EXFO Inc.
EXFO INC. (Form: 6-K, Received: 04/05/2011 15:52:19)



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.   20549


FORM 6-K


Report of Foreign Private Issuer Pursuant to Rule 13a-16 or 15d-16
Under the Securities Exchange Act of 1934

For the month of April 2011

EXFO Inc.
(Translation of registrant’s name into English)

400 Godin Avenue, Quebec, Quebec, Canada   G1M 2K2
(Address of principal executive offices)


Indicate by check mark whether the registrant files or will file annual reports under cover of Form 20-F or Form 40-F.


Form 20-F þ
Form 40-F o

Indicate by check mark whether the registrant by furnishing the information contained in this Form is also thereby furnishing the information to the Commission pursuant to Rule 12g3-2(b) under the Securities Exchange Act of 1934.

Yes o
No þ


If “Yes” is marked, indicate below the file number assigned to the registrant in connection with Rule 12g3-2(b): 82-______.

 


 
 

 
 
 
TABLE OF CONTENTS
 
 
Signatures
Press Release
Unaudited Interim Consolidated Balance Sheet
Unaudited Interim Consolidated Statements of Earnings
Unaudited Interim Consolidated Statements of Comprehensive Income and Accumulated Other Comprehensive Income
Unaudited Interim Consolidated Statements of Retained Earnings and Contributed Surplus
Unaudited Interim Consolidated Statements of Cash Flows
Notes to Unaudited Interim Consolidated Financial Statements
Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
 

 
On March 31, 2011, EXFO Inc., a Canadian corporation, reported its results of operations for the second fiscal quarter ended February 28, 2011. This report on Form 6-K sets forth the news release relating to EXFO’s announcement and certain information relating to EXFO’s financial condition and results of operations for the second fiscal quarter of the 2011 fiscal year.  This press release and information relating to EXFO’s financial condition and results of operations for the second fiscal quarter of the 2011 fiscal year are hereby incorporated as a document by reference to Form F-3 (Registration Statement under the Securities Act of 1933) declared effective as of July 30, 2001 and to Form F-3 (Registration Statement under the Securities Act of 1933) declared effective as of March 11, 2002 and to amend certain material information as set forth in these two Form F-3 documents.


 
Page 1 of 54

 
 
SIGNATURES

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

 
 
EXFO INC.
 
 
 
By: /s/ Germain Lamonde
Name:  Germain Lamonde
Title:    President and Chief Executive Officer
   
 
 
Date: April 5, 2011


 
Page 2 of 54


 

 
EXFO Reports Sales Growth for a Sixth Consecutive Quarter

§  
Sales increase 50.2%  year-over-year to US$72.0 million, 5 th straight quarter of record sales
§  
EBITDA * reaches US$8.4 million (11.6% of sales) despite FX loss of US$2.4 million
§  
Cash position increases US$41.8 million year-to-date to US$73.6 million

QUEBEC CITY, CANADA, March 31, 2011 — EXFO Inc. (NASDAQ: EXFO; TSX: EXF) reported today sales growth for a sixth consecutive quarter, including five straight reporting periods of record sales.

Sales increased 50.2% to US$72.0 million in the second quarter of fiscal 2011 ended February 28, 2011, from US$48.0 million in the second quarter of 2010 and 9.7% from US$65.7 million in the first quarter of 2011. Organic sales growth, excluding the NetHawk acquisition and divested Life Sciences and Industrial Division, improved 40.0% year-over-year and 13.2% sequentially.

Net bookings increased 11.5% to US$57.6 million in the second quarter of fiscal 2011 from US$51.6 million in the same period last year and decreased 35.9% from US$89.8 million in the seasonally high first quarter of 2011. The company’s book-to-bill ratio was 0.80 in the second quarter of 2011 and 1.07 at the mid-point of fiscal 2011.

Gross margin reached 61.4% of sales in the second quarter of fiscal 2011 compared to 60.8% in the second quarter of 2010 and 62.2% in the first quarter of 2011. At the mid-point of the fiscal 2011, gross margin amounted to 61.8% of sales compared to 62.8% in the same period in 2010.

GAAP net earnings in the second quarter of fiscal 2011 totaled US$1.7 million, or US$0.03 per diluted share, compared to US$1.2 million, or US$0.02 per diluted share, in the same period last year and US$14.1 million, or US$0.23 per diluted share, in the first quarter of 2011. It should be noted that in the first quarter of 2011 EXFO recorded an after-tax gain of US$13.1 million, or US$0.21 per diluted share, from the disposal of discontinued operations (Life Sciences and Industrial Division). GAAP net earnings in the second quarter of 2011 included US$2.4 million in amortization of intangible assets and US$0.6 million in stock-based compensation costs. The former item resulted in an income tax recovery of US$0.2 million. The company also reported a foreign exchange loss of US$2.4 million in the second quarter of 2011.

EXFO increased its cash and short-term investments to US$73.6 million at the end of the second quarter of 2011 from US$50.6 million in the previous quarter mainly due to US$20.7 million in cash flows from operations.

“Overall, I am satisfied with our financial performance in the first half of fiscal 2011 based on year-over-year sales growth of 56.0%, or 43.2% organically, bookings increase of 49.8% for a book-to-bill ratio of 1.07, EBITDA * of US$16.5 million despite US$3.5 million in foreign exchange losses, and an increase in our cash position of more than US$40 million to provide us with flexibility,” said Germain Lamonde, EXFO’s Chairman, President and CEO. “As expected, second-quarter bookings were down sequentially due to seasonality and significant year-end money received in the first quarter. Nonetheless, our backlog is now at a more manageable level in our typically strong third quarter. I remain confident that the trends toward explosive bandwidth demand and IP network convergence compel fixed and mobile operators to accelerate their strategic investments in wireless backhaul, 3G/4G, FTTH and VDSL deployments as well as 40G and 100G network upgrades.”
 
 
 
Page 3 of 54

 
 

 
Selected Financial Information
(In thousands of US dollars)

      Q2 2011       Q1 2011       Q2 2010  
Sales:
                       
Continuing operations (formerly the Telecom Division)
  $ 72,046     $ 65,653     $ 47,951  
Discontinued operations (formerly the Life Sciences & Industrial Division
          1,991       6,159  
Total
  $ 72,046     $ 67,644     $ 54,110  
                         
Gross margin:
                       
Continuing operations
  $ 44,225     $ 40,868     $ 29,133  
      61.4 %     62.2 %     60.8 %
Discontinued operations
  $     $ 989     $ 3,344  
      %     49.7 %     54.3 %
Total
  $ 44,225     $ 41,857     $ 32,477  
      61.4 %     61.9 %     60.0 %
                         
Other selected information:
                       
GAAP net earnings
  $ 1,653     $ 14,071     $ 1,154  
Amortization of intangible assets
  $ 2,367     $ 2,570     $ 1,502  
Stock-based compensation costs
  $ 625     $ 738     $ 469  
Net income tax effect of the above items
  $ (157 )   $ (192 )   $ (484 )
After-tax gain on the disposal of discontinued operations
  $     $ (13,071 )   $  
Foreign exchange losses
  $ (2,395 )   $ (1,113 )   $ (1,026 )
Adjusted EBITDA *
  $ 8,351     $ 8,188     $ 5,712  

Operating Expenses
Selling and administrative expenses totaled US$22.2 million, or 30.9% of sales, in the second quarter of fiscal 2011 compared to US$15.3 million, or 31.9% of sales, in the same period last year and US$19.9 million, or 30.3% of sales, in the first quarter of 2011.

Gross research and development expenses amounted to US$13.8 million, or 19.2% of sales, in the second quarter of fiscal 2011 compared to US$9.8 million, or 20.4% of sales, in the second quarter of 2010 and US$13.7 million, or 20.9% of sales, in the first quarter of 2011.

Net R&D expenses totaled US$11.2 million, or 15.6% of sales, in the second quarter of fiscal 2011 compared to US$8.4 million, or 17.5% of sales, in the same period last year and US$11.6 million, or 17.7% of sales, in the first quarter of 2011.

Second-Quarter Business Highlights — Broadband Deployments and IP Fixed-Mobile Network Convergence
§  
EXFO generated record sales of US$72.0 million, reflecting strong traction in its Optical, Protocol and Copper Access businesses.
§  
NetHawk, acquired in mid-March 2010, posted US$4.9 million in sales and US$8.7 million in bookings.
§  
EXFO added deep packet inspection (DPI) technology to its wireless analyzers and service assurance systems during the quarter. This value-added solution will enable subscriber-based, application-level monitoring for assessing long-term evolution (LTE) and other packet-based networks.
§  
EXFO’s top customer accounted for 7.5% of sales and its top three customers 17.9% in the second quarter. At the mid-point of fiscal 2011, EXFO’s top customer represented 7.2% of sales and top three customers 18.5%.
§  
EXFO launched two new products in the second quarter and nine after the first half of fiscal 2011.

 
 
Page 4 of 54

 

 
Profitable Growth Path
EXFO generated EBITDA * of US$8.4 million (11.6% of sales) in the second quarter of fiscal 2011 on revenue of US$72.0 million, despite a pre-tax, foreign exchange loss of US$2.4 million (3.3% of sales). Foreign exchange losses or gains are included in EBITDA. * See the section below entitled “Non-GAAP Financial Measures” for a reconciliation of EBITDA * with GAAP net earnings.

Business Outlook
EXFO forecasts sales between US$67.0 million and US$72.0 million for the third quarter of fiscal 2011, while GAAP net earnings are expected to range between US$0.01 and US$0.05 per diluted share. GAAP net earnings include US$0.04 per share in after-tax amortization of intangible assets and stock-based compensation costs.
 
This guidance was established by management based on existing backlog as of the date of this press release, seasonality, expected bookings for the remaining of the quarter, as well as exchange rates as of the day of this press release.
 
Conference Call and Webcast
EXFO will host a conference call today at 5 p.m. (Eastern time) to review its financial results for the second quarter of fiscal 2011. To listen to the conference call and participate in the question period via telephone, dial 1-416-981-9094.   Germain Lamonde, Chairman, President and CEO, and Pierre Plamondon, CA, Vice-President of Finance and Chief Financial Officer, will participate in the call. An audio replay of the conference call will be available one hour after the event until 7 p.m. on April 7, 2011. The replay number is 1-402-977-9141 and the reservation number is 21513253. The audio Webcast and replay of the conference call will also be available on EXFO’s Website at  www.EXFO.com , under the Investors section.

About EXFO
Listed on the NASDAQ and TSX stock exchanges, EXFO is among the leading providers of next-generation test and service assurance solutions for wireless and wireline network operators and equipment manufacturers in the global telecommunications industry. The company offers innovative solutions for the development, installation, management and maintenance of converged, IP fixed and mobile networks — from the core to the edge. Key technologies supported include 3G, 4G/LTE, IMS, Ethernet, OTN, FTTx, and various optical technologies (accounting for an estimated 35% of the portable fiber-optic test market). EXFO has a staff of approximately 1700 people in 25 countries, supporting more than 2000 telecom customers worldwide. For more information, visit www.EXFO.com .

EXFO Brand Name
The corporate name of the company is EXFO Inc. The company requests that all media outlets and publications use the corporate name (“EXFO Inc.”) or abbreviated name (“EXFO”) in capital letters for branding purposes. EXFO would like to thank all parties in advance for their cooperation.


 
Page 5 of 54

 
 

 
Forward-Looking Statements
This press release contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995, and we intend that such forward-looking statements be subject to the safe harbors created thereby. Forward-looking statements are statements other than historical information or statements of current condition. Words such as may, will, expect, believe, anticipate, intend, could, estimate, continue, or the negative or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events and circumstances are considered forward-looking statements. They are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those in forward-looking statements due to various factors including our ability to successfully integrate our acquired and to-be-acquired businesses; fluctuating exchange rates; consolidation in the global telecommunications test, measurement and service assurance industry and increased competition among vendors; capital spending levels in the telecommunications industry; concentration of sales; the effects of the additional actions we have taken in response to economic uncertainty (including our ability to quickly adapt cost structures with anticipated levels of business, ability to manage inventory levels with market demand); market acceptance of our new products and other upcoming products; limited visibility with regards to customer orders and the timing of such orders; our ability to successfully expand international operations; the retention of key technical and management personnel; and future economic, competitive, financial and market condition. Assumptions relating to the foregoing involve judgments and risks, all of which are difficult or impossible to predict and many of which are beyond our control. Other risk factors that may affect our future performance and operations are detailed in our Annual Report, on Form 20-F, and our other filings with the U.S. Securities and Exchange Commission and Canadian securities commissions. We believe that the expectations reflected in the forward-looking statements are reasonable based on information currently available to us, but we cannot assure you that the expectations will prove to have been correct. Accordingly, you should not place undue reliance on these forward-looking statements. These statements speak only as of the date of this press release. Unless required by law or applicable regulations, we undertake no obligation to revise or update any of them to reflect events or circumstances that occur after the date of this document.

Non-GAAP Financial Measures
EXFO provides non-GAAP financial measures (EBITDA * and adjusted EBITDA * ) as supplemental information regarding its operational performance. The company uses these measures for the purposes of evaluating its historical and prospective financial performance, as well as its performance relative to competitors. These measures also help the company to plan and forecast for future periods as well as to make operational and strategic decisions. EXFO believes that providing this information to investors, in addition to GAAP measures, allows them to see the company's results through the eyes of management, and to better understand its historical and future financial performance.
 
The presentation of this additional information is not prepared in accordance with GAAP. Therefore, the information may not necessarily be comparable to that of other companies and should be considered as a supplement to, not a substitute for, the corresponding measures calculated in accordance with GAAP.
 
*
EBITDA is defined as net earnings before interest, income taxes, amortization of property, plant and equipment, amortization of intangible assets. Adjusted EBITDA represents EBITDA excluding the gain from the disposal of discontinued operations.
 

 
Page 6 of 54




 
The following table summarizes the reconciliation of EBITDA and adjusted EBITDA to GAAP net earnings in thousands of US dollars:
 

EBITDA and adjusted EBITDA (including discontinued operations)
   
Three months
ended
February 28,
2011
   
Three months
ended
November 30,
2010
   
Three months
ended
February 28,
2010
 
                   
GAAP net earnings for the period
  $ 1,653     $ 14,071     $ 1,154  
                         
Add (deduct):
                       
                         
Amortization of property, plant and equipment
                       
Continuing operations
    1,626       1,674       1,274  
Discontinued operations
          14       38  
Amortization of intangible assets
                       
Continuing operations
    2,367       2,566       1,492  
Discontinued operations
          4       10  
Interest expense
                       
Continuing operations
    8       64       76  
Income taxes
                       
Continuing operations
    2,697       2,806       1,299  
Discontinued operations
          201       369  
                         
EBITDA for the period
    8,351       21,400       5,712  
Gain on disposal of discontinued operations
          (13,212 )      
Adjusted EBITDA for the period
  $ 8,351     $ 8,188     $ 5,712  
                         
Adjusted EDITDA in percentage of total sales
    11.6 %     12.1 %     10.6 %


For more information
Vance Oliver
Manager, Investor Relations
(418) 683-0913, Ext. 3733
[email protected]
 

 
Page 7 of 54


 
EXFO Inc.
Unaudited Interim Consolidated Balance Sheet

(in thousands of US dollars)
 
   
As at
February 28,
2011
   
As at
August 31,
2010
 
Assets
           
             
Current assets
           
Cash
  $ 25,879     $ 21,440  
Short-term investments
    47,724       10,379  
Accounts receivable (note 5)
               
Trade
    51,418       50,190  
Other
    6,860       5,217  
Income taxes and tax credits recoverable
    4,304       2,604  
Inventories (note 6)
    47,889       40,328  
Prepaid expenses
    3,738       2,816  
Future income taxes
    6,787       6,191  
Current assets held for sale (note 3)
          3,991  
      194,599       143,156  
                 
Tax credits recoverable
    34,551       29,397  
Forward exchange contracts (note 5)
    421        
Property, plant and equipment
    24,466       23,455  
Intangible assets
    25,817       27,947  
Goodwill
    30,415       29,355  
Future income taxes
    10,312       12,884  
Long-term assets held for sale (note 3)
          7,308  
                 
    $ 320,581     $ 273,502  
Liabilities
               
                 
Current liabilities
               
Accounts payable and accrued liabilities (note 7)
  $ 36,159     $ 30,870  
Income taxes payable
    894       426  
Current portion of long-term debt (note 8)
    619       568  
Deferred revenue
    11,611       10,354  
Current liabilities related to assets held for sale (note 3)
          2,531  
      49,283       44,749  
                 
Deferred revenue
    6,752       5,775  
Long-term debt (note 8)
    1,239       1,419  
Other liabilities
    821       603  
Future income taxes
    2,658        
Long-term liabilities related to assets held for sale (note 3)
          537  
                 
      60,753       53,083  
Contingency (note 9)
               
                 
Shareholders’ equity
               
Share capital (note 10)
    109,558       106,126  
Contributed surplus
    17,621       18,563  
Retained earnings
    66,252       50,528  
Accumulated other comprehensive income
    66,397       45,202  
                 
      259,828       220,419  
                 
    $ 320,581     $ 273,502  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
Page 8 of 54


 
EXFO Inc.
Unaudited Interim Consolidated Statements of Earnings

(in thousands of US dollars, except share and per share data)
  
   
Three months
ended
February 28,
2011
   
Six months
ended
February 28,
2011
   
Three months
ended
February 28,
2010
   
Six months
ended
February 28,
2010
 
                         
Sales
  $ 72,046     $ 137,699     $ 47,951     $ 88,243  
                                 
Cost of sales (1,2)
    27,821       52,606       18,818       32,851  
Gross margin
    44,225       85,093       29,133       55,392  
                                 
Operating expenses
                               
Selling and administrative (1)
    22,235       42,134       15,297       29,101  
Net research and development (1) (note 11)
    11,244       22,845       8,413       16,194  
Amortization of property, plant and equipment
    1,626       3,300       1,274       2,532  
Amortization of intangible assets
    2,367       4,933       1,492       2,952  
Total operating expenses
    37,472       73,212       26,476       50,779  
Earnings from operations
    6,753       11,881       2,657       4,613  
                                 
Interest expense
    (8 )     (72 )     (76 )     (118 )
Foreign exchange loss
    (2,395 )     (3,508 )     (1,026 )     (2,048 )
Earnings before income taxes
    4,350       8,301       1,555       2,447  
                                 
Income taxes (note 12)
    2,697       5,503       1,299       2,421  
                                 
Net earnings from continuing operations
    1,653       2,798       256       26  
                                 
Net earnings from discontinued operations (note 3)
          12,926       898       1,462  
                                 
Net earnings for the period
  $ 1,653     $ 15,724     $ 1,154     $ 1,488  
                                 
Basic and diluted net earnings from continuing operations per share
  $ 0.03     $ 0.05     $ 0.00     $ 0.00  
Basis net earnings from discontinued operations per share
  $     $ 0.22     $ 0.02     $ 0.02  
Diluted net earnings from discontinued operations per share
  $     $ 0.21     $ 0.01     $ 0.02  
Basis net earnings per share
  $ 0.03     $ 0.26     $ 0.02     $ 0.03  
Diluted net earnings per share
  $ 0.03     $ 0.26     $ 0.02     $ 0.02  
                                 
Basic weighted average number of shares outstanding (000’s)
    59,900       59,782       59,427       59,406  
                                 
Diluted weighted average number of shares outstanding (000’s) (note 13)
    61,524       61,314       60,529       60,325  
                                 
(1)    Stock-based compensation costs included in:
                               
Cost of sales
  $ 51     $ 99     $ 40     $ 79  
Selling and administrative
  $ 433     $ 755     $ 279     $ 523  
Net research and development
  $ 141     $ 245     $ 116     $ 217  
Net earnings from discontinued operations
  $     $ 264     $ 34     $ 68  

(2)
The cost of sales is exclusive of amortization, shown separately.


The accompanying notes are an integral part of these consolidated financial statements.
 
Page 9 of 54

 
EXFO Inc.
Unaudited Interim Consolidated Statements of Comprehensive Income
and Accumulated Other Comprehensive Income

(in thousands of US dollars)
 
Comprehensive income
                       
   
Three months
ended
February 28,
2011
   
Six months
ended
February 28,
2011
   
Three months
ended
February 28,
2010
   
Six months
ended
February 28,
2010
 
                         
Net earnings for the period
  $ 1,653     $ 15,724     $ 1,154     $ 1,488  
Foreign currency translation adjustment
    12,974       19,313       989       8,802  
Unrealized gains on forward exchange contracts
    1,794       3,238       158       1,322  
Reclassification of realized gains on forward exchange contracts in net earnings
    (464 )     (653 )     (382 )     (305 )
Future income taxes effect of the above items
    (365 )     (703 )     69       (316 )
                                 
Comprehensive income
  $ 15,592     $ 36,919     $ 1,988     $ 10,991  



Accumulated other comprehensive income
           
   
Six months ended
February 28,
 
             
   
2011
   
2010
 
             
Foreign currency translation adjustment
           
Cumulative effect of prior periods
  $ 44,186     $ 40,458  
Current period
    19,313       8,802  
                 
      63,499       49,260  
                 
Unrealized gains on forward exchange contracts
               
Cumulative effect of prior periods
    1,018       1,076  
Current period, net of realized gains and future income taxes
    1,882       701  
                 
      2,900       1,777  
                 
Unrealized losses on short-term investments
               
Cumulative effect of prior periods
    (2 )     (2 )
                 
Accumulated other comprehensive income
  $ 66,397     $ 51,035  

Total retained earnings and accumulated other comprehensive income amounted to $96,432 and $132,649 as at February 28, 2010 and 2011, respectively.

The accompanying notes are an integral part of these consolidated financial statements.
 
Page 10 of 54

 
EXFO Inc.
Unaudited Interim Consolidated Statements of Retained Earnings
and Contributed Surplus

(in thousands of US dollars)
 
Retained earnings
           
   
Six months ended
February 28,
 
             
   
2011
   
2010
 
             
Balance – Beginning of the period
  $ 50,528     $ 43,909  
                 
Add
               
Net earnings for the period
    15,724       1,488  
                 
Balance – End of the period
  $ 66,252     $ 45,397  



Contributed surplus
           
   
Six months ended
February 28,
 
             
   
2011
   
2010
 
             
Balance – Beginning of the period
  $ 18,563     $ 17,758  
                 
Add (deduct)
               
Stock-based compensation costs
    1,210       858  
Reclassification of stock-based compensation costs to share capital upon exercise of stock awards
    (2,152 )     (627 )
Discount on redemption of share capital
          3  
                 
Balance – End of the period
  $ 17,621     $ 17,992  

The accompanying notes are an integral part of these consolidated financial statements.
 
Page 11 of 54

 
 
Unaudited Interim Consolidated Statements of Cash Flows

(in thousands of US dollars)
 
   
Three months
ended
February 28,
2011
   
Six months
ended
February 28,
2011
   
Three months
ended
February 28,
2010
   
Six months
ended
February 28,
2010
 
Cash flows from operating activities
                       
Net earnings for the period
  $ 1,653     $ 15,724     $ 1,154     $ 1,488  
Add (deduct) items not affecting cash
                               
Change in discount on short-term investments
    (9 )     (27 )     7       9  
Stock-based compensation costs
    625       1,363       469       887  
Amortization
    3,993       8,251       2,814       5,574  
Gain on disposal of discontinued operations (note 3)
          (13,212 )            
Deferred revenue
    3,250       679       3,465       2,923  
Future income taxes
    2,596       4,563       1,904       3,060  
Change in unrealized foreign exchange gain/loss
    1,054       1,591       273       1,043  
                                 
      13,162       18,932       10,086       14,984  
                                 
Change in non-cash operating items
                               
Accounts receivable
    9,085       4,605       (5,127 )     (9,229 )
Income taxes and tax credits
    (2,203 )     (3,205 )     (1,866 )     (3,371 )
Inventories
    (2,098 )     (3,460 )     (762 )     (3,113 )
Prepaid expenses
    (324 )     (709 )     (10 )     (615 )
Accounts payable and accrued liabilities
    3,074       1,850       2,645       3,675  
Other liabilities
    17       152              
                                 
      20,713       18,165       4,966       2,331  
Cash flows from investing activities
                               
Additions to short-term investments
    (88,804 )     (314,950 )     (101,643 )     (180,597 )
Proceeds from disposal and maturity of short-term investments
    70,313       279,918       104,926       186,262  
Additions to capital assets
    (1,316 )     (3,295 )     (1,464 )     (2,809 )
Net proceeds from disposal of discontinued operations (note 3)
    (61 )     22,063              
Business combination
    (111 )     (243 )            
                                 
      (19,979 )     (16,507 )     1,819       2,856  
Cash flows from financing activities
                               
Repayment of long-term debt
    (296 )     (296 )            
Exercise of stock options
    1,219       1,280       127       127  
Redemption of share capital
                      (14 )
                                 
      923       984       127       113  
                                 
Effect of foreign exchange rate changes on cash
    784       1,128       (135 )     (32 )
                                 
Change in cash
    2,441       3,770       6,777       5,268  
Cash – Beginning of the period
    23,438       22,109       9,102       10,611  
Cash – End of the period
  $ 25,879     $ 25,879     $ 15,879     $ 15,879  

The accompanying notes are an integral part of these consolidated financial statements.
 
Page 12 of 54

 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
  1   Interim Financial Information
 
The financial information as at February 28, 2011, and for the three- and six-month periods ended February 28, 2010 and 2011, is unaudited. In the opinion of management, all adjustments necessary to present fairly the results of these periods in accordance with generally accepted accounting principles (GAAP) in Canada have been included. The adjustments made were of a normal and recurring nature. Interim results may not necessarily be indicative of results anticipated for the entire year.
 
These interim consolidated financial statements are prepared in accordance with generally accepted accounting principles in Canada and use the same accounting policies and methods used in the preparation of the company’s most recent annual consolidated financial statements, except for the changes described in note 2. However, all disclosures required for annual financial statements have not been included in these financial statements. Consequently, these interim consolidated financial statements should be read in conjunction with the company’s most recent annual consolidated financial statements.
 
 
  2   New Accounting Standards and Pronouncements
 
Adopted in fiscal 2011
 
In December 2009, the Canadian Institute of Chartered Accountants’ (CICA) Emerging Issues Committee (EIC) issued EIC-175, “Multiple Deliverable Revenue Arrangements”, which is applicable prospectively (with retrospective adoption permitted) to revenue arrangements with multiple deliverables entered into or materially modified in the first annual  period beginning on January 1, 2011. EIC-175 amends the guidance contained in EIC-142, “Revenue Arrangements with Multiple Deliverables”, and establishes additional requirements regarding revenue recognition related to multiple deliverables as well as supplementary disclosures. The company adopted this standard on September 1, 2010 at the same time it adopted similar new U.S. GAAP requirements (note 14), and its adoption had no material effect on its consolidated financial statements.
 
Update to the accounting policy on revenue recognition
 
The company’s multiple deliverable revenue arrangements may include tangible products (software and/or non software components), extended warranties, maintenance contracts, post-contract customer support (PCS) on software components as well as installation.
 
Starting September 1, 2010, when a sales arrangement contains multiple elements and software and non-software components function together to deliver the tangible products’ essential functionality, the company allocates revenue to each element based on the relative selling price of each element. Under this approach, the selling price of a deliverable is determined by using a selling price hierarchy which requires the use of vendor-specific objective evidence (“VSOE”) of fair value if available, third-party evidence (“TPE”) if VSOE is not available, or best estimated selling price (“BESP”) if neither VSOE nor TPE are available.
 
The company establishes VSOE of selling price using the price charged for a deliverable when sold separately and, in some instances, using the price established by management having the relevant authority. TPE of selling price is established by evaluating similar and interchangeable competitor goods or services in sales to similarly situated customers. When VSOE or TPE are not available, the company uses BESP. The company establishes BESP using historical selling price trends, if available, and considering multiple factors including, but not limited to geography, market conditions, competitive landscape, internal costs and pricing practices. When determining BESP, the company’s management applies judgment when establishing pricing strategies and evaluating market conditions and product lifecycles. The determination of BESP is made through consultation with and approval by the company’s management. The company may modify or develop new pricing practices and strategies in the future. As these pricing strategies evolve, the company may modify its pricing practices in the future, which may result in changes in BESP. The aforementioned factors may result in a different allocation of revenue to the deliverables in multiple-element arrangements from the current period, which may change the pattern and timing of revenue recognition for these elements but will not change the total revenue recognized for the arrangement.
 

 
Page 13 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
Maintenance contracts are usually offered to customers for periods of twelve to thirty-six months. They generally include the right to unspecified upgrades and enhancements on a when-and-if available basis and customer service. They qualify as a separate unit of accounting. Revenue from these contracts is recognized ratably over the terms of the maintenance contracts on a straight-line basis. The selling price of the maintenance contracts is determined using VSOE.
 
Extended warranties are usually offered to customers for periods of twelve to forty-eight months. They qualify as a separate unit of accounting. Revenue from these extended warranties is recognized ratably over the warranty period on a straight-line basis. The selling price of the extended warranties is determined using BESP.
 
When a sales arrangement contains multiple elements and software and non-software components do not function together to deliver the tangible products’ essential functionality, the company allocates revenue between the tangible products and the PCS, if any, based on VSOE of selling price of each element. PCS revenues are deferred and recognized ratably over the years of the support arrangement. PCS revenues are recognized at the time the product is delivered when provided substantially within one year of delivery, the costs of providing this support are insignificant (and accrued at the time of delivery), and no (or infrequent) software upgrades or enhancements are provided.
 
To be adopted after fiscal 2011
 
The company will cease to prepare its consolidated financial statements in accordance with Canadian GAAP as set out in Part V of the CICA Handbook – Accounting ("Canadian GAAP") for the periods beginning on September 1, 2011, when it will start to apply as its primary basis of accounting the International Financial Reporting Standards published by the International Accounting Standards Board and set out in Part I of the CICA Handbook – Accounting. Consequently, future accounting changes to Canadian GAAP are not discussed in these consolidated financial statements as they will never be applied by the company.
 
 
  3   Discontinued Operations
 
During the fourth quarter of 2010, the company engaged in a plan to sell its Life Sciences and Industrial Division to focus its activities in the telecom test and service assurance market. On October 1, 2010, the company closed the sale of that Division for total proceeds of $21,623,000, net of a bank overdraft of $303,000, selling costs of $909,000 and future income taxes of $141,000. As such, this Division has been considered as an operation held for sale and presented as discontinued operations. Assets and liabilities for the comparative period ended August 31, 2010 have been classified as assets held for sale and liabilities related to assets held for sale; revenues and expenses have been classified as discontinued operations for all reporting periods. As a result of the classification of the operations of the Life Sciences and Industrial Division as operation held for sale and as discontinued operations, the company has only one operating segment for all reporting periods. The sale of that Division resulted in a gain on disposal of $13,212,000.
 

 
Page 14 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
The results of the discontinued operations are as follows:
 
   
Three months
ended
February 28,
2011
   
Six months
ended
February 28,
2011
   
Three months
ended
February 28,
2010
   
Six months
ended
February 28,
2010
 
         
(30 days)
   
(90 days)
   
(181 days)
 
Sales
  $     $ 1,991     $ 6,159     $ 11,427  
Gross margin
  $     $ 989     $ 3,344     $ 6,207  
Earnings (loss) from operations
  $     $ (6 )   $ 1,278     $ 2,050  
Gain from disposal of discontinued operations
  $     $ 13,212     $     $  
Net earnings from discontinued operations
  $     $ 12,926     $ 898     $ 1,462  
Basic net earnings from discontinued operations per share
  $     $ 0.22     $ 0.02     $ 0.02  
Diluted net earnings from discontinued operations per share
  $     $ 0.21     $ 0.01     $ 0.02  
 
The assets and liabilities of the discontinued operations as at August 31, 2010 are presented as assets held for sale and liabilities related to assets held for sale as follows:
 
Assets
     
       
Current assets
     
Cash
  $ 669  
Accounts receivable
    84  
Income taxes and tax credits recoverable
    188  
Inventories
    2,670  
Prepaid expenses
    158  
Future income taxes
    222  
         
Current assets held for sale
    3,991  
         
Tax credits recoverable
    2,142  
Property, plant and equipment
    349  
Intangible assets
    48  
Goodwill
    4,769  
         
Long-term assets held for sale
    7,308  
         
    $ 11,299  
Liabilities
       
         
Current liabilities related to assets held for sale
  $ 2,531  
         
Long-term liabilities related to assets held for sale
    537  
         
    $ 3,068  
 
 
 
Page 15 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
  4   Capital Disclosures
 
The company is not subject to any external restrictions on its capital.
 
The company’s objectives when managing capital are:
 
·  
To maintain a flexible capital structure, which optimizes the cost of capital at acceptable risk;
·  
To sustain future development of the company, including research and development activities, market development and potential acquisitions of complementary businesses or products; and
·  
To provide the company’s shareholders with an appropriate return on their investment.
 
The company defines its capital as shareholders’ equity, excluding accumulated other comprehensive income. Accumulated other comprehensive income’s main components are the cumulative foreign currency translation adjustment, which is the result of the translation of the company’s consolidated financial statements into US dollars (the reporting currency), as well as after-tax unrealized gains (losses) on forward exchange contracts.
 
The capital of the company amounted to $175,217,000 and $193,431,000 as at August 31, 2010 and February 28, 2011, respectively.
 
 
  5   Financial Instruments
 
Financial assets and liabilities are initially recognized at fair value and their subsequent measurement depends on their classification, as described below. Their classification depends on the intended purpose when the financial instruments have been acquired or issued, as well as on their characteristics and their designation by the company.
 
Classification
 
 
Financial assets
 
 
Cash
Held for trading
 
Short-term investments
Available for sale
 
Accounts receivable
Loans and receivables
 
Forward exchange contracts
Cash flow hedge
 
Financial liabilities
 
 
Accounts payable and accrued liabilities
Other financial liabilities
 
Long-term debt
Other financial liabilities
 
Other liabilities
Other financial liabilities
 
Forward exchange contracts
Cash flow hedge
 
Held-for-trading, available-for-sale and cash flow hedge financial instruments are subsequently measured at fair value. Loans and receivables and other financial liabilities are subsequently measured at amortized cost using the effective interest method.
 
Fair value hierarchy
 
The company’s cash, short-term investments and forward exchange contracts are measured at fair value at each balance sheet date. The company’s short-term investments are classified within level 1 of the fair value hierarchy because they are valued using quoted market prices in active markets. The company’s cash and forward exchange contracts are classified within level 2 of the hierarchy because they are valued using quoted prices that are not active and forward foreign exchange rates at the balance sheet date.
 

 
Page 16 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
Market risk
 
Currency risk
 
The principal measurement currency of the company is the Canadian dollar. The company is exposed to a currency risk as a result of its export sales of products manufactured in Canada, China and Finland, the majority of which are denominated in US dollars and euros. This risk is partially hedged by forward exchange contracts (US dollars) and certain operating expenses (US dollars and euros). Forward exchange contracts, which are designated as cash flow hedging instruments, qualify for hedge accounting.
 
As at February 28, 2011, the company held contracts to sell US dollars for Canadian dollars at various forward rates, which are summarized as follows:
 
 
Expiry dates
 
Contractual
amounts
 
Weighted average contractual
forward rates
           
 
March 2011 to August 2011
 
$        13,500
 
 1.0906
 
September 2011 to August 2012
 
          20,400
 
 1.0802
 
September 2012 to January 2013
 
               1,500
 
 1.0722
 
Total
 
$        35,400
 
 1.0838
 
The carrying amount of forward exchange contracts is equal to fair value, which is based on the amount at which they could be settled based on estimated current market rates. The fair value of forward exchange contracts amounted to net gains of $597,000 as at August 31, 2010 and $3,818,000 as at February 28, 2011.
 
Based on the portfolio of forward exchange contracts as at February 28, 2011, the company estimates that the portion of the net unrealized gains on these contracts as of that date, which will be realized and reclassified from accumulated other comprehensive income to net earnings over the next 12 months, amounts to $2,808,000.
 
As at February 28, 2011, forward exchange contracts in the amount of $2,808,000 are presented as current assets in other receivable in the balance sheet and forward exchange contracts, in the amount of $421,000, are presented as long-term assets in forward exchange contracts in the balance sheet. These forward exchange contracts are not yet recorded within sales.
 
During the three months ended February 28, 2010 and 2011, the company recognized within its sales foreign exchange gains on forward exchange contracts of $432,000 and $591,000, respectively. During the six months ended February 28, 2010 and 2011, the company recognized within its sales foreign exchange gains on forward exchange contracts of $499,000 and $1,051,000, respectively.
 

 
Page 17 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
The following table summarizes significant financial assets and liabilities that are subject to currency risk as at February 28, 2010 and 2011:
 
   
As at February 28,
 
   
2011
   
2010
 
   
Carrying/
nominal
amount
(in thousands
of US dollars)
   
Carrying/
nominal
amount
(in thousands
of euros)
   
Carrying/
nominal
amount
(in thousands
of US dollars)
   
Carrying/
nominal
amount
(in thousands
of euros)
 
                         
Financial assets
                       
Cash
  $ 10,369     1,128     $ 4,645     5,509  
Accounts receivable
    32,010       3,846       24,268       2,586  
      42,379       4,974       28,913       8,095  
Financial liabilities
                               
Accounts payable and accrued liabilities
    9,971       405       7,714       394  
Forward exchange contracts (nominal amount)
    4,800             6,200        
      14,771       405       13,914       394  
Net exposure
  $ 27,608     4,569     $ 14,999     7,701  
 
The value of the Canadian dollar compared to the US dollar was CA$0.9714 = US$1.00 as at February 28, 2011.
 
The value of the Canadian dollar compared to the euro was CA$1.3432 = €1.00 as at February 28, 2011.
 
The following sensitivity analysis summarizes the effect that a change in the value of the Canadian dollar (compared to the US dollar and euro) on financial assets and liabilities denominated in US dollars and euros would have on net earnings, net earnings per diluted share and comprehensive income, based on the foreign exchange rates as at February 28, 2011:
 
·  
An increase (decrease) of 10% in the period-end value of the Canadian dollar compared to the US dollar would decrease (increase) net earnings by $1,503,000 or $0.02 per diluted share and $2,374,000, or $0.04 per diluted share as at February 28, 2010 and 2011, respectively.
 
·  
An increase (decrease) of 10% in the period-end value of the Canadian dollar compared to the euro would decrease (increase) net earnings by $851,000 or $0.01 per diluted share and $618,000, or $0.01 per diluted share as at February 28, 2010 and 2011, respectively.
 
·  
An increase (decrease) of 10% in the period-end value of the Canadian dollar compared to the US dollar would increase (decrease) other comprehensive income by $2,726,000 and $2,134,000 as at February 28, 2010 and 2011, respectively.
 
The impact of the change in the value of the Canadian dollar compared to the US dollar and the euro on these financial assets and liabilities is recorded in the foreign exchange gain or loss line item in the consolidated statements of earnings, except for outstanding forward contracts, which impact is recorded in other comprehensive income. The change in the value of the Canadian dollar compared to the US dollar and the euro also impacts the company’s balances of income tax and tax credits recoverable or payable and future income tax assets and liabilities of its integrated foreign subsidiaries; this may result in additional and significant foreign exchange gain or loss. However, these assets and liabilities are not considered financial instruments and are excluded from the sensitivity analysis above. The foreign exchange rate fluctuations also flow through the statements of earnings line items, as the company has a significant net exposure in Canadian dollars and in euros, and the company reports its results in US dollars; that effect is not reflected in the sensitivity analysis above.
 

 
Page 18 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
Interest rate risk
 
The company is exposed to interest rate risks through its short-term investments and its long-term debt.
 
Short-term investments
 
As at February 28, 2011, the company’s short-term investments, in the amount of $47,724,000, bear interest at rates ranging between 1.0% and 1.2% and mature in March and April 2011.
 
The fair value of short-term investments based on market value amounted to $10,379,000 and $47,724,000 as at August 31, 2010 and February 28, 2011, respectively.
 
Due to their short-term maturity of usually three months or less, the company’s short-term investments are not subject to significant fair value interest rate risk. Accordingly, change in fair value has been nominal to the degree that amortized cost has historically approximated the fair value. Any change in fair value of the company’s short-term investments, all of which are classified as available for sale, is recorded in other comprehensive income.
 
Long-term debt
 
As at February 28, 2011, the company’s long-term debt, in the amount of $1,858,000, bears interest at an annual rate of 2.95% and matures in December 2013 (note 8).
 
Other financial instruments
 
Cash, accounts receivable and accounts payable and accrued liabilities are non-interest-bearing financial assets and liabilities. Accounts receivable and accounts payable and accrued liabilities are financial instruments whose carrying value approximates their fair value due to their short-term maturity.
 
Credit risk
 
Financial instruments that potentially subject the company to credit risk consist primarily of cash, short-term investments, accounts receivable and forward exchange contracts (with a positive fair value). As at February 28, 2011, the company’s short-term investments consist of debt instruments issued by eleven (nine as at August 31, 2010) high-credit quality corporations and trusts. None of these debt instruments are expected to be affected by a significant liquidity risk. The company’s cash and forward exchange contracts are held with or issued by high-credit quality financial institutions; therefore, the company considers the risk of non-performance on these instruments to be limited.
 
Generally, the company does not require collateral or other security from customers for trade accounts receivable; however, credit is extended to customers following an evaluation of creditworthiness. In addition, the company performs ongoing credit reviews of all its customers and establishes an allowance for doubtful accounts receivable when accounts are determined to be uncollectible. Allowance for doubtful accounts amounted to $1,243,000 and $1,318,000 as at August 31, 2010 and February 28, 2011, respectively. Bad debt recovery amounted to nil and $72,000 for the three months ended February 28, 2010 and 2011, respectively, and $17,000 and $211,000 for the six months ended February 28, 2010 and 2011, respectively.
 
For the three months ended February 28, 2010 and 2011, no customer represented more than 10% of consolidated sales.
 

 
Page 19 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
The following table summarizes the age of trade accounts receivable:
 
   
As at
February 28,
2011
   
As at
August 31,
2010
 
             
Current
  $ 36,259     $ 38,663  
Past due, 0 to 30 days
    9,246       6,787  
Past due, 31 to 60 days
    2,575       1,991  
Past due, more than 60 days, less allowance for doubtful accounts of $1,243 and $1,318 as at August 31, 2010 and February 28, 2011, respectively
    3,338       2,749  
Total accounts receivable
  $ 51,418     $ 50,190  
 
Liquidity risk
 
Liquidity risk is defined as the potential that the company cannot meet its obligations as they become due.
 
The following table summarizes the contractual maturity of the company’s derivative and non-derivative financial liabilities as at February 28, 2011:
 
   
As at February 28, 2011
 
                   
   
0-12
months
   
13-24
months
   
25-36
months
 
                   
Accounts payable and accrued liabilities
  $ 34,337     $     $  
Long-term debt
    619       619       620  
Other liabilities
          292        
Forward exchange contracts
                       
Outflow
    26,400       9,000        
Inflow
    (29,496 )     (10,001 )      
Total
  $ 31,860     $ (90 )   $ 620  

 
   
As at August 31, 2010
 
                         
   
0-12
months
   
13-24
months
   
25-36
months
   
Over 36
months
 
                         
                         
Accounts payable and accrued liabilities
  $ 29,711     $     $     $  
Long-term debt
    568       568       568       283  
Other liabilities
          295              
Forward exchange contracts
                               
Outflow
    29,500       20,400       1,500        
Inflow
    (30,141 )     (20,662 )     (1,508 )      
Total
  $ 29,638     $ 601     $ 560     $ 283  
 
As at February 28, 2011, the company had $73,603,000 in cash and short-term investments and $58,278,000 in accounts receivable. In addition to these financial assets, the company has unused available lines of credit totaling $14,137,000 for working capital and other general corporate purposes, including potential acquisitions and its share repurchase program as well as unused lines of credit of $17,862,000 for foreign currency exposure related to its forward exchange contracts.
 

 
Page 20 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
  6   Inventories
 
   
As at
February 28,
2011
   
As at
August 31,
2010
 
             
Raw materials
  $ 26,599     $ 21,505  
Work in progress
    2,064       1,975  
Finished goods
    19,226       16,848  
                 
    $ 47,889     $ 40,328  
 
The cost of sales comprised almost exclusively the amount of inventory recognized as an expense during the reporting periods, except for the related amortization, which is shown separately in operating expenses.
 
Inventory write-down amounted to $620,000 and $835,000 for the three months ended February 28, 2010 and 2011, respectively and $1,210,000 and $1,546,000 for the six months ended February 28, 2010 and 2011, respectively.
 
 
  7   Accounts Payable and Accrued Liabilities
 
   
As at
February 28,
2011
   
As at
August 31,
2010
 
             
Trade
  $ 15,917     $ 14,244  
Salaries and social benefits
    14,759       12,400  
Warranty
    1,424       579  
Commissions
    897       831  
Forward exchange contracts
          232  
Other
    3,162       2,584  
                 
    $ 36,159     $ 30,870  
 
Changes in the warranty provision are as follows:
 
   
Six months ended
February 28,
 
             
   
2011
   
2010
 
             
Balance – Beginning of period
  $ 579     $ 699  
Provision
    1,094       472  
Settlements
    (249 )     (276 )
                 
Balance – End of period
  $ 1,424     $ 895  
 
 
 
Page 21 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
  8   Long-Term Debt
 
   
As at
February 28,
2011
   
As at
August 31,
2010
 
             
Loan collateralized by assets of NetHawk Oyj, denominated in euros (€1,568), bearing interest at 2.95%, repayable in semi-annual installments of $310 (€224), maturing in December 2013
  $ 1,858     $ 1,987  
                 
Less: current portion
    619       568  
                 
    $ 1,239     $ 1,419  
 
 
  9   Contingency
 
On November 27, 2001, a class action suit was filed in the United States District Court for the Southern District of New York against the company, four of the underwriters of its Initial Public Offering and some of its executive officers pursuant to the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder and Sections 11, 12 and 16 of the Securities Act of 1933. This class action alleges that the company’s registration statement and prospectus filed with the Securities and Exchange Commission on June 29, 2000, contained material misrepresentations and/or omissions resulting from (i) the underwriters allegedly soliciting and receiving additional, excessive and undisclosed commissions from certain investors in exchange for which they allocated material portions of the shares issued in connection with the company’s Initial Public Offering; and (ii) the underwriters allegedly entering into agreements with customers whereby shares issued in connection with the company’s Initial Public Offering would be allocated to those customers in exchange for which customers agreed to purchase additional amounts of shares in the after-market at predetermined prices.
 
On April 19, 2002, the plaintiffs filed an amended complaint containing master allegations against all of the defendants in all of the 310 cases included in this class action and also filed an amended complaint containing allegations specific to four of the company’s underwriters, the company and two of its executive officers. In addition to the allegations mentioned above, the amended complaint alleges that the underwriters (i) used their analysts to manipulate the stock market; and (ii) implemented schemes that allowed issuer insiders to sell their shares rapidly after an initial public offering and benefit from high market prices. As concerns the company and its two executive officers in particular, the amended complaint alleges that (i) the company’s registration statement was materially false and misleading because it failed to disclose the additional commissions and compensation to be received by underwriters; (ii) the two named executive officers learned of or recklessly disregarded the alleged misconduct of the underwriters; (iii) the two named executive officers had motive and opportunity to engage in alleged wrongful conduct due to personal holdings of the company’s stock and the fact that an alleged artificially inflated stock price could be used as currency for acquisitions; and (iv) the two named executive officers, by virtue of their positions with the company, controlled the company and the contents of the registration statement and had the ability to prevent its issuance or cause it to be corrected. The plaintiffs in this suit seek an unspecified amount for damages suffered.
 
In July 2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint and a decision was rendered on February 19, 2003. Only one of the claims against the company was dismissed. On October 8, 2002, the claims against its officers were dismissed pursuant to the terms of Reservation of Rights and Tolling Agreements entered into with the plaintiffs.
 

 
Page 22 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
In June 2004, an agreement of partial settlement was submitted to the court for preliminary approval. The proposed partial settlement was between the plaintiffs, the issuer defendants in the consolidated actions, the issuer officers and directors named as defendants, and the issuers’ insurance companies. The court granted the preliminary approval motion on February 15, 2005, subject to certain modifications. On August 31, 2005, the court issued a preliminary order further approving the modifications to the settlement and certifying the settlement classes. The court also appointed the notice administrator for the settlement and ordered that notice of the settlement be distributed to all settlement class members by January 15, 2006. The settlement fairness hearing occurred on April 24, 2006, and the court reserved decision at that time.
 
While the partial settlement was pending approval, the plaintiffs continued to litigate against the underwriter defendants. The district court directed that the litigation proceed within a number of “focus cases” rather than in all of the 310 cases that have been consolidated. The company's case is not one of these focus cases. On October 13, 2004, the district court certified the focus cases as class actions. The underwriter defendants appealed that ruling, and on December 5, 2006, the Court of Appeals for the Second Circuit reversed the district court’s class certification decision.
 
On April 6, 2007, the Second Circuit denied the plaintiffs’ petition for rehearing of that decision and, on May 18, 2007, the Second Circuit denied the plaintiffs’ petition for rehearing en banc . In light of the Second Circuit’s opinion, liaison counsel for all issuer defendants, including the company, informed the court that this settlement cannot be approved, because the defined settlement class, like the litigation class, cannot be certified. On June 25, 2007, the district court entered an order terminating the settlement agreement. On August 14, 2007, the plaintiffs filed their second consolidated amended class action complaints against the focus cases and, on September 27, 2007, again moved for class certification. On November 12, 2007, certain defendants in the focus cases moved to dismiss the second consolidated amended class action complaints. On March 26, 2008, the district court denied the motions to dismiss, except as to Section 11 claims raised by those plaintiffs who sold their securities for a price in excess of the initial offering price and those who purchased outside of the previously certified class period. Briefing on the class certification motion was completed in May 2008. That motion was withdrawn without prejudice on October 10, 2008.
 
On April 2, 2009, a stipulation and agreement of settlement between the plaintiffs, issuer defendants and underwriter defendants was submitted to the Court for preliminary approval. The Court granted the plaintiffs’ motion for preliminary approval and preliminarily certified the settlement classes on June 10, 2009. The settlement fairness hearing was held on September 10, 2009. On October 6, 2009, the Court entered an opinion granting final approval to the settlement and directing that the Clerk of the Court close these actions. On August 26, 2010, based on the expiration of the tolling period stated in the Tolling Agreements, the plaintiffs filed a Notice of Termination of Tolling Agreement and Recommencement of Litigation against the two named executive officers. The plaintiffs stated to the Court that they do not intend to take any further action against the named executive officers at this time. Appeals of the opinion granting final approval have been filed. Given that the settlement remains subject to appeal as of the date of issuance of these financial statements, the ultimate outcome of the contingency is uncertain. However, based on the settlement approved on October 6, 2009, and the related insurance against such claims, management has determined the impact to its financial position and results of operations as at and for the three- and six-month periods ended February   28, 2011 to be immaterial.
 
 
  10   Interim Financial Information
 
On November 5, 2010, the company announced that its Board of Directors had authorized the third renewal of its share repurchase program, by way of a normal course issuer bid on the open market, of up to 10% of its public float (as defined by the Toronto Stock Exchange), or 2,012,562 subordinate voting shares, at the prevailing market price. The company expects to use cash, short-term investments or future cash flows from operations to fund the repurchase of shares. The period of the normal course issuer bid started on November 10, 2010, and will end on November 9, 2011, or at an earlier date if the company repurchases the maximum number of shares permitted under the bid. The program does not require that the company repurchases any specific number of shares, and it may be modified, suspended or terminated at any time and without prior notice. All shares repurchased under the bid will be cancelled.
 

 
Page 23 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
The following tables summarize changes in share capital for the six months ended February 28, 2010 and 2011.
 
   
Six months ended February 28, 2010
 
   
Multiple voting shares
   
Subordinate voting shares
       
   
Number
   
Amount
   
Number
   
Amount
   
Total
amount
 
                               
Balance as at August 31, 2009
    36,643,000     $ 1       22,736,302     $ 104,845     $ 104,846  
Redemption of restricted share units
                13,663              
Reclassification of stock-based compensation costs to share capital upon exercise of stock awards
                      86       86  
Redemption of share capital
                (3,600 )     (17 )     (17 )
                                         
Balance as at November 30, 2009
    36,643,000       1       22,746,365       104,914       104,915  
Exercise of stock options
                31,700       127       127  
Redemption of restricted share units
                75,537              
Reclassification of stock-based compensation costs to share capital upon exercise of stock awards
                      541       541  
                                         
Balance as at February 28, 2010
    36,643,000     $ 1       22,853,602     $ 105,582     $ 105,583  

 
   
Six months ended February 28, 2011
 
   
Multiple voting shares
   
Subordinate voting shares
       
   
Number
   
Amount
   
Number
   
Amount
   
Total
amount
 
                               
Balance as at August 31, 2010
    36,643,000     $ 1       22,936,709     $ 106,125     $ 106,126  
Exercise of stock options
                11,478       61       61  
Redemption of restricted share units
                157,790              
Reclassification of stock-based compensation costs to share capital upon exercise of stock awards
                      861       861  
                                         
Balance as at November 30, 2010
    36,643,000       1       23,105,977       107,047       107,048  
Conversion of multiple voting shares into subordinate voting shares
    (5,000,000 )           5,000,000              
Exercise of stock options
                263,622       1,219       1,219  
Redemption of restricted share units
                90,782              
Redemption of deferred share units
                37,491              
Reclassification of stock-based compensation costs to share capital upon exercise of stock awards
                      1,291       1,291  
                                         
Balance as at February 28, 2011
    31,643,000     $ 1       28,497,872     $ 109,557     $ 109,558  
 
 
 
Page 24 of 54

 
 
EXFO Inc.
Notes to Unaudited Interim Consolidated Financial Statements

(tabular amounts in thousands of US dollars, except share and per share data and as otherwise noted)
 
  11   Net Research and Development Expenses
 
Net research and development expenses comprise the following:
 
   
Three months
ended
February 28,
2011
   
Six months
ended
February 28,
2011
   
Three months
ended
February 28,
2010
   
Six months
ended
February 28,
2010
 
                         
Gross research and development expenses
  $ 13,824     $ 27,514     $ 9,759     $ 18,912  
Research and development tax credits and grants
    (2,580 )     (4,669 )     (1,346 )     (2,718 )
                                 
    $ 11,244     $ 22,845     $ 8,413     $ 16,194  
 
 
  12   Income Taxes
 
For the three- and six-month periods ended February 28, 2010 and 2011, the reconciliation of the income tax provision calculated using the combined Canadian federal and provincial statutory income tax rate with the income tax provision in the financial statements is as follows:
 
   
Three months
ended
February 28,
2011
   
Six months
ended
February 28,
2011
   
Three months
ended
February 28,
2010
   
Six months
ended
February 28,
2010
 
                         
Income tax provision at combined Canadian federal and provincial statutory tax rate (29% in 2011 and 30.5% in 2010)
  $ 1,261     $ 2,407     $ 474     $ 746  
                                 
Increase (decrease) due to: