2010 Financial Results. Fiber Optic Systems Technology, Inc. Management's Discussion and Analysis. May 02, 2011

Transcription

1 2010 Financial Results Fiber Optic Systems Technology, Inc. Management's Discussion and Analysis May 02, 2011 The following Management s Discussion and Analysis ( MD&A ) relates to the financial condition and results of operations of Fiber Optic Systems Technology, Inc. (the Company or Fox Tek ) for the period ended December 31, It should be read in conjunction with the audited consolidated financial statements for the period ended December 31, 2010 and related notes. The Company prepares and files its consolidated financial statements in Canadian dollars and in accordance with Canadian generally accepted accounting principles (GAAP). Additional information relating to the Company is available on SEDAR at The Company prepares and files its consolidated financial statements and MD&A in Canadian dollars and in accordance with Canadian generally accepted accounting principles, ( GAAP ). Unless otherwise noted, all numbers are expressed in thousands except for per share amounts which are expressed in dollars. FORWARD-LOOKING STATEMENTS This MD&A contains certain forward-looking statements, except for historical information, and reflect the Company s present assumptions regarding future events. These statements involve known and unknown risks, uncertainties, and other factors that may cause the Company s actual results, levels of activity, performance, and/or achievements to be materially different from any future results, levels of activity, performance, or achievements expressed or implied by these forward-looking statements. Certain statements contained in this document constitute forward-looking statements. When used in this document, the words may, would, could, will, intend, plan, propose, anticipate, believe, forecast, estimate, expect and similar expressions used by any of the Company s management, are intended to identify forward-looking statements. Such statements reflect the Company s internal projections, expectations, future growth, performance and business prospects and opportunities and are based on information currently available to the Company. Since they relate to the Company s current views with respect to future events, they are subject to certain risks, uncertainties and assumptions. Many factors could cause the Company s actual results, performance or achievements to be materially different from any future results, performance or achievements that may be expressed or implied by such forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue Page 1 of 16

2 reliance on such forward-looking statements. The Company does not intend, and does not assume any obligation, to update any such factors or to publicly announce the result of any revisions to any of the forward-looking statements contained herein to reflect future results, events or developments except as required by applicable securities legislation, regulations or policies. OVERVIEW OF BUSINESS Corporate Overview Fiber Optic Systems Technology, Inc. (the Company or Fox Tek ) incorporated on October 13, 1999 under the laws of the State of Delaware,was formed to develop, integrate and sell fiber optic sensing systems for the rapidly expanding strain/temperature sensing market. The target market includes the monitoring, communication, alarming and prediction of safe/unsafe conditions in structures and facilities. Marcon International Inc. ( Marcon ), a wholly-owned subsidiary of Fox Tek, is in the business of selling equipment to foreign multinational companies operating primarily in the Middle East and to the United States government. The equipment is purchased from various suppliers in Canada, the United States and Europe. Marcon was incorporated under the laws of the Province of Ontario on April 28, On August 1, 2010, Marcon entered into an Asset Purchase Agreement with Knoxbridge Corp ( Knoxbridge ), whereby Knoxbridge transferred certain net assets, to Marcon in exchange for shares and debt. The Asset Purchase Agreement also resulted in the transfer of all the shares of Marcon International (USA), Inc. and Marcon International (UK) Ltd to Marcon.The net assets and transactions within two entities were not material. On September 24, 2010, the Company completed a reverse take-over transaction ( RTO ) with Marcon that did constitute a business. The Company issued 91,815 common shares from treasury to Marcon s sole shareholder, Knoxbridge, in exchange for all of Marcon s outstanding shares. Although legally, the Company is regarded as the parent or the continuing company, Marcon, whose shareholders holds approximately 55.67% of the voting shares of the Company after the reverse takeover, is treated as the acquirer. Consequently, the Company is deemed a continuation of Marcon and control of the net assets and business of the Company is deemed to have been acquired by Marcon in consideration for the issuance of the shares of the Company. The consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles and include the accounts of the Company and its wholly-owned subsidiaries, Fiber Optic Systems Technology (Canada), Inc, Fiber Optic Systems Technology (U.S.A.), Inc., Fox-Tek Canada, Inc., PinPoint FOX-TEK Inc., Marcon International Inc., Marcon International (USA) Inc., and Marcon International Page 2 of 16

3 (UK) Ltd. All inter-company accounts and transactions have been eliminated. The consolidated statement of operations includes the operations of the Company from September 24, 2010 to December 31, 2010 and includes the operations of Marcon from April 28, 2010 to December 31, BUSINESS DEVELOPMENT During the 4th quarter, Fox Tek completed the sale of 10 PinPoint systems. Fox Tek has been able to get a high market acceptance shown by the number of repeated customers who are ordering multiple units per order which demonstrates market traction. Most of our business is repeat business from clients and in addition we are successfully marketing our systems. Fox Tek continues to support its independent sales agents and distributors primarily outside of North America with the intent of utilizing their local contacts and established relationships within the oil and gas industry to expedite the distribution of Fox Tek s products in the local jurisdictions. We have received a 20 PinPoint systems order from Zamil (Saudi Arabia) who are our Middle East partner, the production of these systems will be completed by the third quarter. Zamil is a global holding company with diverse interest and capabilities. It provides innovative, high quality and price competitive products and services as well as investment opportunities for investors, partners and stakeholders in the industrial, petrochemicals and services sectors. Fox Tek has also streamlined its production process to meet the higher demand of our systems. This combined with the significant reductions in overhead expenses shows steady progress towards corporate profitability. Notable events include the following: Multi unit sales orders continued for PinPoint systems, produced and hipped 10 PinPoint units in Q On January 25, 2011 Fox Tek signed a letter of intent (the LOI with Zamil Group Holding Company ( Zamil ). Under the terms of the LOI, the corporation will build up to 20 PinPoint systems for Zamil for an aggregated purchase price of $ 1.5 million. On Feb 16, 2010 FOX-TEK received a purchase order to this effect and started production of these units. Delivery of the 20 PinPoint systems is expected to be completed by the end of 3rd quarter. Page 3 of 16

4 Se le cte d Ope rating and Financial Re sults (in thousands of dollars except per unit and unit amounts) For period ended December $ Revenues 1,681 Cost of sales 1,263 Gross profit 418 Operating expenses 476 Loss before undernoted items (58) Net loss and comprehensive loss (442) Net loss per share (basic and diluted) (0.00) Cash & cash equivalents 1,089 Total assets 5,651 Long term debt 23 Total liabilities 2,266 Total shareholders equity 3,385 Net Working Capital 866 Shares outstanding - Issued 164,928 Cash Dividends declared per share Nil The Company recorded revenue of $ 1,681, for the period ended December 31, 2010, and the Company had a gross profit $418 (24.86%) during the period. The Company s two divisions operating with different gross margins on its products. The Marcon division has a gross margin on its sales of approximately 14%, while the Fox Tek division has a gross margin rate of approximately 55%. The Company will continue expanding the sales of its Fox-tech division to drive greater cash flow from each dollar of sales. Total operating expenses was $476 for the period ended December 31, itemized details are noted below. The Page 4 of 16

5 PERIOD ENDED DECEMBER Engineering $ 74 Selling 59 General and Administrative 316 Amortization 19 Foreign Exchange (gain) loss 8 Total Operating Expenses $ 476 Interest and accretion interest 94 Stock based compensation 290 General and Administrative was $316 for the period ended December 31, 2010, net of investment tax credits in the amount of $137. Engineering and Selling expenses were $ 74 and $ 59 for the period ending December 31, 2010 respectively. The Company is continually making the effort in reducing all expenses in an effort to become cash flow positive over the next fiscal year. Stock based compensation expense of $290 relates mainly to the issuance of 11,250 stock options during the period to employees and director of the corporation, of these, 3,750 vested in The fair value of the vested options was valued using Black Sholes option model which valued the vested options at $0.06 per option granted. Loss from operations before interest and stock based compensation was $58. Net loss and comprehensive loss for the period ending December 31, 2010 was $442 ($0.00 per share) SEGMENTED INFORMATION The Company s reportable segments are strategic business units that offer different services and/or products. They are managed separately because each segment requires different strategies and involves different aspects of management expertise. The accounting policies of the segments are the same as those described in the summary of significant accounting policies. The Company carries out its operations through wholly-owned entities. These entities are located in Canada and the United States. Page 5 of 16

6 For the period from April 28, 2010 to December 31, 2010 Marcon Fox tek Corporate (thousands of dollars) Operations Operations Operations Total Sales revenue $ 1,230 $ 451 $ - $ 1,681 Cost of sales 1, ,263 Gross profit Operating expenses: Engineering - (74) - (74) Selling (2) (57) - (59) General and administrative (251) (65) - (316) Loss before under noted items (86) 55 - (31) Other expenses Interest (6) (6) (82) (94) Amortization (5) (14) - (19) Stock based compensation (87) (126) (77) (290) Foreign exchange loss (5) (3) - (8) Segment loss $ (189) $ (94) $ (159) $ (442) Page 6 of 16

7 Selected Operating Results For the Periods Ended June 30, 2010 and December 31, 2010 (in thousands of dollars except per unit and unit amounts) Q3 Q4 (thousands of dollars) Operations Operations Total Sales revenue $ 454 $ 1,227 $ 1,681 Cost of sales ,263 Gross profit Operating expenses: Engineering (4) (70) (74) Selling (1) (58) (59) General and administrative (98) (218) (316) Amortization (1) (18) (19) Foreign exchange loss - (8) (8) Loss before under noted items (57) (1) (58) Other expenses Interest and accretion interest (9) (85) (94) Stock based compensation (290) (290) Net loss and comprensive loss (66) (376) (442) In the fourth quarter the Company recorded revenue of $ 1,227 compared to $ 454 in the third quarter, representing an increase of $ 773 or approximately 170%. For the fourth quarter the company had a Gross profit of $ 371 (30.23%) compared to $ 47 (10.35%) in the third quarter. The increase in the sales and gross margin for the fourth quarter compared to the third quarter was due to the increase sales for the Fox-tech division. The operating loss before interest and stock based compensation for the fourth quarter was $ 1 compared to a loss of $57 in the third quarter of Net loss and comprehensive loss for the fourth quarter was $ 376 compared to a loss of $ 66 for the third quarter of The increase in the net loss and compressive loss is mainly due to the recording of stock based compensation expense in the amount of $290. Quarterly Revenue and Operating Results May Be Difficult to Predict The Company s revenue continues to be difficult to forecast and is likely to fluctuate significantly from quarter to quarter. In addition, the Company s operating results may not Page 7 of 16

8 follow any past trends. The factors affecting the Company s revenue and results of operations, many of which are outside the Company s control, include: competitive conditions in the industrial sensing industry, including new products, product announcements and special pricing offered by competitors of the Company; market acceptance of the Company s products; ability to hire, train and retain sufficient sales and professional services staff; ability to complete its service obligations related to product sales in a timely manner; varying size, timing and contractual terms of product orders, which may delay the recognition of revenue; ability to maintain existing relationships and to create new relationships to assist with sales and marketing efforts; the length and variability of the sales cycles for the Company s products; strategic decisions by the Company or its competitors, such as acquisitions, divestitures, spin-offs, joint ventures, strategic investments or changes in business strategy; general weakening of the oil and gas industry resulting in a decrease in the overall demand for the products and services offered by the Company or otherwise affecting its customers capital investment levels in workforce management software; changes in the Company s pricing policies and the pricing policies of its competitors; timing of product development and new product initiatives; and changes in the mix of revenue attributable to substantially lower-margin service revenue as opposed to higher-margin product license revenue. Because the Company s revenue will be dependent upon a relatively small number of transactions, even minor variations in the rate and timing of conversion of sales prospects into revenue could cause the Company to plan or budget inaccurately, which variations could adversely affect the Company s financial results. Delays and reductions in the amount of, or cancellations of, customers purchases would adversely affect the Company s revenue, results of operations and financial condition. LIQUIDITY AND CASH RESOURCES As at December 31, 2010, the Company had positive working capital of $866. Cash used in operating activities was $1,271 for the period ending December 31, Cash received from financing activities was $883 for the period ending December 31, The cash flow from financing activities was attributable to a brokered private placement net of repayment of bank indebtedness of $437. The completed brokered private placement was for 23,348 units at a price of $0.06 per unit for gross proceeds of $1,401. Each unit consisted of one common share of the Company and one common share purchase warrant, with each warrant entitling the holder to acquire an additional one common share of the Company for a price of $0.06. Each common share purchase warrant has an exercise price of $0.15 for the first two years and $0.20 for the third year Page 8 of 16

9 from the date of closing. Total share issuance cost was $73, inclusive of $37 of share issuance cost allocated to the common share purchase warrants. The Company s cash flow from investing activities in the amount of $1,477 relates mainly to the cash acquired from the reverse takeover transaction. During the period ended December 31, 2010, the Company had an increase cash position of and cash and cash equivalent of $1,089 derived from the items noted above. The Company has term loan of $43, payable over the next 3 years, $20 in 2011, $ 20 in 2012, and $3 in The Company is committed under operating lease agreements for the rental of its premises. Minimum annual future lease payments for next three year are approximately $69 for 2011, $67 for 2012 and $68 for Management will continue to work on maintaining an optimal inventory level and the timely collection of accounts receivable to minimize its working capital requirements. The Company completed a non-brokered private placement of secured convertible debentures of $365 with 4,056 detachable warrants on May 7, The debentures bear interest at a rate of 12% per annum payable in cash at maturity. Each warrant entitles the holder to purchase one common share at $0.10 for a period of 12 months from the closing date of the offering. The Company is pursuing a number of options, to convert, or to extend and or pay a portion of the debenture The Company will continue to focus on cost reductions and increase margins on its sales to become cash flow positive in the next fiscal year. The Company expects that funds from operations will be sufficient in the short and near-term to meet planned organic growth, anticipated obligations and to fund intended capital expenditures. Fox Tek will investigate funding mechanisms for long term growth including additional engineering and development projects and business development activities. SHARE CAPITAL, WARRANT, AND OPTIONS a) Share capital Authorized: 180,000 shares of voting common stock, par value of US$0.01 per share. Page 9 of 16

10 Issued and outstanding: Common Stock # of Shares $ Balance at date of RTO 48,932 21,653 Share capital eliminated on RTO - (21,653) Shares issued is escrow pursuant to RTO (i) 91,815 1,596 Share issued as transaction cost for RTO (i) Equity portion of convertible debenture (iii) Share issued on private placement (ii) 23,348 1,401 Share issuance costs (ii) - (73) Allocation of warrants issued on private placement (b) (iii) - (464) Balance at December 31, ,928 2,630 i. On September 24, 2010, the Company completed a reverse take-over transaction and issued 91,815 common shares from treasury to Marcon s sole shareholder Knoxbridge in exchange for all of Marcon s outstanding shares for a consideration of $1,596 (see note 3 to the consolidated financial statement). Total transaction costs include the issuance of 833 common shares as a transaction cost valued at $50. ii. Subsequent to the closing of the RTO, the Company completed a brokered private placement of 23,348 units at a price of $0.06 per unit for gross proceeds of $1,401. Each unit consisted of one common share of the Company and one common share purchase warrant, with each warrant entitling the holder to acquire an additional one common share of the Company for a price of $0.06. Each common share purchase warrant has an exercise price of $0.15 for the first two years and $0.20 for the third year from the date of closing. Total share issuance cost was $73, inclusive of $37 of share issuance cost allocated to the common share purchase warrants. iii. As at the date of the RTO the fair value of the conversion option was estimated to be $120 (see note 10 to the consolidated financial statement). The fair value of the conversion option was determined using the Black-Scholes option price model assuming an expected life of 0.62 years, annualized volatility of 107%, a nil dividend payment rate and a risk free rate of 1.1%. b) Common stock purchase warrants: Warrants # $ Balance, April 28, Warrant outstanding at date of RTO (i) 5, Issued on convertible debenture (ii) 4, Issued on private placement (iii) 24, Balance, December 31, , Page 10 of 16

11 i. As of the date of the RTO (note 3) the warrants outstanding were 5,207 with an exercise price of $0.10, expiring March 5, The fair value of the warrants were estimated as at the date of the RTO using the Black-Scholes option pricing model assuming an expected life of 2.45 years, annualized volatility of 107%, a nil dividend payment rate and a risk free rate of 1.59%. ii. The fair value of warrants issued as part of the convertible debenture financing was estimated by management to be $107 (see note 3 to consolidated financial statement). Management as allocated $107 to the warrants valued using the Black- Scholes option pricing model assuming an expected life of 0.62 years, annualized volatility of 107%, nil dividend payment rate and a risk free rate of 1.1%. iii. The fair value of warrants issued on the private placement was estimated to be $464 (inclusive of $37 of share issue costs). The fair value was determined using the Black- Scholes option pricing model assuming an expected life of 3 years, annualized volatility of 107%, a nil dividend payment rate and a risk free rate of 1.70%. The 24,494 warrants issued include 23,348 issued to the participants in the private placement and 1,146 issued to the Broker as transaction cost (see note 8(a)(ii) to the consolidated financial statement). c) Stock option plans: The Company has a stock option plan open to directors, officers, full-time employees and consultants of the Company. Under this plan, the Company may grant total options to a maximum of 10% of the issued and outstanding common shares of the Company on a non-diluted basis. The Company issued 11,250 stock options under the 2010 Stock Option Plan, of these, 3,750 vested in The fair value at the date of grant was $643 or $0.06 per option granted. The fair value was estimated using the Black-Scholes pricing model assuming a risk free interest rate of 1.56%, dividend yield of 0%, expected life of 3 years and a volatility factor using a weighted average of similar proxy companies and the Company s market price over the period of the Company s traded stock of 107%. A summary of the Company s stock option plan is presented below: Page 11 of 16

12 December 31, 2010 Number Weighted of average Changes to stock options: options exercise price Options outstanding as of the reverse takeover 2, Granted 11, Forfeited (10) 0.10 Expired (987) 1.01 Ending balance 12, Exercisable 4, At December 31, 2010 the range of exercise prices of the outstanding options were as follows: Options outstanding Options exercisable Weighted average Weighted Weighted remaining average average Number contractual exercise Number exercise Range of exercise prices outstanding life years price outstanding price $.10-$.20 12, $0.10 4,606 $0.10 $.21-$ $ $0.39 $1.01-$ $ $1.52 The Company issued a 11,250 stock options under the 2010 Stock Option Plan, of these, 3,750 vested in The fair value at the date of grant was $643 or $0.06 per option granted. The fair value was estimated using the Black-Scholes pricing model assuming a risk free interest rates of 1.56%, dividend yield of 0%, expected life of 3 years and a volatility facto using a weighted average of similar proxy companies and the Company s market price over the period of the Company s traded stock of 107%. Share Data As of December 31, 2010 and as at May 02, ,928 common shares issued, 33,757 warrants outstanding and 12,431 options outstanding.. Page 12 of 16

13 Off-Balance Sheet Arrangements Company does not have any off-balance sheet arrangements. TRANSACTIONS WITH RELATED PARTIES At December 31, 2010, $965 note payable is due to Knoxbridge and was issued as part of the consideration for the transfer of assets to Marcon as described in Note 1 and 3 was due to a related party. The note payable is unsecured, non-interest bearing, due on demand, and there are no fixed repayment terms. It is a monetary item measured at the exchange amount. During the period Fox Tek has also purchased office furniture worth $16 from Knoxbridge, a company controlled by the controlling shareholder. These transactions are in the normal course of operations and have been valued in these financial statements at the exchange amount. Amount owing to Knoxbridge at December 31, 2010 is summarized below. These transactions were monetary transactions in the normal course of operations and measured at the exchange amount. A breakdown of these transactions is as follows: 2010 $ Other transactions (10) Due to related party (10) FUTURE ACCOUNTING POLICIES International Financial Reporting Standards The Canadian Accounting Standards Board has determined that profit-oriented publicly accountable enterprises will be required to adopt International Financial Reporting Standards ( IFRS ). IFRS will replace current Canadian generally accepted accounting principles for those enterprises. The Company will adopt IFRS effective for interim and annual periods commencing January 1, Page 13 of 16

14 Risks and Uncertainties Competition The Company has experienced, and expects to continue to experience, competition from a number of companies. The Company s competitors may announce new products, services or enhancements that better meet the needs of customers or changing industry standards. Increased competition may cause price reductions, reduced gross margins and loss of market share, any of which could have a material adverse effect on the Company s business, results of operations and financial condition. Many of the competitors and potential competitors of the Company have significantly greater financial, technical, marketing and/or service resources than does the Company. Many of these companies also have a larger installed base of users, longer operating histories or greater name recognition than the Company. Customers of the Company are particularly concerned that their suppliers will continue to operate and provide upgrades and maintenance over a long-term period. The Company s smaller size and short operating history may be considered negatively by prospective customers. Even if competitors of the Company provide products with more limited system functionality than those of the Company, these products may incorporate other capabilities of interest to some customers and may be appealing due to a reduction in the number of different types of systems used to operate such customers businesses. Further, competitors of the Company may be able to respond more quickly than the Company to changes in customer requirements and devote greater resources to the enhancement, promotion and sale of their products. Market Uncertainty The Company s success depends to a significant degree on its ability to develop the market and gain acceptance for its products and services. There is no assurance that a significant market will develop for the Company s principal products and services. Implementation and adoption of its products have been slow to develop and may continue to be subject to delays. There can be no assurances that the additional commercial applications and markets for the Company s products will develop as currently contemplated. The market for the Company s products is just beginning to develop and the Company s business plan will continue to require significant marketing efforts and working capital. To manage such development, the Company must continue to expand its existing resources and management information systems and must attract, train, and motivate qualified marketing, management, technical and administrative personnel. There can be no assurance that the Company will be able to achieve these goals. The company success in the Marcon Segment total depends on and exposed to both the Middle East Oil & Gas market. The region has gone through some tremendeous changes in Page 14 of 16

15 the last 6 months that has a slight impact on future sales and services in the region, and the United States Government Departments spending patterns in the operating Expenditure side of procurement and contracting rather than the CAPEX side of the business and therefore most contracts signed with the company fall under the MRO (maintenance repair and operations). FINANCIAL RISK MANAGEMENT The Company has exposure to counterparty credit risk, liquidity risk and market risk associated with its financial assets and liabilities. The Board of Directors has overall responsibility for the establishment and oversight of the Company s risk management framework. The Board of Directors has established the Audit Committee which is responsible for developing and monitoring the Company s compliance with risk management policies and procedures. The Audit Committee regularly reports to the Board of Directors on its activities. The Company s risk management program seeks to minimize potential adverse effects on the Company s financial performance and ultimately shareholder value. The Company manages its risks and risk exposures through a combination of insurance, a system of internal and disclosure controls, and sound business practices. The Company s financial instruments and the nature of the risks which these instruments may be subject to are set out in the following table. Credit risk Credit risk arises from cash held with banks and credit exposure to customers, including outstanding accounts receivables. The maximum exposure to credit risk is equal to the carrying value (net of allowances) of the financial assets. The objective of managing counterparty credit risk is to prevent losses on financial assets. The Company assesses the credit quality of counterparties, taking into account their financial position, past experience and other factors. For many new international clients, the Company demands that equipment costs are prepaid prior to shipment. Cash and cash equivalents Cash and cash equivalents consist of bank balances and short-term investments with original maturities of three month or less. Credit risk associated with cash and cash equivalents is minimized substantially by ensuring that these financial assets are invested in debt instruments of highly rated financial institutions. As at December 31, 2010, the Company had cash and cash equivalents consisting of cash on hand and deposits with banks of $124 and investments in securities with financial institutions with terms to maturity of less than three months of $ 965. As at December 31, 2010, the Company does not expect any counterparties to fail to meet their obligations. Accounts receivable Accounts receivable consists primarily of trade accounts receivable from equipment, installation and reporting services. The Company s credit risk arises from the possibility that a counterparty which owes the Company money is unable or unwilling to meet its obligations in accordance with the terms and conditions in the contracts with the Company, which would result in a financial loss Page 15 of 16

16 to the Company. This risk is mitigated through established credit management techniques, including monitoring counterparty creditworthiness, setting exposure limits and monitoring exposure against these customer credit limits. The carrying amount of accounts receivable are reduced through the use of an allowance for doubtful accounts and the amount of the loss is recognized in the statement of operations in other expenses. When a receivable balance is considered uncollectible, it is written off against the allowance for accounts receivable. Subsequent recoveries of amounts previously written off reduce other expenses in the statement of operations. Historically, trade credit losses have been minimal. Liquidity risk Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they fall due. The Company maintains a strong liquidity and working capital position to meet its obligations as they come due. The following table details the Company s contractual maturities for its financial liabilities and operating lease commitments, as at December 31, 2010: Market risk Market risk is the risk that changes in market prices, such as foreign exchange rates and interest rates will affect the fair value of recognized assets and liabilities or future cash flows or the Company s results of operations. To contend with changes in market prices, the Company constantly reviews its current and planned expenditures to ensure it has adequate resources to continue operations. The Company primarily sells goods in Canada and the United States and attempts to limit its exposure by transacting in the local currency and therefore limiting exposure to foreign exchange rates. Foreign exchange The Company operates primarily in Canada and the United States. The functional currency of the parent company is the Canadian dollar and the reporting currency is Canadian dollars. As at December 31, 2010, the Company s US-dollar net monetary assets totaled approximately US$535. Accordingly a 5% change in the US dollar exchange rate as at December 31, 2010 on this amount would have resulted in an exchange gain or loss and therefore net loss would have increased (decreased) by $27. Interest rate The Company has cash and cash equivalent balances which are exposed to interest rate fluctuations. As at December 31, 2010, cash and cash equivalents net of bank indebtedness and long-term debt totals $962. An increase of 100 basis points in the market interest rate would have on average, increased net income by approximately $10, (a 100 basis point decrease would have had the equal but opposite effect) for the period ended December 31, CONVERSION TO INTERNATIONAL FINANCIAL REPORTING STANDARDS ( IFRS ) In October 2009, the Accounting Standards Board issued a third and final IFRS Omnibus Exposure Draft confirming that publicly accountable enterprises will be required to apply IFRS, Page 16 of 16

17 in full and without modification, for financial periods beginning on January 1, The adoption date of January 1, 2011 will require the restatement, for comparative purposes, of amounts reported by the Company for the year ended December 31, 2010, including the opening balance sheet as at January 1, The conversion requirement from GAAP to IFRS raises both financial and non-financial issues. The company has commenced the development of an IFRS implementation plan to prepare for this transition. The plan consists of three phases which are diagnostic, design and planning, and implementation. The Company s IFRS transition project consists of three key phases: (i) Scope and Plan - This phase involves performing a high level impact analysis to identify areas that may be affected by the transition to IFRS. The results of this analysis are priority ranked according to complexity and the amount of time required to assess the impact of changes in transitioning to IFRS. (ii) Impact Analysis and Evaluation - During this phase, items identified in the scope and planning phase are addressed according to the priority levels assigned to them. This phase involves analysis of policy choices allowed under IFRS and their impact on the financial statements. The conclusion of the impact analysis and evaluation phase might potentially require the audit committee of the Board of Directors to review and approve all accounting policy choices as proposed by management. (iii) Implementation and Review - involves implementation of all changes approved in the impact analysis phase and might include changes to information systems, business processes, modification of agreements and training of all staff who are impacted by the conversion. The Company has completed a preliminary review the first two phases subject to the final evaluation and of certain options and selection of implementation methods. The Company has determined that a significant impact of IFRS conversion is to Property and Equipment. Another area that may be affected by IFRS is the currency in which reporting is based. One of the fundamental requirements of IFRS is that when a reporting entity prepares consolidated financial statements each individual entity included in those statements must determine its own functional currency and measure its own results and financial position in that currency. IFRS provides several guidelines to aid in determining the functional currency of each subsidiary. The impact of this has not yet been determined. IFRS conversion will also result in other impacts, some of which may be significant in nature. The Company is in the process of evaluating the impact on the Company s consolidated financial statements. The following IFRS standards are expected to have the most significant impact on Quetzal. IFRS 1 First time adoption of IFRS IFRS 2 Share based payments IAS 16 Property, plant and equipment IAS 36 Impairment of assets IAS 37 Provisions, contingent liabilities and contingent assets IAS 21 Effects of changes in foreign exchange rates First-Time Adoption of IFRS IFRS 1, First-Time Adoption of International Financial Reporting Standards ( IFRS 1 ), provides entities adopting IFRS for the first time with a number of optional exemptions and mandatory exceptions in certain areas to the general requirement for full retrospective application of IFRS. Management has considered the following optional exemptions: Business Combinations IFRS 1 would allow the Company to use the IFRS rules for business combinations on a prospective basis rather than re-stating all business combinations. The IFRS business combination rules converge with the new CICA Handbook section 1582 that is also effective for the Company on January 1, 2011; however, early adoption is permitted. This election will have no impact on the Company s opening balance sheet. Property, Plant and Equipment ( PP&E ) IFRS 1 provides the option to value the PP&E Page 17 of 16

18 assets at their deemed cost being the Canadian GAAP net book value assigned to these assets as at the date of transition, January 1, Share-Based Payments IFRS 1 allows the Company an exemption on IFRS 2, Share-Based Payments to equity instruments which vested before the Company s transition date to IFRS. The Company has not yet completed its assessment on the adoption of IFRS 2 The Effects of Changes in Foreign Exchange Rates IAS 21 allows an entity to deem all cumulative translation differences related to investments in foreign operations to zero at the transition date to avoid retrospective application. The transition from Canadian GAAP to IFRS is a significant undertaking that may materially affect our reported financial position and results of operations. At this time, the Company has identified key differences that will impact the financial statements as follows: Impairment of PP&E assets Under IFRS, impairment of PP&E must be calculated at a more detailed level than what is currently required under Canadian GAAP. Impairment calculations have not yet been performed to determine whether any adjustment is required. Internal Controls over Financial Reporting ("ICFR ) The Company is currently evaluating its internal controls to ensure that all changes in accounting policies include the appropriate additional controls and procedures for future IFRS reporting requirements. It is currently in the process of replacing its accounting software for a more robust package that more effectively records transactions in different currencies and provides a more efficient method for consolidating the accounts of the parent and its subsidiaries and branch operations. Disclosure controls and procedures Throughout the transition process, the Company has assessed stakeholders information requirements and will ensure that adequate and timely information is provided so that all stakeholders are kept apprised. Business activities Based on the expected changes to the Company s accounting policies at this time, there are no foreseen issues as a result of the conversion to IFRS. IT systems The modifications are not expected to be significant. Page 18 of 16