First Quarter Fiscal 2017 Financial Report For the three months ended March 31, 2017 and 2016 TSX: AVO
AVIGILON CORPORATION MANAGEMENT S DISCUSSION AND ANALYSIS INTRODUCTION The following Management s Discussion and Analysis ( MD&A ) provides a review of the financial condition and results of operations of Avigilon Corporation ( Avigilon, the Company, we, us, its or our ), on a consolidated basis, as at and for the three months ended March 31, 2017. It should be read in conjunction with our unaudited condensed consolidated interim financial statements and accompanying notes for the three months ended March 31, 2017 (the Financial Statements ) and with the audited consolidated financial statements and accompanying notes for the year ended December 31, 2016 and the MD&A thereon. All financial information presented in this MD&A was prepared in accordance with International Financial Reporting Standards ( IFRS ), unless otherwise stated. This MD&A has been prepared as of May 15, 2017. All amounts are expressed in thousands of United States ( US ) dollars ( USD ), except with respect to per share amounts, number of shares, and as otherwise stated. Additional information relating to Avigilon, including Avigilon s Annual Information Form dated February 28, 2017 (the AIF ), can be found under Avigilon s profile on SEDAR at www.sedar.com. FORWARD-LOOKING STATEMENTS Certain information and statements contained in this MD&A, including all statements that are not historical facts, contain and constitute forward-looking information or forward-looking statements as defined under applicable securities laws (collectively, forward-looking statements ). Forward-looking statements normally contain words like believe, expect, anticipate, plan, intend, continue, estimate, may, will, should, ongoing, and similar expressions, and within this MD&A include, without limitation, any statements (express or implied) respecting: Avigilon s future plans, strategies, and objectives; projected revenues, and gross margin percentage and profitability; future trends, opportunities, and growth in Avigilon s industry; Avigilon s ability to maintain and enhance its competitive advantages within its industry and in certain markets; Avigilon s product and research and development ( R&D ) plans; new product functionality and suitability; projected operating expenses, interest expenses, and capital expenditures; seasonality of future revenues and expenses; the future availability of working capital and any required additional financing; the ongoing ability of Avigilon to access funds under the Credit Facility (as defined under Financial Position and Liquidity, below); projected uses of the funds available under the Credit Facility; future fluctuations in applicable tax rates, foreign exchange rates, and interest rates; the future availability of tax credits; the addition and retention of personnel; the maintenance and development of Avigilon s reseller network; increases to brand awareness and market penetration; strategies respecting intellectual property protection and licensing; changes and planned changes to accounting policies and standards and their respective impact on our financial reporting; the continued effectiveness of our accounting policies and internal controls over financial reporting; the expansion, development, and adequacy of Avigilon s real property facilities; the completion of the Proposed Transaction (as defined under Corporate Highlights, below) and the proceeds thereunder; the impact and benefits of our new enterprise resource planning ( ERP ) system that was implemented in 2016; and the expected benefits of the Pricing Adjustment (as defined under Discussion of Operations, Gross Profit, below). Forward-looking statements are provided for the purpose of presenting information about management s current expectations and plans relating to the future and allowing investors and others to get a better understanding of our anticipated financial position, results of operations, and operating environment. Readers are cautioned that such information may not be appropriate for other purposes. Forward-looking statements are not guarantees of future performance, actions, or developments and are based on expectations, assumptions, and other factors that Avigilon s management ( Management ) currently believes are relevant, reasonable, and appropriate in the circumstances, including, without limitation, Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 1
assumptions that: Avigilon will be able to successfully execute its plans, strategies, and objectives; Avigilon will be able to leverage its past investments to support growth and focus on increasing profitability; Avigilon will be able to successfully manage cash flow, operating expenses, interest expenses, capital expenditures, and working capital, and credit, liquidity, and market risks; Avigilon will, on an ongoing basis, remain in good standing under the terms of the Credit Facility; future financing will be available to Avigilon on favorable terms when and if required; Avigilon will keep pace with or outpace the growth, direction, and technological advancement in its industry; Avigilon will continue to increase its global market share; industry data and projections obtained from external sources are accurate and reliable; Avigilon will be able to design, develop, and manufacture new products and enhance its existing product lines; Avigilon s new products will function as intended and will be suitable for the intended end users; Avigilon will be able to maintain and develop its reseller network; Avigilon will be able to attract and retain qualified personnel; foreign jurisdictions will not impose unexpected risks; products and parts will be available from suppliers on a timely basis and on favorable terms; Avigilon will be able to enhance and expand its intellectual property portfolio; Avigilon will be able to successfully integrate businesses, intellectual property, products, and technologies that it may acquire, if any; Avigilon will be able to expand, manage, and develop its real property facilities; Avigilon will complete the Proposed Transaction on the terms currently proposed; Avigilon will maintain or enhance its accounting policies and standards and internal controls and procedures over financial reporting; fluctuations in applicable tax rates, foreign exchange rates and interest rates will not have a material impact on Avigilon; certain tax credits will remain or become available to Avigilon; Avigilon will not face any material unexpected costs related to product liability or warranties; Avigilon s protection of its intellectual property is sufficient and its technology does not and will not materially infringe third party intellectual property rights; Avigilon will continue to generate revenue from the Avigilon Patent License Program (the License Program ) and will be able to operate the License Program on an economically viable basis; Avigilon will be able to obtain necessary third party licenses on favorable terms; Avigilon will not become involved in material litigation; Avigilon s ERP system will operate and function as intended; the lower prices of Avigilon s products under the Pricing Adjustment will continue to drive unit volume and revenue, expand addressable market and capture additional market share; Avigilon s plans respecting the pricing of its products and services, including without limitation under the Pricing Adjustment, will proceed in substantially their present form; and Avigilon will be able to achieve greater economies of scale and cost savings from previous investments in infrastructure and in its global sales and marketing teams. Avigilon has also assumed that no significant events will occur outside of Avigilon s normal course of business. Although Management believes that the forward-looking statements contained in this MD&A are reasonable, actual results could be substantially different due to the risks and uncertainties associated with and inherent to Avigilon's business, as more particularly described in the Risk Factors section of the AIF. Additional material risks and uncertainties applicable to the forward-looking statements set out herein include, but are not limited to: fluctuations in Avigilon s operating and capital expenses; fluctuations in foreign exchange rates and interest rates that impact Avigilon; deficiencies in accounting policies or internal controls and procedures over financial reporting; the unavailability of certain tax credits; the risks and uncertainties associated with and inherent to the commercial real estate market in Vancouver; and unforeseen events, developments, or factors causing any of the aforesaid expectations, assumptions, and other factors ultimately being inaccurate or irrelevant. Although Avigilon has attempted to identify important factors that could cause actual actions, events, or results to differ materially from those contained in any forward-looking statement, there may be other factors that cause actions, events or results not to be as anticipated, predicted, estimated, or intended. Many of these factors are beyond the control of Avigilon. Accordingly, readers should not place undue reliance on forward-looking statements. Avigilon undertakes no obligation to reissue or update any forward-looking statements as a result of new information or events after the date hereof except as may be required by law. All forward-looking statements contained in this MD&A are qualified by this cautionary statement. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 2
TRADEMARKS AVIGILON, the AVIGILON logo, AVIGILON CONTROL CENTER, ACC, and AVIGILON APPEARANCE SEARCH are trademarks of Avigilon. Other product names or logos mentioned herein may be the trademarks of their respective owners. The absence of the symbols and in proximity to each trademark or at all in this MD&A is not a disclaimer of ownership of the related trademark. NON-IFRS AND ADDITIONAL IFRS FINANCIAL MEASURES In addition to results reported in accordance with IFRS, the Company also uses certain non-ifrs and additional IFRS financial measures as supplemental indicators of its financial and operating performance. Non-IFRS financial measures include Adjusted EBITDA 1, Adjusted EBITDA Margin, Adjusted Earnings, and Adjusted Earnings per Share ( Adjusted EPS ). Additional IFRS financial measures include gross profit, gross margin percentage and cash from operations before changes in non-cash working capital. Management believes that these supplementary financial measures reflect the Company s ongoing business in a manner that allows for meaningful period-to-period comparisons and analysis of business trends. The Company defines Adjusted EBITDA and Adjusted EBITDA Margin as earnings and earnings as a percentage of revenue, respectively, before deducting share-based payments, foreign exchange gain or loss, business acquisition-related costs, restructuring costs, non-recurring legal costs, non-recurring lease termination costs, amortization, depreciation, revaluation gain on contingent consideration receivable, interest, and taxes. We believe that Adjusted EBITDA and Adjusted EBITDA Margin to be useful measures, as they provide an indication of the operational results of our business. The Company defines Adjusted Earnings as earnings before share-based payments, foreign exchange gain or loss, business acquisition-related costs, financing costs, restructuring costs, non-recurring legal costs, non-recurring lease termination costs, amortization of acquired intangibles, revaluation gain on contingent consideration receivable, and related tax effects. Adjusted EPS is calculated as Adjusted Earnings divided by the basic or diluted weighted average shares outstanding and does not represent actual earnings per share attributable to shareholders. We believe that the disclosure of Adjusted Earnings and Adjusted EPS allows investors to evaluate the operational and financial performance of the Company s ongoing business using the same evaluation measures that Management uses, and is therefore a useful indicator of the Company s performance or expected performance of recurring operations. The Company defines gross profit as revenue less cost of sales, and gross margin percentage as gross profit divided by revenue. Management considers gross profit and gross margin percentage to be key measures as they demonstrate the Company s profitability and its ability to cover its operating expenses from normal operations. The Company defines cash from operations before changes in non-cash working capital as cash from operating activities excluding working capital adjustments, interest paid and received, and amounts paid towards income taxes. Management considers cash from operations before changes in non-cash working capital to be a key measure as it demonstrates the Company s ability to generate cash necessary to fund future capital investments and to repay debt, if applicable. Non-IFRS and additional IFRS financial measures do not have any standardized meaning prescribed by IFRS, and other companies may calculate these measures differently. The presentation of non-ifrs and additional IFRS financial measures is intended to provide additional information and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with IFRS. 1 Earnings Before Interest, Tax, Depreciation and Amortization Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 3
RECENT CORPORATE EVENTS Changes to the Leadership Team On May 10, 2017, the Company announced the promotion of James Henderson to Chief Operating Officer. Mr. Henderson joined Avigilon in 2011, most recently serving as Chief Sales and Marketing Officer. Working closely with Avigilon's senior leadership team, he has been instrumental in the successful creation and execution of Avigilon's global growth strategy. In his new role, James will continue to have oversight over sales and marketing while leading global operations. Corporate Highlights On May 8, 2017, the Company announced that it has entered into an agreement to sell the Company s downtown Vancouver office tower and associated land (the Building ) for expected gross proceeds of approximately CAD $107.5 million (the Proposed Transaction ). The Proposed Transaction is subject to certain conditions that are typical for a transaction of this nature, including completion of the purchaser s due diligence, completion of applicable filings under the Competition Act (Canada), satisfaction of the Company s obligations under its Credit Facility (as defined under Financial Position and Liquidity below), and finalization of the terms of the Building lease. Assuming the conditions to the Proposed Transaction are satisfied in a timely fashion, Management expects the Proposed Transaction will complete in 2017. Avigilon will lease back the Building, thereby securing its facility needs while reducing its debt, providing cash for general working capital purposes, and enhancing shareholder value. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 4
SELECTED FINANCIAL INFORMATION The following tables set out selected consolidated financial information for the quarters indicated, and have been derived from the Financial Statements and should be read in conjunction with the Financial Statements. Financial Performance 2017 2016 Revenue 80,341 69,932 Cost of sales 39,673 30,249 Gross profit 40,668 39,683 Operating expenses 41,363 37,834 Operating (loss) income (695) 1,849 Net (loss) income (1,046) 1,355 Basic (loss) earnings per share (0.02) 0.03 Diluted (loss) earnings per share (0.02) 0.03 Basic Adjusted EPS (1) 0.07 0.09 Diluted Adjusted EPS (1) 0.07 0.09 Adjusted EBITDA (1) 9,443 8,896 Financial Position March 31, 2017 December 31, 2016 Total assets 392,126 395,543 Total liabilities 153,366 158,261 Total non-current financial liabilities (2) 83,063 82,453 (1) Basic and diluted Adjusted EPS, and Adjusted EBITDA are not IFRS financial measures. Please see the Non-IFRS and Additional IFRS Financial Measures section for more information. (2) Non-current financial liabilities represent the long-term portion of long-term debt, excluding deferred transaction costs. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 5
OVERALL PERFORMANCE In the first quarter of 2017, Avigilon had revenue of $80.3 million, a 15% increase over the same period in 2016, or 16% on a constant currency basis. Revenue growth continued to outpace the industry and reflects increased unit volume due to greater customer adoption in existing markets, further penetration of target regions, the ongoing success of the H4 camera platform, new product introductions, and broader adoption of video analytics. Operating expenses increased by 9% in the three months ended March 31, 2017 over the same period in 2016. The increase in operating expenses is driven by an increase in amortization and depreciation due to our previous investments in R&D, an increase in R&D expenses from the expansion of our product portfolio, and increasing full-time personnel to support the Company s global growth from 1,130 as at March 31, 2016 to 1,183 as at March 31, 2017. Historically, operating expenses have been seasonally affected by sales and marketing activities and overall hiring initiatives in the first half of the year benefiting operating leverage in the second half of the year. For the three months ended March 31, 2017, operating expenses as a percentage of revenue decreased from 54% to 51% over the same period in 2016. Management expects the Company s operating expenses as a percentage of revenue to decrease year over year as the Company focuses on increasing profitability, and benefits from efficiencies arising from previous investments and economies of scale. On the innovation front, we have announced several key product introductions in 2017, including the following additions to our product portfolio: Avigilon Control Center (ACC) 6.0 with Avigilon Appearance Search - a sophisticated deep learning artificial intelligence (AI) search engine that sorts through hours of footage with ease, allowing users to quickly locate a specific person of interest across all cameras on an entire site. H4 SL camera line - a new outdoor camera line designed to provide exceptional image quality with an innovative modular design that is easy to install, reducing installation times by up to 50%. As at March 31, 2017, Avigilon held 740 patent assets (inclusive of design rights) globally. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 6
SUMMARY OF QUARTERLY RESULTS The following is a selected summary of quarterly results for the last eight quarters: Selected Quarterly Results (unaudited) 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Revenue 72,972 72,577 81,439 69,932 85,682 95,817 102,191 80,341 Cost of sales 30,682 31,313 35,819 30,249 42,731 46,583 50,089 39,673 Gross profit 42,290 41,264 45,620 39,683 42,951 49,234 52,102 40,668 Operating expenses 36,189 32,731 36,968 37,834 43,690 42,982 39,509 41,363 Operating income (loss) 6,101 8,533 8,652 1,849 (739) 6,252 12,593 (695) Net income (loss) 1,837 7,039 4,207 1,355 (1,965) 3,432 4,368 (1,046) Basic earnings (loss) per share 0.04 0.16 0.10 0.03 (0.05) 0.08 0.10 (0.02) Diluted earnings (loss) per share 0.04 0.15 0.09 0.03 (0.05) 0.08 0.10 (0.02) Basic Adjusted EPS (1) 0.13 0.21 0.21 0.09 0.06 0.21 0.26 0.07 Diluted Adjusted EPS (1) 0.12 0.20 0.21 0.09 0.06 0.21 0.26 0.07 Adjusted EBITDA (1) 12,487 14,389 15,462 8,896 8,003 16,688 20,812 9,443 Total assets 335,150 337,891 347,076 354,303 371,405 391,203 395,543 392,126 Total liabilities 104,012 109,305 132,948 128,715 146,217 159,754 158,261 153,366 Total non-current financial liabilities (2) 59,579 55,621 74,262 79,872 85,483 91,842 82,453 83,063 (1) Basic and diluted Adjusted EPS, and Adjusted EBITDA are not IFRS financial measures. Please see the Non-IFRS and Additional IFRS Financial Measures section for more information. (2) Non-current financial liabilities represent the long-term portion of long-term debt, excluding deferred transaction costs. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 7
DISCUSSION OF OPERATIONS Revenue The Company operates in one segment in which it designs, develops, and manufactures video analytics, network video management software and hardware, surveillance cameras, and access control solutions. Avigilon s solutions are promoted by Avigilon sales staff and sold to a global network of dealers and integrators. Revenue growth reflects increased unit volume due to greater customer adoption in existing markets, further penetration of target regions, the ongoing success of the H4 camera platform, new product introductions, and broader adoption of video analytics. Revenue by Geographic Region Revenue is earned in five main regions: the US; Europe, Middle East and Africa; Canada; Asia Pacific; and Latin America. 2017 2016 % Change United States 46,318 39,037 19% Europe, Middle East and Africa 21,628 19,100 13% Canada 6,229 4,187 49% Asia Pacific 3,559 5,508-35% Latin America 2,607 2,100 24% Total revenue 80,341 69,932 15% For the three months ended March 31, 2017, revenue was strong across most regions, with year over year revenue growth over the same period in 2016 between 13% and 49%, with the exception of Asia Pacific. Record quarterly revenue was achieved for Canada. Quarterly revenue over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 United States 43,984 44,094 48,587 39,037 51,115 58,812 54,826 46,318 Europe, Middle East and Africa 19,235 18,060 20,950 19,100 21,681 22,796 27,699 21,628 Canada 3,429 4,323 4,965 4,187 4,863 5,713 5,964 6,229 Asia Pacific 4,505 3,488 4,045 5,508 5,293 4,744 9,630 3,559 Latin America 1,819 2,612 2,892 2,100 2,730 3,752 4,072 2,607 Total revenue 72,972 72,577 81,439 69,932 85,682 95,817 102,191 80,341 Revenue has historically experienced some seasonality, with the second and fourth quarters generally being the Company s strongest quarters of the year for sequential revenue growth. The second quarter generally benefits from the ramp up of building and development cycles for the year, while the fourth quarter typically benefits from increased spending as annual budget cycles come to a close. Revenue also reflects the impact of foreign exchange rates. Other than USD, a portion of our revenue is denominated in Euro ( EUR ), British Pound Sterling ( GBP ) and Canadian Dollars ( CAD ), although our exposure to the EUR is the most significant. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 8
Cost of Sales Cost of sales consists of the cost of materials and components, manufacturing, depreciation, labor and overhead costs, inventory obsolescence provisions and write-offs, warranty costs, product transportation costs, and other supply chain management costs. To the extent that our sales volume increases, we expect cost of sales to also increase proportionately. 2017 2016 Cost of sales 39,673 30,249 % of revenue 49% 43% Cost of sales for the three months ended March 31, 2017 increased by $9.4 million or 31% over the same period in 2016. As a percentage of revenue, cost of sales was 49% compared to 43% in the first quarter of 2016, primarily due to changes in product mix and pricing. Quarterly cost of sales over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Cost of sales 30,682 31,313 35,819 30,249 42,731 46,583 50,089 39,673 % of revenue 42% 43% 44% 43% 50% 49% 49% 49% Cost of sales as a percentage of revenue fluctuates quarterly due to changes in product mix, pricing, and foreign exchange rates. Gross Profit Gross profit for the three months ended March 31, 2017 increased by $1.0 million over the same period in 2016. The change was primarily due to increased unit volume due to greater customer adoption in existing markets, further penetration of target regions, the ongoing success of the H4 camera platform, new product introductions, and broader adoption of video analytics. As a percentage of revenue, gross margin for the three months ended March 31, 2017 was 51% compared to 57% in the same period in 2016, primarily due to the Pricing Adjustment (defined below). 2017 2016 Gross profit 40,668 39,683 % of revenue 51% 57% In the second quarter of 2016, Management reduced prices on the H3 camera line and select Network Video Recorders to drive unit volume and revenue, expand our addressable market, and capture additional market share (the Pricing Adjustment ). As a result of the Pricing Adjustment, gross margin as a percentage of revenue was strategically exchanged for greater unit volume, revenue, gross profit, and cash flow from operations. Over time, Management expects our gross margin to increase due to growing contributions from the License Program and greater economies of scale from leveraging our previous investments in our US manufacturing facility to support greater unit volume. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 9
Quarterly gross margin percentages over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 % of revenue 58% 57% 56% 57% 50% 51% 51% 51% Gross margin percentages fluctuate quarterly due to changes in product mix, pricing, and foreign exchange rates. Management analyzes pricing and gross margin on an ongoing basis in order to maximize the Company s competitiveness and profitability. Sales and Marketing Sales and marketing expenses consist primarily of salaries and related expenses, advertising, trade shows and other promotional activities. Sales and marketing expenses decreased from 26% to 23% of revenue for the three months ended March 31, 2017, over the same period in 2016. Management believes sales and marketing expenses as a percentage of revenue will continue to decrease year over year as the Company focuses on increasing profitability, and benefits from efficiencies arising from its ERP system and economies of scale from its previous investments in global sales and marketing teams. Sales and marketing expenses for the three months ended March 31, 2017 increased by $0.9 million, or 5%, over the same period in 2016. The increase reflects investments to expand the Company s global sales and marketing team and initiatives, which Management believes will drive continued revenue growth. 2017 2016 Sales and marketing 18,848 17,938 % of revenue 23% 26% Quarterly sales and marketing expenses over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Sales and marketing 17,911 17,316 18,735 17,938 20,519 19,488 18,783 18,848 % of revenue 25% 24% 23% 26% 24% 20% 18% 23% Sales and marketing expenses as a percentage of revenue fluctuate from quarter to quarter due to the timing of trade shows and other marketing initiatives. Research and Development R&D expenses consist primarily of salaries and related expenses for software, firmware and hardware engineering and technical personnel, costs incurred on patent applications, prototypes and other materials and consumables used in product development. The Company incurs most of its R&D expenses in Canada and the US, and receives investment tax credits ( ITCs ) in Canada and the US for certain eligible expenditures. ITCs related to capitalized development are recorded as a reduction of the cost of the associated asset. ITCs not related to capitalized development are netted against the Company s R&D expenses. For the three months ended March 31, 2017, gross R&D expenses increased by $0.9 million over the same period in 2016. Net R&D expenses for the three months ended March 31, 2017 increased by $0.5 million Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 10
over the same period in 2016. The year over year increase in gross R&D expenses is consistent with the Company s ongoing plan to enhance and expand upon its product offerings and intellectual property portfolio. Net R&D expenses are affected by capitalized development costs and ITCs, each of which fluctuate from quarter to quarter depending on the stage and number of products in development. During the three months ended March 31, 2017, ITCs of $Nil were recorded as reductions of the cost of capitalized development assets (2016 - $275). Development costs are capitalized until such time as the related products are commercially launched, and are subsequently amortized over the applicable expected product life. 2017 2016 Gross R&D 8,034 7,110 Investment tax credits (908) (861) Capitalized development (2,603) (2,255) R&D 4,523 3,994 Gross R&D % of revenue 10% 10% R&D expenses over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Gross R&D 5,885 5,479 7,212 7,110 8,418 8,693 8,328 8,034 Investment tax credits (400) (543) (889) (861) (1,052) (1,084) (644) (908) Capitalized development (2,794) (2,721) (2,117) (2,255) (2,719) (3,762) (3,250) (2,603) R&D 2,691 2,215 4,206 3,994 4,647 3,847 4,434 4,523 Gross R&D % of revenue 8% 8% 9% 10% 10% 9% 8% 10% R&D expenses are incurred in advance of the related revenue from new products. Gross R&D expenses vary depending on the Company s product development projects. The year over year increase in R&D expenses is consistent with the Company s ongoing strategy to lead the industry with superior technology in its product offerings in order to maintain its competitive advantage, and increase its addressable market. General and Administrative General and administrative ( G&A ) expenses consist of costs relating to salaries, information systems, customer and technical support, legal and finance functions, professional fees, insurance, facilities, and other corporate expenses. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 11
As a percentage of revenue, G&A expenses for the three months ended March 31, 2017 decreased by 1% over the same period in 2016. G&A expenses for the three months ended March 31, 2017 increased by $0.5 million compared to the same period in 2016. The increase for the three months ended March 31, 2017 was primarily due to share-based payments and non-recurring costs. 2017 2016 G&A 11,907 11,402 % of revenue 15% 16% Quarterly G&A expenses over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 G&A 12,061 9,411 10,179 11,402 13,334 14,098 10,372 11,907 % of revenue 17% 13% 12% 16% 16% 15% 10% 15% As a percentage of revenue, G&A expenses are expected to fluctuate from quarter to quarter based on the timing of expenses and the seasonality of revenue. Management expects the Company s G&A expenses as a percentage of revenue to decrease year over year as the Company focuses on increasing profitability, and benefits from previous investments such as its ERP system. Amortization and Depreciation Amortization and depreciation for the three months ended March 31, 2017 increased by $1.6 million compared to the same period in 2016. Increases in amortization and depreciation in 2017 are primarily due to previous investments in, among other things, R&D, our patent portfolio, and our ERP system. 2017 2016 Amortization and depreciation 6,085 4,500 % of revenue 8% 6% Quarterly amortization and depreciation over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Amortization and depreciation 3,526 3,789 3,848 4,500 5,190 5,549 5,920 6,085 % of revenue 5% 5% 5% 6% 6% 6% 6% 8% Over the last eight quarters, amortization and depreciation expense has increased due to the additions of property, plant, and equipment, acquired intangible assets, ERP system, and capitalized development costs in prior periods. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 12
Interest on Long-Term Debt For the three months ended March 31, 2017, the Company paid $1.0 million in cash interest and amortized $0.1 million of deferred financing costs. Interest of $0.4 million was capitalized during the period, resulting in net interest expense of $0.7 million. 2017 2016 Cash interest paid 985 897 Amortization of deferred financing costs 110 111 Interest capitalized (421) (359) Interest expense 674 649 Quarterly interest expense over the last eight quarters was as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Cash interest paid 567 625 693 897 876 970 1,011 985 Amortization of deferred financing costs 122 77 113 111 141 93 111 110 Interest capitalized (295) (116) (359) (262) (314) (376) (421) Interest expense 689 407 690 649 755 749 746 674 The increase in cash interest paid from the second quarter of 2015 to the fourth quarter of 2016 was incurred to finance previous investments to scale our business. Management expects cash interest paid to decrease over time as we leverage these investments and focus on increasing profitability. Foreign Exchange The Company s foreign exchange gain for the three months ended March 31, 2017 decreased by $0.6 million compared to the same period in 2016. The change is primarily driven by our change in functional currency on April 1, 2016 and is mostly unrealized. 2017 2016 Foreign exchange gain 321 885 Quarterly foreign exchange gains and losses over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Foreign exchange gain (loss) (2,248) 1,916 (1,480) 885 (542) (423) (1,513) 321 The majority of the Company s foreign exchange gain or loss amounts consists of unrealized foreign exchange and is primarily driven by the Company s foreign currency denominated monetary assets and liabilities. The Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 13
fluctuation of foreign exchange gain or loss is primarily driven by the USD s appreciation or depreciation as measured against the CAD, EUR and GBP for each quarter. Income Taxes Income tax expense for the three months ended March 31, 2017 decreased by $0.8 million compared to the same period in 2016. There are a number of items that can significantly impact the Company s worldwide effective income tax rate, including foreign currency exchange rate fluctuations, earnings subject to tax in jurisdictions where the tax rate is different than the Canadian statutory rate, fluctuations in net income, granting of equity-based awards, and other permanent differences between the tax and accounting bases of the Company s assets and liabilities. As a result, the Company s recorded tax provision can be significantly different from the expected tax provision calculated based on the Canadian statutory rate. 2017 2016 Current tax expense 715 545 Deferred tax (recovery) expense (677) 254 Income tax expense 38 799 Quarterly income tax expense (recovery) over the last eight quarters was as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Current tax expense (recovery) 531 3,398 1,175 545 (2,475) (2,066) 2,533 715 Deferred tax expense (recovery) 827 (349) 1,119 254 2,392 3,748 5,374 (677) Income tax expense (recovery) 1,358 3,049 2,294 799 (83) 1,682 7,907 38 Effective income tax rate 43% 30% 35% 37% 4% 33% 64% -4% Due to the number of factors that can potentially impact the effective income tax rate and the sensitivity of income tax expense to these factors, it is expected that the Company s effective income tax rate will fluctuate in future periods. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 14
Net (Loss) Income and Adjusted EBITDA 2017 2016 Net (loss) income (1,046) 1,355 % of revenue -1% 2% Adjusted EBITDA 9,443 8,896 Adjusted EBITDA Margin 12% 13% For the three months ended March 31, 2017, Adjusted EBITDA increased over the same period in 2016 due to increased revenue and gross profit as a result of strong unit volume from the ongoing success of the H4 camera platform, new product introductions, and broader adoption of video analytics. For the three months ended March 31, 2017, net income decreased by $2.4 million over the same period in 2016. Net income for the three months ended March 31, 2017 was impacted by increases in amortization and depreciation, share-based payments and non-recurring costs. Below is a reconciliation of net income to Adjusted EBITDA: 2017 2016 Net (loss) income (1,046) 1,355 Share-based payments 2,262 1,635 Foreign exchange gain (321) (885) Business acquisition-related and other non-recurring costs 1,200 470 Amortization and depreciation 6,676 4,942 Interest on long-term debt 674 649 Interest income (40) (69) Income tax expense 38 799 Adjusted EBITDA 9,443 8,896 Quarterly net income (loss) and Adjusted EBITDA over the last eight quarters were as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Net income (loss) 1,837 7,039 4,207 1,355 (1,965) 3,432 4,368 (1,046) % of revenue 3% 10% 5% 2% -2% 4% 4% -1% Adjusted EBITDA 12,487 14,389 15,462 8,896 8,003 16,688 20,812 9,443 Adjusted EBITDA Margin 17% 20% 19% 13% 9% 17% 20% 12% We estimate that every $0.01 change in the exchange rate of CAD per USD will have a $0.5 million annual impact on our Adjusted EBITDA. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 15
The quarterly reconciliation of net income (loss) to Adjusted EBITDA is as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Net income (loss) 1,837 7,039 4,207 1,355 (1,965) 3,432 4,368 (1,046) Share-based payments 2,014 423 1,512 1,635 1,444 2,042 1,458 2,262 Foreign exchange (gain) loss 2,248 (1,916) 1,480 (885) 542 423 1,513 (321) Business acquisition-related and other non-recurring costs 534 1,428 1,028 470 1,628 2,352 352 1,200 Amortization and depreciation 3,838 4,005 4,270 4,942 5,670 6,042 6,409 6,676 Revaluation gain on contingent consideration receivable (1,924) Interest on long-term debt 689 407 690 649 755 749 746 674 Interest (income) expense (31) (46) (19) (69) 12 (34) (17) (40) Income tax expense (recovery) 1,358 3,049 2,294 799 (83) 1,682 7,907 38 Adjusted EBITDA 12,487 14,389 15,462 8,896 8,003 16,688 20,812 9,443 Adjusted Earnings and Adjusted EPS 2017 2016 Net (loss) income (1,046) 1,355 Share-based payments 2,262 1,635 Foreign exchange gain (321) (885) Business acquisition-related and other non-recurring costs 1,290 517 Amortization of acquired intangible assets 2,232 2,233 Related tax effects (1,247) (1,041) Adjusted Earnings 3,170 3,814 Basic weighted average number of shares outstanding (000's) 43,680 43,285 Basic Adjusted EPS 0.07 0.09 Diluted weighted average number of shares outstanding (000's) 45,027 44,032 Diluted Adjusted EPS 0.07 0.09 For the three months ended March 31, 2017, Adjusted Earnings decreased over the same period in 2016, primarily due to increases in non-cash amortization and depreciation, investments to expand the Company s sales and marketing initiatives, and investments in R&D. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 16
The quarterly reconciliation of net income (loss) to Adjusted Earnings and calculation of basic and diluted Adjusted EPS is as follows: 2015 2016 2017 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Net income (loss) 1,837 7,039 4,207 1,355 (1,965) 3,432 4,368 (1,046) Share-based payments 2,014 423 1,512 1,635 1,444 2,042 1,458 2,262 Foreign exchange (gain) loss 2,248 (1,916) 1,480 (885) 542 423 1,513 (321) Business acquisition-related and other non-recurring costs 534 1,502 1,077 517 1,727 2,425 443 1,290 Amortization of acquired intangible assets 2,210 2,411 2,220 2,233 2,225 2,232 2,232 2,232 Revaluation gain on contingent consideration receivable (1,924) Related tax effects (2,994) (194) (1,369) (1,041) (1,400) (1,433) 3,363 (1,247) Adjusted Earnings 5,849 9,265 9,127 3,814 2,573 9,121 11,453 3,170 Basic weighted average number of shares outstanding (000's) 46,474 44,738 43,792 43,285 43,372 43,477 43,596 43,680 Basic Adjusted EPS 0.13 0.21 0.21 0.09 0.06 0.21 0.26 0.07 Diluted weighted average number of shares outstanding (000's) 47,371 45,463 44,462 44,032 44,133 44,343 44,516 45,027 Diluted Adjusted EPS 0.12 0.20 0.21 0.09 0.06 0.21 0.26 0.07 Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 17
FINANCIAL POSITION AND LIQUIDITY Cash and cash equivalents were $25.2 million at March 31, 2017, compared to $30.0 million at December 31, 2016. As at March 31, 2017, the Company had net working capital of $98.6 million, compared to $105.4 million as at December 31, 2016. The change in cash consists of: 2017 2016 Cash from (used in) operating activities 8,357 (4,145) Cash used in investing activities (13,521) (8,332) Cash from financing activities 262 5,213 Cash from operations before changes in non-cash working capital, a non-ifrs financial measure, was $7.4 million for the three months ended March 31, 2017. 2017 2016 Net (loss) income (1,046) 1,355 Adjustments for: Amortization expense 4,436 3,240 Depreciation expense 2,240 1,702 Leasehold incentives received, net of amortization (126) 1,198 Share-based payments 2,262 1,635 Income tax expense 38 799 Investment tax credits (908) (586) Interest on long-term debt 674 649 Unrealized foreign exchange (gain) loss (179) 653 Interest income (40) (69) Cash from operations before changes in non-cash working capital 7,351 10,576 For the three months ended March 31, 2017, the change in working capital of $1.6 million reflected net collections on accounts receivable of $9.2 million, a decrease in inventory of $0.7 million, offset by a decrease in trade and other payables of $7.7 million, and an increase in prepaids of $0.6 million. As part of our operating activities, $0.7 million of cash was paid in income taxes. For the three months ended March 31, 2017, net cash from operating activities increased by $12.5 million, or 302%, over the same period in 2016. The increase is the result of effective working capital management. Cash used in investing activities for the three months ended March 31, 2017 was $13.5 million and comprised the following: additions of $3.3 million to intangible assets primarily related to additions to capitalized development costs; and additions of $10.2 million to sales and demonstration equipment, and to property, plant and equipment primarily related to construction for the Building. Cash from financing activities for the three months ended March 31, 2017 was $0.3 million and comprised the following: proceeds of $5.0 million from long-term debt; proceeds of $0.3 million from the exercise of incentive stock options ( Options ); offset by repayment of $4.0 million of long-term debt; and payment of $1.0 million of interest on long-term debt. In addition to available net working capital, at March 31, 2017 we had available the multi-tranche senior secured syndicated credit facility (the Credit Facility ), which included a $100 million multi-currency revolving Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 18
acquisition facility (the Acquisition Facility ), a $100 million multi-currency revolving line (the Revolver ), and a $40 million real estate term loan (the Real Estate Loan ). As at March 31, 2017, $48.2 million was drawn on the Acquisition Facility, $22.4 million was drawn on the Real Estate Loan, and $30.0 million was drawn on the Revolver, all of which bore interest at LIBOR plus a margin between 2.25% and 2.50% for the period from January 1, 2017 to March 31, 2017. As at March 31, 2017, $139.4 million was undrawn on the Credit Facility. We expect our working capital needs to continue growing with our sales. We believe that our ongoing operations and associated cash flows, in addition to our cash resources and the Credit Facility, will provide sufficient liquidity to continue financing our planned growth in the near term, and that we will have access to additional debt and equity capital as we grow to support further expansion. CAPITAL RESOURCES We define capital as debt and shareholders equity. Our objective when managing capital is to provide sufficient resources to meet day-to-day operating requirements, and to enhance and develop new product offerings and expand operations. In managing our capital structure, we take into consideration various factors, including the growth of our business and related infrastructure and the up-front cost of taking on new customers. Management is responsible for managing capital and do so through quarterly meetings and regular review of financial information. The Company s Board of Directors is responsible for overseeing this process. We manage our resources while maximizing the return to shareholders through the optimization of debt and equity balances. The Credit Facility contains restrictive covenants that affect the manner in which the Company may structure or operate its business, including by limiting the Company s ability to incur indebtedness, create liens, sell assets, make capital expenditures, and engage in acquisitions, mergers, or restructurings. The Credit Facility also requires the Company to maintain certain financial ratios. As at March 31, 2017, the Company was in compliance with the financial covenants of the Credit Facility, which consist of a leverage ratio and fixed charge coverage ratio as defined in the Credit Facility. Subject to the leverage ratio, the Company may be required to make certain mandatory repayments. As at March 31, 2017, the Company was also in compliance with the restrictive covenants of the Credit Facility. CONTRACTUAL OBLIGATIONS In the normal course of business, we enter into contracts that give rise to commitments for future minimum payments. The Company has such obligations under the Credit Facility and operating leases for its office and manufacturing premises. As at March 31, 2017, the obligations under the Credit Facility incurred in addition to those disclosed in our consolidated financial statements as at December 31, 2016 are as follows: Total Less than 1 year 1-3 years 4-5 years After 5 years Long-term debt - the Revolver 5,000 5,000 CAPITAL EXPENDITURES During the three months ended March 31, 2017, we incurred capital expenditures of $12.0 million. In the first quarter of 2017 we have made capital investments in research and development, and the Building. As the majority of the Company s capital investments are now substantially complete, Management expects capital expenditures in 2017 to decrease year over year as we leverage previous investments to support business growth and focus on increasing profitability. As at the date of this MD&A, the Company has outstanding commitments of approximately $3.3 million related to the development of the Building. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 19
CAPITAL STRUCTURE AND OUTSTANDING SHARE DATA As at May 12, 2017, the Company has 43,771,744 common shares issued and outstanding. We maintain an Incentive Security Plan (the Incentive Plan ) that enables us to grant Options and Restricted Share Units ( RSUs and, collectively with Options, Compensation Securities ) to Directors, officers, employees, and consultants of the Company. The Incentive Plan permits the granting of Compensation Securities up to an aggregate maximum of 10% of our issued and outstanding common shares from time to time on a non-diluted basis, provided that the maximum number of RSUs that may be granted thereunder is further limited to 5% of our issued and outstanding common shares from time to time on a non-diluted basis. During the three months ended March 31, 2017, we granted 478,600 RSUs. The common shares, Options and RSUs outstanding and exercisable as at the following dates are shown below: March 31, 2017 May 12, 2017 Number Weighted average exercise price (CAD) Number Weighted average exercise price (CAD) Common shares outstanding 43,768,494 43,771,744 Options Outstanding 2,962,125 $ 14.66 2,901,375 $ 14.62 Exercisable 889,657 $ 13.77 885,907 $ 13.79 RSUs Outstanding 1,161,946 n/a 1,149,762 n/a OFF-BALANCE SHEET ARRANGEMENTS As at March 31, 2017, the Company had no off-balance sheet arrangements. TRANSACTIONS WITH RELATED PARTIES Key Management Personnel Key management personnel consist of the Company s executive officers and its Directors. During the three months ended March 31, 2017 and 2016, compensation of key management personnel was as follows: 2017 2016 Short-term employee benefits 1,617 1,146 Share-based payments 1,606 1,180 3,223 2,326 Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 20
Other Related Party Transactions Other related parties include a company owned by a Director of the Company. Transactions with such parties are conducted on a normal commercial basis, including terms and prices. The aggregate value of transactions with other related parties during the three months ended March 31, 2017 and 2016 was as follows: 2017 2016 Sale of goods and services 79 97 As at March 31, 2017, $32 (December 31, 2016 - $151) of sales to a related party were included in trade and other receivables. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT The Company s financial instruments consist of cash and cash equivalents, deposits, trade and other receivables, trade and other payables, and long-term debt. The carrying values of these financial instruments approximate their fair values because of the short-term nature of these instruments or the indexed rate of interest on the bank debt. The Company enters into foreign exchange contracts to minimize exposure to foreign currencies. During the three months ended March 31, 2017, the Company incurred an unrealized gain on foreign exchange contracts of $6 (2016 - $Nil). As at March 31, 2017 the fair value of the foreign exchange contracts was a net asset of $6 (December 31, 2016 - $25), presented within trade and other receivables. The Company s financial instruments are discussed in greater detail in the Company s MD&A for the year ended December 31, 2016. There have been no material changes to the composition of or risks associated with these financial instruments since December 31, 2016. JUDGMENTS AND CRITICAL ACCOUNTING ESTIMATES The preparation of the Financial Statements requires Management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and the disclosure of contingent assets and liabilities. These estimates are based upon Management s historical experience and various other assumptions that are believed by Management to be reasonable under the circumstances, and are reviewed on an ongoing basis. Actual results may differ from the estimates under different assumptions and conditions, and may materially affect financial results of the Company s statement of financial position reported in future periods. Information about the judgments, estimates and assumptions made by Management are as described under Judgments and critical accounting estimates in the Company s MD&A for the year ended December 31, 2016, as filed under the Company s profile on SEDAR at www.sedar.com. CONTROLS AND PROCEDURES Changes in Internal Controls over Financial Reporting There were no changes in the Company s internal controls over financial reporting during the three months ended March 31, 2017 that materially affected, or are reasonably likely to materially affect, the Company s internal controls over financial reporting. Avigilon Corporation - Management s Discussion and Analysis Q1 2017 Page 21