued interest was returned to the Company and
is included as a component of prepaid insurance in the Company’s Consolidated Balance Sheet at December 31,
2003. 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 of December 31, 2003, the Company also had $21.3 million of long-term deposits, including $10.8

million of collateral and $10.5 million of claim deposits with the Company’s workers’ compensation carrier, AIG.
See Note 1.

5. Investments

During 2000, the Company purchased convertible preferred stock of Virtual Growth, Inc. (“VGI”) for a

total cost of approximately $3.2 million. During 2001, the Company purchased an additional $319,000 of
convertible preferred stock and made loans to VGI totaling $224,000. In December 2001, VGI filed for bankruptcy
protection. As a result of the filing, the Company wrote-off its investments in VGI as of that date totaling $3.8
million.

Subsequent to December 2001, the Company purchased substantially all of the assets of VGI through

bankruptcy proceedings for a total cost of $1.6 million. The Company established a subsidiary, FMS, to provide
outsourcing accounting and bookkeeping services using the assets acquired from VGI. During 2003, the Company
ceased operations of FMS and incurred after tax asset impairment charges of $800,000 to write off the assets of
FMS. FMS operating results are included in discontinued operations in the accompanying Consolidated Statements
of Operations. Revenues were immaterial to the Consolidated Statements of Operations.

During 2000, the Company purchased 500,000 shares of convertible preferred stock of eProsper, Inc.

(“eProsper”) for $2.5 million. In 2002, the Company made an additional $500,000 investment in convertible
preferred stock of eProsper. The Company has accounted for this investment using the cost method. Under the cost
method, the Company periodically evaluates the realizability of this investment based on its review of the investee’s
financial condition, financial results, financial projections and availability of additional financing sources. In
December 2002, the Company determined that the fair value of its investment in eProsper had declined below its
carrying value, for reasons that were other than temporary, resulting in the Company writing-off its entire investment
totaling approximately $3.1 million. During 2003, the Company collected $457,000 from the sale of its investment
in eProsper, which is included as a component of other income in the accompanying Consolidated Statements of
Operations.

6. Debt Obligations

The Company’s debt obligations consist of the following:

December 31,

2003

2002

(in thousands)

Mortgage loan..............................................................
Term loan ........................................................................
Capital lease obligations..............................................
Total debt .................................................................
Less current maturities.................................................
Long-term debt, net of current maturities ................

$ 34,880
4,221
3,261
$ 42,362
1,860
$ 40,502

$ 36,000
4,465
3,704
$ 44,169
1,676
$ 42,493

F-17

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Maturities of long-term debt at December 31, 2003 are summarized as follows (in thousands):

2004.............................................................................
2005.............................................................................
2006.............................................................................
2007.............................................................................
2008.............................................................................
Thereafter ....................................................................

$ 1,860
1,920
1,981
1,947
31,305
3,349
$ 42,362

Mortgage Loan

On December 20, 2002, the Company entered into a $36 million mortgage agreement (“Mortgage”) that

matures in January 2008. The proceeds were used to repay the Company’s outstanding balance under its revolving
credit agreement. The Mortgage bears interest at a variable rate equal to the greater of (a) 4.5%; or (b) the 30-day
LIBOR rate (1.1% at December 31, 2003) plus 2.9%. The Mortgage is secured by the Company’s real estate and
related fixtures located at Administaff’s headquarters in Kingwood, Texas, which has a net book value of $42.0
million at December 31, 2003. Monthly principal and interest payments are approximately $230,000, with the
remaining balance due upon maturity. The Mortgage provides for prepayment penalties as a percentage of the
outstanding principal balance, ranging from 5% down to 1% during the first four years of the term. There is no
prepayment premium during the final year of the Mortgage.

Term Loan

In October 2002, the Company entered into a $4.5 million term loan agreement that matures in October

2012 and bears interest at the one-month commercial paper rate plus 3.1% (4.1% at December 31, 2003). The loan
is secured by the Company’s aircraft, which has a net book value of $3.5 million at December 31, 2003. The loan is
payable in monthly installments of $36,000, with the remaining balance due upon maturity.

Capital Lease Obligations

In October 2002, the Company entered into a capital lease arrangement to finance the purchase of office

furniture. The assets under capital lease were capitalized using an effective interest rate of 7.5%. The current
monthly lease payments are $58,000 per month over the seven-year lease term. As of December 31, 2003, the
capitalized cost and accumulated depreciation under the capital lease arrangement were $3.8 million and $656,000,
respectively. Depreciation of the capitalized lease costs is included in depreciation and amortization in the
Consolidated Statements of Operations.

Revolving Line of Credit

On June 25, 2002, the Company entered into a six-month, $30 million revolving credit agreement, replacing

its former $21 million line of credit (collectively, “the Credit Agreements”), which expired in December 2002. The
proceeds of the Credit Agreements were used to finance the construction of the Company’s new corporate
headquarters facility. In December 2002, the Company repaid the outstanding balance of the revolving line of credit
with the proceeds from the Mortgage. During 2002 and 2001, the Company capitalized interest expense of $371,000
and $84,000, respectively, incurred under the Credit Agreements.

F-18

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

7. Income Taxes

Deferred taxes reflect the net tax effects of temporary differences between the carrying amounts of assets

and liabilities used for financial reporting purposes and the amounts used for income tax purposes. Significant
components of the net deferred tax assets and net deferred tax liabilities as reflected on the balance sheet are as
follows:

Deferred tax liabilities:

Software development costs .................................................................
Depreciation .........................................................................................
Workers’ compensation dividend receivable........................................
Prepaid commissions ............................................................................
Unrealized gains on marketable securities............................................
Total deferred tax liabilities ............................................................

Deferred tax assets:

Long-term capital loss carry-forward ...................................................
Workers’ compensation accruals ..........................................................
Accrued rent .........................................................................................
Uncollectible accounts receivable ........................................................
State income taxes ................................................................................
Other.....................................................................................................
Total deferred tax assets..................................................................
Valuation allowance .............................................................................
Total net deferred tax assets ............................................................

December 31,

2003

2002

(in thousands)

$ (1,552)
(3,647)
—
(250)
—

(5,449)

2,248
2,767
531
254
—
288
6,088
(2,276)
3,812

(2,430)
(1,873)
(1,004)
(417)
(100)
(5,824)

2,480
—
372
290
244
163
3,549
(2,480)
1,069

Net deferred tax liabilities ........................................................................

$ (1,637)

(4,755)

Net current deferred tax assets .................................................................
Net noncurrent deferred tax liabilities......................................................

$ 3,423
(5,060)
$ (1,637)

641
(5,396)
(4,755)

The components of income tax expense from continuing operations are as follows:

Current income tax expense (benefit):

Federal ..................................................................................................
State......................................................................................................
Total current income tax expense....................................................

Deferred income tax expense (benefit):

Federal ..................................................................................................
State......................................................................................................
Total deferred income tax (benefit) expense ...................................
Total income tax expense from continuing operations .........................

2003

Year ended December 31,
2001
2002
(in thousands)

$11,115
1,388
12,503

(2,632)
(386)
(3,018)
$ 9,485

554
610
1,164

59
18
77
$ 1,241

$ 9,422
1,442
10,864

(1,438)
(396)
(1,834)
$ 9,030

In 2003, 2002 and 2001, income tax benefits of $249,000, $203,000 and $1,957,000, respectively, resulting

from deductions relating to nonqualified stock option exercises and disqualifying dispositions of certain employee
incentive stock options were recorded as increases in stockholders’ equity.

F-19

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The reconciliation of income tax expense computed at U.S. federal statutory tax rates to the reported

income tax expense from continuing operations is as follows:

Year ended December 31,
2001
2002

2003

(in thousands)

Expected income tax expense at 35%...................................................
State income taxes, net of federal benefit .............................................
Nondeductible expenses .......................................................................
Tax-exempt interest income .................................................................
Valuation allowance against long-term capital loss carry-forward.......
Other, net ..............................................................................................
Reported total income tax expense from continuing operations ...........

$ 8,565
688
375
—
(160)
17
$ 9,485

$ (588)
518
262
(20)

1,069
—
$ 1,241

$ 6,786
924
255
(122)
1,208
(21)
$ 9,030

As a result of the write-off of the investments in eProsper and VGI, the Company has capital loss

carryforwards totaling $5.8 million that will expire during 2006 and 2007, but can only be used to offset future
capital gains. The Company has recorded a valuation allowance against these related deferred tax assets as it is
uncertain that the Company will be able to utilize the capital loss carryforwards prior to their expiration.

8. Stockholders’ Equity

In 1998, the Company entered into a Securities Purchase Agreement with American Express Travel Related

Services Company, Inc. (“American Express”) whereby the Company issued warrants to purchase 4,131,030 shares
of common stock to American Express with exercise prices ranging from $20 to $40 per share and terms ranging
from three to seven years. In February and November 2001, American Express exercised 800,000 and 273,729
common stock purchase warrants at $20.00 and $25.00 per share, respectively. In March 2002, American Express
exercised 526,271 common stock purchase warrants at $25.00.

The Company’s Board of Directors (the “Board”) has authorized a program to repurchase up to 6,000,000

shares of the Company’s outstanding common stock. The purchases are to be made from time to time in the open
market or directly from stockholders at prevailing market prices based on market conditions or other factors. During
2003, 2002 and 2001, the Company repurchased 1,373,252, 726,271 and 900,000 shares at a cost of $8.2 million,
$17.1 million and $21.6 million, respectively. As of December 31, 2003, the Company had repurchased 5,341,523
shares under this program at a total cost of approximately $65.6 million, including 2,612,523 shares repurchased
from American Express.

At December 31, 2003, 20 million shares of preferred stock were authorized and were designated as Series

A Junior Participating Preferred Stock that is reserved for issuance on exercise of preferred stock purchase rights
under Administaff’s Share Purchase Rights Plan (the “Rights Plan”). Each issued share of the Company’s common
stock has one-half of a preferred stock purchase right attached to it. No preferred shares have been issued and the
rights are not currently exercisable. The Rights Plan expires on February 9, 2008.

On October 16, 2000, the Company effected a two-for-one stock split in the form of a 100% stock dividend.

All share and per share amounts presented in these financial statements have been retroactively restated to reflect
this change in the Company’s capital structure.

9. Employee Incentive Plans

The Administaff, Inc. 1997 Incentive Plan, as amended, and the 2001 Incentive Plan (collectively, the

“Incentive Plans”) provide for options and other stock-based awards that may be granted to eligible employees and
non-employee directors of the Company or its subsidiaries. An aggregate of 4,465,914 shares of common stock of
the Company are authorized to be issued under the Incentive Plans. At December 31, 2003, 109,965 and 887,270

F-20

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

shares of common stock were available for future grants under the 1997 and 2001 Incentive Plans, respectively. All
awards previously granted to employees under the Incentive Plan have been stock options, primarily intended to
qualify as “incentive stock options” within the meaning of Section 422 of the Internal Revenue Code (the “Code”).
The Incentive Plans also permit stock awards, phantom stock awards, stock appreciation rights, performance units,
other stock-based awards and cash awards, all of which may or may not be subject to the achievement of one or
more performance objectives. The purposes of the Incentive Plans generally are to retain and attract persons of
training, experience and ability to serve as employees of the Company and its subsidiaries and to serve as non-
employee directors of the Company, to encourage the sense of proprietorship of such persons and to stimulate the
active interest of such persons in the development and financial success of the Company and its subsidiaries. The
Incentive Plans are administered by the Compensation Committee of the Board of Directors (the “Committee”). The
Committee has the power to determine which eligible employees will receive awards, the timing and manner of the
grant of such awards, the exercise price of stock options (which may not be less than market value on the date of
grant), the number of shares and all of the terms of the awards. The Board has granted limited authority to the
President of the Company regarding the granting of stock options to employees who are not officers. The Company
may at any time amend or terminate the Incentive Plans. However, no amendment that would impair the rights of
any participant, with respect to outstanding grants, can be made without the participant’s prior consent. Stockholder
approval of amendments to the Incentive Plans is necessary only when required by applicable law or stock exchange
rules.

The Administaff Nonqualified Stock Option Plan (the “Nonqualified Plan”) provides for options to

purchase shares of the Company’s common stock that may be granted to employees who are not officers. An
aggregate of 3,600,000 shares of common stock of the Company are authorized to be issued under the Nonqualified
Plan. At December 31, 2003, 562,521 shares of common stock were available for future grants under the
Nonqualified Plan. The purpose of the Nonqualified Plan is similar to that of the Incentive Plans. The Nonqualified
Plan is administered by the Chief Executive Officer of the Company (the “CEO”). The CEO has the power to
determine which eligible employees will receive stock option rights, the timing and manner of the grant of such
rights, the exercise price (which may not be less than market value on the grant date), the number of shares and all of
the terms of the options. The Committee may at any time terminate or amend the Nonqualified Plan, provided that
no such amendment may adversely affect the rights of optionees with regard to outstanding options.

F-21

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

The following summarizes stock option activity and related information:

2003

Year ended December 31,
2002

4,986
594
(114)
(427)
5,039
3,242

Outstanding – beginning of year
Granted
Exercised
Canceled
Outstanding – end of year
Exercisable – end of year
Weighted average fair value of
options granted during year

Weighted
Average
Exercise
Price
(in thousands, except per share amounts)

Weighted
Average
Exercise
Price

2001

Weighted
Average
Exercise
Price

$ 19.77
7.70
7.73
20.53
$ 18.56
$ 21.55

5.54

4,276
1,117
(59)
(348)
4,986
2,454

$ 21.99
12.25
12.59
23.15
$ 19.77
$ 20.44

8.48

3,433
1,419
(341)
(235)
4,276
1,441

$ 21.58
20.25
10.61
23.37
$ 21.99
$ 18.62

$ 12.25

The following summarizes information related to stock options outstanding at December 31, 2003:

Options Outstanding
Weighted Average Weighted
Average
Exercise
Price

Remaining
Contractual
Life (Years)

Options Exercisable

Weighted Average Weighted

Remaining
Contractual
Shares Life (Years)

Average

Exercise
Price

Range of Exercise Prices

(share amounts in thousands)

$ 4.02 to
$ 15.00 to
$ 20.00 to
$ 30.00 to
Total

$15.00
$20.00
$30.00
$43.69

2,211
1,502
655
671
5,039

7.4
6.5
7.4
6.7
7.0

9.24
18.64
24.16
43.59
$ 18.56

961
1,270
346
665
3,242

5.4
6.3
7.1
6.7
6.2

9.02
18.72
24.29
43.63
$ 21.55

10. Earnings (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:

2003

Year ended December 31,
2002
(in thousands)

2001

Denominator:

Basic - weighted average shares outstanding .......................................
Effect of dilutive securities:

Common stock purchase warrants - treasury stock method......
Common stock options - treasury stock method.......................

26,821

27,890

27,531

—
432
432

—
—
—

51
1,239
1,290

Diluted - weighted average shares outstanding

plus effect of dilutive securities...............................................

27,253

27,890

28,821

F-22

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Options and warrants to purchase 5,866,000, 7,327,000 and 3,333,000 shares of common stock were not
included in the diluted net income (loss) per share calculation for 2003, 2002 and 2001, respectively, because their
inclusion would have been anti-dilutive.

11. Leases

The Company leases various office facilities, furniture, equipment and vehicles under capital and
operating lease arrangements, some of which contain rent escalation clauses. Most of the leases contain purchase
and/or renewal options at fair market and fair rental value, respectively. Rental expense relating to all operating
leases was $8,179,000, $10,222,000 and $7,295,000 in 2003, 2002 and 2001, respectively. At December 31, 2003,
future minimum rental payments under noncancelable operating and capital leases are as follows (in thousands):

2004 ...........................................................................
2005 ...........................................................................
2006 ...........................................................................
2007 ...........................................................................
2008 ...........................................................................
Thereafter ..................................................................
Total minimum lease payments .................................
Less amount representing interest..............................
Total present value of minimum payments ................
Less current portion ...................................................
Long-term capital lease obligations ...........................

Operating
Leases

$ 8,473
8,066
7,492
6,726
5,072
7,077
$ 42,906

Capital
Leases

$ 695
695
695
695
695
554
$ 4,029
768
3,261
466
$ 2,795

12. Commitments and Contingencies

The Company enters into non-cancelable purchase and service obligations in the ordinary course of business.

These arrangements primarily consist of software service contracts and advertising commitments. At December 31,
2003, future non-cancelable purchase and service obligations with terms greater than one year were as follows (in
thousands):

$ 2,841
2,380
790
210
211
570
$ 7,002

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.

F-23

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

Aetna Healthcare Litigation

On November 5, 2001, the Company filed a lawsuit against Aetna Life Insurance Company (“Aetna”). The

Company alleged, among other things, that during the third quarter of 2001, Aetna breached its contract with the
Company 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, and 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. Aetna filed a counterclaim
alleging, among other things, that the Company 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. Certain other claims made by the parties
were dismissed on motions for summary judgment prior to the trial.

On October 30, 2003, a jury returned a verdict in favor of the Company, awarding the Company $15.5 million

in compensatory damages. The following findings were included in the jury’s verdict:

Aetna breached an agreement with Administaff by failing to use the care and diligence of a reasonably prudent

financial accounting manager when providing Administaff financial reports concerning the Administaff health plan.

1. Aetna breached an agreement with Administaff by imposing rate increases contrary to the agreed upon two-

quarter waiting period.

2. Aetna breached an agreement with Administaff in September of 2001 by threatening to terminate Administaff’s

health insurance coverage unless Administaff agreed to pay retroactive and immediate rate increases.

3. Administaff did not make a negligent misrepresentation to Aetna.

4. Administaff did not orally agree to pay Aetna the accumulated health plan deficit, if any.

On November 7, 2003, the court entered a final judgment in favor of Administaff in the amount of $15.5

million, with post judgment interest at a rate of 1.3% per annum. On December 10, 2003, the court granted Aetna’s
motion to reduce the judgment to $10.6 million. The judgment is subject to post-judgment motions and appeal;
therefore, the damages awarded to the Company have not been recorded in the Company’s Consolidated Balance Sheet
or Statements of Operations. While the Company cannot predict the ultimate outcome or the timing of a resolution of
this lawsuit or the appeal, the Company plans to continue to vigorously pursue its case and defend the counterclaims.
However, an adverse ultimate 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. Through September 30, 2003, the
Company had submitted claims for approximately $4.2 million in defense costs to National Union for reimbursement, of
which National Union had reimbursed the Company only $200,000. As a result, the Company filed a lawsuit against
National Union requesting the court to determine National Union’s obligations to reimburse the Company for defense
costs. During the fourth quarter of 2003, the Company settled its claims against National Union and another insurance
carrier for reimbursement of defense-related legal fees and costs associated with the Aetna counterclaim. Pursuant to
the settlement, the insurers paid Administaff an additional $2 million, which was recorded as an offset to general and
administrative expenses in 2003.

F-24

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

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 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 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. A motion has been filed to consolidate the seven lawsuits into one action and for the appointment of
lead plaintiff and lead counsel. The court has not yet ruled on the pending motion.

Reliance National Indemnity Co. Bankruptcy Liquidation and Related Litigation

In October 2001, Reliance National Indemnity Co. (“Reliance”), a former workers’ compensation insurance

carrier of the Company, was forced into bankruptcy liquidation. 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 disputed the right of the guaranty association to be reimbursed for such claims.

On August 1, 2003, the Company filed a lawsuit against the Texas Property and Casualty Insurance Guaranty

Association (“TPCIGA”) seeking a declaratory judgment that the Company is not required to reimburse TPCIGA for
workers’ compensation benefits paid or to be paid by TPCIGA under the Company’s workers’ compensation policies
with Reliance. On August 15, 2003, TPCIGA filed its answer, denying the claims asserted by the Company as well as
filing a counterclaim that TPCIGA is entitled to full reimbursement from the Company for workers’ compensation
benefits paid or to be paid by TPCIGA under the Company’s workers’ compensation policies with Reliance.
Administaff estimated that TPCIGA’s claim for reimbursement was approximately $6.8 million. During the fourth
quarter of 2003, the Company paid $1.1 million to settle the lawsuit, including TPCIGA’s claim for reimbursement.
The cost of the settlement has been reported as a component of workers’ compensation expense in the Company’s 2003
Consolidated Statement of Operations.

The Company initially secured $1.8 million in insurance coverage to cover potential claims returned to the

Company related to its Reliance policies. Administaff has submitted the TPCIGA settlement as a claim under the
policy. Although the settlement is expected to be fully covered by its insurance policy, the Company has deferred
recording the reimbursement until such reimbursement takes place. As of December 31, 2003, after deducting the
TPCIGA settlement from the policy limits, there was $208,000 in coverage remaining on the policy. At December 31,
2003, the estimated outstanding claims under the Company’s former policies with Reliance totaled approximately
$329,000, which excludes the Texas claims resolved in the TPCIGA settlement. The Company has accrued and
recorded its estimate of the outstanding claims in excess of the remaining insurance coverage as of December 31, 2003.
It is possible that such losses could exceed the Company’s estimates, resulting in an increase to workers’ compensation
expense, which would reduce net income.

F-25

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

State Unemployment Taxes

The Company records its state unemployment (“SUI”) tax expense based on taxable wages and tax rates

In January 2002, as a result of a 2001 corporate restructuring plan, the Company filed for a partial transfer

Pending computation of the Company’s Texas unemployment tax rate in 2002, the Company paid its

unemployment taxes to the state of Texas at the higher new employer rate as required by state law. In September
2003, the Company received its final 2002 and 2003 unemployment tax rates from the TWC. The impact of the final
rates resulted in a $3.9 million reduction in payroll tax expense in the third quarter of 2003 and a state
unemployment tax prepayment, which the Company is utilizing to offset its future unemployment tax liabilities as
incurred. The prepayment balance at December 31, 2003 was $5.1 million.

As a result of the 2001 corporate reorganization, the Company filed for a transfer of its reserve account with

F-26

ADMINISTAFF, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)

13. Quarterly Financial Data (Unaudited)

Year ended December 31, 2003:

Quarter ended

March 31

June 30

Sept. 30

Dec. 31

(in thousands, except per share amounts)

Revenues................................................
Gross profit ............................................
Operating income (loss) .........................
Net income (loss) ...................................
Basic net income (loss) per share...........
Diluted net income (loss) per share........

$ 225,520
35,981
(6,568)
(4,361)
(0.16)
(0.16)

$ 219,226
46,822
2,747
1,713
0.06
0.06

$ 217,849
56,578
13,778
7,476
0.28
0.28

$ 229,126
58,586
14,317
8,036
0.30
0.29

Year ended December 31, 2002:

$ 195,958
30,453
(9,651)
(5,704)
(0.20)
(0.20)

$ 204,966
36,377
(5,393)
(3,164)
(0.11)
(0.11)

$ 218,069
46,746
6,489
3,779
0.14
0.14

$ 229,423
52,214
8,622
1,008
0.04
0.04

Year ended December 31, 2001:

$ 171,139
27,829
(8,503)
(4,337)
(0.16)
(0.16)

$ 174,955
41,539
4,779
3,774
0.14
0.13

$ 182,808
49,321
13,291
8,659
0.32
0.30

$ 191,317
46,326
8,972
2,261
0.08
0.08

F-27

Paul J. Sarvadi
Chairman and Chief Executive Officer

Richard G. Rawson
President

A. Steve Arizpe
Executive Vice President, Client Services
and Chief Operating Officer

Jay E. Mincks
Executive Vice President, Sales and Marketing

John H. Spurgin, II
Senior Vice President, Legal,
General Counsel and Secretary

Douglas S. Sharp
Vice President, Finance,
Chief Financial Officer and Treasurer

O f f i c e r s

Gregory R. Clouse
Vice President, Service Operations

Roger L. Gaskamp
Vice President, Client Selection and Pricing

Jeff W. Hutcheon
Vice President, Service Development

Samuel G. Larson
Vice President, Enterprise and Technology Solutions

Randall H. McCollum
Vice President, Strategic Alliances

Gregory J. Morton
Vice President, Marketing

John F. Orth
Vice President, Sales

C o r p o r a t e I n f o r m a t i o n

Corporate Headquarters
19001 Crescent Springs Drive
Kingwood, Texas 77339-3802
281-358-8986

Sales Department
800-465-3800

Web Site
www.administaff.com

Independent Auditors
Ernst & Young LLP
5 Houston Center
1401 McKinney, Suite 1200
Houston, Texas 77010

Legal Counsel
Baker Botts L.L.P.
One Shell Plaza
910 Louisiana
Houston, Texas 77002-4995

Board of Directors
Members of the Board of Directors can be contacted at
directors@administaff.com.

Stock Transfer Agent
Mellon Investor Services LLC
P.O. Box 3315
South Hackensack, New Jersey 07606
1-800-635-9270

TDD for Hearing Impaired: 800-231-5469
Foreign Shareholders: 201-329-8660
TDD Foreign Shareholders: 201-329-8354
Web Site: www.melloninvestor.com

Common Stock
Administaff, Inc.’s common stock is traded on the New York
Stock Exchange under the symbol “ASF”.

Annual Meeting
Administaff, Inc.’s Annual Meeting of Shareholders will be held
at 10 a.m. CDT on Thursday, May 6, 2004, at the Company’s
corporate headquarters, Centre I in the Auditorium, located at
22900 Highway 59N (Eastex Freeway), Kingwood, Texas 77339.

Investor Relations
Shareholders are encouraged to contact the Company with
questions or requests for information. Copies of the Company’s
Annual Report on Form 10-K as filed with the Securities and
Exchange Commission are available without charge upon
written request.

Inquiries should be directed to:

Investor Relations Administrator
Administaff, Inc.
19001 Crescent Springs Drive
Kingwood, Texas 77339-3802
281-348-3987

19001 Crescent Springs Drive
Kingwood, Texas 77339-3802
www.administaff.com