EXFO Inc. - Management Reports 2020

Management’s Discussion and Analysis of Financial Condition and Results of Operations

This discussion and analysis contains forward-looking statements within the meaning of the U.S. Private Securities Litigation Reform Act of 1995, and we intend that such forward-looking statements be subject to the safe harbors created thereby. Forward-looking statements are statements other than historical information or statements of current condition. Words such as may, expect, believe, plan, anticipate, intend, could, estimate, continue, or similar expressions or the negative of such expressions are intended to identify forward-looking statements. In addition, any statements that refer to expectations, projections or other characterizations of future events and circumstances are considered forward-looking statements. They are not guarantees of future performance and involve risks and uncertainties. Actual results may differ materially from those in forward-looking statements due to various factors including, but not limited to, macroeconomic uncertainty, namely the impact of the coronavirus pandemic on our employees, customers and global operations, including the ability of our suppliers to fulfil raw material requirements and services, and our ability to manufacture and deliver our products and services to our customers; the effects and length of emergency measures related to isolation periods for individuals in affected areas, lockdown restrictions imposed by national governments on businesses in countries where we operate and have employees, and limitations on travel to attract new customers and serve existing ones; deteriorating financial and market conditions as well as potential recession; trade wars; our ability to successfully integrate businesses that we acquire; capital spending and network deployment levels in the communications industry (including our ability to quickly adapt cost structures to anticipated levels of business and our ability to manage inventory levels with market demand); consolidation in the global communications test, monitoring and analytics solutions markets and increased competition among vendors; capacity to adapt our future product offering to future technological changes; limited visibility with regard to the timing and nature of customer orders; delay in revenue recognition due to longer sales cycles for complex systems involving customers’ acceptance; fluctuating exchange rates; concentration of sales; timely release and market acceptance of our new products and other upcoming products; our ability to successfully expand international operations and to conduct business internationally; and the retention of key technical and management personnel. Assumptions relating to the foregoing involve judgments and risks, all of which are difficult or impossible to predict and many of which are beyond our control. Other risk factors that may affect our future performance and operations are detailed in our Annual Report, on Form 20-F, and our other filings with the U.S. Securities and Exchange Commission and the Canadian securities commissions. We believe that the expectations reflected in the forward-looking statements are reasonable based on information currently available to us, but we cannot assure you that the expectations will prove to have been correct. Accordingly, you should not place undue reliance on these forward-looking statements. These statements speak only as of the date of this document. Unless required by law or applicable regulations, we undertake no obligation to revise or update any of them to reflect events or circumstances that occur after the date of this document. This discussion and analysis should be read in conjunction with the consolidated financial statements.

The following discussion and analysis of financial condition and results of operations is dated November 25, 2020.

All financial data are expressed in US dollars, except as otherwise noted, and determined based on International Financial Reporting Standards (IFRS) as issued by the International Accounting Standards Board (IASB). This discussion and analysis also contains financial data that do not comply with IFRS. Where such measures are presented, they are defined, and the reader is informed.

COMPANY OVERVIEW AND RECENT DEVELOPMENTS

We are a leading provider of test, monitoring and analytics solutions for fixed and mobile network operators, web-scale companies, as well as for optical component and network equipment manufacturers in the global communications industry. Our broad portfolio of intelligent hardware and software solutions enables transformations related to fiber, 4G/LTE, 5G, and cloud-native network deployments. Ultimately, customers rely on our solutions to increase network capacity and improve quality of experience for end-users while driving operational efficiencies.

Our success has been largely predicated on our core expertise in developing test equipment for fixed networks. These solutions are available as handheld test instruments, portable platforms with related modules, benchtop instruments, benchtop platforms with modules, and rack-mounted chassis with modules. Our PC-centric, openended platforms, combined with cloud-based software applications, can be transformed into a fully connected test environment that allows customers to automate complex, labor-intensive tasks like fiber-to-the-antenna (FTTA), distributed antenna system (DAS) and small cell deployments. Leveraging platform connectivity, customers can also keep track of their entire test fleet, manage software updates and schedule calibration procedures. All test data can be stored in a central database and used as a point of reference against future measurements. Consequently, this enhanced test environment enables them to increase productivity and reduce operating expenses.

Over the years, we have expanded our product portfolio into fiber monitoring, IP (Internet protocol) service assurance as well as monitoring of 2G, 3G, 4G/LTE and 5G mobile networks. Our fiber-monitoring solution leverages EXFO’s expertise and market leadership in optical time domain reflectometry (OTDR) by using this technology as remote test units (RTUs) to monitor an optical plant 24 hours per day, seven days per week. This fiber-monitoring solution proactively detects any fiber degradation or locates any fiber cut to optimize quality of service along long-haul, metro and access networks. Our IP service assurance solution is a probe-based hardware and software offering that delivers quality-of-service visibility as well as real-time service monitoring and verification of nextgeneration IP networks. We have enriched our IP service assurance offering, which can also be virtualized, with infrastructure performance management tools, analytics software and network topology discovery solutions via technology acquisitions.

Following the acquisition of Astellia S.A. (renamed EXFO Solutions S.A.S.) in January 2018, we offer monitoring solutions for multi-technology mobile networks (2G, 3G, 4G, 5G). This portfolio provides mobile network operators with capabilities to detect, correlate, analyze, report, geolocate and troubleshoot issues related to network performance, handset behavior and service usage. These solutions can be fully virtualized and combined with information from call traces, third-party probes, customer relationship management, billing, etc., to optimize network visibility.

Our mobile portfolio also consists of network simulators and optical radio frequency (RF) test solutions. Our network simulators simulate real-world, large-scale network traffic and end-user behavior in a laboratory environment to predict network behavior, uncover faults and optimize networks before mobile networks and services are deployed. Our optical RF test solutions are dedicated to turning up and troubleshooting fiber-based mobile networks. These solutions are critical for locating and analyzing RF interference issues in FTTA, DAS, remote radio heads and baseband units that support 4G/LTE and 5G networks.

The competitive advantages of our products include a high degree of innovation, modularity (especially wireline products) and ease of use. Our products enable optical component and network equipment manufacturers, fixed and mobile network operators as well as web-scale operators to design, deploy, troubleshoot and monitor networks and, in the process, help them reduce the cost of operating their networks.

We have a staff of approximately 1,900 people in 25 countries, supporting more than 2,000 customers around the world. We operate three main manufacturing sites, which are located in Québec City, Canada, Shenzhen, China, and Lannion, France, and we have facilities in Rennes, France, and Oulu, Finland, for product configuration, software loading, quality control and shipping of monitoring systems. We also have five main research and development expertise centers in Montréal, Québec City, Rennes, Oulu and London, which are supported by a software development center in India.

In fiscal 2020, we modified certain credit facilities, whereby revolving credit facilities, which provided advances up to CA$70 million (US$53.7 million), were extended to CA$90.0 million (US$69.0 million) until May 31, 2021, to return to CA$70 million on June 1, 2021.

In August 2020, we implemented a restructuring plan to align our cost structure with challenges imposed by the coronavirus pandemic and to strengthen our focus on high-growth drivers like fiber, 5G and cloud-native deployments. During the fourth quarter of fiscal 2020, we recorded pre-tax restructuring charges of $2.9 million, mainly comprised of severance expenses for the employees laid-off. This plan, which is expected to generate $5 million in annual savings, will be completed in fiscal 2021.

On September 7, 2020, we entered into a share swap agreement (SSA) to acquire all of the issued and outstanding shares of InOpticals Inc. (InOpticals), a Taiwan-based company that offers ultra-high-speed test instruments for the laboratory and manufacturing markets. The SSA is subject to closing conditions by Taiwanese regulatory authorities. We expect the acquisition to close in the second quarter of fiscal 2021. The fair value of the total consideration for this acquisition is not expected to be material.

Our sales decreased 7.4% to $265.6 million in fiscal 2020 from $286.9 million in 2019 mainly due to the global impact of the coronavirus pandemic, as ongoing constraints and preventive measures affected our ability to ship our products and deliver our services. Bookings (purchase orders received from customers) decreased 11.1% to $264.9 million in fiscal 2020, for a book-to-bill ratio of 1.00, from $297.8 million in 2019 also mainly due to the global impact of the coronavirus pandemic on our customers.

Net loss amounted to $9.5 million, or $0.17 per share, in fiscal 2020, compared to $2.5 million, or $0.04 per share, in fiscal 2019. Net loss in fiscal 2020 included net expenses totaling $10.3 million, comprising $5.5 million in aftertax amortization of intangible assets, $2.0 million in stock-based compensation costs, $2.4 million in after-tax restructuring charges, and a foreign exchange loss of $0.4 million. Net loss in fiscal 2020 also included an amount of $2.4 million in after-tax wage subsidy granted by the Canadian government as a result of the coronavirus pandemic. Net loss in fiscal 2019 included net expenses totaling $15.1 million, comprising $7.8 million in after-tax amortization of intangible assets, $1.8 million in stock-based compensation costs, $3.2 million in after-tax restructuring charges, $1.4 million for the acquisition-related deferred revenue fair value adjustment, and a foreign exchange loss of $0.9 million. Net loss also includes $1.7 million for a gain on disposal of capital assets and $2.4 million for a deferred income tax recovery.

Adjusted EBITDA (net loss before interest and other expense, income taxes, depreciation and amortization, stockbased compensation costs, restructuring charges, acquisition-related deferred revenue fair value adjustment, and foreign exchange gain or loss) amounted to $18.2 million, or 6.8% of sales, in fiscal 2020, compared to $25.6 million, or 8.9% of sales, in 2019. Adjusted EBITDA is a non-IFRS measure. See page 23 of this document for a complete reconciliation of adjusted EBITDA to IFRS net loss.

BUSINESS OUTLOOK

Short-term and mid-term adjusted EBITDA target

We had forecasted adjusted EBITDA of $33 million for fiscal 2020 and set an adjusted EBITDA margin target of 15% of sales by the end of fiscal 2021. Due to the uncertainty surrounding the breadth and duration of this coronavirus pandemic, we have suspended indefinitely our short-term and mid-term adjusted EBITDA outlook.

Sales

We sell our products to a diversified customer base in approximately 100 countries through our direct sales force and channel partners, such as sales representatives and distributors. Most of our sales are denominated in US dollars, euros and Canadian dollars.

In fiscal 2018, 2019 and 2020, no customer accounted for more than 10% of our sales, with our top customer representing 9.1%, 6.9% and 8.3% of our sales respectively.

We believe that we have a vast array of products, a diversified customer base and a good spread across geographical areas, which provides us with reasonable protection against concentration of sales and credit risk.

Cost of Sales

The cost of sales includes raw materials, salaries and related expenses for direct and indirect manufacturing personnel and professional services, as well as overhead costs. Excess, obsolete and scrapped materials are also included in the cost of sales. However, the cost of sales is presented exclusive of depreciation and amortization, which are shown separately in the consolidated statements of earnings.

Selling and administrative, and research and development expenses

Selling and administrative expenses consist primarily of salaries and related expenses for personnel, sales commissions, travel expenses, marketing programs, professional services, information systems, human resources and other corporate expenses.

Gross research and development expenses consist primarily of salaries and related expenses for engineers and other technical personnel, material component costs as well as fees paid to third-party consultants. We are eligible to receive research and development tax credits on research and development activities carried out in Canada and France. All related research and development tax credits are recorded as a reduction of gross research and development expenses.

RESULTS OF OPERATIONS

(in thousands of US dollars, except per share data, and as a percentage of sales for the years indicated)

Consolidated statement of earnings data:(1)		2020		2019		2018	2020	2019	2018
Sales ...........................................................	$	265,583	$	286,890	$	269,546	100.0 %	100.0 %	100.0 %
Cost of sales(2)............................................		114,558		118,677		105,004	43.1	41.4	39.0
Selling and administrative ..........................		92,293		98,646		98,794	34.8	34.4	36.7
Net research and development ..................		45,487		50,553		57,154	17.1	17.6	21.2
Depreciation of property, plant and
equipment .............................................		5,563		5,469		5,444	2.1	1.9	2.0
Depreciation of lease right-of-use assets ...		3,349		–		–	1.2	–	–
Amortization of intangible assets ..............		6,467		9,012		10,327	2.4	3.1	3.8
Change in fair value of cash-contingent
consideration .........................................		–		–		(670)	–	–	(0.3)
Interest and other expense ........................		956		718		1,378	0.4	0.3	0.5
Foreign exchange (gain) loss ......................		428		949		(1,309)	0.2	0.3	(0.5)
Share in net loss of an associate.................		–		–		2,080	–	–	0.8
Gain on deemed disposal of the
investment in an associate .....................		–		–		(2,080)	–	–	(0.8)
Earnings (loss) before income taxes ..........		(3,518)		2,866		(6,576)	(1.3)	1.0	(2.4)
Income taxes ..............................................		6,022		5,346		5,678	2.3	1.9	2.1
Net loss for the year ...................................		(9,540)		(2,480)		(12,254)	(3.6)	(0.9)	(4.5)
Net loss for the year attributable to non-
controllinginterest ................................		–		–		(352)	–	–	(0.1)
Net loss for the year attributable to the
parent interest .......................................	$	(9,540)	$	(2,480)	$	(11,902)	(3.6) %	(0.9)%	(4.4)%
Basic and diluted net loss attributable to
the parent interest per share .................	$	(0.17)	$	(0.04)	$	(0.22)
Other selected information:
Gross margin before depreciation and
amortization(4).......................................	$	151,025	$	168,213	$	164,542	56.9 %	58.6 %	61.0 %
Gross research and development...............	$	54,564	$	57,972	$	65,243	20.5 %	20.2 %	24.2 %
Restructuring charges included in:
Cost of sales ...........................................	$	898	$	304	$	517	0.4 %	0.1 %	0.2 %
Selling and administrative expenses ......	$	1,882	$	495	$	673	0.7 %	0.2 %	0.2 %
Net research and development
expenses ............................................	$	106	$	2,506	$	3,219	–%	0.9 %	1.2 %
Canadian emergency wage subsidy
included in:
Cost of sales ...........................................	$	(723)	$	–	$	–	(0.3) %	– %	– %
Selling and administrative expenses ......	$	(1,082)	$	–	$	–	(0.4) %	– %	– %
Net research and development
expenses ............................................	$	(1,457)	$	–	$	–	(0.5) %	– %	– %
Adjusted EBITDA(3, 4, 5)................................	$	18,152	$	25,585	$	17,198	6.8 %	8.9 %	6.4 %
Consolidated balance sheet data:(1)
Total assets ................................................	$	310,654	$	277,602	$	284,544

(1) Consolidated statement of earnings and balance sheet data has been derived from our consolidated financial statements prepared according with IFRS, as issued by the IASB, except for non-IFRS measures.

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

(3) IFRS net loss for the year ended August 31, 2020 takes into account the impact of the adoption of IFRS 16, Leases, on September 1, 2019. The adoption of IFRS 16 had a positive impact on adjusted EBITDA of $3.3 million, or 1.2% of sales for year ended August 31, 2020. Comparative figures were not adjusted.

(4) Refer to page 23 for non-IFRS measures.

(5) Includes acquisition-related costs of $2.2 million or 0.8% of sales in fiscal 2018 (nil in 2019 and 2020).

RESULTS OF OPERATIONS

Sales and Bookings

The following tables summarize sales and bookings by product line, in thousands of US dollars:

Sales

ales
Test and measurement Service assurance, systems and services Foreign exchange gains (losses) on forward exchange contracts Total sales	Years ended August 31,
	2020 $ 197,419 69,192 266,611 (1,028) $ 265,583	2019 $ 204,693 82,788 287,481 (591) $286,890	2018
			$ 197,423 71,248
			268,671 875
			$269,546

Bookings

ookings
Test and measurement Service assurance, systems and services Foreign exchange gains (losses) on forward exchange contracts Total bookings	Years ended August 31,
	2020 $ 197,141 68,750 265,891 (1,028) $ 264,863	2019 $ 210,055 88,341 298,396 (591) $297,805	2018
			$ 193,836 72,982
			266,818 875
			$267,693

Sales by geographic region

The following table summarizes sales by geographic region:

Years ended August 31,	Years ended August 31,	Years ended August 31,
2020 49 % 30 21 100 %	2019 50 % 32 18 100 %	2018
		50 % 32 18
		100 %

Fiscal 2020 vs. 2019

In fiscal 2020, our sales decreased 7.4% to $265.6 million, compared to $286.9 million in 2019, and our bookings decreased 11.1% year-over-year to $264.9 million in 2020 from $297.8 million in 2019, for a book-to-bill ratio of 1.00.

Sales

In fiscal 2020, the 7.4% decrease in total sales year-over-year came from both product lines.

In fiscal 2020, sales of our Test and Measurement (T&M) product line decreased by $7.3 million, or 3.6% year-overyear, mainly due to the impact the coronavirus pandemic. In particular, sales were negatively impacted in the Americas and the EMEA regions mainly for our optical test as ongoing constraints and preventive measures affected our ability to ship our products and deliver our services. We also witnessed a pause in large-scale fiber installations with communications service providers (CSPs) mainly focusing on maintenance work during the peak of the pandemic. Finally, sales of our T&M product line were to some extent negatively affected by currency fluctuations year-over-year. Otherwise, we made strong progress in China for our advanced equipment for labs and network equipment manufacturers (NEMs), mainly for 5G deployments, as China was the first region to re-open after the lock down, which offset in part the overall year-over-year decrease in T&M sales in fiscal 2020.

In fiscal 2020, sales of our Service Assurance, Systems and Services (SASS) product line decreased by $13.6 million, or 16.4% year-over-year. Sales of our SASS product line in fiscal 2019 included a negative impact of $1.4 million for EXFO Solutions’ acquisition-related deferred revenue fair value adjustment. Excluding this adjustment, sales of our SASS product line would have decreased 17.8% year-over-year in fiscal 2020. The year-over-year decrease in sales of our SASS product line in fiscal 2020 is due in part to the $4.9 million order for our real-time network topology solution recognized in 2019 (no such large order in 2020). In addition, the coronavirus pandemic had a negative impact on the sales of our SASS product line in fiscal 2020, as delivery and commissioning of our solutions were more difficult to execute as a result of the pandemic. Finally, sales of our SASS product line were to some extent negatively affected by currency fluctuations year-over-year.

Bookings

In fiscal 2020, the 11.1% decrease in total bookings year-over-year can be attributed to both product lines.

In fiscal 2020, bookings of our T&M product line decreased $12.9 million or 6.1% year-over-year. In particular, bookings were negatively impacted in the Americas and the EMEA regions mostly for our optical test mainly due to the negative impact of the coronavirus pandemic. In addition, bookings of our T&M product line were to some extent negatively affected by currency fluctuations year-over-year. These declines were offset in part by strong progress made in China for our advanced equipment for labs and NEMs, mainly for 5G deployments, and a good performance of our high-speed optical transport solutions, which overall delivered a slight increase year-over-year despite the negative impact of the pandemic.

In fiscal 2020, bookings of our SASS product line decreased $19.6 million or 22.2% year-over-year. In fiscal 2019, we had received large orders for our real-time network topology solution totaling approximately $11 million. We did not have such order in fiscal 2020. In addition, the coronavirus pandemic had a negative impact on the bookings of our SASS product line year-over-year, as we experienced longer delays to close deals. Finally, bookings of our SASS product line were to some extent negatively affected by currency fluctuations year-over-year.

Fiscal 2019 vs. 2018

In fiscal 2019, our sales increased 6.4% to $286.9 million, compared to $269.5 million in 2018, while our bookings increased 11.2% year-over-year to $297.8 million in 2019 from $267.7 million in 2018, for a book-to-bill ratio of 1.04.

Sales

In fiscal 2019, the 6.4% increase in total sales year-over-year can be attributed to the positive effect of the acquisition of EXFO Solutions. EXFO Solutions contributed to our sales for the full reporting year in fiscal 2019 versus seven months in 2018. We also benefited from a $4.9 million order that was recognized in fiscal 2019 for our real-time network topology solution (no such order in fiscal 2018). Otherwise, our total sales were negatively affected by currency fluctuations year-over-year.

In fiscal 2019, sales of our T&M product line improved $7.3 million or 3.7% year-over-year, despite a negative currency impact. In fiscal 2019, we generated increased sales from our high-speed optical transport solutions, as well as higher sales from EXFO Optics for advanced solutions dedicated to labs and NEM environments, compared to 2018.

In fiscal 2019, sales of our SASS product line increased $11.5 million or 16.2% year-over-year, despite a negative currency impact, mainly because we benefited from the EXFO Solutions acquisition for the full reporting year versus seven months in 2018. We also benefited from a $4.9 million order that was recognized in fiscal 2019 for our realtime network topology solution (no such order in fiscal 2018).

Bookings

In fiscal 2019, our total bookings increased 11.2% year-over-year, mainly due to the positive effect of the acquisition of EXFO Solutions. EXFO Solutions contributed to our bookings for the full reporting year in fiscal 2019 versus seven months in 2018.

We also benefited from larger calendar year-end budget spending from CSPs in the Americas for our T&M products, and we received a $4.9 million order for our real-time network topology solution (no such order in fiscal 2018), as well as four monitoring orders related to 5G deployments in fiscal 2019. Otherwise, in fiscal 2019, total bookings were negatively impacted by currency fluctuations year-over-year.

In fiscal 2019, bookings of our T&M product line increased $16.2 million or 8.4% year-over-year mainly due to larger calendar year-end budget spending on the part of some CSPs in the Americas. Our high-speed optical transport and advanced solutions for NEMs and R&D labs also delivered higher bookings compared to 2018. This bookings increase was partially mitigated by the negative currency impact year-over-year.

In fiscal 2019, bookings of our SASS product line increased $15.4 million or 21.0% year-over-year mainly due to the positive effect of the acquisition of EXFO Solutions. EXFO Solutions contributed to our bookings for the full period in fiscal 2019 versus seven months in 2018. We also benefited from the $4.9 million order for our real-time network topology solution, as well as four monitoring orders related to 5G deployments. Otherwise, in fiscal 2019, total bookings were negatively impacted by currency fluctuations year-over-year.

GROSS MARGIN BEFORE DEPRECIATION AND AMORTIZATION (non-IFRS measure – refer to page 23 of this document)

Gross margin before depreciation and amortization amounted to 56.9%, 58.6% and 61.0% of sales in fiscal 2020, 2019 and 2018 respectively.

In fiscal 2020, the adoption of IFRS 16 had a positive effect of $1.1 million or 0.4% of sales on our gross margin before depreciation and amortization. Previous year figures were not adjusted.

In addition, in fiscal 2020, gross margin before depreciation and amortization included $0.7 million for the wage subsidy granted by the Canadian government as a result of the coronavirus pandemic; this represented a positive impact of 0.3% of sales on our gross margin before depreciation and amortization year-over-year.

Finally, in fiscal 2019, gross margin before depreciation and amortization included a negative impact of $1.4 million or 0.5% of sales for the acquisition-related deferred revenue fair value adjustment from the acquisition of EXFO Solutions (nil in fiscal 2020).

However, in fiscal 2020, gross margin before depreciation and amortization included a negative impact of $0.9 million or 0.3% of sales for restructuring charges, compared to $0.3 million or 0.1% of sales in fiscal 2019.

Excluding these elements, our gross margin before depreciation and amortization would have decreased 2.7% year-over-year in fiscal 2020.

Fiscal 2020 vs. 2019

In fiscal 2020, the coronavirus pandemic resulted in extended shutdown of businesses, including the temporary shutdown of our manufacturing facility in Shenzhen, China, which negatively impacted our sales and our gross margin before depreciation and amortization for that year, as lower sales resulted in a lower absorption of our fixed costs.

In addition, in fiscal 2019, our gross margin before depreciation and amortization was positively impacted by the $4.9 million order received for our real-time network topology software. This software-intensive solution delivered above-average gross margin and represents a positive impact of 0.7% on the gross margin before depreciation and amortization for that year.

Finally, in fiscal 2020, our gross margin before depreciation and amortization was negatively affected by a less favorable sales mix overall compared to 2019.

Fiscal 2019 vs. 2018

In fiscal 2019, EXFO Solutions, which contributed to our gross margin before depreciation and amortization for the full period compared to seven months in the same period last year, delivered lower margins than our typical corporate margin, as a large portion of its sales comprise professional services, which had a negative impact on our gross margin before depreciation and amortization year-over-year.

In addition, in fiscal 2019, our gross margin before depreciation and amortization was negatively affected by a less favorable sales mix overall compared to 2018.

Furthermore, in fiscal 2019, we recorded in our sales foreign exchange losses on our forward exchange contracts of $0.6 million, compared to foreign exchange gains of $0.9 million in 2018. This gap reduced our gross margin before depreciation and amortization by 0.2% year-over-year.

In addition, in fiscal 2019, we recorded higher inventory write-offs compared to 2018, which contributed to decrease our gross margin before depreciation and amortization by 0.3% year-over-year.

SELLING AND ADMINISTRATIVE EXPENSES

Selling and administrative expenses amounted to $92.3 million, $98.6 million and $98.8 million for fiscal 2020, 2019 and 2018 respectively. As a percentage of sales, selling and administrative expenses amounted to 34.8%, 34.4% and 36.7% for fiscal 2020, 2019 and 2018 respectively.

Fiscal 2020 vs. 2019

In fiscal 2020, our selling and administrative expenses decreased $6.3 million compared to 2019.

In fiscal 2020, our selling and administrative expenses included $1.1 million for the wage subsidy granted by the Canadian government as a result of the coronavirus pandemic; this represented a positive impact of 0.4% of sales on our selling and administrative expenses.

In addition, in fiscal 2020, the adoption of IFRS 16 had a positive effect of $1.5 million or 0.6% of sales on our selling and administrative expenses. Previous years were not adjusted.

Also, in fiscal 2020, worldwide restrictions on various forms of transportation and lockdown periods due to the coronavirus pandemic resulted in lower travel expenses year-over-year.

Furthermore, in fiscal 2020, commissions on our sales were lower compared to 2019 due to the year-over-year decrease in sales.

In addition, in fiscal 2020, more favorable exchange rates year-over-year resulted in lower selling and administrative expenses compared to 2019.

Otherwise, in fiscal 2020, we incurred restructuring charges of $1.9 million or 0.7% of sales, compared to $0.5 million or 0.2% of sales in 2019.

In addition, in fiscal 2020, inflation and salary increases contributed to a rise in our selling and administrative expenses year-over-year.

Fiscal 2019 vs. 2018

In fiscal 2019, our selling and administrative expenses were slightly down ($0.2 million) in dollars compared to 2018.

In fiscal 2019, our selling and administrative expense includes $0.5 million in restructuring expenses compared to $ 0.7 million in fiscal 2018. In addition, in fiscal 2018, our selling and administrative expenses included $2.1 million (1.0% of sales) in acquisition-related costs following our business acquisitions, compared to nil in 2019.

In addition, in fiscal 2019, the positive impact of our 2018 restructuring plan reduced our selling and administrative expenses compared to 2018. Finally, the increase in the average value of the US dollar compared to other currencies had a positive impact on our selling and administrative expenses year-over-year.

However, in fiscal 2019, we incurred additional expenses compared to 2018, as we had the full-year contribution of EXFO Solutions, compared to a seven-month contribution in 2018. In addition, inflation and salary increases contributed to increasing our selling and administrative expenses year-over-year.

RESEARCH AND DEVELOPMENT EXPENSES

Gross research and development expenses

Gross research and development expenses totaled $54.6 million, $58.0 million and $65.2 million for fiscal 2020, 2019 and 2018 respectively. As a percentage of sales, gross research and development expenses amounted to 20.5%, 20.2% and 24.2% for fiscal 2020, 2019 and 2018 respectively, while net research and development expenses accounted for 17.1%, 17.6% and 21.2% of sales for these respective years.

Fiscal 2020 vs. 2019

In fiscal 2020, our gross research and development expenses decreased $3.4 million compared to 2019.

In fiscal 2019, we incurred restructuring charges of $2.5 million or 0.9% of sales compared to $0.1 million in 2020, which resulted in lower gross research and development expenses year-over-year.

In addition, in fiscal 2020, our gross research and development expenses included $1.5 million for the wage subsidy granted by the Canadian government as a result of the coronavirus pandemic; this represented a positive impact of 0.5% of sales on our gross research and development expenses year-over-year.

Furthermore, in fiscal 2020, the adoption of IFRS 16 had a positive effect of $0.8 million or 0.3% of sales on our gross research and development expenses. Previous years were not adjusted.

Finally, in fiscal 2020, more favorable exchange rates year-over-year resulted in lower gross research and development expenses compared to 2019.

Otherwise, in fiscal 2020, we incurred additional expenses compared to the same period last year due to inflation and salary increases.

Fiscal 2019 vs. 2018

In fiscal 2019, our gross research and development expenses decreased $7.3 million compared to 2018.

In fiscal 2019, the positive impact of our 2018 restructuring plan reduced our gross research and development expenses compared to 2018. In addition, in fiscal 2019, the increase in the average value of the US dollar compared to other currencies had a positive impact on our gross research and development expenses year-over-year.

In addition, in fiscal 2018, we incurred restructuring charges of $3.2 million as part of our 2018 plan, compared to $2.5 million in 2019, which reduced our gross research and development expenses year-over-year.

On the other hand, in fiscal 2019, we incurred additional expenses compared to 2018, as we had the full contribution of EXFO Solutions, compared to a seven-month contribution in 2018. Gross research and development expenses were also subject to inflation and salary increases in fiscal 2019, which increased our expenses year-over-year.

In fiscal 2019, the impact of our fiscal 2018 restructuring plan resulted in lower gross research and development expenses as a percentage of sales compared to 2018.

Tax Credits and Grants

We are entitled to tax credits for eligible research and development activities conducted in Canada and France.

Tax credits and grants for research and development activities were $9.1 million, $7.4 million and $8.1 million for fiscal 2020, 2019 and 2018 respectively. As a percentage of gross research and development expenses, tax credits and grants reached 16.6%, 12.8% and 12.4% for fiscal 2020, 2019 and 2018 respectively.

Fiscal 2020 vs. 2019

The increase in our tax credits and grants in fiscal 2020, compared to 2019, mainly comes from the $1.5 million wage subsidy granted by the Canadian government as a result of the coronavirus pandemic, which the company received in fiscal 2020.

Fiscal 2019 vs. 2018

The decrease in our tax credits and grants in fiscal 2019, compared to 2018, comes from reduced gross research and development expenses in Canada and France as a result of the impact of our 2018 restructuring plan.

DEPRECIATION OF LEASE RIGHT-OF-USE ASSETS

On September 1, 2019, following the adoption of IFRS 16, we recorded $11.3 million for lease right-of-use (ROU) assets in the consolidated balance sheet. These assets are depreciated over the lease terms and resulted in a depreciation expense of $3.3 million in fiscal 2020 compared to nil in fiscal 2018 and 2019 as comparative figures were not adjusted. Upon the adoption of IFRS 16, the lease expense, previously recorded under the cost of sales, selling and administrative expenses and net research and development expenses line items is now mainly recorded under depreciation expenses for the lease ROU asset in the consolidated statements of earnings. This new standard was adopted using the modified retrospective method and, accordingly, comparative figures were not adjusted.

AMORTIZATION OF INTANGIBLE ASSETS

In conjunction with the business combinations we completed, we recorded intangible assets primarily consisting of core technologies, customer relationships and software. These intangible assets resulted in amortization expenses of $6.5 million, $9.0 million and $10.3 million for fiscal 2020, 2019 and 2018 respectively.

Fiscal 2020 vs. 2019

In fiscal 2020, amortization of intangible assets decreased $2.5 million compared to 2019 mainly because some acquired intangible assets became fully amortized in 2019.

Fiscal 2019 vs. 2018

In fiscal 2019, amortization of intangible assets decreased of 1.3 million year-over-year, despite the full contribution of EXFO Solutions, compared to a seven-month contribution in 2018. The year-over-year decrease is due to the fact that some acquired intangible assets became fully amortized in fiscal 2019.

FOREIGN EXCHANGE GAIN (LOSS)

Foreign exchange gains and losses are mainly the result of the translation of operating activities denominated in currencies other than our functional currency, which is the Canadian dollar. A portion of our foreign exchange gains or losses results from the translation of cash balances and deferred income taxes denominated in US dollars. We manage our exposure to currency risk in part with forward exchange contracts. In addition, some of our entities’ operating activities are denominated in US dollars, euros and British pounds, which further hedges this risk. However, we remain exposed to currency risk; namely, any increase in the value of the Canadian dollar compared to the US dollar would have a negative impact on our operating results.

We reported foreign exchange losses of $0.4 million and $0.9 million in fiscal 2020 and 2019 respectively, compared to a gain of $1.3 million in 2018.

Fiscal 2020

In fiscal 2020, we witnessed some volatility in the value of the Canadian dollar as it fluctuated compared to the US dollar, which overall resulted in a foreign exchange loss of $0.4 million. The period-end value of the Canadian dollar increased 1.9% versus the US dollar to CA$1.3041 = US$1.00 in fiscal 2020 compared to CA$1.3294 = US$1.00 at the end of the previous year. In fiscal 2020, the average value of the Canadian dollar versus the US dollar was CA$1.3458 = US$1.00.

Fiscal 2019

In fiscal 2019, we witnessed some volatility in the value of the Canadian dollar as it fluctuated compared to the US dollar, which overall resulted in a foreign exchange loss of $0.9 million. The period-end value of the Canadian dollar decreased 1.8% versus the US dollar to CA$1.3294 = US$1.00 in fiscal 2019 compared to CA$1.3055 = US$1.00 at the end of the previous year. In fiscal 2019, the average value of the Canadian dollar versus the US dollar was CA$1.3247 = US$1.00.

Fiscal 2018

In fiscal 2018, the period-end value of the Canadian dollar decreased versus the US dollar, compared to the previous year-end, which resulted in a foreign exchange gain of $1.3 million. The period-end value of the Canadian dollar decreased 4.1% versus the US dollar to CA$1.3055 = US$1.00 in fiscal 2018, compared to CA$1.2536 = US$1.00 at the end of the previous year. In fiscal 2018, the average value of the Canadian dollar versus the US dollar was CA$1.2768 = US$1.00.

Foreign exchange rate fluctuations also flow through the consolidated statement of earnings line items as portions of our sales are dominated in Canadian dollars and euros and significant portions of our cost of sales and operating items are denominated in Canadian dollars, euros, Indian rupees, British pounds, and CNY, and we report our results in US dollars. In fiscal 2020, the increase in the average value of the US dollar compared to the Canadian dollar, the euro, the British pound, the Indian Rupee and the CNY year-over-year, resulted in a positive impact on our expenses. The average value of the US dollar increased 1.6%, 1.9%, 1.1%, 2.8% and 2.7% respectively year-over-year, compared to the Canadian dollar, the euro, the British pound, the Indian Rupee and the CNY.

INCOME TAXES

In fiscal 2020, we reported income tax expenses of $6.0 million on a loss before income taxes of $3.5 million, compared to income tax expenses of $5.3 million on earnings before income taxes of $2.9 million in 2019 and income tax expenses of $5.7 million on a loss before income taxes of $6.6 million in 2018.

Discrete items affecting our effective income tax rate

Fiscal 2019

In fiscal 2019, as part of our fiscal 2018 restructuring plan and the shutdown of some of our facilities in the United States, we transferred the ownership of certain intellectual property held in the United States to Canada. This created a deductible tax asset in Canada and resulted in the recognition of a deferred income tax recovery of $2.4 million in fiscal 2019 as the recovery of this asset was probable.

Fiscal 2018

In December 2017, the US tax reform ("Tax Cuts and Jobs Act") was substantively enacted and reduced the maximum corporate income tax rate from 35% to 21%, effective January 1, 2018. Based on our estimate of deferred tax assets expected to be used in fiscal 2018 and beyond against taxable income in the United States, we recorded a deferred income tax expense of $1.5 million in fiscal 2018 to account for the effect of this new substantively enacted tax rate.

Our distorted tax rates for all periods mainly resulted from the fact that we did not recognize deferred income tax assets for some of our subsidiaries at loss and acquisition-related costs for business combinations incurred in 2018 were non-deductible for tax purposes. In addition, we had some other non-deductible losses and expenses, such as stock-based compensation costs. Finally, a significant portion of our foreign exchange gain or loss was a result of the translation of the financial statements of our foreign subsidiaries from their local currency to the functional currency and was therefore non-taxable or non-deductible. Otherwise, our effective tax rate would have been closer to the combined Canadian and provincial statutory tax rate of 27% for these years.

Please refer to note 22 to our consolidated financial statements for a full reconciliation of our income tax provision.

LIQUIDITY AND CAPITAL RESOURCES

Cash Requirements and Capital Resources

As at August 31, 2020, cash and short-term investments totaled $33.7 million, while our working capital was at $35.2 million. Our cash and short-term investments increased $14.3 million in fiscal 2020, compared to 2019.

The following table summarizes the increase of cash and short-term investments in fiscal 2020 in thousands of US dollars:

Increase in bank loan Increase in other liabilities Cash flows used by operating activities Purchases of capital assets Repayment of long-term debt and lease liabilities Other	$ 26,532 2,355 (2,137) (7,646) (5,181) 378
	$ 14,301

Our short-term investments consist of debt instruments issued by high-credit-quality corporations; therefore, we consider the risk of non-performance of these financial instruments to be limited. These debt instruments are not expected to be affected by a significant liquidity risk. For the purpose of managing our cash position, we have established a cash management policy, which we follow and monitor on a regular basis.

We believe that our cash balances and short-term investments totaling $33.7 million, combined with our available revolving credit facilities of up to $44.5 million until May 31, 2021 and $29.2 million thereafter, will be sufficient to meet our liquidity and capital requirements for the foreseeable future. In addition to these assets and credit facilities, we have unused available lines of credit of $22.4 million for foreign currency exposure related to forward exchange contracts. However, the potential prolonged slowdown or a recession due to effect of the coronavirus pandemic, possible operating losses, additional restructuring costs and/or possible investments in or acquisitions of complementary businesses, products or technologies may require additional financing. There can be no assurance that additional debt or equity financing will be available when required or, if available, that it can be secured on satisfactory terms.

Sources and Uses of Cash

We finance our operations and meet our capital expenditure requirements through a combination of cash flows from operating activities, the use of our cash and short-term investments, borrowing under our existing credit facilities as well as the issuance of subordinate voting shares.

Operating activities

Cash flows used by operating activities were $2.1 million in fiscal 2020, compared to cash flows provided of $17.2 million in 2019 and $14.4 million in 2018.

Fiscal 2020 vs. 2019

Cash flows used by operating activities in fiscal 2020 were attributable to net earnings after items not affecting cash of $10.2 million, more than offset by the negative net change in non-cash operating items of $12.4 million; this was mainly due to the negative effect on cash of the increase of $1.6 million in our accounts receivable due to the timing of receipts and sales during the year, the negative effect on cash of the increase of the $2.9 million increase in our income tax and tax credits recoverable due to tax credits earned during the year not yet recovered, the negative effect on cash of the increase of the $1.9 million increase in our other assets due to timing of payments during the year, and the negative effect on cash of the decrease of the $6.4 million increase in our accounts payable, accrued liabilities and provisions due to the timing of purchases and payments during the year. These negative effects on cash were offset in part by the positive effect on cash of the $0.5 million decrease in our prepaid expenses due to timing of payments during the year.

Fiscal 2019 vs. 2018

Cash flows provided by operating activities in fiscal 2019 were attributable to net earnings after items not affecting cash of $21.8 million, offset in part by the negative net change in non-cash operating items of $4.6 million; this was mainly due to the negative effect on cash of the increase of $4.8 million in our accounts receivable due to the timing of receipts and sales during the year, the negative effect on cash of the increase of $1.3 million in our prepaid expenses due to timing of payments during the year, the negative effect on cash of the $1.5 million increase in our other assets due to the timing of payments during the year, and the negative effect on cash of the $1.6 million decrease in our other liabilities due to the repayments made during the year. These negative effects on cash were offset in part by the positive effect on cash of the $1.5 million decrease in our income tax and tax credits recoverable due to tax credits recovered during the year and the positive effect on cash of the increase of $3.2 million in our accounts payable and accrued liabilities and provisions due to timing of purchases and payments during the year.

Investing activities

Cash flows used by investing activities amounted to $5.7 million in fiscal 2020, compared to $4.9 million in 2019 and $43.9 million in 2018.

Fiscal 2020

In fiscal 2020, we made cash payments of $7.7 million for the purchase of capital assets. However, we disposed (net of acquisitions) $1.7 million worth of short-term investments and we received net proceeds of $0.3 million from the sale of capital assets.

Fiscal 2019

In fiscal 2019, we made cash payments of $7.5 million for the purchase of capital assets, and we acquired (net of disposal) $0.7 million worth of short-term investments. However, during the year, we received net proceeds of $3.3 million from the sale of capital assets.

Fiscal 2018

In fiscal 2018, we made cash payments of $10.5 million and $32.1 million respectively for the purchase of capital assets and the acquisitions of EXFO Optics and EXFO Solutions. In addition, we acquired (net of disposal) $1.3 million worth of short-term investments during the year.

Financing activities

Cash flows provided by financing activities amounted to $23.5 million in fiscal 2020, compared to cash flows used of $8.3 million in 2019 and cash flows provided of $4.3 million in 2018.

Fiscal 2020

In fiscal 2020, our bank loan increased by $26.5 million and our other liabilities increased by $2.4 million. However, we repaid $5.2 million of our lease liabilities and our long-term debt, and we redeemed share capital for $0.2 million.

Fiscal 2019

In fiscal 2019, our bank loan decreased by $5.2 million, we repaid $2.8 million of our long-term debt and other liabilities, and we redeemed share capital for $0.3 million.

Fiscal 2018

In fiscal 2018, our bank loan increased by $11.1 million, but we repaid $3.1 million of our long-term debt and other liabilities and paid $3.7 million for the purchase of the non-controlling interest in EXFO Solutions.

Contractual obligations

We are committed under the terms of contractual obligations, which have various expiration dates, primarily for our lease liabilities, our long-term debt and licensing of intellectual property. The following table summarizes our contractual obligations as at August 31, 2020 in thousands of US dollars:

No later than 1 year Later than 1 year and no later than 5 years Later than 5 years	Lease liabilities $ 3,249 6,377 957 $ 10,583	Long-term debt $ 2,076 2,144 – $ 4,220	Licensing agreements $ 1,779 621 – $ 2,400	Total
				$ 7,104 9,142 957
				$ 17,203

In addition, on August 31, 2020, we had letters of guarantee amounting to $1.3 million for our own selling and purchasing requirements, which were reserved from our lines of credit; these letters of guarantee expire at various dates through fiscal 2022.

FORWARD EXCHANGE CONTRACTS

We are exposed to currency risk as a result of our export sales of products manufactured in Canada, China, France, and Finland, the majority of which are denominated in US dollars and euros. In addition, we are exposed to currency risk as a result of our research and development activities in India (Indian rupees). These risks are partially hedged by forward exchange contracts. Forward exchange contracts, which are designated as cash flow hedging instruments, qualify for hedge accounting.

As at August 31, 2020, we held forward exchange contracts to sell US dollars for Canadian dollars and Indian rupees at various forward rates, which are summarized as follows:

US dollars – Canadian dollars

Expiry dates September 2020 to August 2021 September 2021 to August 2022 September 2022 to February 2023 Total	Contractual Amounts $ 36,100,000 18,800,000 3,600,000 $ 58,500,000	Weighted average contractual forward rates
		1.3283 1.3492 1.3324
		1.3353

US dollars – Indian rupees

Expiry dates September 2020 to February 2021	Contractual amount $ 1,500,000	Weighted average contractual forward rate
		77.56

The carrying amount of forward exchange contracts is equal to fair value, which is based on the amount at which they could be settled based on estimated current market rates. The fair value of forward exchange contracts amounted to net losses $1.0 million as at August 31, 2019 and net gains of $1.5 million as at August 31, 2020. The US dollar – Canadian dollar year-end exchange rate was CA$1.3041 = US$1.00 as at August 31, 2020.

SHARE CAPITAL

As at November 16, 2020, EXFO had 31,643,000 multiple voting shares outstanding, entitling to 10 votes each and 24,131,121 subordinate voting shares outstanding. The multiple voting shares and the subordinate voting shares are unlimited as to number and are without par value.

OFF-BALANCE SHEET ARRANGEMENTS

As at August 31, 2020, our off-balance sheet arrangements consisted of letters of guarantee amounting to $1.3 million for our own selling and purchasing requirements, which were reserved from our lines of credit; these letters of guarantee expire at various dates through fiscal 2022.

STRUCTURED ENTITIES

As at August 31, 2020, we did not have interests in any structured entities.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Coronavirus pandemic

In December 2019, a novel strain of coronavirus was identified in China and resulted in preventive measures imposed by the Chinese public health authorities including an extended shutdown of businesses, restrictions on various forms of public transportation and lockdown periods for individuals—all of which affected the our factory and supply chain during a certain period. In March 2020, this coronavirus epidemic was declared a pandemic by the World Health Organization, and most countries have been imposing ongoing constraints and preventive measures that have affected and are still affecting the global economy. Significant fluctuations in the stock market have occurred for various reasons linked to the coronavirus pandemic. Although constraints and preventive measures are progressively being relaxed in many countries, the breadth and duration of this pandemic are unknown and raise uncertainties that may impact the measurement of assets and liabilities in future periods.

This pandemic had a negative impact on our sales and operating results in fiscal 2020, and we believe it might continue to negatively impact our sales and operating results to a certain extent over an undetermined period. In addition, over the last months, our stock price significantly fluctuated as a result of the pandemic. As a result of these impacts, during the third quarter of fiscal 2020, we concluded they represented a triggering event and performed goodwill impairment testing for all CGUs. We also perform our annual goodwill impairment test for all CGUs as at August 31, 2020. As at May 31 and August 31, 2020, the recoverable amount for all CGUs exceeded their carrying value.

The preparation of financial statements in accordance with IFRS requires us to make judgments, estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses and the disclosures of contingent assets and liabilities at the date of the financial statements. On an ongoing basis, we evaluate these estimates and assumptions, including those related to the fair value of assets and liabilities acquired in business combinations, the fair value of financial instruments, the allowance for doubtful accounts receivable, the amount of tax credits recoverable, the provision for excess and obsolete inventories, the estimated useful lives of capital assets, the valuation of long-lived assets, the impairment of goodwill, the recoverable amount of deferred income tax assets, the amount of certain accrued liabilities, provisions and deferred revenue as well as stock-based compensation costs. We base our estimates and assumptions on historical experience and on other factors that we believe to be reasonable under the circumstances. Actual results could differ from those judgments, estimates and assumptions.

Critical Judgments in Applying Accounting Policies

(a) Determination of functional currency

We operate in multiple countries and generate revenue and incur expenses in several currencies, namely the Canadian dollar, the US dollar, the euro, the British pound, the Indian rupee and the CNY (Chinese currency). The determination of the functional currency of EXFO and its subsidiaries may require significant judgment. In determining the functional currency of EXFO and its subsidiaries, we take into account primary, secondary and tertiary indicators. When indicators are mixed, and the functional currency is not obvious, we use our judgment to determine the functional currency.

(b) Determination of cash-generating units and allocation of goodwill

For the purpose of impairment testing, goodwill must be allocated to each CGU or group of CGUs that are expected to benefit from the synergies of the business combination. Initial allocation and possible reallocation of goodwill to a CGU or a group of CGUs requires judgment.

Critical Estimates and Assumptions

(a) Inventories

We state our inventories at the lower of cost, determined on an average cost basis, and net realizable value, and we provide reserves for excess and obsolete inventories. We determine our reserves for excess and obsolete inventories based on the quantities on hand at the reporting dates compared to foreseeable needs, taking into account changes in demand, technology or market. It is possible that additional inventory reserves may occur if future sales are less than our forecasts or if there is a significant shift in product mix compared to our forecasts, which could adversely affect our results.

(b) Income taxes

We are subject to income tax laws and regulations in several jurisdictions. Under these laws and regulations, uncertainties exist with respect to the interpretation of complex tax regulations and the amount and timing of future taxable income. We maintain provisions for uncertain tax positions that we believe appropriately reflect our risk based on our interpretation of laws and regulations. In addition, we make reasonable estimates and assumptions to determine the amount of deferred tax assets that can be recognized in our consolidated financial statements, based upon the likely timing and level of anticipated future taxable income together with tax-planning strategies. The ultimate realization of our deferred income tax assets is dependent upon the generation of sufficient future taxable income during the periods in which those assets are expected to be realized.

(c) Tax credits recoverable

Tax credits are recorded if there is reasonable assurance that we have complied and will comply with all the conditions related to the tax credits and that the tax credits will be received. The ultimate recovery of our Canadian non-refundable tax credits is dependent upon the generation of sufficient future taxable income during the tax credits carry-forward periods. We have made reasonable estimates and assumptions to determine the amount of non-refundable tax credits that can be recognized in our consolidated financial statements, based upon the likely timing and level of anticipated future taxable income together with tax-planning strategies.

As at August 31, 2020, our Canadian non-refundable research and development tax credits recognized in the consolidated balance sheet amounted to $39.3 million. To recover these non-refundable research and development tax credits, we need to generate approximately $261 million (CA$341 million) in pre-tax earnings at the Canadian federal level. To generate this level of pre-tax earnings at the Canadian federal level over the estimated recovery period of 16 years, we must generate a pre-tax earnings compound annual growth rate of 2%, which we believe is probable. Our non-refundable research and development tax credits can be carried forward over a 20-year period.

(d) Impairment of non-financial assets

Impairment exists when the carrying value of an asset or group of assets (CGU) exceeds its recoverable amount, which is the higher of its fair value less costs of disposal and its value in use. The fair value less costs of disposal calculation for the company’s CGUs might be based on several different approaches that relies on unobservable inputs, such as market, cost or income approaches. The company applies judgment in making adjustments to the unobservable inputs for factors such as size, risk profile or profitability. Also, the income approach involves significant judgment with respect to estimating cash flows (based on market participant assumptions) and the appropriate discount rate. The company also considers the company’s value derived from its market capitalization, adjusting for a control premium considered appropriate based on other comparable companies with significant controlling interests.

As mentioned above, as at May 31, and August 31, 2020, we performed goodwill impairment tests for all CGUs.

For the purposes of the impairment test, goodwill has been allocated to the lowest level within EXFO at which it is monitored by management to make business decisions, which are the following CGUs:

EXFO CGU EXFO Optics CGU Service assurance, systems and services (SASS) CGU Total	$ 13,200,000 3,648,000 23,442,000
	$ 40,290,000

In performing the goodwill impairment review of our CGUs as at May 31, 2020 and August 31, 2020, we determined the recoverable amount of goodwill based on fair value less costs of disposal. In estimating the recoverable amount of EXFO Optics CGU, we used a capitalized cash flows method. In addition, for the SASS CGU, we used a cost approach based on the level of research and development expenses incurred over the last two years. Finally, as the sales and operations of the EXFO CGU constitutes the significant majority of the company’s sales and operations, we compared the carrying amount of the EXFO CGU to EXFO’s overall market capitalization, after adjustment for a control premium and the adjustment to deduct the recoverable amount of the EXFO Optics and SASS CGU.

As at May 31 and August 31, 2020, the recoverable amount for all CGUs exceeded their carrying value.

(e) Purchase price allocation in business combinations

The fair value of the total consideration transferred in business combinations (purchase price) must be allocated based on the estimated fair value of acquired net assets at the date of acquisition. Allocating the purchase price requires management to make estimates and judgments to determine assets acquired and liabilities assumed, useful lives of certain long-lived assets and the respective fair value of assets acquired, and liabilities assumed; this may require the use of unobservable inputs, including management’s expectations of future revenue growth, operating costs and profit margins as well as discount rates.

i) Growth rates

The assumptions used are based on acquired companies’ historical growth, expectations of future revenue growth, expected synergies as well as industry and market trends.

ii) Discount rate

We use a discount rate to calculate the present value of estimated future cash flows, which represents our weighted average cost of capital (WACC).

(f) Identification of performance obligations

Customer contracts may include promises to transfer multiple products and services to a customer. Determining whether the products and services are considered distinct performance obligations that should be accounted for separately or as one single performance obligation may require significant judgment. We assess whether each promised good or service is distinct for the purpose of identifying the various performance obligations in each contract. Promised goods and services are considered distinct provided that (i) the customer can benefit from the good or service either on its own or together with other resources that are readily available to the customer; and (ii) our promise to transfer the good or service to the customer is separately identifiable or distinct from other promises in the contract.

NEW IFRS PRONOUNCEMENTS

Recently issued IFRS pronouncements adopted in fiscal 2020

Leases

IFRS 16, Leases, was issued in January 2016. IFRS 16 sets out the principles for the recognition, measurement, presentation and disclosure of leases for both parties to a contract, i.e., the customer (lessee) and the supplier (lessor). IFRS 16 supersedes IAS 17, Leases, and related interpretations. Under IFRS 16, lessees recognize an ROU asset and a lease liability measured at the present value of lease payments for virtually all their leases. Short-term leases with a term of 12 months or less are not required to be recognized. This new standard is effective for annual periods beginning on or after January 1, 2019.

We adopted this new standard on September 1, 2019, using the modified retrospective method, which did not require adjustments to comparative periods. We applied IFRS 16 at the adoption date and recognized ROU assets and lease liabilities in the period of adoption. The new standard provides several optional practical expedients in transition. Upon implementation of the new standard, we elected the practical expedients to combine lease and non-lease components, and to not recognize ROU assets and lease liabilities for short-term leases and low-value assets. We identified appropriate changes to our accounting policies, information technology systems, business processes, and related internal controls to support recognition and disclosure requirements under IFRS 16.

The adoption of IFRS 16 on September 1, 2019 resulted in the recognition of lease ROU assets of $11.3 million, lease liabilities of $10.8 million, and the elimination of prepaid rent of $0.5 million in the consolidated balance sheet as of that date. In addition, lease payments for lease ROU assets, previously reported in cash flows from operating activities, are reported in cash flows from financing activities in the consolidated statements of cash flows. However, the adoption of this standard had no significant impact on net loss.

Upon the adoption of IFRS 16, the lease expense, previously recorded under the cost of sales, selling and administrative expenses and net research and development expenses line items is recorded as depreciation expenses for the lease ROU assets and as interest expenses on the lease liabilities in the consolidated statements of earnings.

Finally, the adoption of IFRS 16 had no significant impact on liquidity and debt covenant compliance under existing debt agreements.

Uncertainty over income tax treatments

IFRIC 23, Uncertainty over Income Tax Treatments, was issued in June 2017. IFRIC 23 provides guidance on how to value uncertain income tax positions based on the probability of whether the relevant tax authorities will accept the company's tax treatments. A company is to assume that a taxation authority with the right to examine any amounts reported to it will examine those amounts and will have full knowledge of all relevant information when doing so. IFRIC 23 is effective for annual periods beginning on or after January 1, 2019. We adopted this interpretation on September 1, 2019, and its adoption had no significant impact on our consolidated financial statements.

RISKS AND UNCERTAINTIES

In December 2019, a novel strain of coronavirus was identified in China and resulted in preventive measures imposed by the Chinese public health authorities including an extended shutdown of businesses, restrictions on various forms of public transportation and lockdown periods for individuals—all of which affected our factory and supply chain during a certain period. In March 2020, this coronavirus epidemic was declared a pandemic by the World Health Organization, and most countries have been imposing ongoing constraints and preventive measures that have affected and are still affecting the global economy. Significant fluctuations in the stock market have occurred for various reasons linked to the coronavirus pandemic. Although constraints and preventive measures are progressively being relaxed in many countries, the breadth and duration of this pandemic are unknown and raise uncertainties that may impact our sales and operating results, as well as the measurement of assets and liabilities in future periods.

Over the past several years, we have managed our business in a difficult environment, including the current coronavirus pandemic; gradually evolved from a supplier of dedicated test instruments to a supplier of end-to-end solutions, focused on research and development programs for new and innovative solutions aimed at expected growth pockets in our sector; continued the development of our domestic and international markets; and made strategic acquisitions. However, we operate in a highly competitive and complex sector that is in constant evolution, and, as a result, we encounter various risks and uncertainties that must be given appropriate consideration in our strategic management plans and policies.

While strategic acquisitions and possibly others in the future are essential to our long-term growth, they also expose us to certain risks and uncertainties related to the rapid and effective integration of these businesses, their products, technologies and personnel as well as key personnel retention. Finally, integration of new acquisitions requires the dedication of management resources, which may draw management’s attention away from our day-to-day business and operations.

Our business is subject to the effects of general global and regional economic conditions, particularly conditions in the communications test, service assurance and analytics markets. In recent months, our operating results have been adversely affected as a result of the coronavirus pandemic. Also, in the past, our operating results have been adversely affected as a result of unfavorable economic conditions and reduced or delayed capital spending in the Americas, EMEA and APAC. Global and regional economic conditions continue to be volatile and uncertain as a result of the coronavirus pandemic as well as by trade actions by the US government. If global and/or regional economic and market conditions, or economic conditions in key markets, remain uncertain or deteriorate, we may experience material adverse impacts on our business. Unfavorable and/or uncertain economic and market conditions may result in lower capital spending or delayed spending by our customers on network test, service assurance and analytics solutions, and, therefore, demand for our products could decline and adversely impact our revenue.

Our functional currency is the Canadian dollar. We are exposed to a currency risk because of our export sales of products manufactured in Canada, China, France and Finland, the majority of which are denominated in US dollars and euros, while a significant portion of our cost of sales and operating expenses are denominated in Canadian dollars and currencies such as the euro, British pound, Indian rupee and CNY (China). As a result, even though we manage our exposure to currency risk to some extent with forward exchange contracts (by selling US dollars for Canadian dollars and US dollars for Indian rupees) and certain cost of sales and operating expenses are denominated in currencies other than the Canadian dollar, namely the US dollar and euro, we are exposed to fluctuations in the exchange rates between the Canadian dollar on one hand and the US dollar, euro and other currencies on the other. In recent months, as a result of the coronavirus pandemic, we have witnessed increased volatility in currencies, which impacted our operating results. Any increase in the value of the Canadian dollar relative to the US dollar and other currencies, or any unfavorable variance between the value of the Canadian dollar and the contractual rates of our US dollar - Canadian dollar forward exchange contracts, could result in foreign exchange losses and have a material adverse effect on our operating results. Foreign exchange rate fluctuations also flow through the consolidated statement of earnings line items as a significant portion of cost of sales and our operating expenses are denominated in Canadian dollars, euros, Indian rupees and CNY, and we report our results in US dollars. Any decrease in the value of the US dollar relative to the Canadian dollar and other currencies could have a material adverse effect on our operating results.

Risks and uncertainties related to the communications test, monitoring and analytics industry involve the rapid and timely development of new products that may have short lifecycles and require extensive research and development; the difficulty of adequately predicting market size, trends and customer needs; the ability to quickly adapt our cost structure to changing market conditions to achieve profitability; and the challenge of retaining highly skilled employees.

Given our strategic goals for growth and competitive positioning in our industry, we are continually expanding into international markets, such as the operation of our manufacturing facilities in China and our software development center in India as well as operating other subsidiaries in many countries. This exposes us to certain risks and uncertainties, namely changes in local laws and regulations, multiple technological standards, protective legislation, inter-company transfer price audits, pricing pressure, cultural differences and the management of operations in different countries.

The economic environment of our industry could also result in some of our customers experiencing difficulties, which, consequently, could have a negative effect on our results, especially in terms of future sales and the recoverability of accounts receivable. However, the sectorial and geographic diversity of our customer base provides us with a reasonable level of protection in this area. Finally, other financial instruments, which potentially subject us to credit risks, consist mainly of cash, short-term investments and forward exchange contracts. Our short-term investments consist of debt instruments issued by high-credit-quality corporations. Our cash and forward exchange contracts are held with or issued by high-credit quality-financial institutions; therefore, we consider the risk of non-performance on these instruments to be limited.

We depend on a single supplier or a limited number of suppliers for some of the parts used to manufacture our products for which alternative sources may not be readily available. In addition, all our orders are placed through individual purchase orders, and, therefore, our suppliers may experience difficulties, suffer from natural disasters, delay or stop supplying parts to us at any time. The reliance on a single source or limited number of suppliers could result in increased costs, delivery problems and reduced control over product pricing and quality. Any interruption or delay in the supply of any of these parts could significantly harm our ability to meet scheduled product deliveries to our customers and cause us to lose sales. Furthermore, the process of qualifying a new manufacturer for complex parts designed to our specifications, such as our optical, electronic or mechanical parts, is lengthy and would consume a substantial amount of time for our technical personnel and management. If we were required to change a supplier in a short period of time, our business would be disrupted. In addition, we may be unsuccessful in identifying a new supplier capable of meeting and willing to meet our needs on terms that we would find acceptable.

We rely upon the capacity, efficiency and security of our information technology (IT) hardware and software infrastructures and those from third parties, as well as our ability to expand and update these infrastructures, in response to our evolving needs. Any failure to manage, expand, update or secure our information technology infrastructures or any failure in the operation of these infrastructures could harm our business. Our information systems and third-party systems may be vulnerable to damages from a computer virus and malware. In fiscal 2020 we experienced an IT issue, but it was deemed non-material. We may also be subject to natural disasters, unauthorized access, theft of information and other similar disruptions. Any system failure, accident or security breach could result in disruptions to our operations. To the extent that any disruption, security breach or cyberattack results in a loss or damage to our data, or inappropriate disclosure of confidential information, it could harm our business. In addition, these events may force us to devote more money and resources in order to protect ourselves against damages caused by these disruptions or security breaches in the future.

For a more complete understanding of risk factors that may affect us, please refer to the risk factors set forth in our Annual Report, on Form 20-F, published with securities commissions at www.EXFO.com, or at www.sedar.com in Canada or www.sec.gov/edgar.shtml in the U.S.

NON-IFRS MEASURES

We provide non-IFRS measures (gross margin before depreciation and amortization and adjusted EBITDA) as supplemental information regarding our operational performance. Gross margin before depreciation and amortization represents sales, less cost of sales, excluding depreciation and amortization. Adjusted EBITDA represents net loss attributable to the parent interest before interest and other expense, income taxes, depreciation and amortization, stock-based compensation costs, restructuring charges, change in fair value of cash-contingent consideration, acquisition-related deferred revenue fair value adjustment, and foreign exchange gain or loss.

These non-IFRS measures eliminate the effect on our IFRS results of non-cash statement of earnings elements, restructuring charges as well as elements subject to significant volatility such as foreign exchange gain or loss. We use these measures for evaluating our historical and prospective financial performance, as well as our performance relative to our competitors. These non-IFRS measures are also used by financial analysts that evaluate and compare our performance against that of our competitors and industry players in our sector.

Finally, these measures help us plan and forecast future periods as well as make operational and strategic decisions. We believe that providing this information to our investors, in addition to the IFRS measures, allows them to see the company’s results through the eyes of management, and to better understand our historical and future financial performance. More importantly, it enables the comparison of our performance on a relatively similar basis against that of other public and private companies in our industry worldwide.

The presentation of this additional information is not prepared in accordance with IFRS. Therefore, the information may not necessarily be comparable to that of other companies and should be considered as a supplement to, not a substitute for, the corresponding measures calculated in accordance with IFRS.

The following table summarizes the reconciliation of adjusted EBITDA to IFRS net loss attributable to the parent interest, in thousands of US dollars:

Years ended August 31,	Years ended August 31,	Years ended August 31,
2020 $ (9,540) 15,379 956 6,022 2,021 2,886 – – 428 $ 18,152 6.8%	2019 $ (2,480) 14,481 718 5,346 1,831 3,305 – 1,435 949 $ 25,585 8.9%	2018
		$ (11,902) 15,771 1,378 5,678 1,748 4,409 (670) 2,095 (1,309)
		$ 17,198
		6.4%

(1) IFRS net loss for the year ended August 31, 2020 takes into account the impact of the adoption of IFRS 16 on September 1, 2019. The adoption of IFRS 16 on September 1, 2019 had a positive impact on adjusted EBITDA of $3.3 million or 1.2% of sales for the year ended August 31, 2020. Comparative figures were not adjusted.

(2) Includes acquisition-related costs of $2.2 million or 0.8% of sales in fiscal 2018 (nil in fiscal 2019 and 2020).

QUARTERLY SUMMARY FINANCIAL INFORMATION[(1)]

(tabular amounts in thousands of US dollars, except per share data)

2020 Sales Cost of sales(2) Net earnings (loss) Basic and diluted net earnings (loss)	1st quarter 2nd quarter 3rd quarter 4th quarter Year ended August 31,
	$ 73,551 $ 55,313 $ 66,147 $ 70,572 $ 265,583 $ 30,241 $ 23,796 $ 27,948 $ 32,573 $ 114,558 $ (63) $ (9,021) $ 3,177 $ (3,633) $ (9,540) $ (0.00) $ (0.16) $ 0.06 $ (0.07) $ (0.17)

2019 Sales Cost of sales(2) Net earnings (loss) Basic and diluted net earnings (loss)(3)	1st quarter 2nd quarter 3rd quarter 4th quarter Year ended August 31,
	$ 69,201 $ 73,927 $ 73,587 $ 70,175 $ 286,890 $ 28,897 $ 29,062 $ 30,458 $ 30,260 $ 118,677 $ (7,467) $ 5,193 $ 21 $ (227) $ (2,480) $ (0.14) $ 0.09 $ 0.00 $ (0.00) $ (0.04)

(1) Quarterly financial information has been derived from our unaudited condensed interim consolidated financial statements, which are prepared in accordance with IFRS, as issued by the IASB, applicable to the preparation of interim financial statements, including IAS 34, Interim Financial Reporting. The presentation currency is the US dollar, which differs from the functional currency of the company (Canadian dollar).
(2) The cost of sales is exclusive of depreciation and amortization.
(3) Per share data is calculated independently for each quarter presented. Therefore, the sum of this quarterly information does not equal the corresponding annual information.

Quarterly Sales Analysis

Overall in fiscal 2020, our sales decreased 7.4% to $265.6 million compared to $286.9 million in 2019. Refer to section ‘’Sales and bookings’’ elsewhere in this document for explanations about the year-over-year annual increase in sales. On a quarterly basis, our sales fluctuate from quarter to quarter due to timing and magnitude of orders.

Fourth Quarter Results

Gross margin before depreciation and amortization

In the fourth quarter of fiscal 2020, our gross margin before depreciation and amortization reached 53.8%, 3.1% lower compared to 56.9% for the same period last year.

In the fourth quarter of fiscal 2020, gross margin before depreciation and amortization included $0.9 million, or 1.3% of sales, in restructuring charges for severance expenses, compared to nil in the same period last year.

However, in the fourth quarter of fiscal 2020, the adoption of IFRS 16 had a positive effect of $0.3 million or 0.4% of sales on our gross margin before depreciation and amortization. Previous years were not adjusted.

Excluding restructuring charges and the impact of the adoption of IFRS 16, gross margin before depreciation and amortization would have amounted to 54.7% of sales in the fourth quarter of fiscal 2020, 2.2% lower compared to 56.9% of sales during the same period last year.

In the fourth quarter of fiscal 2020, our gross margin before depreciation and amortization was unfavorably affected by product mix compared to the same period last year, which reduced our gross margin before depreciation and amortization year-over-year.

Net loss

Net loss amounted to $3.6 million, or $0.07 per share, in the fourth quarter of fiscal 2020 compared to $0.2 million, or $0.00 per share, for the same period last year.

In the fourth quarter of fiscal 2020, we recorded after-tax restructuring charges of $2.4 million compared to nil in the same period last year. Excluding restructuring charges, net loss would have amounted to $1.3 million in the fourth quarter of fiscal 2020, $1.1 million higher compared to $0.2 million in the same period last year.

In the fourth quarter of fiscal 2020, excluding the impact of restructuring costs, our gross margin before depreciation and amortization was much lower due to an unfavorable product mix year-over-year, which increased our net loss year-over-year.

Also, in the fourth quarter of fiscal 2020, general inflation and salary increases resulted in higher selling and administrative and net research and development expenses year-over-year.

On the other hand, in the fourth quarter of fiscal 2019, we reported a write-off of capital assets of $1.1 million compared to a gain on disposal of capital assets of $0.3 million this quarter.

Finally, in the fourth quarter of fiscal 2020, we reported an income tax expense of $1.6 million compared to $0.8 million for the same period last year.

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EXFO Inc. — Management Reports 2020

45014_rns_2020-11-25_20ca6b42-073b-4427-a286-d3dfa0bf65ed.pdf

Management’s Discussion and Analysis of Financial Condition and Results of Operations

COMPANY OVERVIEW AND RECENT DEVELOPMENTS

BUSINESS OUTLOOK

Short-term and mid-term adjusted EBITDA target

Sales

Cost of Sales

Selling and administrative, and research and development expenses

RESULTS OF OPERATIONS

RESULTS OF OPERATIONS

Sales and Bookings

Sales

Bookings

Sales by geographic region

Fiscal 2020 vs. 2019

Sales

Bookings

Fiscal 2019 vs. 2018

Sales

Bookings

GROSS MARGIN BEFORE DEPRECIATION AND AMORTIZATION (non-IFRS measure – refer to page 23 of this document)

Fiscal 2020 vs. 2019

Fiscal 2019 vs. 2018

SELLING AND ADMINISTRATIVE EXPENSES

Fiscal 2020 vs. 2019

Fiscal 2019 vs. 2018

RESEARCH AND DEVELOPMENT EXPENSES

Gross research and development expenses

Fiscal 2020 vs. 2019

Fiscal 2019 vs. 2018

Tax Credits and Grants

Fiscal 2020 vs. 2019

Fiscal 2019 vs. 2018

DEPRECIATION OF LEASE RIGHT-OF-USE ASSETS

AMORTIZATION OF INTANGIBLE ASSETS

Fiscal 2020 vs. 2019

Fiscal 2019 vs. 2018

FOREIGN EXCHANGE GAIN (LOSS)

Fiscal 2020

Fiscal 2019

Fiscal 2018

INCOME TAXES

Discrete items affecting our effective income tax rate

Fiscal 2019

Fiscal 2018

LIQUIDITY AND CAPITAL RESOURCES

Cash Requirements and Capital Resources

Sources and Uses of Cash

Operating activities

Fiscal 2020 vs. 2019

Fiscal 2019 vs. 2018

Investing activities

Fiscal 2020

Fiscal 2019

Fiscal 2018

Financing activities

Fiscal 2020

Fiscal 2019

Fiscal 2018

Contractual obligations

FORWARD EXCHANGE CONTRACTS

US dollars – Canadian dollars

SHARE CAPITAL

OFF-BALANCE SHEET ARRANGEMENTS

STRUCTURED ENTITIES

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Coronavirus pandemic

Critical Judgments in Applying Accounting Policies

(a) Determination of functional currency

(b) Determination of cash-generating units and allocation of goodwill

Critical Estimates and Assumptions

(a) Inventories

(b) Income taxes

(c) Tax credits recoverable

(d) Impairment of non-financial assets

(e) Purchase price allocation in business combinations

i) Growth rates

ii) Discount rate

EXFO Inc. Management Reports 2020