MANAGEMENT S DISCUSSION AND ANALYSIS

Transcription

1 MANAGEMENT S DISCUSSION AND ANALYSIS ON FORM F1 THREE MONTHS ENDED November 30, 2011 January 10, 2012

2 TABLE OF CONTENTS CAUTION CONCERNING FORWARD-LOOKING INFORMATION... 1 INTRODUCTION... 1 Our Business... 1 Financial Strategy and Rate Stabilization Mechanism... 2 Financial Highlights for the three months ended November 30, RESULTS OF OPERATIONS... 6 Revenues... 7 Air Traffic... 8 Customer Service Charges... 8 Outlook: Revenues Operating Expenses Other Expenses Outlook: Operating and Other Expenses Other Loss (Income) Outlook: Other Loss (Income) Retained Earnings (Deficit) Changes in Rate Stabilization Account Outlook: Rate Stabilization Account Earnings Coverage Credit Ratings SUMMARY OF QUARTERLY RESULTS Quarterly Financial Information (unaudited) Discussion of Quarterly Results LIQUIDITY AND CAPITAL RESOURCES Working Capital Requirements Cash flows for the three months ended November 30, Outlook: Cash Flow Sources of Liquidity Restructured and Other Investments in Asset-Backed Commercial Paper (ABCP) Reserve Funds and Financial Instruments Treasury Management and Financial Risk Mitigation Contractual Obligations Capital Expenditures Capital Management LEGAL PROCEEDINGS CHANGES IN ACCOUNTING POLICIES CRITICAL ACCOUNTING ESTIMATES Employee Future Benefits Restructured and other investments in ABCP Salaries and Benefits Depreciation and Amortization Asset Retirement Obligations DISCLOSURE CONTROLS AND PROCEDURES AND INTERNAL CONTROL OVER FINANCIAL REPORTING... 46

3 CAUTION CONCERNING FORWARD-LOOKING INFORMATION This management discussion and analysis (MD&A) contains certain statements about our future expectations. These statements are generally identified by words like anticipate, plan, believe, expect, estimate, approximate and the like. Because forward-looking statements involve future risks and uncertainties, actual results may be quite different from those expressed or implied in these statements. Examples include terrorist attacks, war, epidemics or pandemics, natural disasters, weather patterns, environmental concerns, labour negotiations, arbitrations, workforce recruitment, training and retention, general industry conditions, capital market and economic conditions, the ability to collect customer service charges and reduce operating costs, credit losses on investments, changes in interest rates, changes in laws, tax changes, adverse regulatory developments or proceedings and lawsuits. Some of these risks and uncertainties are explained under Risk Factors in our 2011 Annual Information Form (AIF). The forward-looking statements contained in this MD&A represent our expectations as of January 10, 2012 and are subject to change after this date. We disclaim any intention or obligation to update or revise any forward-looking statements included in this document whether as a result of new information, future events or for any other reason, except as required by applicable securities legislation. INTRODUCTION This interim MD&A relates to our unaudited consolidated financial condition, results of operations and cash flows for the three months ended November 30, 2011 (Q1 fiscal 2012). It should be read in conjunction with our unaudited consolidated financial statements for the quarter ended November 30, 2011, our audited consolidated financial statements and the accompanying notes for the year ended August 31, 2011 (fiscal 2011) as well as our fiscal 2011 AIF dated October 20, Additional information about NAV CANADA, including our financial statements for Q1 fiscal 2012 and fiscal 2011 and our fiscal 2011 AIF are filed on the System for Electronic Document Analysis and Retrieval (SEDAR) at Our financial statements are prepared in Canadian dollars and in accordance with Canadian generally accepted accounting principles Part V Pre-changeover accounting standards. Our Audit Committee reviewed this MD&A and our Board of Directors approved it before it was filed. Our Business NAV CANADA is the private sector, non-share capital company that operates Canada s civil air navigation system (ANS). With operations across Canada, we provide air navigation services to aircraft owners and operators within Canadian controlled airspace. These services include air traffic control, flight information, weather briefings, airport advisories, aeronautical information and electronic navigation aids. Our core business is to manage and operate the Canadian air navigation system and services in a safe, efficient and cost effective manner. Our mandate covers both Canadian airspace and airspace delegated to Canada under international agreements. 1

4 Financial Strategy and Rate Stabilization Mechanism In establishing new charges or revising existing charges, we must follow the charging principles set out in our governing statute, the Civil Air Navigation Services Commercialization Act (ANS Act), which prevents us from setting customer service charges higher than what is needed to meet our financial requirements for the provision of air navigation services. As a result, our aim is to essentially achieve breakeven financial results on an annual basis. Due to seasonal and other fluctuations in air traffic and given that our costs are predominantly fixed in nature, our quarterly financial results may have an excess of expenses over revenues and other income. This is illustrated in the table under the heading SUMMARY OF QUARTERLY RESULTS Quarterly Financial Information (unaudited). Customer service charges are set based on estimated air traffic volumes and planned expenses. Since actual revenues and expenses will differ from these estimates, a method to accumulate the variances is required so that they may be taken into account when setting future customer service charges. There is also a need to absorb the immediate effect of unpredictable factors mainly fluctuations in air traffic volumes resulting from unforeseen events. We meet these objectives through a rate stabilization mechanism. If our actual revenues exceed actual expenses, the excess is reflected as a liability in the rate stabilization account and is returnable to customers through future customer service charges. Similarly, if actual revenues turn out to be less than actual expenses, the revenue shortfall is reflected as an asset in the rate stabilization account and is recoverable from customers through future customer service charges. In the process of determining future customer service charges, we take into account the balance in the rate stabilization account, adjusted notionally for the non-credit related portion of the fair value adjustments that have been provided on investments. We also consider the balance of the accrued pension benefit asset (net of its regulatory liability) when determining the level of customer service charges (see RESULTS OF OPERATIONS Revenues Customer Service Charges ). In 2008 the Board of Directors approved a policy by which the fiscal 2008 balance of pension contributions made in excess of pension expense would be expensed over a period no longer than 15 years (see LIQUIDITY AND CAPITAL RESOURCES Treasury Management and Financial Risk Mitigation Pension Plan Expenses ). In addition, effective September 1, 2010, the Board of Directors approved that if at the end of a quarterly reporting period the notional balance in the rate stabilization account is greater than the target balance, the excess over the target will be recorded as additional pension expense in the reporting period. This results in accelerating the recovery of the accrued pension benefit asset (net of its regulatory liability), which represents contributions previously made to the pension plan that have not yet been recovered through customer service charges. In preparing our financial statements, we adjust our actual revenues and expenses through transfers to or from the rate stabilization account, based on variations from the amounts that were used when establishing customer service charges. Our financial strategy is to fulfil our essential services mandate based on a sound financial foundation, reflected in part through high credit ratings in the financial markets. Maintaining this strong foundation requires a prudent approach that balances the interests of our key stakeholders while complying with our statutory and contractual obligations. 2

5 Financial Highlights for the three months ended November 30, 2011 The Company has achieved positive financial performance in Q1 fiscal 2012 as compared to the prior year. (millions) Three months ended November Change Before rate stabilization Revenue $ 305 $ 299 $ 6 Expenses (1) Other loss (income) 6 (19) (25) (4) 16 (20) Rate stabilization adjustments: Variances from planned results 2 (41) 43 Initial approved (adjustment) drawdown (3) 5 (8) Additional drawdown related to pension 6 18 (12) 5 (18) 23 Excess (shortfall) of revenue and other loss (income) over expenses after rate stabilization $ 1 $ (2) $ 3 For the first three months of fiscal 2012, revenues and other income exceeded expenses by $ 1 million. Excluding rate stabilization adjustments, expenses exceeded revenues and other income by $ 4 million, primarily due to negative fair value adjustments on investments of $ 8 million and higher pension expense of $ 6 million, partially offset by lower than planned operating and other expenses. Based on preliminary favourable variances with respect to budget totalling $ 6 million (before fair value adjustments not considered for rate setting purposes), the Company recorded an additional $ 6 million of pension expense in order to accelerate the recovery of pension contributions previously made that have not yet been recorded as costs for rate setting purposes. Rate stabilization adjustments/drawdowns are described below under Rate Stabilization Account. The following items have significant financial importance to the Company: 1. Rate Stabilization Account At November 30, 2011 the rate stabilization account had an asset balance of $ 3 million and the notional balance in the rate stabilization account (described immediately below) was a liability balance of $ 92 million, which is equal to its fiscal 2012 target balance. The Company expects that the majority of the fair value adjustments that it has recorded on its ABCP and restructured notes since August 2007 will be recovered over the terms to maturity of the related investments. For rate setting purposes, the Company has not taken into consideration the non-credit portion of the fair value variances from face value on its investments. The non-credit portion has been notionally added to the balance in the rate stabilization account, to arrive at a notional balance in the 3

6 rate stabilization account for rate setting purposes. This is discussed in more detail under the heading RESULTS OF OPERATIONS Changes in Rate Stabilization Account. The rate stabilization account declined by $ 5 million during Q1 fiscal This decrease is primarily due to positive variances of $ 6 million and the $ 3 million initial approved adjustment to the rate stabilization account, more than offset by $ 8 million of fair value adjustments and the additional drawdown related to pension of $ 6 million. The Board of Directors, which is the Company s rate regulator, approved a $ 3 million adjustment to be recorded in Q1 fiscal 2012 in order to achieve planned breakeven results of operations and to increase the notional balance of the rate stabilization account to its new target level. Accordingly, during Q1 fiscal 2012, $ 3 million was transferred from revenue to the rate stabilization account. As part of the Company s financial strategy to accelerate the recovery of pension contributions previously made, an additional $ 6 million was recorded in the three months ended November 30, 2011 in the statement of operations as pension expense, thereby reducing the balance in the rate stabilization account and the accrued pension benefit asset (net of its regulatory liability). 2. Air Traffic and Customer Service Charges During Q1 fiscal 2012, air traffic volumes increased by 1.9 per cent year-over-year, resulting in lower revenues than planned as the 2012 budget had assumed a 3.2 per cent year-over-year growth rate in air traffic during the first quarter. In light of the current and expected notional balance in the rate stabilization account at the end of fiscal 2012, the Company does not intend to increase customer service charges at this time. We continuously monitor air traffic and revenue, and will on a quarterly basis consider the need for a change in rates. Any change in customer service charges would be implemented in accordance with the ANS Act. 3. Pension Plan In accordance with the Office of the Superintendent of Financial Institutions of Canada ( OSFI ) regulations, the Company is making contributions to its defined benefit pension plan in accordance with the actuarial valuations that were performed as of January 1, Strong asset returns during calendar year 2009 contributed to the emergence of both a going concern surplus of $ 55 million and a solvency surplus of $ 117 million as at January 1, On June 25, 2010, OSFI issued an amendment to the Directives of the Superintendent, requiring a pension plan that has a solvency surplus as at January 1, 2010 to file its next actuarial valuation two years later, i.e. as at January 1, The Company is currently underway with its January 1, 2012 pension funding valuations which are to be filed by June 30, The Company s going concern current service contributions to the pension plan were $ 72 million in fiscal 2011 and are expected to increase to approximately $ 86 million in fiscal year The total amount of required Company contributions and letters of credit in fiscal 2012 and future years will be dependent on the investment experience of plan assets, the discount rates that will be used in future actuarial valuations to determine plan liabilities, as well as changes in pension funding requirements that may be enacted. Based on very preliminary estimates of the funded status and economic assumptions applicable for the actuarial valuation of the pension plans as of January 1, 2012, total pension contributions are 4

7 expected to increase from $ 72 million in fiscal 2011 to approximately $ 141 million in fiscal 2012 (which includes a very preliminary estimate for solvency special payments of $ 55 million). The Company may choose to utilize letters of credit instead of cash to secure solvency special payments. The pension plans had an accounting deficit of $ 579 million as at the annual measurement date of May 31, Between May 31, 2011 and November 30, 2011, the pension plan s accounting deficit worsened to approximately $ 1,035 million (August 31, 2011 $ 904 million), primarily due to a 0.5 per cent (August 31, per cent) decline in the market-based discount rate used to determine pension obligations for accounting purposes. The differences in the reported surplus or deficit position between the accounting and funding valuations (going concern and solvency) are primarily due to: (a) different discount rates to value the obligations of the plan based on each valuation s required actuarial methodology; (b) the use of asset smoothing in the funding valuations whereas market values are used to determine asset values in the accounting valuation; and (c) the different dates at which the valuations are performed. Further information on the Company s pension plan is discussed under the heading LIQUIDITY AND CAPITAL RESOURCES Treasury Management and Financial Risk Mitigation Pension Plan. 4. Settlement of Collective Agreements: In Q1 fiscal 2012 the following collective agreement was finalized. - On November 17, 2011, the Canadian Auto Workers (CAW) Local 1016, representing approximately 270 employees working as air traffic operations specialists, operational training specialists and other employees working in areas such as aeronautical information, flight billing, the national systems control centre and notices to airmen office ratified their new collective agreement. The new agreement runs until June 30, 2013 and provides for wage increases of 3.0 per cent on July 1, 2011, followed by a 3.0 per cent increase on July 1, Subsequent to Q1 fiscal 2012 the following collective agreements were finalized. a. On December 19, 2011, the Canadian Federal Pilots Association (CFPA), representing approximately 35 pilots who perform Aeronautical Information Services, Flight Inspection and ANS Service Design ratified their new collective agreement. The new agreement runs for 30 months or until April 30, 2013 and provides for wage increases of 3.0 per cent on October 25, 2010 and 3.0 per cent on October 25, A number of amendments also form part of the agreement including reductions to severance benefits. b. On December 22, 2011, the International Brotherhood of Electrical Workers (IBEW) which represents approximately 680 employees working as Air Navigation Service Technologists ratified their new collective agreement. The new collective agreement runs for 28 months or until December 31, 2013, and provides for wage increases of 3.0 per cent on January 1, 2012 and 3.0 per cent on January 1, A number of amendments also form part of the agreement, including reductions to severance benefits. c. On January 4, 2012, an arbitration decision finalized the collective agreement with the Professional Institute of the Public Service of Canada (PIPSC), representing approximately 400 engineering, computer service, physical science, purchasing, economic and social science specialties. The resulting two-year collective agreement covers the period to April 30, The award provides for wage increases on May 1, 2011 and May 1, 2012 of 2.75 per cent. 5

8 RESULTS OF OPERATIONS (millions) Three months ended November Change % Revenue $ 305 $ 299 $ 6 2% Initial approved rate stabilization (adjustment) drawdown (1) (3) 5 (8) Rate stabilization - (11) % Expenses before rate stabilization % Rate stabilization 6 12 (6) Additional rate stabilization drawdown related to pension (2) (6) (18) % Other loss (income) before rate stabilization 6 (19) 25 Rate stabilization (8) 18 (26) (2) (1) (1) 100% Excess (shortfall) of revenue and other loss (income) over expenses after rate stabilization $ 1 $ (2) $ 3 (1) The Board of Directors approved a $ 3 million transfer to the rate stabilization account to be recorded in the first quarter, in order to achieve planned breakeven results of operations in fiscal 2012 and to increase the notional balance of the rate stabilization account to its new target level. Accordingly, $ 3 million was transferred from revenue to the rate stabilization account in the first quarter. With respect to fiscal 2011, the Board of Directors approved a $ 20 million drawdown of the rate stabilization account to be recorded during the year, in order to achieve planned breakeven results of operations. Accordingly, during the three months ended November 30, 2010, $ 5 million was transferred to revenue from the rate stabilization account. (2) In accordance with the Company s financial strategy to recover the cost of pension contributions previously made, the Company recorded an additional $ 6 million of pension expense (Q1 fiscal 2010 $ 18 million) for the three months ended November 30, Also see LIQUIDITY AND CAPITAL RESOURCES Treasury Management and Financial Risk Mitigation Pension Plan Expenses. 6

9 Revenues The following table provides a breakdown of our revenues by category. Our fiscal 2011 AIF and the notes to our financial statements for fiscal 2011 provide more information about the different categories of our customer service charges. (millions) Three months ended November Change % Revenues En route $ 155 $ 153 $ 2 1% Terminal % Daily/annual/quarterly % North Atlantic and international communication % Total customer service charges % Other (1) (8%) $ 305 $ 299 $ 6 2% Other revenues consist of conference and accommodation rentals at our facility in Cornwall (Ontario), sales or licensing of technology, provision of equipment maintenance services, the sale of civil aeronautical information products and other miscellaneous revenue. Revenues before rate stabilization adjustments for Q1 fiscal 2012 were $ 305 million compared to $ 299 million for Q1 fiscal The $ 6 million increase is primarily due to: a $ 7 million increase in aeronautical revenues arising from an increase of 1.9 per cent in air traffic during Q1 fiscal 2012, partially offset by a $ 1 million decrease in other revenues. 7

10 Air Traffic Air traffic increased by 1.9 per cent in Q1 fiscal 2012 when compared to Q1 fiscal This increase is illustrated in the following chart showing air traffic by month since September The chart illustrates the seasonal variation in traffic. The chart shows traffic in weighted charging units, which reflect the number of flights, aircraft size and distance flown. Weighted Charging Units FY 2011 to FY 2012 Millions Weighted Charging Units Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Month FY 2011 FY 2012 Although traffic growth has been slower than originally planned, it can be seen that positive air traffic growth occurred in each month of Q1 fiscal Future air traffic volumes may be influenced by several factors, including the rate of economic growth or decline, changing air passenger demand, fuel costs, air carrier competition, airline restructurings and insolvencies, terrorist activities, epidemics or pandemics, weather patterns, natural disasters, environmental concerns and other factors. Customer Service Charges The level of our customer service charges is a function of our costs, the required level of service, air traffic volumes, revenues from non-aeronautical sources, the notional balance of the rate stabilization account and the balance of the accrued pension benefit asset (net of its regulatory liability). Our business operates 24 hours a day, 365 days a year providing an essential, national and international safety infrastructure. Given that the majority of our costs are predominantly fixed in nature and are directly 8

11 related to service delivery, we have relatively few opportunities to significantly reduce these costs further without reducing service, which is not acceptable in most cases. We continue to focus on cost management, productivity improvements and opportunities for new revenue sources from licensing or sales of technology and other non-aeronautical sources. This is assisting in keeping customer service charges as low as possible, while continuing to meet our safety and service obligations. The following chart illustrates the evolution of our levels of customer service charges over time. On average, customer service charges are approximately five per cent higher than they were when fully implemented over twelve years ago in March 1999, which is approximately twenty five percentage points less than the compounded inflation rate. In addition, the level of our current service charges is about one third below the former Air Transportation Tax that the charges replaced. 135 HISTORY OF NAV CANADA RATE CHANGES (1) VERSUS CONSUMER PRICE INDEX (2) 130 INDEX TO Mar-99 Jun-99 Sep-99 NAV CANADA RATES Dec-99 Mar-00 Jun-00 Sep-00 Dec-00 Mar-01 CONSUMER PRICE INDEX Jun-01 Sep-01 Dec-01 Mar-02 Jun-02 Sep-02 Dec-02 Mar-03 Jun-03 Sep-03 Dec-03 Mar-04 Jun-04 Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Mar AVERAGE CHANGES SINCE CHARGES WERE FULLY IMPLEMENTED ON MARCH 1, CONSUMER PRICE INDEX - GROWTH ASSUMED TO BE 2.9 PER CENT FOR 2011 The Company does not intend to increase customer service charges at this time, given the acceptable notional balance in the rate stabilization account (which is described under RESULTS OF OPERATIONS Change in Rate Stabilization Account ). Jun-11 Sep-11 Dec-11 9

12 For customer rate setting purposes, the Board of Directors considers the notional balance of the rate stabilization account, together with the balance of the accrued pension benefit asset (net of its regulatory liability). At November 30, 2011 these amounts were: (millions) November "Notional" balance of rate stabilization account (1) $ 92 Accrued pension benefit asset $ (462) Regulatory liability 307 (155) Deficit for rate setting purposes $ (63) (1) See RESULTS OF OPERATIONS Changes in Rate Stabilization Account for additional information on the notional liability balance of the rate stabilization account at November 30, The Company intends to eliminate this deficit over time. Reductions in the level of customer service charges may not occur until the above deficit has become a surplus. We will continuously monitor air traffic levels and consider on a quarterly basis the need for changes in rates. Any change in customer service charges would be implemented in accordance with the ANS Act. Outlook: Revenues Note: See CAUTION CONCERNING FORWARD LOOKING INFORMATION, page 1. Total revenues before rate stabilization for fiscal 2012 are expected to be higher by approximately $ 11 million from $ 1,210 million in fiscal 2011 due primarily to expected increases in other revenues and marginal increases in air traffic levels of 0.3 per cent. See also LIQUIDITY AND CAPITAL RESOURCES Treasury Management and Financial Risk Mitigation and RESULTS OF OPERATIONS Customer Service Charges. 10

13 Operating Expenses Operating expenses consist of salaries and benefits, technical services, facilities and maintenance, and other. A breakdown is provided in the following table. (millions) Three months ended November Change % Operating Expenses * Salaries and benefits excluding pensions $ 154 $ 145 $ 9 6% Pensions (8) (21%) Technical services % Facilities and maintenance (1) (8%) Other % $ 241 $ 237 $ 4 2% * In arriving at the amounts shown, operating expenses have been reduced by the following amounts allocated to capital expenditures: Salaries and benefits excluding pensions 8 12 (4) Pensions 1 2 (1) Other $ 10 $ 15 $ (5) Salaries and benefits expense (excluding pension expense) in Q1 fiscal 2012 increased by $ 9 million compared to Q1 fiscal 2011 due to increases in compensation levels, higher overtime, higher benefit costs and lower salary costs capitalized to projects, which were higher than savings achieved from active management of staffing levels. The $ 8 million decrease in pension expense in Q1 fiscal 2012 compared to Q1 fiscal 2011 is primarily due to lower additional regulatory pension expense of $ 12 million recorded in Q1 fiscal 2012, partially offset by higher planned regulatory pension expense in Q1 fiscal 2012 of $ 4 million. This is discussed further under the heading LIQUIDITY AND CAPITAL RESOURCES Treasury Management and Financial Risk Mitigation Pension Plan. Facilities and maintenance as well as technical services expenses were comparable to Q1 fiscal The increase in other operating expense for the quarter relates primarily to higher travel, professional fees and other miscellaneous costs. 11

14 Q1 Fiscal 2012 Operating Expenses before Rate Stabilization Adjustments Salaries and benefits (including pensions) 77% Other 7% Technical Services 11% Facilities and Maintenance 5% Other Expenses Other expenses consist of interest, depreciation and amortization expense. A breakdown is provided in the following table. (millions) Three months ended November Change % Other Expenses Interest $ 29 $ 29 $ - -% Depreciation and amortization (3) (8%) $ 62 $ 65 $ (3) (5%) Interest expense for the three month period ended November 30, 2011 is comparable to the three month period ended November 30, The decrease in depreciation and amortization expense for the three month period ended November 30, 2011 resulted from lower depreciation as certain assets become fully depreciated and fewer capital assets were put into service. 12

15 Outlook: Operating and Other Expenses Note: See CAUTION CONCERNING FORWARD LOOKING INFORMATION, page 1. Total operating and other expenses before rate stabilization for fiscal 2012 are expected to increase by approximately $ 8 million, from $ 1,221 million in fiscal 2011 primarily due to: increased compensation levels; fiscal 2011 expenses were lower due to a one-time adjustment for a negotiated LTD premium refund of $ 11 million; increased operational requirements in the areas of facilities and systems maintenance as well as improvements to service delivery which will contribute to safety and other customer benefits; and the effects of inflation; partially offset by a budgeted decrease in pension expense. Our fiscal 2012 outlook is currently forecasting additional pension expense of $ 6 million to accelerate the recovery of the accrued pension benefit asset. We will monitor the funded status of our pension plans over the course of the fiscal year, and pension expense may be adjusted in future quarters to reflect the valuations that will be performed as at January 1, Across the Company, there is an ongoing focus on cost management. Over the past several years the Company has been able to achieve cost decreases per flight hour while continuing to deliver safe and efficient service. We remain focused on cost saving measures that are consistent with safety, which is our top priority. Our efforts are aimed at managing staffing levels and discretionary expenses, as well as continuing to implement process improvement initiatives and efficiencies. Other Loss (Income) Other income is comprised primarily of fair value adjustments on investments (discussed further under LIQUIDITY AND CAPITAL RESOURCES Restructured and Other Investments in Asset-Backed Commercial Paper (ABCP) ). Interest received on investments is incorporated in fair value adjustments since the related investments are designated as held-for-trading. (millions) Three months ended November Change Other Loss (Income) Fair value adjustments $ 6 $ (19) $ 25 The fair value adjustments for the three months ended November 30, 2011 consist of an $ 8 million decrease in the fair value of investments due to changes in market conditions partially offset by $ 2 million of interest income. 13

16 Outlook: Other Loss (Income) Note: See CAUTION CONCERNING FORWARD LOOKING INFORMATION, page 1. Other loss (income) before rate stabilization for fiscal 2012 is expected to decrease by approximately $ 30 million, from income of $ 33 million in fiscal The expected decrease is primarily due to the $ 24 million in positive fair value adjustment investments that were recognized in fiscal 2011 as compared to the $ 8 million in negative fair value adjustment recognized in Q1 fiscal 2012 (since the extent and timing of such adjustments is uncertain, no amount has been included in the outlook for the remainder of fiscal 2012). This decrease is partially offset by higher assumed interest rates and the anticipated receipt of interest income on Master Asset Vehicle Class A1 and A2 notes. The Company expects that a portion of the non-credit related fair value variances from face value on restructured and non-restructured ABCP (amounting cumulatively to $ 95 million at November 30, 2011) will be recovered in fiscal 2012 with the remaining balance being recovered over the terms of the related investments. In addition, there is no assurance that the fair value of our investments will not decline further or that our estimate of expected credit losses will not increase. Retained Earnings (Deficit) The balance in retained earnings (deficit) as at November 30, 2011 reflects the earnings up to that date. We plan our operations to essentially result in an annual financial breakeven position after expenditures are met through customer service charges and other revenue sources, and after adjustments are made to the rate stabilization account. As a result, the balance in the retained earnings account at the end of each fiscal year has remained stable at $ 28 million. Any variation from this amount at the end of any interim period reflects planned seasonal or other fluctuations in revenues and expenses. Changes in Rate Stabilization Account Our rate stabilization mechanism and accounting are also discussed at the beginning of this MD&A and in notes 1 and 8 to our financial statements. The table below shows the changes in the rate stabilization account for the three months ended November 30, (millions) Rate stabilization liability, beginning of period $ 2 Variances from planned results: Revenue different than planned $ - Operating expenses lower than planned 5 Other expenses lower than planned 1 Other loss greater than planned (8) (2) Initial approved adjustment 3 Additional drawdown related to pension (6) Rate stabilization liability (asset), end of period $ (3) - 14

17 The $ 5 million decline in the rate stabilization account during the three month period ended November 30, 2011 is primarily due to the following: (i) (ii) (iii) operating expenses that were $ 5 million lower than planned, mainly in salary and benefits expense as a result of staffing levels lower than anticipated due to active management of staffing levels and lower overtime; other expenses that were $ 1 million lower than planned, due to lower depreciation and amortization expense as certain assets become fully depreciated and fewer capital assets are put into service and due to lower interest costs due to annual principal repayments; and the planned adjustment of $ 3 million, representing the anticipated excess of revenues and other income over expenses in the fiscal 2012 budget; partially offset by: (iv) other loss that was $ 8 million higher than planned due primarily to unbudgeted fair value decline on investments due to deterioration of market conditions during the quarter; (v) an additional drawdown of $ 6 million to further accelerate the reduction of the balance in the accrued pension benefit asset, net of its regulatory liability. When establishing customer service charges, the Company s Board of Directors, which is the rate regulator, considers the balance in the rate stabilization account, adjusted notionally for the non-credit related portion of the fair value variance from face value on investments. The long-term target liability balance of the rate stabilization account is 7.5 per cent of total planned annual expenses net of other income, excluding non-recurring items. For fiscal 2012, the target balance is $ 92 million. The table below shows the notional liability balance of the rate stabilization account at November 30, (millions) Rate stabilization liability (asset) $ (3) Credit loss provisions (8) Fair value adjustment on investments 100 Face value variance on A-2 notes when purchased in fiscal Net non-credit related fair value variances from face value 95 "Notional" balance of the rate stabilization liability (asset) $ 92 The fair value variance from face value on investments held by the Company at November 30, 2011 of $ 103 million includes cumulative fair value adjustments on these investments of $ 95 million. The $ 95 million in fair value adjustments have reduced the amount in the rate stabilization account. Of the fair value variance from face value of $ 103 million, the Company currently estimates that $ 95 million will be recovered over time, as the fair value of these investments should ultimately reflect the face value of the notes less credit losses, which are currently estimated at $ 8 million. 15

18 Outlook: Rate Stabilization Account Note: See CAUTION CONCERNING FORWARD LOOKING INFORMATION, page 1. Assuming no further change in the fair value provision on restructured notes and ABCP investments, the Company currently anticipates that the rate stabilization account balance will be an asset balance of $ 3 million by the end of fiscal 2012, resulting from estimated revenues of $ 1,221 million (excluding the approved drawdown of the rate stabilization account) and total expenses and other loss (income) of $ 1,226 million. The estimated revenues for fiscal 2012 are approximately 0.9 per cent higher than in fiscal 2011, reflecting an anticipated marginal increase in air traffic levels of 0.3 per cent. Total expenses and other loss (income), excluding fair value adjustments on investments are estimated to increase by approximately 0.3 per cent or $ 4 million. It is anticipated that the notional balance of the rate stabilization account will be a liability balance of approximately $ 92 million, which is equal to its target balance for fiscal Earnings Coverage During a fiscal year, quarterly revenues will reflect seasonal or other fluctuations in the airline industry and therefore our net results vary from quarter to quarter. Our mandate to operate on essentially a financial breakeven basis results in a planned earnings coverage ratio calculated on the basis of earnings before interest divided by interest expense that is close to one-to-one. However, the seasonal nature of our revenue flow may result in an earnings coverage ratio of less than one-to-one for any interim period. For the twelve months ended November 30, 2011, our interest cost was $ 115 million. Consolidated earnings (after rate stabilization) before interest was $ 118 million, which is 1.03 times our interest requirement for the year. Depreciation and amortization expense for this period was $ 136 million. Our cash flow coverage calculated on the basis of earnings (after rate stabilization) before interest, depreciation and amortization divided by interest expense was 2.21 times our interest requirements for this period. Under the Income Tax Act (Canada), we are not subject to income taxes and accordingly, no deduction for income taxes has been made. In addition, we maintain a debt service reserve fund and an operations and maintenance reserve fund under our Master Trust Indenture and we are subject to liquidity covenants under our General Obligation Indenture, designed to cover 12 months interest on borrowings, and 25 per cent of our annual operating and maintenance expenses. As at November 30, 2011, we were in full compliance with our debt indentures, including the Master Trust Indenture s requirements regarding the reserve funds, the flow of funds and with the rate covenants, as well as the liquidity and other provisions of the General Obligation Indenture. 16

19 Credit Ratings The Company s debt obligations have been assigned the following credit ratings: Rating Agency Senior Debt General Obligation Notes Outlook DBRS Limited (DBRS) AA AA (low) Stable Moody s Investors Service (Moody s) Aa2 Aa3 Stable Standard & Poor s (S&P) AA AA- Stable On September 8, 2011, DBRS issued a press release and rating report confirming the Company s ratings and outlook. DBRS stated that the rating confirmation incorporates the sound traffic growth experienced during the current fiscal year (fiscal 2011) which has led to an upturn in operating results, but remains tempered by the potential volatility inherent in the travel industry and the uncertain economic climate set against the backdrop of sovereign debt concerns. DBRS noted that NAV CANADA s estimated Debt Service Coverage Ratio (DSCR) of roughly 1.8 times provides support to the credit. They also noted that the Company s expected 2.6 per cent traffic growth for fiscal 2012 could prove somewhat optimistic given the uncertain economic climate and volatility caused by sovereign debt concerns. (As described in RESULTS OF OPERATIONS Revenues Outlook: Revenues, the Company now expects traffic to grow by 0.3 per cent in fiscal 2012). DBRS stated that going forward, the absence of material capital expenditures should help to curtail growth of debt and lend support to financial metrics, although pension funding pressures may reappear as current going concern and solvency surpluses could reverse over time. On February 23, 2011, Moody s issued a credit opinion confirming the Company s ratings and outlook. Moody s noted that the Company continued to show a good control of costs in fiscal 2010 and managed to generate cash flows sufficient to finance all capital expenditures and pension contributions without any additional debt or drawing down any material amount of its liquidity. Moody s noted that the Company has built its 2011 budget on the basis of a very modest 2.6 per cent traffic growth which they felt should be easily achievable given that the Company had already recorded a 5.0 per cent growth in the first five months of the fiscal year. Moody s expressed the view that while the aviation sector had been in recovery mode for a year, with traffic growth at NAV CANADA and at most Canadian airports for the better part of the 2010 calendar year, there were some uncertainties on the horizon which could result in weakened numbers again. If this were to occur in a material respect, Moody s noted that any inclination by NAV CANADA to use the full notional liability amount of the rate stabilization account in order to further delay rate increases would weaken the Company s debt service coverage ratio quite substantially and thus create pressure on the ratings. On December 9, 2010, S&P issued a research update confirming the Company s ratings and outlook on solid business profile. S&P cited the Company s legislated perpetual monopoly over civil air traffic services in a geographically diverse area and the ability to levy user charges to meet current and future financial requirements. They noted that the Company has increased user charges far below the rate of growth in the consumer price index which they believe gives the Company ample scope to potentially increase user charges to buttress revenues in the event of a financial shock. S&P stated that they view 17

20 the Company as maintaining adequate liquidity and that the Company has achieved adequate debt service coverage metrics in recent years thanks to effective cost reduction measures. In S&P s view, these credit strengths are partially offset by the fact that the Company s revenue depends almost entirely on air traffic demand, for which recessions, geopolitical events, and natural catastrophes are influencing factors. They also noted the Company s exposure to Canada s two principal airlines: Air Canada and WestJet. An interruption or permanent retrenchment in their services would impair the Company s revenue collections. S&P also noted the Company s high fixed cost structure and safety mandate which limit the ability to cut spending in periods of declining revenues. A credit rating is not a recommendation to buy, sell, or hold securities and may be subject to revision or withdrawal at any time by the rating organization. Our fiscal 2011 AIF contains more detailed information about the credit ratings, including each rating agency s rationale for assigning the given rating. 18

21 SUMMARY OF QUARTERLY RESULTS Quarterly Financial Information (unaudited) (millions) Three months ended Q1 Q4 Q3 Q2 November 30 August 31 May 31 February Revenue before rate stabilization $ 305 $ 340 $ 300 $ 271 Rate stabilization (3) (3) (6) (2) Operating expenses before rate stabilization Rate stabilization (1) (7) (5) - Other expenses (interest, depreciation and amortization) Rate stabilization (2) Other loss (income) 6 20 (14) (20) Rate stabilization (8) (23) Excess (shortfall) of revenue and other (2) (3) (3) (2) loss (income) over expenses $ 1 $ 37 $ (8) $ (27) Three months ended Q1 Q4 Q3 Q2 November 30 August 31 May 31 February Revenue before rate stabilization $ 299 $ 328 $ 283 $ 264 Rate stabilization (6) Operating expenses before rate stabilization Rate stabilization (3) Other expenses (interest, depreciation and amortization) Rate stabilization (3) (1) Other loss (income) (19) (2) (1) - Rate stabilization (1) (1) - - Excess (shortfall) of revenue and other loss (income) over expenses $ (2) $ 40 $ (5) $ (29) 19

22 Discussion of Quarterly Results The quarterly variations in revenues mainly reflect seasonal fluctuations. Typically, revenues are highest in our fourth quarter (June to August) as a result of increased air traffic in the summer months. The second quarter (December to February) typically has the lowest air traffic volumes. Air traffic for Q1 fiscal 2012 was 1.9 per cent higher on average than in Q1 fiscal The majority of our operating expenses are incurred evenly throughout the year. Quarterly results are impacted by one-time events such as the negotiated return of $ 11 million of LTD premiums which reduced operating expenses during the second quarter of fiscal Fair value adjustments on investments and derivative instruments have fluctuated significantly from quarter to quarter based on changes in market factors and changing expectations of credit losses. During the first quarter, like many financial assets, the MAV notes continued to be negatively impacted by uncertainty over the pace of economic growth and concerns about the implications of a potential European sovereign default (similar decrease occurred in Q4 fiscal 2011). The first three quarters of fiscal 2011 had seen a fairly steady improvement in MAV note values as the credit fundamentals of the underlying assets were seen to be improving. LIQUIDITY AND CAPITAL RESOURCES Working Capital Requirements Our non-cash current assets are less than our current liabilities. This results from accounts receivable collections that are more rapid than the settlement of accounts payable and accrued liabilities. Should our working capital requirements increase, the Company has adequate credit facilities and cash as noted below. We set customer service charges to essentially achieve a financial breakeven position on an annual basis, after considering changes in the rate stabilization account. The inclusion of non-cash depreciation and amortization expenses in the calculation of service charge rates leads to a positive cash flow from operations. Our strategy is to use this positive cash flow to fund capital expenditures and contributions to our working capital, if required. In addition, our strategy is to maintain a financial structure and credit ratings that will allow the Company to access the capital markets to meet debt maturities as they come due. Should we believe that conditions are not appropriate to undertake a refinancing at a particular time or should we experience a temporary downturn in revenues from seasonal or other factors, at November 30, 2011 we had $ 365 million of cash and cash equivalents plus a $ 675 million credit facility at our disposal, of which $ 367 million of the credit facility was available as described in the table below. 20

23 The revolving credit facility as at November 30, 2011 is utilized as follows: (millions) November Total available credit facility (1) $ 675 Less: Outstanding letters of credit 8 Undrawn committed borrowing capacity 667 Less: Operations and maintenance reserve fund allocation (2) 250 Less: Capital leasing transaction restriction 50 Credit facility available for unrestricted use $ 367 (1) On September 14, 2011, the Company entered into an amended and restated loan agreement in the amount of $ 675 million comprised of two equal tranches maturing on September 14, 2014 and September 14, (2) The operations and maintenance reserve fund may be used to pay operating and maintenance expenses, if required. Cash flows for the three months ended November 30, 2011 Cash flow provided by (used for): (millions) Three months ended November Change % Operations $ 76 $ 83 $ (7) (8%) Investments (28) (32) 4 (13%) Free cash flow (non-gaap financial measure) (3) Financing % Increase (decrease) in cash and cash equivalents (3) Cash and cash equivalents, beginning of period % Cash and cash equivalents, end of period $ 365 $ 261 $ % As shown above, the Company experienced positive free cash flow for the three month period ended November 30, 2011, which is a non-gaap financial measure. For the three month period ended November 30, 2011, cash flow from operations is lower primarily due to higher payments to employees 21

24 and suppliers and lower other receipts, partially offset by higher receipts from customer service charges and lower pension and other and other post-employment contributions representing approximately $ 9 million of the difference between the two years shown. For the three month period ended November 30, 2011 our cash balance increased by $ 48 million. This is primarily the result of cash inflows from operations of $ 76 million partially offset by capital expenditures of $ 28 million. For the three month period ended November 30, 2010 our cash balance increased by $ 51 million. This was primarily the result of cash inflows from operations of $ 83 million partially offset by capital expenditures of $ 32 million. Outlook: Cash Flow Note: See CAUTION CONCERNING FORWARD LOOKING INFORMATION, page 1. Given the expected net cash inflows from operations more than offset by capital expenditures and the planned repayments of the current portion of long-term debt, the Company s cash position at November 30, 2011 is currently expected to decline by approximately $ 350 million during the remainder of fiscal This decrease would be partially offset by any amount that the Company may decide to refinance. Long-term debt levels are expected to decrease from $ 2,200 million at August 31, 2011 to $ 1,925 million at August 31, 2012 due to the planned repayments of amortizing revenue bonds and the series MTN general obligation notes. The Company may choose to refinance a portion of the MTN notes on a long-term basis, which would impact the cash balance. As discussed below, the Company has adequate existing sources of financing to cover all of its anticipated requirements. Sources of Liquidity As a corporation without share capital, NAV CANADA finances its operations with borrowed money. When the Company was created, we developed a financing plan called the Capital Markets Platform. All borrowings were incurred and secured under a Master Trust Indenture, which initially provided a total drawn and undrawn borrowing capacity of $ 3 billion. The Master Trust Indenture provides for a gradually escalating reduction of the initial borrowing capacity over 33 years. In February 2006, we entered into a trust indenture (the General Obligation Indenture) that establishes a borrowing program that qualifies as subordinated debt under the Master Trust Indenture. As subordinated debt, general obligation notes are not subject to the mandatory annual debt reduction provisions of the Master Trust Indenture. Provided that we meet an additional indebtedness test, we are not limited in the amount of debt we can issue under the General Obligation Indenture. Under the terms of the General Obligation Indenture, no new indebtedness may be incurred under the Master Trust Indenture. Therefore, as bonds mature or are redeemed under the Master Trust Indenture, they will be replaced with general obligation notes or borrowings under our credit facility, as discussed above under Working Capital Requirements. Borrowings under the Master Trust Indenture are secured by an assignment of revenues and a security interest over the debt service reserve fund and revenue account maintained under the Master Trust Indenture. The General Obligation Indenture is unsecured but contains positive and negative covenants similar to the Master Trust Indenture. In December 2010, the Company filed a Base Shelf Prospectus qualifying up to $ 750 million of general obligation notes to be issued pursuant to the Company s medium term notes program. A final receipt for 22