Velan
Annual Report 2013

Plain-text annual report

Annual report 2013 Front Cover: Velan Securaseal™ metal-seated ball valve. Above: On December 3, 2012, inauguration ceremonies were held at our new plant, Velan Valves India, located in Coimbatore in the Tamil Nadu province of India. Left: Ramesh Babu, Managing Director, Velan Valves India (left), and Tom Velan, President and CEO, Velan (right), watch as the guest of honor, Mr. Stewart Beck, Canadian High Commissioner to The Republic of India, cuts the ribbon during the inauguration ceremonies of Velan Valves India. Velan’s newly launched advertising campaign featuring Velan employees. Velan 10” Class 150 Securaseal™ severe service ball valves installed in a nickel mining facility. 2013 Highlights Sales(1) (in millions of U.S. dollars) 560 520 480 440 400 360 320 280 240 200 160 120 80 40 0 Consolidated Overseas U.S.A. Canada Adjusted net earnings(3) (in millions of indicated currency) Prior Canadian GAAP Canadian dollars *7.6% IFRS U.S. dollars *7.7% *5.6% *3.1% *1.3% 40 35 30 25 20 15 10 5 0 (2) 2009 2010 2011 2012 2013 2009 2010 *Adjusted net earnings % 2011 2012 2013 (in thousands of indicated currency, except per share amounts and number of employees) Years Ended Income statement data Sales Gross profit Gross profit % Administration costs Income before income taxes Adjusted net earnings (3) Adjusted net earnings (3) % Adjusted net earnings (3) per share Net earnings (4) Net earnings (4) % Net earnings (4) per share (5) Statement of financial position data Net cash (6) Working capital Property, plant and equipment Total assets Total debt Equity Number of employees Canada United States Overseas Total IFRS In U.S. Dollars Feb 2012 12 months Feb 2013 12 months Prior Canadian GAAP In Canadian Dollars Feb 2011 12 months Feb 2010 12 months Feb 2009 9 months $ 500,574 113,899 22.8% $ 437,135 87,262 20.0% $ 380,706 101,426 26.6% $ 465,945 149,012 32.0% $ 326,859 92,302 28.2% 90,985 12,018 15,425 3.1% 0.70 6,169 1.2% 0.28 83,620 6,097 5,662 1.3% 0.26 7,892 1.8% 0.36 73,597 28,424 21,224 5.6% 0.96 21,224 5.6% 0.96 74,635 56,304 35,523 7.6% 1.60 35,523 7.6% 1.60 57,497 69,987 25,143 7.7% 1.13 61,733 18.9% 2.77 $ 19,787 213,814 90,630 619,774 26,850 328,173 $ 35,376 217,522 72,961 601,970 9,587 335,577 $ 113,024 264,930 64,622 516,037 5,011 337,723 $ 103,741 275,928 73,418 512,697 4,002 346,184 $ 62,955 258,074 70,270 506,520 4,927 327,115 923 182 925 2,030 926 178 877 1,981 923 178 667 1,768 911 189 640 1,740 937 198 668 1,803 (1) Prior Canadian GAAP sales figures converted at average CAD-USD foreign exchange rate for the applicable fiscal year. (2) The 2009 sales data is composed of the sales for the nine month 2009 fiscal year plus the fourth quarter of the Company’s 2008 fiscal year. (3) This measure is not a measure of performance defined under Prior Canadian GAAP and IFRS. Therefore, it is unlikely to be comparable to similar measures shown by other companies. However, it is used by management to assess the operating performance of the Company. This measure is defined as net income attributable to Subordinate and Multiple Voting Shares excluding any goodwill impairment loss and positive fair value adjustments to the purchase price proceeds payable as a result of the acquisition of Velan ABV S.p.A. The 2009 fiscal year amount further excludes a tax exempt gain of $36.6 million resulting from the sale by the Company of its 50% interest in an Italian joint venture company for net proceeds of $44.1 million on July 21, 2008. (4) Net earnings refers to net income attributable to Subordinate and Multiple Voting Shares. (5) See note 22 in the Notes to the Consolidated Financial Statements. (6) This measure is not a measure of financial condition defined under Prior Canadian GAAP and IFRS. Therefore, it is unlikely to be comparable to similar measures shown by other companies. However, it is used by management to assess the financial condition of the Company. This measure is defined as cash & cash equivalents plus short-term investments less bank indebtedness, short-term bank loans and the current portion of long-term bank borrowings. 1 Message to our shareholders and employees (In U.S. dollars, unless otherwise stated) Highlights • Sales of $500.6 million • Adjusted net earnings (1) of $15.4 million • Order backlog of $531 million • Order bookings of $370.1 million This was a milestone year with sales surpassing $500 million for the first time in our history. This represents a sales increase of 14.5% from last year and 270% in 10 years. We made adjusted net earnings(1) of $15.4 million which excludes a non-cash goodwill impairment writedown of $11.7 million and positive fair value adjustments to the purchase price proceeds payable of $2.4 million related to our acquisition of ABV Energy S.p.A. (“ABV”) in Italy in 2011. Tom Velan, President and Chief Executive Officer (left), with A.K. Velan, Founder and Executive Chairman of the Board (right). Sales, order bookings and backlog Our record sales of $500.6 million, which represents a 14.5% increase, would have been $11.2 million higher if not for the negative currency change. Our sales were diversified by customer, market, and geography including in the “BRIC” countries (Brazil, Russia, India, and China) where we sold $118 million. During the year we sold more than 600,000 valves to customers in 64 countries. Our valves range in price from about $15 to $800,000 and weigh from less than 0.3 kg to more than 34 tons. Order bookings were $370.1 million, a decline of 30% from the previous year. The decline was mainly due to our large backlog, which necessitated quoting longer lead-times than many customers could accept. Another factor in the decline was weaker demand in some of our key markets and, in particular, the nuclear market following the Fukushima accident. Billings exceeded bookings so our backlog declined by 19.8% to $531 million, of which $132.8 million is scheduled for delivery after February 2014. We expect that the decline in backlog and resulting shorter lead-times will give us opportunities to increase bookings this year. Earnings Our adjusted net earnings(1) were $15.4 million compared to $5.7 million in the prior year. Our adjusted net operating results(2) were $19.2 million compared to $12.5 million last year. The net earnings(3) were $6.2 million compared to $7.9 million in the previous year. While results at ABV improved this year, there was still a loss so the analysis of the goodwill concluded that there was an impairment requiring a partial writedown of the goodwill. (1) The term “adjusted net earnings” is defined as net income attributable to Subordinate and Multiple Voting Shares excluding the goodwill impairment loss and positive fair value adjustments to the ABV purchase price proceeds payable. This is not a term of performance defined under International Financial Reporting Standards (“IFRS”) and, therefore, it is unlikely to be comparable to similar measures shown by other companies. However, it is used by management to assess the operating performance of the company. (2) The term “adjusted net operating results” is defined as net income attributable to Subordinate and Multiple Voting Shares excluding the net loss of ABV, the goodwill impairment loss, the purchase price accounting and interest accretion adjustments, the positive fair value adjustments to the ABV purchase price proceeds payable, and the impact of currency changes. This is not a term of performance defined under IFRS and, therefore, it is unlikely to be comparable to similar measures shown by other companies. However, it is used by management to assess the operating performance of the company. (3) Net earnings refer to net income attributable to Subordinate and Multiple Voting Shares. 2 Message to our shareholders and employees Our gross profit improved 2.8 percentage points from 20% to 22.8% mainly due to the increased volume and product mix. Excluding the results of ABV, purchase price adjustments from the acquisition, and impact of currency changes, the gross profit percentage would have been 24.8%. As we explained in our last Annual Report, similar to some other U.S. valve manufacturers, our U.S. subsidiary has been named as a defendant in a number of pending lawsuits brought on behalf of individuals seeking to recover damages for their alleged asbestos exposure. These lawsuits are related to products manufactured and sold many years ago. Our costs related to these asbestos lawsuits were $8.8 million, compared to $6.9 million last year. We strongly believe that our products, which were supplied with encapsulated packing and gaskets in accordance with valve industry practice and customer-mandated specifications, did not contribute to any asbestos-related sicknesses. We also have independent laboratory test results that support this conclusion. We think that any asbestos-related health problems were caused by friable, asbestos-containing products such as the spray application of asbestos insulation and the process of removing asbestos from buildings or confined spaces, which resulted in heavy concentrations of asbestos fibers in the air. Unfortunately, these companies are no longer in existence so plaintiffs are pursuing valve and other equipment manufacturers like Velan. Velan has invested in robotic seat seal and wedge guide welding machines to improve efficiency. We will continue to vigorously defend against these claims but given the ongoing course of asbestos litigation in the U.S. and the unpredictability of jury trials, it is not possible to make an estimate of our settlement costs and legal fees related to these claims. Investments in our global manufacturing infrastructure During the last year we invested $28.5 million in our global manufacturing infrastructure with an aim to improve efficiency, increase our global presence, and improve our cost competitiveness. In our North American operations we invested in Members of Velan’s North American TPI Kaizen team responsible for implimenting improved production flow in accordance with lean principles. 3 Message to our shareholders and employees large test fixtures, robotic welding, and computer numeric control (“CNC”) machines capable of operating unattended. We also modified some of our production cells for improved production flow in accordance with Lean principles. This year, we completed construction of a new greenfield plant in southern India and started to manufacture small forged valves; the plant will expand into other products in the future and will supply valves to the Indian and global markets. In China, we invested in test fixtures, CNC machines, and robotic welding to produce pressure seal valves for the Chinese power market. In Korea, we are establishing a new production line for larger valves to better service Korean engineering, procurement, and construction customers. Financial strength We continue to have a strong balance sheet with net cash(4) of $19.8 million or $0.90 per share and equity of $328.2 million or $14.97 per share. The net cash(4) decreased by $15.6 million during the year, mainly due to unfavourable non-cash working capital movements, specifically an increase in accounts receivable resulting from the higher sales volume. Outlook 16” Velan Velflex cryogenic butterfly valve on an LNG Carrier. We are pleased to have reached the $500 million sales milestone and we are starting this year with a good order backlog of $531 million. Our challenge will be to continue the high level of production of our complex project order backlog while using our shorter lead-times to increase our order bookings from last year’s level. We have expanded our local manufacturing presence in Korea, China, and India with an objective to lower production costs and increase our local sales in Asia. We are continuing to take measures to improve our operational excellence and cost competitiveness, while strengthening our presence in international markets in order to improve our performance. We would like to take this opportunity to thank our 2,030 employees around the world for the record sales output and improved operating results. Now we are working to continue to build on the positive momentum to further improve our performance and operating results. A.K. Velan Founder and Executive Chairman of the Board T. C. Velan President and Chief Executive Officer (4) The term “net cash” is defined as cash and cash equivalents plus short-term investments less bank indebtedness, short-term bank loans, and current portion of long-term bank borrowings. This is not a term of financial condition defined under IFRS and, therefore, it is unlikely to be comparable to similar measures shown by other companies. However, it is used by management to assess the financial condition of the company. 4 Management’s discussion and analysis May 28, 2013 The following discussion provides an analysis of the consolidated operating results and financial position of Velan Inc. (“the Company”) for the year ended February 28, 2013. This Management’s Discussion and Analysis (“MD&A”) should be read in conjunction with the Company’s audited consolidated financial statements for the years ended February 28, 2013 and February 29, 2012. The Company’s consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). The significant accounting policies upon which these consolidated financial statements have been prepared are detailed in Note 2 of the Company’s audited consolidated financial statements. All foreign currency transactions, balances and overseas operations have been converted to U.S. dollars, the Company’s reporting currency. Selected annual information for the three most recently completed reporting periods and a summary of quarterly results for each of the eight most recently completed quarters is included further in this report. Additional information relating to the Company, including the Annual Information Form and Proxy Information Circular, can be found on SEDAR at www.sedar.com. BASIS OF PRESENTATION AND ANALYSIS In this MD&A, the Company has presented measures of performance or financial condition which are not defined under IFRS (“non-IFRS measures”) and are, therefore, unlikely to be comparable to similar measures presented by other companies. These measures are used by management in assessing the operating results and financial condition of the Company and are reconciled with the performance measures defined under IFRS. Reconciliations of these amounts can be found at the end of this report. FORWARD-LOOKING INFORMATION This MD&A may include forward-looking statements, all of which are subject to risks and uncertainties. These risks and uncertainties are disclosed in the Company’s filings with the appropriate securities commissions and include among other matters, risks related to foreign exchange, raw material pricing, tax matters, foreign investment and operations as well as contingent liabilities. No forward-looking statement can be guaranteed and actual future results may differ materially from those expressed herein. The Company disclaims any responsibility to update or revise these forward-looking statements except as required by the applicable securities laws. OVERVIEW The Company designs, manufactures and markets on a worldwide basis a broad range of industrial valves for use in most industry applications including power generation, oil and gas, refining and petrochemicals, chemical, LNG and cryogenics, pulp and paper, geothermal processes and shipbuilding. The Company is a world leader in steel industrial valves operating 16 manufacturing plants worldwide with 2,030 employees. The Company’s head office is located in Montreal, Canada. The Company’s business strategy is to design, manufacture, and market new and innovative valves with emphasis on quality, safety, ease of operation, and long service life. The Company’s strategic goals include, but are not limited to, increasing market share in power markets, investing in talent development of high-potential employees, adding talent where necessary, providing high customer service, enhancing manufacturing and/or sales capabilities in emerging markets such as Brazil, Russia, India and China, and continually improving operational excellence. The consolidated financial statements of the Company include the North American operations comprising four manufacturing plants and one distribution facility in Canada, as well as one manufacturing plant and three distribution facilities in the U.S. Significant overseas operations include manufacturing plants in France, Italy, Portugal, U.K., Korea, Taiwan, India, and China. The Company’s operations also include a 50%-owned Korean foundry and a distribution facility in Germany. 5 Management’s discussion and analysis CONSOLIDATED HIGHLIGHTS1 (millions, excluding per share amounts) Consolidated statements of earnings Sales Gross profit Gross profit % Net earnings2 Net earnings2 % Earnings (Loss) per share – basic – diluted Weighted average shares outstanding Consolidated statements of cash flows Cash provided (used) by operating activities Cash provided (used) by investing activities Cash provided (used) by financing activities Demand data Net new orders received Period ending backlog of orders Fiscal year ended February 28, 2013 Fiscal year ended February 29, 2012 Increase (decrease) % Increase (decrease) $500.6 113.9 22.8% 6.2 1.2% 0.28 0.28 22.0 14.4 (23.9) 4.8 370.1 531.0 $437.1 87.3 20.0% 7.9 1.8% 0.36 0.36 22.2 (12.8) (56.7) (11.4) 529.0 661.8 $63.5 26.6 14.5% 30.5% (1.7) (21.5)% (0.08) (0.08) (22.2)% (22.2)% 27.2 32.8 16.2 (158.9) (130.8) 212.5% 57.8% 142.1% (30.0)% (19.8)% 1 All dollar amounts in this schedule are denominated in U.S. dollars. 2 Net earnings or loss refers to net income or loss attributable to Subordinate and Multiple Voting Shares. 6 Management’s discussion and analysis Highlights of fiscal 2013 as well as factors that may impact fiscal 2014 (unless otherwise noted, all amounts are in U.S. dollars and all comparisons are to the prior fiscal year)  Net earnings1 amounted to $6.2 million or $0.28 per share compared to $7.9 million or $0.36 per share last year. Net earnings1 for the current year were significantly impacted by an $11.7 million non-cash goodwill impairment charge related to the Company’s 70%-owned Italian subsidiary, Velan ABV S.p.A. (“ABV”). Excluding this charge, as well as other ABV and currency impacts, the Company’s adjusted net operating results2 would have been $19.2 million or $0.87 per share this year compared to $12.5 million or $0.56 per share last year.  Net new orders received (“bookings”) amounted to $370.1 million, a decrease of $158.9 million or 30.0% compared to last year. Excluding the results of ABV, bookings decreased by $138.9 million or 28.7%. Further adjusting for currency impacts, the decrease would have been $144.2 million or 27.3%. The Company ended the current year with a backlog of $531.0 million, a decrease of $130.8 million from the end of the prior year. Excluding currency impacts, the backlog would have decreased by $124.0 million to $537.8 million.  Sales amounted to a record total of $500.6 million, an increase of $63.5 million or 14.5%. Excluding the results of ABV and currency impacts, sales would have increased by $52.4 million or 12.6%.  Gross profit percentage increased by 2.8 percentage points from 20.0% to 22.8%. Excluding the results of ABV and the effects of purchase price accounting, the gross profit percentage increased by 2.4 percentage points from 22.2% to 24.6%. Further adjusting for currency impacts, gross profit percentage would have been 24.8% for the current year.  The Company generated net cash2 from operations of $14.4 million. This source of net cash2 is primarily attributable to an increase in operational profitability combined with improved non-cash working capital management.  While there were no significant fluctuations in the average rate of the U.S. dollar against the Canadian dollar over the course of the current year, the Company’s results were impacted by the fluctuations of the euro. Based on average exchange rates, the euro weakened 6.9% against the U.S. dollar when compared to the same period last year. This weakening resulted in the Company’s net profits from its European subsidiaries being reported as lower U.S. dollar amounts in the current year. Notwithstanding the goodwill impairment charge discussed below, the Company’s operational profitability improved over the course of the year. It achieved a record sales level for a fiscal year as the Company began to work through its large order backlog by shipping certain large export project orders which had encountered various supply chain issues, customer-related issues and internal operational issues in the prior year. This increase in sales output coupled with lower bookings resulted in a decrease of the order backlog over the course of the year. The decrease in bookings is primarily attributable to two factors, namely the Company’s continued policy of quoting longer lead times in order to decrease its large order backlog, and a softening of demand for the Company’s nuclear products, especially with respect to its French operations, as the effects of the Fukushima nuclear disaster in Japan begin to take hold. Despite the drop in bookings, the Company believes that the global demand for its non-nuclear products is on the rise. The increase in sales output and volume was also the most significant factor in the improvement of the Company’s gross profit percentage, as well as the 53.6% increase of its adjusted net operating results2. On an annual basis, the Company is required to perform an impairment test on goodwill acquired in a business combination. As a result of this analysis, the Company determined that the carrying amount of the goodwill associated with ABV exceeded its recoverable amount and, accordingly, the Company recorded a non-cash goodwill impairment loss of $11.7 million in the fourth quarter of the current fiscal year. This impairment charge was the result of actual results of ABV coming in below the expectations at the time of the acquisition. The reasons for these lower achieved results are due to a variety of factors, including a business process integration that proved to be more difficult than planned, as well as profitability issues related to the complexity of the manufactured products. In addition, the increasingly competitive landscape of the last two years, particularly amongst upstream oil and gas flow control manufacturers in Italy, negatively impacted margins. As a result of these factors, ABV contributed a net loss (including purchase price accounting adjustments) of $2.1 million to the Company’s consolidated results in fiscal year 2013 and $6.9 million in fiscal year 2012. Despite these poor results, the Company remains confident about the long term prospects of ABV and its product range as the continued integration efforts have resulted in driving process improvements. 1 Net earnings or loss refers to net income or loss attributable to Subordinate and Multiple Voting Shares. 2 Non-IFRS measures – see reconciliations at the end of this report. 7 Management’s discussion and analysis Like many other U.S. valve manufacturers, two of the Company’s U.S. subsidiaries have been named as defendants in a number of pending lawsuits brought on behalf of individuals seeking to recover damages for their alleged asbestos exposure. These lawsuits are related to products manufactured and sold in the past. Management believes that any asbestos was incorporated entirely within the product in such a way that it would not allow for any ambient asbestos during normal operation, inspection or repairs. Management strongly believes its products, which were supplied in accordance with valve industry practice and customer mandated specifications, did not contribute to any asbestos-related illness. The Company will continue to vigorously defend against these claims but, given the ongoing course of asbestos litigation in the U.S. and the unpredictability of jury trials, it is not possible to make an estimate of any legal or related costs. Settlement costs and legal fees increased from $6.9 million in fiscal year 2012 to $8.8 million in fiscal year 2013. Other factors that may impact fiscal year 2014 The challenge facing the Company for fiscal year 2014 will be to improve the productive efficiency of its operations and to balance its production lead times with its backlog and capacity. The Company is currently investing heavily in capital expenditures in order to increase its global manufacturing capacity and presence, and improve production efficiency, on-time delivery and cost competitiveness. In fiscal year 2013, the Company invested $28.5 million in capital expenditures and it expects to spend a further $20 million in fiscal year 2014. The Company will also continue to work to improve its operational excellence through lean, global sourcing, working capital management and cost controls. The Company believes that these initiatives will have a positive impact on future profitability. Despite the negative impact on its consolidated results to date, the Company continues to view the acquisition of ABV as a great opportunity to grow its sales and earnings over the coming years. The Company continues to work with the local management of ABV to help improve operations, as well as increase output and profitability. After two challenging fiscal years, the Company turned the corner in fiscal year 2013 with record sales, improved gross profit and higher operating results. As at February 28, 2013, the Company’s order backlog was $531 million and its net cash1 plus unused credit facilities amounted to $47.9 million, which, it believes, along with future cash flows generated from operations, is sufficient to meet its financial obligations, improve its capacity, satisfy its working capital requirements, and execute on its business strategy. However, there can be no assurance that outside economic factors, such as the continued recession in Europe, will not materially adversely affect the Company’s results of operations or financial condition. 1 Non-IFRS measures – see reconciliations at the end of this report. 8 Management’s discussion and analysis SUMMARY OF RESULTS Summary financial data derived from the Company’s financial statements prepared in accordance with IFRS for the three most recently completed reporting periods are as follows: For the reporting periods ended on the following dates (in thousands of U.S. dollars, excluding number of shares and per share amounts) Fiscal year ended February 28, 2013 Fiscal year ended February 29, 2012 Fiscal year ended February 28, 2011 Operating Data Sales Net Earnings1 Earnings per Share - Basic - Diluted Balance Sheet Data Total Assets Total Long-term financial liabilities Shareholder Data Cash dividends per share - Multiple Voting Shares2 - Subordinate Voting Shares Outstanding Shares at report date - Multiple Voting Shares2 - Subordinate Voting Shares $437,135 7,892 0.36 0.36 601,970 17,109 0.32 0.32 $380,706 21,224 0.96 0.95 516,037 11,064 0.31 0.31 $500,574 6,169 0.28 0.28 619,774 24,393 0.32 0.32 15,566,567 6,357,201 Sales reached a record level for fiscal year 2013, increasing by $63.5 million or 14.5% compared to fiscal year 2012. The increase was due to the Company increasing its sales volume due to improved production execution on large export project orders. Sales for fiscal year 2012 increased by $56.4 million or 14.8%, compared to fiscal year 2011. The increase was due to the acquisition of ABV, positive currency fluctuations and improved deliverable backlog. Adverse currency fluctuations and lower deliverable backlog negatively impacted the reported sales figure for fiscal year 2011. Gross profit for fiscal year 2013 amounted to $113.9 million, an increase of $26.6 million from fiscal year 2012. Gross profit percentage for fiscal year 2013 also increased from the 20.0% reported in fiscal year 2012 to 22.8%. The increase in gross profit percentage reported for fiscal year 2013 is attributable to a combination of sales mix, as well as the fixed cost component of cost of sales as compared to the increased sales in the year. Gross profit for fiscal year 2012 amounted to $87.3 million, a decrease of $14.1 million from the $101.4 million reported for fiscal 2011. Gross profit percentage for fiscal year 2012 also decreased from the 26.6% reported in fiscal 2011 to 20.0%. Higher material costs, lower-than-expected sales volume and adverse currency impacts were the main reasons for the decrease. Administration costs for fiscal year 2013 increased by $7.4 million when compared to fiscal 2012. Such increase was principally due to an increase in sales commissions on international export orders, an increase in freight costs for the increased customer shipments and an increase in costs associated with the Company’s ongoing asbestos litigation (see Contingencies section). Administration costs for fiscal 2012 increased by $10.0 million when compared to fiscal 2011. The increase was mainly related to the acquisition of ABV. Adjusting for this impact as well as currency impacts, administration costs would have increased by $3.4 million, such increase being principally due to increases in freight costs for customer shipments due to the higher sales volume, as well as the professional fees related to the ABV acquisition and the establishment of a new subsidiary in India. The fiscal year 2013 net earnings1 were also negatively impacted by an $11.7 million non-cash goodwill impairment loss related to the acquisition of ABV. 1 Net earnings or loss refers to net income or loss attributable to Subordinate and Multiple Voting Shares. 2 Multiple Voting Shares (five votes per share) are convertible into Subordinate Voting Shares on a 1 to 1 basis. 9 Management’s discussion and analysis RESULTS OF OPERATIONS – for the year ended February 28, 2013 compared to the year ended February 29, 2012 (unless otherwise noted, all amounts are in U.S. dollars and all comparisons are to the prior fiscal year) Sales Year ended February 28, 2013 Year ended February 29, 2012 (millions) Sales $500.6 $437.1 The Company realized record sales in the fiscal year with an increase of $63.5 million or 14.5% from the prior year. Excluding the results of ABV and currency impacts, sales increased $52.4 million or 12.6% for the year. The increase in sales is primarily attributable to the Company’s North American and Korean operations. For the North American operations, sales increased because the Company began to ship certain large export project orders which had encountered various supply chain issues, customer-related issues and internal operational issues in the prior year. The sales increase in the Korean operations was due to the prior year’s increase in backlog working its way through the production cycle. Net bookings and backlog (millions) Year ended February 28, 2013 Year ended February 29, 2012 Net bookings $370.1 $529.0 Net bookings decreased by $158.9 million or 30.0% for the fiscal year. Excluding the results of ABV and currency impacts, the decrease would have been $144.2 million or 27.3% for the year. The decrease in net bookings is primarily attributable to two factors, namely the Company’s continued policy of quoting longer lead times in order to decrease its large order backlog to ease pressure on production, and a softening of demand for the Company’s nuclear products, especially with respect to its French operations, as the effects of the Fukushima nuclear disaster in Japan take hold. Notwithstanding this drop in nuclear order bookings, the Company believes that the long-term outlook for the nuclear industry is generally positive. The Company is now quoting shorter delivery times in order to increase its sales output and its net bookings for the future. (millions) Backlog February 2013 February 2012 February 2011 $531.0 $661.8 $548.0 For delivery within the subsequent fiscal year $398.2 $460.5 $350.8 For delivery beyond the subsequent fiscal year $132.8 $201.3 $197.2 Percentage – beyond the subsequent fiscal year 25.0% 30.4% 36.0% The Company’s book-to-bill ratio was 0.74 resulting in a $130.8 million or 19.8% decrease in backlog since the beginning of the fiscal year. The decrease is mainly attributable to higher sales output and lower net bookings, as described above. The Company ended the year with a backlog of $531.0 million. Gross profit (millions) Year ended February 28, 2013 Year ended February 29, 2012 Gross profit $113.9 $87.3 Gross profit percentage 22.8% 20.0% 10 Management’s discussion and analysis Excluding the results of ABV and the effects of purchase price accounting, the gross profit percentage for the year would have been 24.6% or an increase of 2.4 percentage points from the prior year. Further adjusting for currency impacts, the gross profit percentage would have been 24.8% for the current year. The improvement in the gross profit percentage was attributable to a combination of sales mix, as well as the fixed cost component of cost of sales as compared to the increased sales in the current year. Administration costs (millions) Year ended February 28, 2013 Year ended February 29, 2012 Administration costs $91.0 $83.6 As a percentage of sales 18.2% 19.1% Administration costs increased by $7.4 million, or 8.9%. Excluding the results of ABV and currency impacts, administration costs would have increased by $8.9 million or 11.3%. The increase was mainly a result of a $4.3 million increase in sales commissions on international export orders coupled with a $0.8 million increase in freight costs for the increased customer shipments. There was also a $1.9 million increase in costs associated with the Company’s ongoing asbestos litigation (see Contingencies section). Like many other U.S. valve manufacturers, two of the Company’s U.S. subsidiaries have been named as defendants in a number of pending lawsuits brought on behalf of individuals seeking to recover damages for their alleged asbestos exposure. These lawsuits are related to products manufactured and sold in the past. Management believes that any asbestos was incorporated entirely within the product in such a way that it would not allow for any ambient asbestos during normal operation, inspection or repairs. Management strongly believes its products, which were supplied in accordance with valve industry practice and customer mandated specifications, did not contribute to any asbestos-related illness. The Company will continue to vigorously defend against these claims but given the ongoing course of asbestos litigation in the U.S. and the unpredictability of jury trials, it is not possible to make an estimate of any settlement costs and legal fees. Goodwill impairment loss and other income (millions) Year ended February 28, 2013 Year ended February 29, 2012 Goodwill impairment loss $11.7 Other income $3.4 $ - $3.8 As a result of the annual goodwill impairment test required under IFRS, the Company recorded an impairment charge of $11.7 million in the current fiscal year related to its ABV cash-generating unit. See Highlights section above for more details. The other income of $3.4 million for the current year consists primarily of a $2.4 million fair value adjustment on the contingent payments related to the ABV acquisition and a $0.4 million unrealized foreign exchange gain on the remaining proceeds payable on the ABV acquisition. During the first quarter of the year, the Company signed an agreement with the previous owners of ABV extending the required disbursement date of the €1.5 million contingent payment to be paid in the event that ABV had satisfied certain non-financial criteria from July 29, 2012 to March 15, 2013. In addition, the requirement that ABV satisfy the non-financial criteria was removed. As a result, the Company recorded a $0.2 million fair value adjustment on the contingent payment to other income. In the fourth quarter, the Company evaluated the likelihood that the financial criteria related to the second of two €2 million contingent payments to be paid upon ABV satisfying certain earnings before interest, taxes, depreciation and amortization (“EBITDA”) targets would be met. Based on this evaluation, the Company determined that it would be more likely than not that such financial criteria would not be satisfied. As a result, the Company recorded an additional fair value adjustment with respect to the applicable contingent payment of $2.2 million to other income in the current year. For the first of the two €2 million contingent payments to be paid upon ABV satisfying certain EBITDA targets, the Company had determined that it would be more likely than not that such financial criteria would not be satisfied in the fourth quarter of the prior fiscal year. As such, it recorded a $2.2 million fair value adjustment on the contingent payment to other income in fiscal year 2012. In addition, a $1.0 million unrealized foreign exchange gain on the remaining proceeds payable on the ABV acquisition was recorded to other income in the prior year. 11 Management’s discussion and analysis Net finance costs (millions) Year ended February 28, 2013 Year ended February 29, 2012 Net finance costs $2.6 $1.4 The increase in net finance costs relates primarily to the increase in long-term debt and short-term borrowings discussed in the Liquidity and Capital Resources section below. Income taxes (in thousands, excluding percentages) Year ended February 28, 2013 % $ Year ended February 29, 2012 % $ Income before income tax 12,018 100.0 6,097 100.0 Tax calculated at domestic tax rates applicable to earnings in the respective countries 4,277 35.6 2,659 43.6 (314) 3,147 178 (657) (1,178) (169) (2.6) 26.2 1.5 (5.5) (9.8) (1.4) (401) - 266 (628) (1,105) (443) (6.6) - 4.4 (10.3) (18.1) (7.3) 5,284 44.0 348 5.7 Tax effects of: Non-deductible (taxable) foreign exchange loss (gain) Non-deductible goodwill impairment loss Non-deductible interest accretion of proceeds payable Non-taxable income on fair value adjustment of proceeds payable Benefit attributable to a financing structure Other permanent differences Provision for income taxes Net earnings1 (millions) Net earnings1 As a percentage of sales Adjusted net operating results2 As a percentage of sales Year ended February 28, 2013 Year ended February 29, 2012 $6.2 1.2% $19.2 3.8% $7.9 1.8% $12.5 2.9% Net earnings1 for the current year were significantly impacted by the goodwill impairment loss. In order to adequately compare the operations with the prior year, the Company normalized its net earnings1 by calculating the adjusted net operating results2 for the two years in question. Adjusted net operating results2 amounted to $19.2 million or $0.87 per share for the current fiscal year compared to $12.5 million or $0.56 per share achieved in the prior fiscal year. As a percentage of sales, the adjusted net operating results2 margin was 3.8% for the current year, compared to 2.9% for the prior year. As discussed in the sections above, this increase is due primarily to increased sales volume resulting from improved production execution, especially of large export project orders. 1 Net earnings or loss refers to net income or loss attributable to Subordinate and Multiple Voting Shares. 2 Non-IFRS measures – see reconciliations at the end of this report. 12 Management’s discussion and analysis SUMMARY OF QUARTERLY RESULTS Summary financial data derived from the Company’s unaudited financial statements from each of the eight most recently completed quarters are as follows: For the quarters in months ending May, August, November and February (in thousands of U.S. dollars, excluding per share amounts) February 2013 $142,070 (3,555) November 2012 $134,203 5,712 August 2012 $108,449 3,318 May 2012 $115,852 694 February 2012 $117,784 5,864 November 2011 $118,939 3,992 QUARTERS ENDED May August 2011 2011 $105,023 $95,389 147 (2,111) (0.16) (0.16) 0.26 0.26 0.15 0.15 0.03 0.03 0.27 0.27 0.18 0.18 (0.10) (0.10) 0.01 0.01 Sales Net Earnings1 (loss) Earnings per share - Basic - Diluted Sales were low in the August 2011 quarter. For various reasons, the Company could not ship certain project orders in the August 2011 quarter. In the quarters ended August 2012, May 2012, February 2012, November 2011 and May 2011, sales remained fairly constant when adjusted for ABV and currency impacts. Sales can vary from one quarter to the next due to the timing of the shipment of project orders. Sales were higher in February 2013 and November 2012 as the Company improved its production execution on large export project orders. Net losses1 were recorded in the quarters ended August 2011, which was due to low sales, and in February 2013, which was due to a goodwill impairment loss. Purchase price accounting adjustments lowered results for all eight quarters discussed. RESULTS OF OPERATIONS – quarter ended February 28, 2013 compared to the quarter ended February 29, 2012 (unless otherwise noted, all amounts are in U.S. dollars and all comparisons are to the fourth quarter of the last fiscal year) Sales (millions) Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Sales $142.1 $117.8 Sales increased by $24.3 million or 20.6% for the quarter. Excluding currency impacts, sales increased $22.0 million or 18.7% for the quarter. The increase in sales for the quarter is primarily attributable to the Company’s North American and Italian operations. For the North American operations, sales increased because the Company began to ship certain large export project orders which had encountered various supply chain issues, customer-related issues and internal operational issues in the prior year. The sales increase in the Italian operations was due to improved production efficiencies at ABV which resulted from the Company’s continued integration efforts with regards to this acquisition. Net bookings and backlog Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 (millions) Net bookings $96.7 $125.9 Bookings decreased by $29.2 million, or 23.2% for the quarter. Excluding currency impacts, bookings would have decreased 24.7%. The decrease in net bookings is primarily attributable to the Company’s continued policy of quoting longer lead times in order to decrease its large order backlog. While its bookings were down for the full year, the Company’s French operations showed improved bookings in the quarter as it booked a significant amount of spare parts orders which offset the drop in demand for its nuclear products following the Fukushima nuclear disaster in Japan. 1 Net earnings or loss refers to net income or loss attributable to Subordinate and Multiple Voting Shares. 13 Management’s discussion and analysis Gross profit (millions) Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Gross profit $30.4 $23.0 Gross profit percentage 21.4% 19.5% Excluding currency impacts, the gross profit percentage for the quarter would have been 21.9% or an increase of 2.4 percentage points from the prior year quarter. This favourable variance was principally due to higher sales volume to cover production overhead expenses, especially in the Company’s North American operations, coupled with improved production efficiencies in its Italian operations. Administration costs (millions) Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Administration costs $22.4 $21.4 As a percentage of sales 15.8% 18.2% Administration costs increased by $1.0 million, or 4.7%. The increase was due primarily to increased settlement costs and legal fees associated with the Company’s ongoing asbestos litigation (see Contingencies section). Goodwill impairment loss and other income (millions) Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Goodwill impairment loss $11.7 Other income $2.6 $ - $3.5 As a result of the annual goodwill impairment test required under IFRS, the Company recorded an impairment charge of $11.7 million in the quarter related to its ABV cash-generating unit. See Highlights section above for more details. The $0.9 million decrease in other income is due principally to a $1.0 million decrease in the amount of unrealized foreign exchange gain on the remaining proceeds payable on the ABV acquisition recognized in the current quarter compared to the prior year quarter. Finance costs (millions) Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Net finance costs $0.5 $0.6 Net finance costs for the quarter remained relatively stable when compared to the prior year quarter. 14 Management’s discussion and analysis Income taxes (in thousands, excluding percentages) Three-month period ended February 28, 2013 % $ Three-month period ended February 29, 2012 % $ Income (Loss) before income tax (1,552) 100.0 4,543 100.0 Tax calculated at domestic tax rates applicable to earnings in the respective countries (151) 9.7 1,809 39.8 - 3,147 42 (604) (308) (159) - (202.8) (2.7) 38.9 19.9 10.3 (138) - 68 (628) (288) (678) (3.0) - 1.5 (13.8) (6.4) (14.9) 1,967 (126.7) 145 3.2 Tax effects of: Non-deductible (taxable) foreign exchange loss (gain) Non-deductible goodwill impairment loss Non-deductible interest accretion of proceeds payable Non-taxable income on fair value adjustment of proceeds payable Benefit attributable to a financing structure Other permanent differences Provision for income taxes Net earnings1 (millions) Net earnings1 As a percentage of sales Adjusted net operating results2 As a percentage of sales Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 $(3.6) (2.5)% $6.3 4.4% $5.9 5.0% $2.5 2.1% Net earnings1 for the current quarter were significantly impacted by the goodwill impairment loss. In order to adequately compare the operations with the prior year quarter, the Company normalized its net earnings1 by calculating the adjusted net operating results2 for the two quarters in question. Adjusted net operating results2 amounted to $6.3 million or $0.28 per share for the current quarter compared to $2.5 million or $0.11 per share achieved in the prior fiscal year quarter. As a percentage of sales, the adjusted net operating results2 margin was 4.4% for the current quarter, compared to 2.1% for the prior year quarter. As discussed in the sections above, this increase is due primarily to increased sales volume resulting from improved production execution, especially as it relates to large export project orders. 1 Net earnings or loss refers to net income or loss attributable to Subordinate and Multiple Voting Shares. 2 Non-IFRS measures – see reconciliations at the end of this report. 15 Management’s discussion and analysis LIQUIDITY AND CAPITAL RESOURCES – a discussion of liquidity risk, credit facilities, cash flows and proposed transactions (unless otherwise noted, all dollar amounts are denominated in U.S. dollars) Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they come due. The Company manages its liquidity risk by continually monitoring its future cash requirements. Cash flow forecasting is performed in the operating entities and aggregated by the Company’s corporate finance team. The Company’s policy is to maintain sufficient cash and cash equivalents and available credit facilities in order to meet its present and future operational needs. The following table presents the Company’s financial obligations identified by type and future contractual dates of payment: (In thousands) Long-term debt Accounts payable and accrued liabilities Customer deposits Accrual for performance guarantees Bank indebtedness and short-term bank loans Derivative liabilities Total $ 26,850 78,431 76,682 28,525 50,864 1,380 Less than 1 year $ 10,463 78,431 76,682 28,525 50,864 1,380 As at February 28, 2013 4 to 5 Years $ After 5 years $ 2,013 2,158 - - - - - - - - - - 1 to 3 Years $ 12,216 - - - - - On February 28, 2013, the Company’s order backlog was $531 million and its net cash1 plus unused credit facilities amounted to $47.9 million, which it believes, along with future cash flows generated from operations, is sufficient to meet its financial obligations, increase its capacity, satisfy its working capital requirements, and execute on its business strategy. However, there can be no assurance that the risk of another sharp downturn in the economy will not materially adversely affect the Company’s results of operations or financial condition. The Company continues to closely monitor the continued weakness of the euro currency. The Company is in compliance with all covenants related to its debt and credit facilities. As a corollary to the managing its liquidity risk the Company also monitors the financial health of its key suppliers. Proposed transactions The Company has not committed to any material asset or business acquisitions or dispositions, other than those already discussed in this MD&A. 1 Non-IFRS measures – see reconciliations at the end of this report. 16 Management’s discussion and analysis Cash flows (unless otherwise noted, all amounts are in U.S. dollars and all comparisons are to same period in the prior fiscal year) Net cash1 (millions) Net cash1 February 2013 November 2012 February 2012 November 2011 February 2011 $19.8 $5.5 $35.4 $27.7 $113.1 The Company’s net cash1 increased $14.3 million during the quarter and decreased $15.6 million from the beginning of the fiscal year. The increase in the quarter was driven primarily by an increase in operating results as a result of the increase in sales volume coupled with favourable non-cash working capital movements, specifically a decrease in inventory. The decrease in net cash1 for the year was driven primarily by unfavourable non-cash working capital movements, specifically an increase in accounts receivable resulting from the higher sales volume. Cash provided (used) by operating activities (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Cash provided (used) by operating activities $14.4 $(12.8) $23.1 $15.6 Cash provided by operating activities for the current fiscal year increased by $27.2 million when compared to last year. This increase was principally related to the increase in operating results as a result of the increase in sales volume which was only partially offset by unfavourable non-cash working capital movements, specifically an increase in accounts receivable. Cash provided by operating activities for the quarter increased by $7.5 million when compared to the prior year period. This increase was principally related to non-cash working capital movements, specifically a decrease in inventory. Accounts receivable (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Accounts receivable decrease (increase) $(23.3) $(8.5) $(2.2) $15.8 Accounts receivable balances are a function of the timing of sales and cash collections. For all of the indicated periods, accounts receivable increased when compared to the prior year period due to the increased sales volume in the second half of the year which resulted in higher billings. Inventory (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Inventory decrease (increase) Customer deposits increase (decrease) $11.3 $(10.2) $(38.4) $11.1 $17.7 $(8.4) $(11.3) $2.5 Inventory typically increases in times of rising backlog and order bookings and decreases when the opposite occurs. Inventory is also a function of timing between receipts and shipments. For all of the indicated periods, inventory decreased as a result of the increase in sales volume and the decrease in backlog for the corresponding period. In order to help finance its investment in inventory, the Company, where possible, obtains customer deposits for large orders. The customer deposit decrease in all of the indicated periods appears in line with the inventory decreases. 1 Non-IFRS measures – see reconciliations at the end of this report. 17 Management’s discussion and analysis Accounts payable and accrued liabilities (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Accounts payable and accrued liabilities (decrease) increase $(3.8) $4.7 $0.1 $3.9 For all of the indicated periods, the fluctuations in accounts payable and accrued liabilities were primarily related to timing. Additions to property, plant and equipment (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Additions to property, plant and equipment $28.5 $12.7 $5.8 $3.8 The additions to property, plant and equipment relate mainly to the Company’s North American and Indian operations. In North America, the Company is investing in machinery and equipment in order to increase production capacity and improve operational efficiency. In India, the Company completed construction of a new manufacturing plant which began trial production activities in December 2012. The Company believes that its presence in India will improve its cost competitiveness as well as the ability to access the rapidly growing Indian market. Dividends (millions) Dividends paid Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 $7.1 $7.2 $1.8 $1.8 The Company maintained its dividend policy of CDN$0.32 per share, payable quarterly. Long-term debt (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Increase in long-term debt $21.1 $5.2 $0.3 $0.6 In order to fund its investment in property, plant and equipment, as well as its current working capital needs, the Company borrowed $21.1 million during the year. Of this amount, $20.0 million consists of a term bank loan that bears interest at 2.74% and is repayable in monthly installments of $0.4 million over a 48-month period, expiring in the 2016-2017 fiscal year. Other Liabilities (millions) Fiscal Year ended February 28, 2013 Fiscal Year ended February 29, 2012 Three-month period ended February 28, 2013 Three-month period ended February 29, 2012 Payment of proceeds payable $3.5 $ - $0.6 $ - In accordance with the provisions of the purchase and sale agreement for ABV, the Company paid $3.5 million to the former majority shareholders of ABV over the course of the current fiscal year as partial settlement of the proceeds payable at the time of the acquisition. 18 Management’s discussion and analysis FINANCIAL INSTRUMENTS AND FINANCIAL RISK MANAGEMENT The Company’s activities expose it to a variety of financial risks: market risk (including currency risk, cash flow interest rate risk and fair value interest rate risk), credit risk and liquidity risk. The Company’s overall financial risk management program focuses on mitigating unpredictable financial market risks and their potential adverse effects on the Company’s financial performance. The Company’s financial risk management is generally carried out by the corporate finance team, based on policies approved by the Board of Directors. The identification, evaluation and hedging of the financial risks are the responsibility of the corporate finance team in conjunction with the finance teams of the Company’s subsidiary companies and SPEs. The Company uses derivative financial instruments to hedge certain risk exposures. Use of derivative financial instruments is subject to a policy which requires that no derivative transaction be entered into for the purpose of establishing a speculative or leveraged position (the corollary being that all derivative transactions are to be entered into for risk management purposes only). Risk overview The Company’s financial instruments and the nature of risks which they may be subject to are set out in the following table: Risks Market risks Financial instrument Credit Liquidity Currency Interest rate x x x x Cash and cash equivalents Short-term investments Accounts receivable Derivative assets Bank indebtedness Short-term bank loans Accounts payable and accrued liabilities Customer deposits Dividend payable Accrual for performance guarantees Derivative liabilities Long-term debt x x x x x x x x x x x x x x x x x x x x x x x x x Market risk Currency risk Currency risk on financial instruments is the risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. The Company operates internationally and is exposed to foreign exchange risk arising from various currency exposures. Currency risk arises when future commercial transactions and recognized assets and liabilities are denominated in a currency other than a company’s functional currency. The Company has operations with different functional currencies, each of which will be exposed to currency risk based on its specific functional currency. When possible, the Company matches cash receipts in a foreign currency with cash disbursements in that same currency. The remaining anticipated net exposure to foreign currencies is hedged. To hedge this exposure, the Company uses foreign currency derivatives, primarily foreign exchange forward contracts. These derivatives are not designated as hedges for accounting purposes. 19 Management’s discussion and analysis The amounts outstanding as at February 28, 2013 and February 29, 2012 are as follows: Range of exchange rates Gain (loss) (In thousands of U.S. dollars) Notional amount (In thousands of indicated currency) February 28, 2013 February 29, 2012 February 28, 2013 $ February 29, 2012 $ February 28, 2013 February 29, 2012 Foreign exchange forward contracts Sell US$ for CA$ – 0 to 12 months Sell US$ for € – 0 to 13 months Buy US$ for € – 0 to 12 months Buy ₤ for € – 0 to 12 months Sell US$ for ₤ – 0 to 21 months Sell US$ for KW – 0 to 12 months Sell € for US$ – 0 to 12 months Buy € for US$ – 0 to 12 months Buy £ for US$ – 0 to 12 months 0.97-1.04 1.28-1.43 1.28-1.41 - 1.52 - 1.25-1.35 1.26 1.51-1.61 0.97-1.04 1.28-1.42 1.28-1.41 0.80-0.89 - 1,197-1,202 1.30-1.42 - 1.56-1.62 (951) (192) 1 - (6) - 103 67 (62) (13) US$43,245 US$8,664 51 US$33 (9) - 30 US$1,485 - - 19 €30,693 1,095 €1,420 - £889 30 US$42,000 US$13,921 US$1,437 £1,564 - US$333 €25,617 - £1,919 Foreign exchange forward contracts are contracts whereby the Company has the obligation to sell or buy the currencies at the strike price. The fair value of the foreign currency instruments is recorded in the consolidated statement of income and reflects the estimated amounts the Company would have paid or received to settle these contracts as at the financial position date. Gains are recorded as derivative assets and losses as derivative liabilities on the consolidated statement of financial position. Cash flow and fair value interest rate risk The Company’s exposure to interest rate risk is related primarily to its credit facilities, long-term debt and cash and cash equivalents. Items at variable rates expose the Company to cash flow interest rate risk, and items at fixed rates expose the Company to fair value interest rate risk. The Company’s long-term debt and credit facilities predominantly bear interest, and its cash and cash equivalents earn interest at variable rates. An assumed 0.5% change in interest rates would have no significant impact on the Company’s net income or cash flows. Credit risk Credit risk is the risk of an unexpected loss if a customer or counterparty to a financial instrument fails to meet its contractual obligations. Credit risk arises primarily from the Company’s trade accounts receivable. The Company’s credit risk related to its trade accounts receivable is concentrated. As at February 28, 2013, three (February 29, 2012 – six) customers accounted for more than 5% each of its trade accounts receivable, of which one customer accounted for 6.2% (February 29, 2012 – 10.9%), and the Company’s ten largest customers accounted for 43.1% (February 29, 2012 – 62.8%). In order to mitigate its credit risk, the Company performs a continual evaluation of its customers’ credit and performs specific evaluation procedures on all its new customers. In performing its evaluation, the Company analyzes the ageing of accounts receivable, historical payment patterns, customer creditworthiness and current economic trends. A specific credit limit is established for each customer and reviewed periodically. An allowance for doubtful accounts is recorded when, based on management’s evaluation, the collection of an account receivable is not reasonably certain. The Company is also exposed to credit risk relating to derivative financial instruments, cash and cash equivalents and short-term investments, which it manages by dealing with highly rated financial institutions. The Company’s primary credit risk is limited to the carrying value of the trade accounts receivable and gains on derivative assets. 20 Management’s discussion and analysis The table below summarizes the ageing of the trade accounts receivable as at: (In thousands of U.S. dollars) Current Past due 0 to 30 days Past due 31 to 90 days Past due more than 90 days Less: Allowance for doubtful accounts Trade accounts receivable Other receivables Total accounts receivable The table below summarizes the movement in the allowance for doubtful accounts: (In thousands of U.S. dollars) Balance – Beginning of year Bad debt expenses Recoveries of trade accounts receivable Write-off of trade accounts receivable Foreign exchange Balance – End of year February 28, 2013 $ February 29, 2012 $ 97,741 10,351 8,702 10,793 127,587 1,525 126,062 8,312 78,838 13,221 5,054 10,482 107,595 1,144 106,451 5,405 134,374 111,856 February 28, 2013 $ February 29, 2012 $ 1,144 916 (472) (50) (13) 1,525 1,661 331 (720) (453) 325 1,144 Liquidity risk – see discussion in liquidity and capital resources section CONTINGENCIES (in thousands of U.S. dollars, excluding number of cases) Two of the Company’s U.S. subsidiaries have been named as defendants in a number of pending lawsuits that seek to recover damages for personal injury allegedly caused by exposure to asbestos-containing products manufactured and sold in the past. Management believes it has a strong defence related to certain products that may have contained an internal asbestos containing component. 764 claims were outstanding at the end of the reporting period (February 29, 2012 – 671). These claims were filed in the states of Arizona, California, Colorado, Connecticut, Delaware, Florida, Georgia, Hawaii, Illinois, Louisiana, Maine, Maryland, Massachusetts, Mississippi, Missouri, New Jersey, New York, Ohio, Oregon, Pennsylvania, Rhode Island, South Carolina, Texas, Virginia, Washington and West Virginia. During the current fiscal year, the Company resolved 330 claims (February 29, 2012 – 262) and was the subject of 423 new claims (February 29, 2012 – 447). Because of the many uncertainties inherent in predicting the outcome of these proceedings, as well as the course of asbestos litigation in the United States, management believes that it is not possible to make an estimate of the Company’s asbestos liability. Accordingly, no provision has been set up in the accounts. Settlement costs and legal fees related to these asbestos claims amounted to $3,173 for the quarter (February 29, 2012 - $1,293) and $8,763 for the year (February 29, 2012 - $6,920). 21 Management’s discussion and analysis OFF-BALANCE SHEET ARRANGEMENTS The Company has entered into certain off-balance sheet arrangements. They are fully described in notes 23 and 26 of the Company’s audited consolidated financial statements. The types of transactions entered into, all of which are in the normal course of business, are as follows: Performance bond guarantees related to product warranty and on-time delivery • • Letters of credit issued to overseas suppliers • Operating leases RELATED PARTY TRANSACTIONS (in thousands of U.S. dollars) The Company has entered into the following transactions with related parties, which are measured at their exchange value. a) PDK Machine Shop Ltd. (“PDK”) is a company owned by certain relatives of the controlling shareholder. PDK is a supplier of machined material components for use in Velan’s plants. Purchases of material components Sales of raw material Three months ended Twelve months ended Feb. 29, Feb. 28, 2012 2013 $2,030 $385 131 9 Feb. 29, 2012 $436 24 Feb. 28, 2013 $1,909 168 The Company entered into an agreement with PDK pursuant to which it has the right to purchase the shares of PDK for a consideration equal to the book value thereof in the event that they propose to sell their shares to a third party. In the event that PDK proposes to sell all or substantially all of its assets to a third party, the Company has the right to purchase inventory at cost and other assets at book value. In the event of a proposed liquidation or sale of sufficient assets such that PDK cannot fulfill its obligations to the Company under any outstanding purchase orders, the Company also has the right and the obligation to purchase PDK’s inventory at an amount equal to the cost thereof. The maximum obligation of the Company pursuant to such put right is $200. b) SteamTree Systems, Inc. (“SteamTree”) is a company, which is 50%-owned by a different relative of the controlling shareholder. SteamTree provides consulting and custom design services related to computer software and software applications. SteamTree developed and implemented a computerized quotations system presently used by Velan’s Marketing department. Software development and consulting services Three months ended Twelve months ended Feb. 29, Feb. 28, 2012 2013 $29 $3 Feb. 29, 2012 $1 Feb. 28, 2013 $17 c) One of the Company`s subsidiaries and certain of its executives lease, on a weekly basis, a property from Velan Holdings Co. Ltd., the controlling shareholder. Velan Holdings Co. Ltd. charges weekly rates based on usage. Three months ended Twelve months ended Feb. 29, Feb. 28, 2012 2013 $29 $6 Feb. 29, 2012 $4 Feb. 28, 2013 $25 Rent 22 Management’s discussion and analysis CONTROLS AND PROCEDURES Disclosure controls and procedures Disclosure controls and procedures are designed to provide reasonable assurance that all relevant information is gathered and reported to senior management, including the Chief Executive Officer (“CEO”), and the Chief Financial Officer (“CFO”), in a timely manner so that appropriate decisions can be made regarding public disclosure. The CEO and the CFO of the Company have evaluated, or caused the evaluation of, under their direct supervision, the effectiveness of the Company’s disclosure controls and procedures (as defined in National Instrument 52-109 – Certification of Disclosure in Issuer’s Annual and Interim Filings) as at February 28, 2013 and have concluded that such disclosure controls and procedures were designed and operating effectively. Internal control over financial reporting Management is responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with IFRS. Management has evaluated the design and effectiveness of its internal controls and procedures over financial reporting (as defined in National Instrument 52-109 – Certification of Disclosure in Issuer’s Annual and Interim Filings). The evaluation was based on the “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”). This evaluation was performed by the CEO and the CFO of the Company with the assistance of other Company Management and staff to the extent deemed necessary. Based on this evaluation, the CEO and the CFO concluded that the internal controls and procedures over financial reporting were appropriately designed and operating effectively as at February 28, 2013. In spite of its evaluation, Management does recognize that any controls and procedures no matter how well designed and operated, can only provide reasonable assurance and not absolute assurance of achieving the desired control objectives. In the unforeseen event that lapses in the disclosure of internal controls and procedures occur and/or mistakes happen of a material nature, the Company intends to take the steps necessary to minimize the consequences thereof. Changes in internal control over financial reporting The Company did not make any material changes to the design of internal control over financial reporting during the year and three- month period ended February 28, 2013 that have materially affected, or are reasonably likely to have materially affected, the Company’s internal control over financial reporting. CRITICAL ACCOUNTING ESTIMATES & JUDGEMENTS The Company’s financial statements are prepared in accordance with IFRS as issued by the IASB. The Company’s significant accounting policies as described in note 2 of the Company’s audited consolidated financial statements are essential to understanding the Company’s financial positions, results of operations and cash flows. Certain of these accounting policies require critical accounting estimates that involve complex and subjective judgments and the use of assumptions, some of which may be for matters that are inherently uncertain and susceptible to change. The assumptions and estimates used are based on parameters which are derived from the knowledge at the time of preparing the financial statements and believed to be reasonable under the circumstances. In particular, the circumstances prevailing at this time and assumptions as to the expected future development of the global and industry-specific environment were used to estimate the Company’s future business performance. Where these conditions develop differently than assumed and beyond the control of the Company, the actual results may differ from those anticipated (see Forward- looking information section above). These estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is changed. There were no significant changes made to critical accounting estimates during the past two financial years. The estimates and assumptions that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next financial year are addressed below: Accounts receivable The Company must report its accounts receivable at their net realizable value. This involves management judgment and requires the Company to perform continuous evaluations of their collectability and to record an allowance for doubtful accounts when required. In performing its evaluation, the Company analyzes the ageing of accounts receivable, concentration of receivables by customer, customer creditworthiness and current economic trends. Any change in the assumptions used could impact the carrying value of the 23 Management’s discussion and analysis accounts receivable on the consolidated statement of financial position with a corresponding impact made to administration costs on the consolidated statement of income. Inventory Inventories must be valued at the lower of cost and net realizable value. A writedown of inventory will occur when its estimated market value less applicable variable selling expenses is below its carrying amount. This involves significant management judgment and is based on the Company’s assessment of market conditions for its products determined by historical usage, estimated future demand and, in some cases, the specific risk of loss on specifically identified inventory. Any change in the assumptions used in assessing this valuation or selling costs could impact the carrying amount of the inventory on the consolidated statement of financial position with a corresponding impact made to cost of sales on the consolidated statement of income. Provisions Provisions must be established for possible product warranty expenses. The Company estimates its warranty exposure by taking into account past experience as well as any known technical problems and estimates of costs to resolve these issues. The Company estimates its exposure under these obligations based on an analysis of all identified or expected claims. Any change in the assumptions used could impact the value of the provision on the consolidated statement of financial position with a corresponding impact made to cost of sales on the consolidated statement of income. Accrual for performance guarantees Accruals for performance guarantees must be established for possible late delivery and other contractual non-compliance penalties or liquidated damages. The Company estimates its exposure by taking into account past experience, as well as any known non- compliance with its contractual obligations, and estimates of costs to resolve these issues. The Company estimates its exposure under these obligations based on an analysis of all identified or expected claims. Any change in the assumptions used could impact the value of the accrual on the consolidated statement of financial position with a corresponding impact made to cost of sales on the consolidated statement of income. Asset impairment test Assets that have an indefinite life, such as goodwill, are tested annually by the Company for impairment, or more frequently if events or circumstances indicate there may be impairment. All other assets must be reviewed by the Company at the end of each reporting period in order to determine whether there is an indication of possible impairment. For the purposes of impairment testing, assets are grouped at the lowest levels for which there are separately identifiable cash flows. A cash-generating unit (“CGU”) is the smallest group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. If an indication of impairment exists, the Company estimates the recoverable amount of the CGU in order to determine the extent of the impairment loss, if any. An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the greater of an asset’s fair value less costs to sell and its value in use. In assessing value in use, the Company estimates future cash flows which are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. Any change in the assumptions used could impact the carrying amount first of any goodwill allocated to the CGU and then to the other assets of the CGU on a pro rata basis of the carrying amount of each asset in the CGU on the consolidated statement of financial position with a corresponding impact made to the consolidated statement of income. Income taxes The Company must estimate its income taxes in each jurisdiction in which it operates. This involves assessing the probability of using net operating losses against future taxable income as well as evaluating positions taken in tax returns with respect to situations in which applicable tax regulation is subject to interpretation. In the event these assessments are changed, there would be an adjustment to income tax expense with a corresponding adjustment to income tax balances on the consolidated statement of financial position. 24 Management’s discussion and analysis ACCOUNTING STANDARDS AND AMENDMENTS ISSUED BUT NOT YET ADOPTED Unless otherwise noted, the following revised standards and amendments are effective for annual periods beginning on or after January 1, 2013, with earlier application permitted. Based on a preliminary assessment, the Company does not expect any significant impact on the consolidated financial statements upon adoption of these standards and amendments. The Company has also determined that it will not early adopt these standards and amendments. (i) IFRS 9, Financial Instruments, was issued in November 2009 and addresses classification and measurement of financial assets. It replaces the multiple category and measurement models in IAS 39, Financial Instruments: Recognition and Measurement, for debt instruments with a new mixed measurement model having only two categories: amortized cost and fair value through profit or loss. IFRS 9 also replaces the models for measuring equity instruments. Such instruments are either recognized at fair value through profit or loss or at fair value through other comprehensive income. Where equity instruments are measured at fair value through other comprehensive income, dividends are recognized in profit or loss to the extent that they do not clearly represent a return of investment; however, other gains and losses (including impairments) associated with such instruments remain in accumulated comprehensive income indefinitely. Requirements for financial liabilities were added to IFRS 9 in October 2010 and they largely carried forward existing requirements in IAS 39, except that fair value changes due to credit risk for liabilities designated at fair value through profit or loss are generally recorded in other comprehensive income. The above revisions are effective for annual periods beginning on or after January 1, 2015, with earlier application permitted. (ii) (iii) (iv) (v) IFRS 10, Consolidated Financial Statements, requires an entity to consolidate an investee when it has power over the investee, is exposed or has rights to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Under existing IFRS, consolidation is required when an entity has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. IFRS 10 replaces SIC–12, Consolidation—Special Purpose Entities and parts of IAS 27, Consolidated and Separate Financial Statements. IFRS 11, Joint Arrangements, requires a venturer to classify its interest in a joint arrangement as a joint venture or joint operation. Joint ventures will be accounted for using the equity method of accounting whereas for a joint operation the venturer will recognize its share of the assets, liabilities, revenue and expenses of the joint operation. Under existing IFRS, entities have the choice to proportionately consolidate or equity account for interests in joint ventures. IFRS 11 supersedes IAS 31, Interests in Joint Ventures, and SIC–13, Jointly Controlled Entities—Non-monetary Contributions by Venturers. IFRS 12, Disclosure of Interests in Other Entities, establishes disclosure requirements for interests in other entities, such as subsidiaries, joint arrangements, associates, and unconsolidated structured entities. The standard carries forward existing disclosures and also introduces significant additional disclosure that address the nature of, and risks associated with, an entity’s interests in other entities. IFRS 13, Fair Value Measurement, is a comprehensive standard for fair value measurement and disclosure for use across all IFRS standards. The new standard clarifies that fair value is the price that would be received to sell an asset, or paid to transfer a liability in an orderly transaction between market participants, at the measurement date. Under existing IFRS, guidance on measuring and disclosing fair value is dispersed among the specific standards requiring fair value measurements and does not always reflect a clear measurement basis or consistent disclosures. (vi) There have been amendments to existing standards, including IAS 27, Separate Financial Statements, and IAS 28, Investments in Associates and Joint Ventures. IAS 27 addresses accounting for subsidiaries, jointly controlled entities and associates in non-consolidated financial statements. IAS 28 has been amended to include joint ventures in its scope and to address the changes in IFRS 10 to 13. (vii) IAS 19, Employee Benefits, has been amended to make significant changes to the recognition and measurement of defined benefit pension expense and termination benefits and to enhance the disclosure of all employee benefits. The amended standard requires immediate recognition of actuarial gains and losses in other comprehensive income as they arise, without subsequent recycling to net income. Past service cost (which will now include curtailment gains and losses) will no longer be recognized over a service period but instead will be recognized immediately in the period of a plan 25 Management’s discussion and analysis amendment. Pension benefit cost will be split between (i) the cost of benefits accrued in the current period (service cost) and benefit changes (past-service cost, settlements and curtailments); and (ii) finance expense or income. The finance expense or income component will be calculated based on the net defined benefit asset or liability. A number of other amendments have been made to recognition, measurement and classification, including redefining short-term and other long-term benefits, guidance on the treatment taxes related to benefit plans, guidance on risk/cost-sharing features, and expanded disclosures. (viii) IAS 1, Presentation of Financial Statements, has been amended to require entities to separate items presented in other comprehensive income into two groups, based on whether or not items may be recycled in the future. Entities that choose to present other comprehensive income items before tax will be required to show the amount of tax related to the two groups separately. The amendment is effective for annual periods beginning on or after July 1, 2012 with earlier application permitted. CERTAIN RISKS THAT COULD AFFECT OUR BUSINESS Cyclical nature of end user markets The demand for the Company’s products in any particular industry or market can vary significantly according to the level of economic activity in that industry or market. These potential variations may be mitigated by the fact that the Company’s sales are diversified geographically as well as by end user market. There can be no assurance that an economic recession or downturns in certain industries or geographic locations will not have a significant adverse effect on the Company’s sales. Competition Competitive pressures in the Company’s markets could lead to a loss of market share, which could negatively impact revenues, margins and net income. The Company also competes with manufacturers based in low wage countries that offer valves at substantially lower prices. There can be no assurance that the Company will be able to compete successfully against its current or future competitors or that competition will not have a material adverse effect on the Company's results of operations and financial condition. Backlog The Company’s order backlog consists of sales orders that are considered firm. It is also an indication of future sales revenues. However, there can be no assurance that subsequent cancellations or scope adjustments will not occur, that the order backlog will ultimately result in earnings, or when the related revenues and earnings from such order backlog will be recognized. Dependence upon key personnel The Company is dependent upon the abilities and experience of its executive officers and other key employees. There can be no assurance that the Company can retain the services of such executive officers and key employees. If several executive officers or other key employees were to leave the employ of the Company, its operations could be adversely affected. Foreign currency exchange risks Due to the geographic mix of the Company’s customers and its operations, the Company is exposed to foreign currency exchange risk. The Company enters into simple foreign currency forward contracts in order to manage a portion of its net exposure to foreign currencies. Such forward contracts contain an inherent credit risk related to default on obligations by the counterparty, which the company mitigates by entering into contracts with sound financial institutions that it anticipates will satisfy their obligations. Risk related to currency fluctuations could have a material adverse effect on the Company's results of operations and its financial position. Interest rate risk A portion of the Company’s liabilities consist of debt instruments that bear interest at variable rates. As such, the Company is exposed to the risk of interest rate fluctuations. This risk could have an adverse effect on the Company’s results of operations. Availability and prices of raw materials The price of raw materials, principally steel, represents a substantial portion of the cost of manufacturing the Company’s products. Historically, there have been fluctuations in these raw material prices and, in some instances, price movements have been volatile. There can be no certainty that the Company will be able to pass on increases resulting from higher costs of raw materials to its customers through increases in selling prices, or otherwise absorb such cost increases without significantly affecting its margins. 26 Management’s discussion and analysis In addition, certain raw materials are in short supply for a period of time. Typically, these shortages do not last long and the Company is usually able to ensure that its needs are met. However, there can be no assurances that its sources of supply will be adequate to supply all of its needs on a timely basis. Labour relations A substantial portion of the Company’s workforce is covered by union agreements. Although the Company has been successful in the past in negotiating renewals, there can be no assurance that this will continue. Failure to renegotiate these agreements could lead to work disruptions or higher labour costs, which could negatively impact results. Reliance on key suppliers The Company has several key suppliers with whom it has invested in forging dies and casting patterns. While the Company has alternate sources for most material purchases, the loss of a key supplier could impact negatively on the Company. Reliance on distributors and sales agents The Company is directly affected by the ability of independent third party distributors and sales agents retained by the Company to sell its products in their respective markets. The Company’s continued success is thus dependent on its ability to attract and retain the distributors and sales agents it requires to support its existing business and to continue to grow. Project undertakings In competing for the sales of valves, the Company may enter into contracts that provide for the production of valves at specified prices and in accordance with time schedules. These contracts may involve greater risks as a result of unforeseen increases in the prices of raw materials and other costs due to more stringent terms and conditions. Although contract terms may vary from customer to customer, production delays and other performance issues may call for liquidated damages or other penalties in case of non- performance or warranty issues due to the more stringent terms and conditions of such contracts. Political and economic risks associated with international sales and operations Since the Company sells and manufactures its products worldwide, the business is subject to risks associated with doing business internationally. The Company’s business and operating results could be impacted by trade protection measures, changes in tax laws, possibility of expropriation and embargo, foreign exchange restrictions and political, military and/or terrorist disruptions or changes in regulatory environments. Force majeure events Force majeure events are unforeseeable events or circumstances that occur beyond the control of the Company. Such events include but are not limited to political unrest, war, terrorism, strikes, riots, and crime, as well as seismic or severe weather related events such as earthquakes, hurricanes, tsunamis, tornadoes, ice storms, flooding and volcanic eruptions. The risk of occurrence of a force majeure event is unpredictable and may result in delays or cancellations of orders and deliveries to customers, delays in the receipt of materials from suppliers, damage to facilities or equipment, personal injury or fatality, and possible legal liability. Asbestos litigation Two of the Company’s U.S. subsidiaries have been named as defendants in a number of pending lawsuits that seek to recover damages for personal injury allegedly caused by exposure to asbestos-containing products manufactured and sold in the past. Management believes it has a strong defense related to certain products that may have contained an internal component containing asbestos. Although it is defending these allegations vigorously, there can be no assurance that the Company will prevail. Unfavorable rulings, judgments or settlement terms could have a material adverse impact on the Company’s business, financial condition, results of operations and cash flows. Product liability and other lawsuits The Company, like other worldwide manufacturing companies, has been, and will continue to be, subject to a variety of potential liability claims or other lawsuits connected with its business operations, including potential liabilities and expenses associated with possible product defects or failures. While the Company maintains comprehensive general liability insurance coverage which it considers to generally be in accordance with industry practice, such insurance does not cover certain categories of claims (such as ongoing asbestos claims) to which the Company is subject. Comprehensive general liability premiums have also increased significantly during the last several years. Accordingly, the Company cannot be certain that comprehensive general liability insurance coverage will continue to be available to it at a reasonable cost, or, if available, would be adequate to cover its liabilities. Health and safety risk The Company is committed to providing all employees, contractors, and visitors to its premises with a healthy and safe work environment. The Company has implemented a program throughout its operations with policies and procedures that must be followed to ensure that it meets all applicable health and safety laws, regulations, and standards. The Company recognizes that a 27 Management’s discussion and analysis lack of a strong health and safety program may expose it to lost production time, penalties and lawsuits, and may impact future orders as customers may take into account the Company’s health and safety record when awarding sales contracts. Environmental compliance matters The Company’s operations and properties are subject to increasingly stringent laws and regulations relating to environmental protection, including air and water discharges, waste management and disposal and employee safety. Such laws and regulations both impose substantial fines for violations and mandate cessation of operations in certain circumstances, the installation of costly pollution control equipment, or the undertaking of costly site remediation activities. Furthermore, new laws and regulations, or stricter enforcement of existing laws and regulations, the discovery of previously unknown contamination or the imposition of new clean up requirements could require the Company to incur additional costs which could be significant. Controls over disclosures and financial reporting In accordance with National Instrument 52-109, the CEO and the CFO of the Company are responsible for designing, maintaining, and evaluating the effectiveness of disclosure controls and procedures. The CEO and the CFO are also responsible for the effective design of internal controls over financial reporting to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with IFRS. A system of controls is subject to certain inherent limitations and is partially based on the possibility or probability of future events. Accordingly, a system of internal controls can provide only reasonable, and not absolute, assurance of reaching the desired objectives. Control of the company Velan Holding Co. Ltd. (the “Controlling Shareholder”) owns 15,566,567 Multiple Voting Shares representing, in the aggregate, approximately 92.5% of the voting interests in the Company. Voting control enables the Controlling Shareholder to determine all matters requiring shareholder approval. The Controlling Shareholder has advised the Company that the disposition of the shares requires the consent of certain Velan family members and controlled entities. The Controlling Shareholder effectively has sufficient voting power to prevent a change in control of the Company. The sale of a significant number of Subordinate Voting Shares by the Controlling Shareholder pursuant to the exercise of the conversion right attached to the Multiple Voting Shares may impact upon the market price and liquidity thereof. Income and other tax risks The Company operates in a number of different tax jurisdictions and has a significant amount of cross-border purchase and sale transactions. The tax rules and regulations in various countries are becoming more complex. There is a risk that one or more tax authorities could disagree with the tax treatment adopted by the Company, resulting in defense costs and possible tax assessments. Compliance with international laws Due to the international nature of its operations, the Company is subject to differing systems of laws and regulations which are often complex and differ from one country to the next. Such laws and regulations include but are not limited to anti-bribery legislation, export and customs controls, foreign currency exchange controls, transfer pricing regulations and economic sanctions imposed by governmental authorities. Failure to comply with such laws could negatively impact earnings and may result in criminal, civil and administrative legal sanctions. The Company has implemented policies and procedures to effect compliance with these laws by its employees and representatives. Special purpose entities and non-controlling interest The Company’s operations in China, Taiwan and Italy, and certain of its operations in France and Korea are undertaken with partners that are classified as special purpose entities or non-controlling interest. The success of these operations depends on the satisfactory performance of such partners in their obligations. The failure of such partners to perform their obligations could impose additional financial and performance obligations on the Company that could negatively impact its earnings and financial condition. Business acquisitions The success of a business acquisition depends in part upon the integration of the acquired business through such tasks as the realization of synergies, elimination of cost duplication, information systems integration, and establishment of controls and procedures. The inability to adequately integrate an acquired business in a timely manner might result in lost business opportunities, higher than expected integration costs and departures of key personnel, all of which could have a negative impact on earnings. 28 Management’s discussion and analysis RECONCILIATIONS AND NON-IFRS MEASURES In this MD&A, the Company presented measures of performance or financial condition which are not defined under IFRS (“non- IFRS measures”) and are therefore unlikely to be comparable to similar measures presented by other companies. These measures are used by management in assessing the operating results and financial condition of the Company and are reconciled with the performance measures defined under IFRS. Reconciliations of these amounts can be found below. Net cash (millions) Cash and cash equivalents Short-term investments Bank indebtedness Short-term bank loans Current portion of long-term bank borrowings Fiscal year ended Fiscal year ended Feb. 28, 2013 Feb. 29, 2012 77.2 0.4 65.4 5.0 (48.6) (32.4) (2.3) (6.9) (0.9) (1.7) 19.8 35.4 Adjusted net operating results (millions) Net income (loss) attributable to Subordinate Voting Shares and Multiple Voting Shares Adjustments for: ABV net loss Goodwill impairment loss Purchase price accounting and interest accretion adjustments Fair value adjustment for ABV proceeds payable Currency impact Fiscal year ended Fiscal year ended Feb. 28, 2013 Feb. 29, 2012 Quarter ended Feb. 28, 2013 Quarter ended Feb. 29, 2012 6.2 7.9 (3.6) 5.9 1.2 11.7 1.6 (2.4) 0.9 4.9 - 2.9 (2.2) (1.0) - 11.7 - (2.2) 0.4 - - - (2.2) (1.2) Adjusted net operating results 19.2 12.5 6.3 2.5 For the calculation of the adjusted net operating results for the quarter, the net loss of ABV, as well as the purchase price accounting and interest accretion adjustments were not included as adjustments because both comparable periods included such items for the entire applicable period. The Company included these adjustments in the calculation of adjusted net operating results for the full fiscal year since the acquisition of ABV occurred part way through the 2012 fiscal year. As such, both periods would not be comparable since fiscal year 2012 includes 10 months of activity for ABV while fiscal year 2013 includes 12 months of activity. 29 Velan Inc. Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 30 May 28, 2013 Independent Auditor’s Report To the Shareholders of Velan Inc. We have audited the accompanying consolidated financial statements of Velan Inc. and its subsidiaries, which comprise the consolidated statements of financial position as at February 28, 2013 and February 29, 2012 and the consolidated statements of income, consolidated statements of comprehensive income (loss), consolidated statements of changes in equity and consolidated statements of cash flows for the years then ended, and the related notes, which comprise a summary of significant accounting policies and other explanatory information. Management’s responsibility for the consolidated financial statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. PricewaterhouseCoopers LLP/s.r.l./s.e.n.c.r.l. 1250 René-Lévesque Boulevard West, Suite 2800, Montréal, Quebec, Canada H3B 2G4 T: +1 514 205 5000, F: +1 514 876 1502 “PwC” refers to PricewaterhouseCoopers LLP, an Ontario limited liability partnership. 31 We believe that the audit evidence we have obtained in our audits is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Velan Inc. and its subsidiaries as at February 28, 2013 and February 29, 2012 and their financial performance and their cash flows for the years then ended in accordance with International Financial Reporting Standards. 1 CPA auditor, CA, public accountancy permit No. A119714 32 Velan Inc. Consolidated Statements of Financial Position (in thousands of U.S. dollars) Assets Current assets Cash and cash equivalents Short-term investments Accounts receivable Income taxes recoverable Inventories (note 6) Deposits and prepaid expenses Derivative assets Non-current assets Property, plant and equipment (notes 7 and 12) Intangible assets and goodwill (note 8) Deferred income taxes (note 21) Other assets Total assets Liabilities Current liabilities Bank indebtedness (note 10) Short-term bank loans Accounts payable and accrued liabilities (note 9) Income tax payable Dividend payable Customer deposits Provisions (note 11) Accrual for performance guarantees Derivative liabilities Current portion of long-term debt (note 12) Current portion of other liabilities (note 4) Non-current liabilities Long-term debt (note 12) Deferred income taxes (note 21) Other liabilities (note 4) Total liabilities Equity Equity attributable to Subordinate and Multiple Voting shareholders Share capital (note 13) Contributed surplus Retained earnings Accumulated other comprehensive loss Non-controlling interest Total equity Total liabilities and equity Commitments and contingencies (note 23) The accompanying notes are an integral part of these consolidated financial statements. Approved by the Board of Directors As at February 28, 2013 $ As at February 29, 2012 $ 77,172 398 134,374 7,672 246,983 6,048 340 472,987 90,630 43,194 11,226 1,737 146,787 619,774 48,580 2,284 78,431 2,831 1,701 76,682 6,345 28,525 1,380 10,463 1,951 259,173 16,387 8,035 8,006 32,428 65,414 4,954 111,856 9,682 258,684 6,209 1,737 458,536 72,961 58,845 10,152 1,476 143,434 601,970 32,438 858 82,088 2,484 1,791 86,544 5,149 21,679 534 1,696 5,753 241,014 7,891 8,270 9,218 25,379 291,601 266,393 76,314 1,746 250,129 (8,676) 319,513 78,764 1,871 250,951 (4,217) 327,369 8,660 8,208 328,173 619,774 335,577 601,970 ________________________________ A. K. Velan, Director ________________________________ T.C. Velan, Director 33 Velan Inc. Consolidated Statements of Income For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding per share amounts) Sales (notes 14 and 25) Cost of sales (notes 6, 14, 15 and 20) Gross profit Administration costs (notes 16 and 20) Goodwill impairment loss (notes 5 and 8) Other income (note 4) Operating profit Finance income (note 18) Finance costs (note 18) Finance costs – net Income before income taxes Income taxes (note 21) Net income for the year Net income attributable to: Subordinate Voting Shares and Multiple Voting Shares Non-controlling interest Earnings per share (note 22) Basic Diluted 2013 $ 2012 $ 500,574 437,135 386,675 349,873 113,899 87,262 90,985 11,700 (3,364) 14,578 631 3,191 83,620 - (3,806) 7,448 318 1,669 (2,560) (1,351) 12,018 5,284 6,734 6,169 565 6,734 0.28 0.28 6,097 348 5,749 7,892 (2,143) 5,749 0.36 0.36 Dividends declared per Subordinate and Multiple Voting Share 0.32 (CA$0.32) 0.32 (CA$0.32) The accompanying notes are an integral part of these consolidated financial statements. 34 Velan Inc. Consolidated Statements of Comprehensive Income (Loss) For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars) Comprehensive income (loss) Net income for the year Other comprehensive loss Foreign currency translation adjustment on foreign operations whose functional currency is other than the U.S. dollar Comprehensive income (loss) Comprehensive income (loss) attributable to: Subordinate Voting Shares and Multiple Voting Shares Non-controlling interest The accompanying notes are an integral part of these consolidated financial statements. 2013 $ 2012 $ 6,734 5,749 (4,531) (7,461) 2,203 (1,712) 1,710 493 2,203 1,400 (3,112) (1,712) 35 Velan Inc. Consolidated Statements of Changes in Equity For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars) Equity attributable to Subordinate and Multiple Voting shareholders Accumulated other comprehensive income (loss) Contributed surplus Retained earnings Total Share capital Non-controlling interest Total equity Balance - March 1, 2011 79,271 1,898 2,275 250,254 333,698 4,025 337,723 Net income (loss) for the year Other comprehensive loss - - - - - (6,492) 7,892 - 7,892 (6,492) (2,143) (969) 5,749 (7,461) 79,271 1,898 (4,217) 258,146 335,098 913 336,011 Effect of share-based compensation (note 13 (d)) Dividends Multiple Voting Shares Subordinate Voting Shares Non-controlling interest Share repurchase (note 13 (c)) Non-controlling interest arising on acquisition - - - - (507) - 71 - - - (98) - - - - - - - - 71 - (5,022) (2,173) - - - (5,022) (2,173) - (605) - - - (948) - 8,243 71 (5,022) (2,173) (948) (605) 8,243 Balance - February 29, 2012 78,764 1,871 (4,217) 250,951 327,369 8,208 335,577 Balance - March 1, 2012 78,764 1,871 (4,217) 250,951 327,369 8,208 335,577 Net income for the year Other comprehensive loss - - - - - (4,459) 6,169 - 6,169 (4,459) 565 (72) 6,734 (4,531) 78,764 1,871 (8,676) 257,120 329,079 8,701 337,780 Effect of share-based compensation (note 13 (d)) Dividends Multiple Voting Shares Subordinate Voting Shares Non-controlling interest Share repurchase (note 13 (c)) - - - - (2,450) 58 - - - (183) - - - - - - (4,988) (2,003) - - 58 (4,988) (2,003) - (2,633) - - - (41) - 58 (4,988) (2,003) (41) (2,633) Balance - February 28, 2013 76,314 1,746 (8,676) 250,129 319,513 8,660 328,173 The accompanying notes are an integral part of these consolidated financial statements. 36 Velan Inc. Cononsolidated Statements of Cash Flows For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars) Cash flows from Operating activities Net income for the year Adjustments to reconcile net income to cash provided by operating activities (note 28) Changes in non-cash working capital items (note 29) Cash provide d (use d) by ope rating activitie s Investing activities Short-term investments Additions to property, plant and equipment Additions to intangible assets Proceeds on disposal of property, plant and equipment, and intangible assets Net change in other assets Business acquisition – net of cash acquired (note 4) Cash provide d (use d) by inve sting activitie s Financing activities Dividends paid to Subordinate and Multiple Voting shareholders Dividends paid to non-controlling interest Repurchase of shares (note 13(c)) Payment of proceeds payable (note 4) Short-term bank loans Increase in long-term debt Repayment of long-term debt Cash provide d (use d) by financing activitie s Effect of exchange rate differences on cash Net change in cash during the year Net cash – Beginning of the year Net cash – End of the year Net cash is composed of: Cash and cash equivalents Bank indebtedness S upplementary information Interest received (paid) Income taxes reimbursed (paid) The accompanying notes are an integral part of these consolidated financial statements. 37 2013 $ 2012 $ 6,734 23,389 (15,711) 14,412 4,556 (28,452) (684) 905 (270) - (23,945) (7,081) (41) (2,633) (3,465) 1,426 21,057 (4,478) 4,785 5,749 10,376 (28,893) (12,768) (4,867) (12,710) (1,840) 100 (87) (37,281) (56,685) (7,234) (948) (605) - (4,831) 5,221 (3,002) (11,399) 364 (534) (4,384) 32,976 (81,386) 114,362 28,592 32,976 77,172 (48,580) 28,592 65,414 (32,438) 32,976 (1,895) (2,042) (555) (6,742) Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 1 General information and basis of preparation These consolidated financial statements represent the consolidation of the accounts of Velan Inc. (the “Company”) and the entities over which it has control, its subsidiary companies and special-purpose entities (“SPEs”). The Company is an international manufacturer of industrial valves. The Company is a public company listed on the Toronto Stock Exchange under the symbol “VLN”. It was incorporated under the name Velan Engineering Ltd. on December 12, 1952 and continued under the Canada Business Corporations Act on February 11, 1977. It changed its name to Velan Inc. on February 20, 1981. Velan Inc. maintains its registered head office at 7007 Côte de Liesse, Montréal, Quebec, Canada, H4T 1G2. The Company’s ultimate parent company is Velan Holdings Co. Ltd. The Company’s consolidated financial statements have been prepared in accordance with International Financial Reporting Standards (“IFRS”) as issued by the International Accounting Standards Board (“IASB”). These consolidated financial statements were approved by the Company’s Board of Directors on May 28, 2013. 2 Summary of significant accounting policies Functional and presentation currency Functional currency is defined as the currency of the primary economic environment in which an entity operates. Indicators for determining an entity’s functional currency are broken down into primary and secondary indicators. Primary indicators include: • • • the currency of sales and cash inflows; the currency of the country having primary influence over sales prices; and the currency of expenses and cash outflows. Primary indicators receive more weight than secondary indicators. If a functional currency can be determined based on the primary indicators, the secondary indicators are not considered. The functional and presentation currency of the Company is the U.S. dollar. 38 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Consolidation These financial statements represent the consolidation of the accounts of the Company and the entities over which it has control, its subsidiary companies and SPEs. Control exists when the Company has the power to govern the financial and operating policies of an entity in a manner generally associated with a shareholding of more than one half of the voting rights. Potential voting rights currently exercisable or convertible are considered when assessing control over an entity. Subsidiary companies and SPEs are fully consolidated from the date control has been transferred to the Company and deconsolidated from the date control ceases. The Company’s principal operating subsidiaries and SPEs are: • Velan Valve Corp. • Velan Ltd. • Juwon Special Steel Co. Ltd. • Velan Valvulas Industrias, Lda. • Velan Valves Limited • Velan S.A.S. • Segault S.A.S. • Velan GmbH • Velan ABV S.p.A. • Velan Valvac Manufacturing Co. Ltd. • Velan Valve (Suzhou) Co. Ltd. All subsidiary companies and SPEs prepare their financial statements at the same reporting date as the Company except for Velan Valvac Manufacturing Co. Ltd., which has a December 31 fiscal year-end. Consolidated earnings include the Company’s share of the results of its operations to that date. Intercompany transactions, balances and unrealized gains or losses on transactions between companies are eliminated. Foreign currency transactions and balances The Company and its subsidiary companies and SPEs translate foreign currency transactions and balances into their functional currency. Foreign currency is defined as any currency that is different from an individual entity’s functional currency. Monetary assets and liabilities in foreign currencies are translated at year-end exchange rates. Non-monetary assets are translated at rates prevailing at the transaction dates. Revenue and expenses in foreign currencies are translated at weekly rates throughout the year. Gains and losses arising on translation are included in the consolidated statement of income for the year. Translation of accounts of foreign subsidiary companies and SPEs The financial statements of the Company’s foreign subsidiary companies and SPEs whose functional currency is not the U.S. dollar are translated into U.S. dollars for reporting purposes. All assets and liabilities are translated at year-end rates, and revenue and expenses at the average rate for the period. Resulting gains and losses are included in other comprehensive income (loss) for the period. 39 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Financial instruments A financial instrument is any contract that gives rise to a financial asset of one entity and a financial liability or equity instrument of another entity. The Company’s financial assets comprise mainly cash and cash equivalents, short-term investments, accounts receivable and derivative assets. The Company’s financial liabilities comprise mainly bank indebtedness, short-term bank loans, accounts payable and accrued liabilities, customer deposits, dividend payable, accrual for performance guarantees, long-term debt and derivative liabilities. The Company recognizes a financial instrument on its consolidated statement of financial position when the Company becomes party to the contractual provisions of the financial instrument or non-financial derivative contract (see Embedded derivatives). Financial assets are derecognized when the rights to receive cash flows from the assets have expired or been transferred and the Company has transferred substantially all risks and rewards of ownership. All financial instruments are initially recognized at fair value and are classified into one of these five categories: held for trading, available-for-sale assets, held-to-maturity investments, loans and receivables and other financial liabilities. The classification depends on the purpose for which the financial instruments were acquired and their characteristics. Except in very limited circumstances, the classification is not changed subsequent to initial recognition. Held for trading Financial instruments classified as held for trading are carried at fair value at each statement of financial position date with the changes in fair value recorded in the consolidated statement of income in the period in which these changes arise. The Company has classified its derivative financial instruments as held for trading. Loans and receivables, held-to-maturity investments and other financial liabilities Financial instruments classified as loans and receivables, held-to-maturity investments and other financial liabilities are carried at amortized cost using the effective interest rate method. The interest income or expense is included in the consolidated statement of income over the expected life of the instrument. Cash and cash equivalents, short-term investments and accounts receivable are classified as loans and receivables. Bank indebtedness, short-term bank loans, accounts payable and accrued liabilities, customer deposits, dividend payable, accrual for performance guarantees and long-term debt, including interest payable, are classified as other financial liabilities, all of which are measured at amortized cost. Embedded derivatives Derivatives may be embedded in other financial instruments (the “host instrument”). Embedded derivatives are treated as separate derivatives if their economic characteristics and risks are not closely related to those of the host instrument, the terms of the embedded derivative are the same as those of a stand-alone derivative, and the combined contract is not held for trading or designated at fair value through profit or loss. These embedded derivatives are classified as held for trading. 40 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) The Company and its subsidiary companies and SPEs enter into certain contracts for the purchase and sale of non-financial items that are denominated in currencies other than their respective functional currencies. In cases where the foreign exchange component is not leveraged and does not contain an option feature, the contract is denominated in the functional currency of the counterparty or the non-financial item is routinely denominated in the currency of the contract or the currency of the contract is commonly used in the economic environment in which the transaction takes place, the embedded derivative is considered to be closely related and is not accounted for separately. The fair value of the embedded derivatives related to sales contracts is recorded in sales; purchase contracts are recorded in cost of sales. On the consolidated statement of financial position, gains are recorded as derivative assets and losses are recorded as derivative liabilities. Transaction costs are expensed when incurred. Fair value Estimated fair values for financial instruments are designed to approximate amounts at which the instruments could be exchanged in a current arm’s-length transaction between knowledgeable willing parties. The fair value of derivative instruments is determined using valuation techniques. The Company has evaluated the fair values of its financial instruments based on the current interest rate environment, related market values and current pricing of financial instruments with comparable terms. Revenue recognition Revenue comprises the fair value of the consideration received or receivable for the sale of goods and services in the ordinary course of the Company’s activities. Revenue is shown net of sales and value-added taxes, returns, rebates and discounts. Revenue is recognized when the amount of revenue and associated costs can be reliably measured, it is probable that future economic benefits will flow to the Company and when specific criteria have been met for each of the Company’s activities as described below. Sales of goods Sales of goods are recognized when the Company has delivered products to the customer and there is no unfulfilled obligation that could affect the customer’s acceptance of the products. Delivery of the products does not occur until the products have been shipped to a specified location in accordance with the agreed-upon shipping terms, the risk of obsolescence and loss have been transferred to the customer, and either the customer has accepted the products in accordance with the sales contract, the acceptance provisions have lapsed, or the Company has objective evidence that all criteria for acceptance have been satisfied. Customers have a right to return faulty products, and some products are sold with volume discounts. Sales are recorded based on the price specified in the sales contract, net of the estimated volume discounts and returns at the time of sale. Accumulated experience is used to estimate and provide for the discounts and returns. The volume discounts are assessed based on anticipated annual purchases. 41 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Sales of services Sales of services are recognized when the Company renders services. Interest income Interest income is recognized using the effective interest rate method. Cash and cash equivalents Cash and cash equivalents include cash on hand, cash in banks, other short-term highly liquid investments with original maturities of three months or less, and bank indebtedness. Bank indebtedness is shown in current liabilities on the consolidated statement of financial position. Interest is earned on cash and cash equivalents at rates ranging from 0% to 3.5%. Interest is paid on bank indebtedness at rates ranging from 0.4% to 5.0%. Short-term investments Short-term investments include all highly liquid investments with original maturities greater than three months but less than one year. Interest is earned on short-term investments at rates ranging from 2.0% to 8.0%. Inventories Inventories are valued at the lower of cost and net realizable value. Net realizable value is the estimated selling price in the ordinary course of business, less applicable variable selling expenses. Cost of inventories is determined as follows: a) raw materials principally using the weighted average method except for items that are not ordinarily interchangeable, in which case specific identification of their individual costs is used; and b) work in process, finished parts and finished goods using the raw material cost described in (a) plus applicable direct labour and manufacturing overhead. The value of obsolete or unmarketable inventory is based on the Company’s assessment of market conditions for its products determined by historical usage, estimated future demand and, in some cases, the specific risk of loss on specifically identified inventory. The writedown may be reversed if the circumstances which caused it no longer exist. 42 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Property, plant and equipment Property, plant and equipment are valued at acquisition or manufacturing costs less any related government assistance, accumulated depreciation and any accumulated impairment losses. Acquisition costs include any expenditure that is directly related to the acquisition of the item. Manufacturing costs include direct material and labour costs plus applicable manufacturing overheads. Borrowing costs directly attributable to the acquisition, construction or production of assets that necessarily take a substantial period of time to be ready for their intended use are added to the cost of those assets, until such time as those assets are ready for their intended use. Subsequent costs are included in the asset’s carrying amount or recognized as a separate asset, as appropriate, only when it is probable that future economic benefits associated with the item will flow to the Company and the cost of the item can be reliably measured. The carrying amount of the replaced part is derecognized. All other repairs and maintenance are charged to the consolidated statement of income during the period in which they are incurred. Depreciation of assets commences when the assets are ready for their intended use. The assets’ residual values and useful lives are reviewed, and adjusted if appropriate, at the end of each reporting period. Changes in expected useful life or the expected pattern of consumption of future economic benefits embodied in the asset are accounted for by changing the depreciation period or method, as appropriate, and treated on a prospective basis as a change in estimate. Land is not depreciated. Depreciation on the other property, plant and equipment is determined principally using the following methods and annual rates or terms: Buildings Machinery and equipment and furniture and fixtures Data processing equipment Rolling stock Leasehold improvements Goodwill Method Declining balance Declining balance Straight-line Declining balance Straight-line Rate/Term 4% to 5% 10% to 31% 3 years 30% Over lease terms Goodwill represents the excess of the purchase price over the fair value of the Company’s share of the net identifiable assets of the acquired subsidiary at the date of acquisition. Goodwill is carried at cost less accumulated impairment losses. Intangible assets Purchased intangible assets relate primarily to production and technology rights and computer software. Internally generated intangible assets relate to development costs. Research and development costs are expensed as incurred unless the development costs meet the criteria for deferral. As at February 28, 2013 and February 29, 2012, the Company had not capitalized any development costs. 43 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Amortization expense is recognized in the consolidated statement of income in the expense category consistent with the function of the intangible asset. The assets’ useful lives are reviewed, and adjusted if appropriate, at the end of each reporting period. Changes in expected useful life or the expected pattern of consumption of future economic benefits embodied in the asset are accounted for by changing the amortization period or method, as appropriate, and treated on a prospective basis as a change in estimate. Amortization is determined principally using the following methods and terms: Patents, products and designs Customer lists Non-compete agreements Purchased backlog Computer software Government assistance Method Straight-line Straight-line Straight-line Straight-line Straight-line Term 15 years 10 years 5 years 1 to 2 years 1 to 3 years The Company receives assistance in the form of investment tax credits (“ITCs”). ITCs are accounted for using the cost reduction method. Under this method, assistance relating to eligible expenditures is deducted from the cost of the related assets or related expenses in the period in which the expenditures are incurred, provided there is reasonable assurance of realization. Asset impairment Assets that have an indefinite life (e.g. goodwill) are not subject to amortization and are tested annually for impairment, or more frequently if events or circumstances indicate there may be impairment. All other non-current and non-financial assets must be reviewed at the end of each reporting period in order to determine whether there is an indication of possible impairment. For the purposes of impairment testing, assets are grouped at the lowest levels for which there are separately identifiable cash flows. A cash-generating unit (“CGU”) is the smallest group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. If an indication of impairment exists, the recoverable amount of the CGU is estimated in order to determine the extent of the impairment loss, if any. An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its recoverable amount. If the recoverable amount of the CGU is less than the carrying amount, the impairment loss is allocated first to reduce the carrying amount of any goodwill allocated to the CGU and then to the other assets of the CGU on a pro rata basis of the carrying amount of each asset in the CGU. The recoverable amount is the greater of an asset’s fair value less costs to sell and its value in use. In assessing value in use, the estimated future cash flows are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. Goodwill is allocated to CGUs for the purpose of impairment testing based on the level at which it is monitored by management. The allocation is made to those CGUs that are expected to benefit from the business combination in which the goodwill arose. Non-current and non-financial assets, other than goodwill, that have previously suffered an impairment loss are reviewed for possible reversal of the impairment at each reporting date. 44 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Income taxes The provision for income taxes for the year comprises current and deferred taxes. Tax is recognized in the consolidated statement of income, except to the extent that it relates to items recognized in other comprehensive income or directly in equity, in which case the tax is recognized in other comprehensive income or equity, respectively. Current income tax The current income tax charge is calculated on the basis of the tax laws enacted or substantively enacted at the statement of financial position date in the countries where the Company generates taxable income. When an asset is transferred between entities within the consolidated group, the difference between the tax rates of the two entities is recognized as a tax expense in the period in which the transfer occurs. Current tax payable is recognized for any taxes payable in the current period. Current tax liabilities are recognized for current tax to the extent that it remains unpaid for current and prior periods. Management periodically evaluates positions taken in tax returns with respect to situations in which applicable tax regulation is subject to interpretation and establishes provisions where appropriate. Uncertain income tax provisions are recorded when probable and are recorded at the Company’s best estimate of the amount. Deferred income tax Deferred income tax is recognized using the liability method on temporary differences arising between the tax bases of assets and liabilities and their carrying amount in the consolidated financial statements. However, the deferred income tax is not accounted for if it arises from initial recognition of an asset or liability in a transaction other than a business combination that at the time of the transaction affects neither accounting nor taxable profit or loss. Deferred income tax is determined using tax rates and laws that have been enacted or substantively enacted by the statement of financial position date and are expected to apply when the related deferred income tax asset is realized or the deferred income tax liability is settled. Deferred income tax assets are recognized only to the extent that it is probable that future taxable profit will be available against which the temporary differences can be used. Deferred income tax assets are reviewed at each statement of financial position date and amended to the extent that it is no longer probable that the related tax benefit will be realized. Deferred income tax is provided on temporary differences arising on investments in subsidiary companies and SPEs, except where the timing of the reversal of the temporary difference is controlled by the Company and it is probable that the temporary difference will not reverse in the foreseeable future. 45 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Current income tax assets and liabilities are offset when the Company has a legally enforceable right to offset the recognized amounts and intends either to settle on a net basis or to realize the asset and settle the liability simultaneously. Normally, the Company would only have a legally enforceable right to set off a current tax asset against a current tax liability when they relate to income taxes levied by the same taxation authority and the taxation authority permits the Company to make or receive a single net payment. Deferred income tax assets and liabilities are offset when the Company has a legally enforceable right to set off current income tax assets against current income tax liabilities and deferred tax assets and liabilities related to income taxes levied by the same taxation authority on either: (1) the same taxable entity; or (2) different taxable entities which intend either to settle current tax liabilities and assets on a net basis, or to realize assets and settle the liabilities simultaneously, in each future period in which significant amounts of deferred tax liabilities or assets are expected to be settled or recovered. Provisions Provisions are recognized when the Company has a present legal or constructive obligation as a result of a past event, it is probable that an outflow of resources will be required to settle the obligation, and the amount has been reliably estimated. Provisions are not recognized for costs that need to be incurred to operate in the future or expected future operating losses. Provisions are measured at the present value of the expenditures required to settle the obligation using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the obligation. Leases Leases are classified as either finance or operating leases. Leases that transfer substantially all of the risks and rewards of ownership of the asset to the Company are accounted for as finance leases. Finance leases are capitalized at the commencement of the lease at the lower of the fair value of the leased asset and the present value of the minimum lease payments. Assets acquired under a finance lease are depreciated over the shorter of the period of expected use on the same basis as other similar assets and the lease term. Leases in which a significant portion of the risks and rewards of ownership are retained by the lessor are classified as operating leases. Rental payments under operating leases are expensed in the consolidated statement of income on a straight-line basis over the term of the lease. 46 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Share-based compensation plans Grants under the Company’s share-based compensation plans are accounted for in accordance with the fair value based method of accounting. The Company operates a share-based compensation plan under which it receives services from employees as consideration for share options. The fair value of the employee services received in exchange for the grant of the options is amortized over the vesting period as compensation expense, with a corresponding increase to contributed surplus. The total amount to be expensed is determined by multiplying the number of options expected to vest with the fair value of one option as of the grant date as determined by the Black-Scholes option pricing model. Remaining an employee of the Company for a specified period of time is the only condition for vesting. Vesting typically occurs one-third per year over three years from the grant date. This non-market performance condition is factored into the estimate of the number of options expected to vest. If it becomes obvious that the number of options expected to vest differs from that originally expected, the expense is adjusted accordingly. When options are exercised, the Company issues new shares. The proceeds received, together with the amount recorded in contributed surplus, net of any directly attributable transaction costs, are recorded in share capital. Critical accounting estimates and judgments The Company’s significant accounting policies as described above are essential to understanding the Company’s results of operations, financial positions and cash flows. Certain of these accounting policies require critical accounting estimates that involve complex and subjective judgments and the use of assumptions, some of which may be for matters that are inherently uncertain and susceptible to change. The assumptions and estimates used are based on parameters which are derived from the knowledge at the time of preparing the financial statements and believed to be reasonable under the circumstances. In particular, the circumstances prevailing at this time and assumptions as to the expected future development of the global and industry-specific environment were used to estimate the Company’s future business performance. Where these conditions develop differently than assumed and beyond the control of the Company, the actual results may differ from those anticipated. These estimates and underlying assumptions are reviewed on an ongoing basis. Revisions to accounting estimates are recognized in the period in which the estimate is changed. There were no significant changes made to critical accounting estimates during the past two fiscal years. The estimates and assumptions that have a significant risk of causing a material adjustment to the carrying amounts of assets and liabilities within the next fiscal year are addressed below. Accounts receivable The Company must report its accounts receivable at their net realizable value. This involves management judgment and requires the Company to perform continuous evaluations of their collectability and to record an allowance for doubtful accounts when required. In performing its evaluation, the Company analyzes the ageing of accounts receivable, concentration of receivables by customer, customer creditworthiness and current economic trends. Any change in the assumptions used could impact the carrying value of the accounts receivable on the consolidated statement of financial position with a corresponding impact made to administration costs on the consolidated statement of income. 47 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Inventory Inventories must be valued at the lower of cost and net realizable value. A writedown of inventory will occur when its estimated market value less applicable variable selling expenses is below its carrying amount. This involves significant management judgment and is based on the Company’s assessment of market conditions for its products determined by historical usage, estimated future demand and, in some cases, the specific risk of loss on specifically identified inventory. Any change in the assumptions used in assessing this valuation or selling costs could impact the carrying amount of the inventory on the consolidated statement of financial position with a corresponding impact made to cost of sales on the consolidated statement of income. Provisions Provisions must be established for possible product warranty expenses. The Company estimates its warranty exposure by taking into account past experience as well as any known technical problems and estimates of costs to resolve these issues. The Company estimates its exposure under these obligations based on an analysis of all identified or expected claims. Any change in the assumptions used could impact the value of the provision on the consolidated statement of financial position with a corresponding impact made to cost of sales on the consolidated statement of income. Asset impairment test Assets that have an indefinite life, such as goodwill, are tested annually by the Company for impairment, or more frequently if events or circumstances indicate there may be impairment. All other assets must be reviewed by the Company at the end of each reporting period in order to determine whether there is an indication of possible impairment. For the purposes of impairment testing, assets are grouped at the lowest levels for which there are separately identifiable cash flows. A cash-generating unit (“CGU”) is the smallest group of assets that generates cash inflows that are largely independent of the cash inflows from other assets or groups of assets. If an indication of impairment exists, the Company estimates the recoverable amount of the CGU in order to determine the extent of the impairment loss, if any. An impairment loss is recognized for the amount by which the asset’s carrying amount exceeds its recoverable amount. The recoverable amount is the greater of an asset’s fair value less costs to sell and its value in use. In assessing value in use, the Company estimates future cash flows which are discounted to their present value using a pre-tax discount rate that reflects current market assessments of the time value of money and the risks specific to the asset. Any change in the assumptions used could impact the carrying amount first of any goodwill allocated to the CGU and then to the other assets of the CGU on a pro rata basis of the carrying amount of each asset in the CGU on the consolidated statement of financial position with a corresponding impact made to the consolidated statement of income. Income taxes The Company must estimate its income taxes in each jurisdiction in which it operates. This involves assessing the probability of using net operating losses against future taxable income as well as evaluating positions taken in tax returns with respect to situations in which applicable tax regulation is subject to interpretation. In the event these assessments are changed, there would be an adjustment to income tax expense with a corresponding adjustment to income tax balances on the consolidated statement of financial position. 48 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 3 Accounting standards and amendments issued but not yet adopted Unless otherwise noted, the following revised standards and amendments are effective for annual periods beginning on or after January 1, 2013, with earlier application permitted. Based on a preliminary assessment, the Company does not expect any significant impact on the consolidated financial statements upon adoption of these standards and amendments. The Company has also determined that it will not early adopt these standards and amendments. (i) IFRS 9, Financial Instruments, was issued in November 2009 and addresses classification and measurement of financial assets. It replaces the multiple category and measurement models in IAS 39, Financial Instruments: Recognition and Measurement, for debt instruments with a new mixed measurement model having only two categories: amortized cost and fair value through profit or loss. IFRS 9 also replaces the models for measuring equity instruments. Such instruments are either recognized at fair value through profit or loss or at fair value through other comprehensive income. Where equity instruments are measured at fair value through other comprehensive income, dividends are recognized in profit or loss to the extent that they do not clearly represent a return of investment; however, other gains and losses (including impairments) associated with such instruments remain in accumulated comprehensive income indefinitely. Requirements for financial liabilities were added to IFRS 9 in October 2010 and they largely carried forward existing requirements in IAS 39, except that fair value changes due to credit risk for liabilities designated at fair value through profit or loss are generally recorded in other comprehensive income. The above revisions are effective for annual periods beginning on or after January 1, 2015, with earlier application permitted. (ii) (iii) IFRS 10, Consolidated Financial Statements, requires an entity to consolidate an investee when it has power over the investee, is exposed or has rights to variable returns from its involvement with the investee and has the ability to affect those returns through its power over the investee. Under existing IFRS, consolidation is required when an entity has the power to govern the financial and operating policies of an entity so as to obtain benefits from its activities. IFRS 10 replaces SIC–12, Consolidation—Special Purpose Entities and parts of IAS 27, Consolidated and Separate Financial Statements. IFRS 11, Joint Arrangements, requires a venturer to classify its interest in a joint arrangement as a joint venture or joint operation. Joint ventures will be accounted for using the equity method of accounting whereas for a joint operation the venturer will recognize its share of the assets, liabilities, revenue and expenses of the joint operation. Under existing IFRS, entities have the choice to proportionately consolidate or equity account for interests in joint ventures. IFRS 11 supersedes IAS 31, Interests in Joint Ventures, and SIC–13, Jointly Controlled Entities—Non-monetary Contributions by Venturers. (iv) IFRS 12, Disclosure of Interests in Other Entities, establishes disclosure requirements for interests in other entities, such as subsidiaries, joint arrangements, associates, and unconsolidated structured entities. The standard carries forward existing disclosures and also introduces significant additional disclosure that address the nature of, and risks associated with, an entity’s interests in other entities. 49 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) (v) IFRS 13, Fair Value Measurement, is a comprehensive standard for fair value measurement and disclosure for use across all IFRS standards. The new standard clarifies that fair value is the price that would be received to sell an asset, or paid to transfer a liability in an orderly transaction between market participants, at the measurement date. Under existing IFRS, guidance on measuring and disclosing fair value is dispersed among the specific standards requiring fair value measurements and does not always reflect a clear measurement basis or consistent disclosures. (vi) There have been amendments to existing standards, including IAS 27, Separate Financial Statements, and IAS 28, Investments in Associates and Joint Ventures. IAS 27 addresses accounting for subsidiaries, jointly controlled entities and associates in non-consolidated financial statements. IAS 28 has been amended to include joint ventures in its scope and to address the changes in IFRS 10 to 13. (vii) IAS 19, Employee Benefits, has been amended to make significant changes to the recognition and measurement of defined benefit pension expense and termination benefits and to enhance the disclosure of all employee benefits. The amended standard requires immediate recognition of actuarial gains and losses in other comprehensive income as they arise, without subsequent recycling to net income. Past service cost (which will now include curtailment gains and losses) will no longer be recognized over a service period but instead will be recognized immediately in the period of a plan amendment. Pension benefit cost will be split between (i) the cost of benefits accrued in the current period (service cost) and benefit changes (past- service cost, settlements and curtailments); and (ii) finance expense or income. The finance expense or income component will be calculated based on the net defined benefit asset or liability. A number of other amendments have been made to recognition, measurement and classification, including redefining short- term and other long-term benefits, guidance on the treatment taxes related to benefit plans, guidance on risk/cost-sharing features, and expanded disclosures. (viii) IAS 1, Presentation of Financial Statements, has been amended to require entities to separate items presented in other comprehensive income into two groups, based on whether or not items may be recycled in the future. Entities that choose to present other comprehensive income items before tax will be required to show the amount of tax related to the two groups separately. The amendment is effective for annual periods beginning on or after July 1, 2012 with earlier application permitted. 4 Business acquisition On April 29, 2011, the Company acquired a 70% voting interest in ABV Energy S.p.A., now Velan ABV S.p.A. (“ABV”), an Italian manufacturer of engineered valves, actuators and control systems supplied to energy markets. The former shareholders retained a 30% interest. ABV’s product line is entirely complementary to the Company’s valve range, allowing it to significantly broaden the scope of its offerings to energy markets. 50 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) ABV was acquired for a maximum consideration of $50,833 (€34,300). The Company, using its own cash resources, paid $38,384 (€25,900) on closing. Another $4,298 (€2,900) was required (“Holdback”) to be paid on July 29, 2012. The $8,151 (€5,500) balance was to be paid to the extent of $2,223 (€1,500) on July 29, 2012 in the event that ABV has satisfied certain non-financial criteria, and the remaining $5,928 (€4,000) was to be payable in two tranches based on ABV meeting certain earnings before interest, taxes, depreciation and amortization (“EBITDA”) targets for the period from May 1, 2011 through February 28, 2014. The future Holdback payment was discounted to its net present value using a discount rate of 2%. The future contingent payments were recorded at their fair value, which was determined by discounting the amounts to their net present value using a discount rate of 18%. The total transaction costs related to this acquisition amounted to $384, of which $231 was expensed in the fiscal year 2012 and $153 in fiscal year 2011. Purchase consideration Cash paid on closing Net present value of Holdback Net present value of contingent payment – non-financial criteria Net present value of contingent payment – financial criteria Total net present value of purchase consideration $ 38,384 4,191 1,807 3,772 48,154 In April 2012, the required disbursement date of the contingent payment to be paid in the event that ABV had satisfied certain non-financial criteria of $2,223 (€1,500) was extended to March 15, 2013. In addition, the requirement that ABV satisfy the non-financial criteria was removed. As a result of these changes, the Company recorded a fair value adjustment with respect to the applicable contingent payment of $196 to other income during the fiscal year ended February 28, 2013. On an annual basis at each statement of financial position date, the Company evaluates the likelihood that the financial and non-financial criteria related to the contingent payments would be satisfied, based on current projections prepared by local management which factor in the delays in the return to profitability of the operation after the acquisition. Based on these annual evaluations, the Company determined that it would be more likely than not that the financial criteria for the two tranches of the contingent payment based on ABV meeting certain EBITDA targets would not be satisfied. As a result, the Company recorded a fair value adjustment with respect to the applicable contingent payment of $2,248 (2012 – $2,230) to other income. The net present value of the Holdback and the fair value of the contingent payments have been recorded in other liabilities. A foreign exchange gain of $407 (2012 – $978) was recognized in other income on the outstanding Holdback and contingent payments. 51 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Acquisition date fair values: The acquisition date fair values assigned to assets acquired and liabilities assumed are set out as follows: Assets Cash and cash equivalents Accounts receivable (net of provision of $373) Inventories Deposits and prepaid expenses Property, plant and equipment Patents, products and designs Backlog Customer lists Non-compete agreement Computer software Total assets Liabilities Bank indebtedness Short-term bank loans Accounts payable and accrued liabilities Income tax payable Customer deposits Accrual for performance guarantees Current portion of long-term debt Other long-term liabilities Deferred income taxes Total liabilities Fair value of net assets Non-controlling interest (30% of net assets) Goodwill Total purchase consideration Cash and cash equivalents in subsidiary acquired Net present value of future payments Cash outflow on acquisition $ 1,103 8,995 15,598 463 5,379 14,820 2,371 8,003 889 51 57,672 3 4,866 11,934 535 2,150 321 2,505 9 7,871 30,194 27,478 (8,243) 28,919 48,154 1,103 9,770 37,281 The acquisition date fair value is completed, as of the date of issuance of these consolidated financial statements, following an in-depth review of ABV’s books and records and the receipt of certain final valuations. 52 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) The primary factor giving rise to the goodwill is the earnings capacity of ABV in excess of its net tangible and net intangible assets. Such excess being attributable to: economies of scale; - ABV’s assembled workforce; - - ABV’s established operation and capabilities in the industry; and - ABV’s geographical location. The amount assigned to goodwill is not deductible for tax purposes. Impact of the acquisition The following supplemental information represents the impact of ABV on certain results of operations for fiscal year 2012. Note that the sum of the last two columns corresponds to the full impact of ABV on the Company’s consolidated results for the fiscal year February 29, 2012: Purchase price adjustments included in consolidated results $ Contribution of ABV to the consolidated results $ Consolidated results $ Revenues Gross profit (loss) Net income (loss) for the period Net income (loss) attributable to Subordinate and Multiple Voting Shares Net income (loss) per Subordinate and Multiple Voting Share - Basic - Fully diluted 437,135 87,262 5,749 - (4,082) (2,917) 21,560 (4,116) (6,980) 7,892 (2,042) (4,886) 0.36 0.36 (0.09) (0.22) (0.09) (0.22) 53 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Pro forma disclosures The following pro forma supplemental information represents certain results of operations for fiscal year 2012 as if the acquisition of ABV had been completed as at March 1, 2011: As reported $ 437,135 87,262 5,749 7,892 Purchase price adjustments $ - (4,743) (3,394) (2,376) 0.36 0.36 (0.11) (0.11) Pro forma $ 443,682 87,779 4,452 6,984 0.31 0.31 Revenues Gross profit Net income for the period Net income attributable to Subordinate and Multiple Voting Shares Net income (loss) per Subordinate and Multiple Voting Share - Basic - Fully diluted 5 Impairment of goodwill In the context of its annual impairment testing at year-end, the Company completed its impairment analysis and assessed the recoverability of the assets allocated to its various CGUs. The Company calculated the recoverable amounts of its CGUs using valuation methods which were consistent with those used in prior years. As a result of the impairment analysis, the Company determined that the carrying amount of the goodwill associated with the CGU related to its subsidiary in Italy, ABV, exceeded its recoverable amount and, accordingly, the Company recorded a goodwill impairment loss of $11,700. The recoverable amount was determined based on the fair value less costs to sell approach using a discounted cash flow model. The significant key assumptions included forecasted cash flows based on updated financial plans prepared by management covering a five-year period taking into consideration the following assumptions and trends: - - - Expected EBITDA as a percentage of sales for the CGU of 7.3% in 2014, 11.8% in 2015, 14.4% in 2016, 16% in 2017 and 19% in 2018. Expected working capital cash absorption ratio for the CGU of 19% of annual incremental sales increases. Expected annual capital expenditure needs for the CGU of $500 in 2014, 2015 and 2016, and $1,000 thereafter. The discounted cash flow model was established using a discount rate of 18.5% and a terminal growth rate of 2%. 54 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) This impairment charge was the result of actual results of the CGU coming in below the expectations at the time of the acquisition. The reasons for these lower achieved results are due to a variety of factors, including a business process integration that proved to be more difficult than planned, as well as profitability issues related to the complexity of the manufactured products. In addition, the increasingly competitive landscape of the last two years, particularly amongst upstream oil and gas flow control manufacturers in Italy, negatively impacted margins. Management based its selection of assumptions upon its assessment of the ability of the restructured CGU to return to is pre-acquisition levels of growth and profitability, as well as its evaluation of the longer term potential of its key end-user markets, particularly upstream oil and gas flow control. The margin assumptions used are also generally comparable to those currently obtained in our other similar European project manufacturing operations. The following table provides a sensitivity analysis of the Company’s current year goodwill impairment loss assuming a one percentage point increase of the selected variables below. Note that this sensitivity analysis assumes that all other assumptions and trends remain constant for each independent variable. Increase in expected EBITDA as a percentage of sales Increase in discount rate Increase in terminal growth rate Increase (Decrease) in impairment loss $ (2,866) 2,722 (1,951) A one percentage point decrease of the selected variables below, assuming all other assumptions and trends remain constant for each independent variable, would have the following impact on the goodwill impairment loss: Increase (Decrease) in impairment loss $ 2,934 (3,132) 1,690 Decrease in expected EBITDA as a percentage of sales Decrease in discount rate Decrease in terminal growth rate 55 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 6 Inventories Raw materials Work in process and finished parts Finished goods As at February 28, 2013 $ As at February 29, 2012 $ 54,093 141,027 51,862 56,463 157,533 44,688 246,982 258,684 As a result of variations in the ageing of its inventories, the Company recognized an inventory provision for the year of $2,382 (2012 – $4,592), net of reversals of $5,963 (2012 – $6,483). The net book value of inventories pledged as security under the Company’s credit facilities amounted to $3,514 (2012 – $2,911). 56 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 7 Property, plant and equipment At February 28, 2011 Cost Accumulated depreciation Year ended February 29, 2012 At M arch 1, 2011 Additions Disposals Depreciation Business acquisitions Exchange differences At February 29, 2012 At February 29, 2012 Cost Accumulated depreciation Year ended February 28, 2013 At M arch 1, 2012 Additions Disposals Depreciation Internal transfers Exchange differences At February 28, 2013 At February 28, 2013 Cost Accumulated depreciation Land Buildings M achinery & equipment Furniture & fixtures Data processing equipment Rolling stock Leasehold improvements $ $ $ $ $ $ $ Total $ 10,245 42,767 108,653 - (18,827) (80,854) 10,245 23,940 27,799 5,151 (4,485) 666 3,348 (2,144) 1,204 1,800 (1,097) 703 194 (129) 65 172,158 (107,536) 64,622 10,245 1,547 - - 237 (549) 23,940 2,633 - (1,388) - (951) 11,480 24,234 27,799 6,512 (19) (6,035) 2,795 1,149 32,201 666 555 (111) (310) 866 (143) 1,523 1,204 589 111 (706) 81 (120) 1,159 703 488 (37) (292) - 15 877 65 386 (30) (116) 1,400 (218) 1,487 64,622 12,710 (86) (8,847) 5,379 (817) 72,961 11,480 44,468 123,735 - (20,234) (91,534) 11,480 24,234 32,201 6,827 (5,304) 1,523 4,234 (3,075) 1,159 2,021 (1,144) 877 2,438 195,203 (951) (122,242) 1,487 72,961 11,480 171 (28) - - 284 11,907 24,234 4,211 - (1,472) 3,164 (330) 29,807 32,201 21,771 (567) (6,268) (3,773) (916) 42,448 1,523 1,159 837 - (344) 580 (25) 761 - (688) - (15) 2,571 1,217 877 360 (5) (518) 29 248 991 1,487 341 - (282) - 143 72,961 28,452 (600) (9,572) - (611) 1,689 90,630 11,907 50,964 136,462 - (21,157) (94,014) 11,907 29,807 42,448 7,960 (5,389) 2,571 4,875 (3,658) 1,217 2,584 (1,593) 991 2,897 217,649 (1,208) (127,019) 1,689 90,630 Property, plant and equipment include assets under finance lease obligations with a cost of $155 (2012 – $666) and accumulated depreciation of $82 (2012 – $497). Depreciation expense of $9,572 (2012 – $8,847) is included in the consolidated statement of income: $8,345 (2012– $7,605) in ‘cost of sales’ and $1,227 (2012 – $1,242) in ‘administration costs’. 57 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 8 Intangible assets and goodwill At March 1, 2011 Cost Accumulated amortization Year ended February 29, 2012 At M arch 1, 2011 Additions Disposals Amortization Business acquisitions Exchange differences At February 29, 2012 At February 29, 2012 Cost Accumulated amortization Year ended February 28, 2013 At M arch 1, 2012 Additions Disposals Amortization Impairment loss Exchange differences At February 28, 2013 At February 28, 2013 Cost Accumulated amortization Goodwill Computer software Patents, products & designs Customer lists Non-compete agreements Purchased backlog Other Total 10,720 - 10,720 10,720 84 - - 28,919 (2,991) 36,732 36,732 - 36,732 4,980 (4,043) 937 937 1,519 - (939) 51 (38) 1,530 6,664 (5,134) 1,530 - - - - - - (773) 14,820 (1,364) 12,683 14,085 (1,402) 12,683 - - - - - - (625) 8,003 (730) 6,648 7,254 (606) 6,648 36,732 1,530 12,683 6,648 - - - (11,700) (952) 24,080 659 (6) (859) - (32) - - (860) - (341) 1,292 11,482 - - (696) - (182) 5,770 24,080 - 24,080 6,953 (5,661) 1,292 13,720 (2,238) 11,482 7,067 (1,297) 5,770 - - - - - - (139) 889 (79) 671 806 (135) 671 671 - - (155) - (20) 496 784 (288) 496 - - - - - - (1,853) 2,371 (166) 352 2,149 (1,797) 352 352 - - (338) - (14) - 2,093 (2,093) - - - - - 237 - - (1) (7) 229 230 (1) 229 229 25 (165) (7) - (8) 74 15,700 (4,043) 11,657 11,657 1,840 - (4,330) 55,053 (5,375) 58,845 67,920 (9,075) 58,845 58,845 684 (171) (2,915) (11,700) (1,549) 43,194 82 (8) 74 54,779 (11,585) 43,194 Amortization expense of $2,915 (2012 – $4,330) is included in the consolidated statement of income: $2,220 (2012 – $3,225) in ‘cost of sales’ and $695 (2012 – $1,105) in ‘administration costs’. 58 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 9 Accounts payable and accrued liabilities Trade accounts payable Accrued liabilities Other 10 Credit facilities As at February 28, 2013 $ As at February 29, 2012 $ 35,530 39,094 3,807 78,431 43,215 36,548 2,325 82,088 a) The Company and its U.S. subsidiary company, Velan Valve Corp., have the following credit facilities available as at February 28, 2013: Unsecured Credit facilities available Borrowing rates $105.412 (CA$85,000 and US$23,000) (2012 – $108,901 (CA$85,000 and US$23,000)) (note 26) $4,848 (CA$5,000) (2012 – $5,053 (CA$5,000)) to purchase readily convertible foreign exchange forward contracts (note 26) Prime to prime + 0.75% Prime rate The above unsecured facilities are available by way of demand operating lines of credit, bank loans, letters of credit, bankers’ acceptances, LIBOR loans, letters of guarantee and bank overdrafts. These facilities are subject to annual renewal. As at February 28, 2013, an amount of $31,567 (2012 – $17,756) was drawn against these unsecured credit facilities. 59 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) b) Foreign subsidiaries and SPEs have the following credit facilities available as at February 28, 2013: Secured by corporate guarantees Credit facilities available Foreign subsidiaries $70,846 (€44,550; £4,875; KW4,725,500; CNY5,127) (2012 – $63,671 (€39,750; £2,875; KW5,434,750; CNY5,400)) (note 26) Borrowing rates 0.57% to 6.25% (2012 – 0.87% to 10.7%) Foreign SPEs $7,837 (KW8,500,000) (2012 – $5,689 (KW6,356,248)) (note 26) 3.59% to 4.21% (2012 – 3.92% to 6.35%) The above credit facilities are available by way of bank loans, guarantees, letters of credit and foreign exchange forward contracts. The majority of these credit facilities have variable borrowing rates based on LIBOR, EONIA or prime rate. The borrowing rates listed above are the rates in effect as at February 28, 2013 and February 29, 2012. The terms of the above facilities range from annual renewal to an indefinite term. The aggregate net book value of the assets pledged under the above credit facilities amounted to $21,689 (2012 – $24,884). As at February 28, 2013, an amount of $17,837 (2012 – $15,540) was drawn against the secured credit facilities. 11 Provisions Balance – Beginning of year Additional provisions Used during the year Exchange differences Balance – End of year As at February 28, 2013 $ As at February 29, 2012 $ 5,149 2,845 (1,546) (103) 6,345 4,288 1,654 (650) (143) 5,149 The Company’s provisions consist entirely of warranties. The Company offers various warranties to the purchasers of its valves. Management estimates the related provision for future warranty claims based on historical warranty claim information, as well as recent trends that might suggest that past cost information may differ from future claims. Factors that could impact the estimated claim information include the success of the Company’s productivity and quality initiatives, as well as parts and labour costs. 60 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 12 Long-term debt The Company Unsecured bank loan (note 12(a)) French subsidiary Unsecured bank loan (€246; 2012 – €324) (note 12(b)) Secured bank loan (€199; 2012 – €262) (note 12(c)) Secured bank loan (€1,018; 2012 – €1,679) (note 12(d)) Italian subsidiary Unsecured bank loan (€850; 2012 – €941) (note 12(e)) Unsecured bank loan (€782; 2012 – €800) (note 12(f)) Unsecured state bank loan (€472; 2012 – nil) (note 12(g)) Secured finance lease obligations (€9; 2012 – €47) (note 12(h)) Korean SPE Secured bank loan (KW336,500; 2012 – KW424,000) (note 12(i)) Other (note 12(j)) Less: Current portion a) Unsecured bank loan As at February 28, 2013 $ As at February 29, 2012 $ 17,333 322 260 1,332 1,112 1,023 618 12 338 4,500 26,850 10,463 16,387 - 435 352 2,255 1,264 1,075 - 63 379 3,764 9,587 1,696 7,891 The unsecured bank loan of $17,333 bears interest at 2.74% and is repayable in monthly instalments of $444 over a 48-month period, expiring in 2016. b) Unsecured bank loan The unsecured bank loan of $322 (€246) bears interest at 2.6% and is repayable in quarterly instalments of $29 over a 60-month period, expiring in 2016 c) Secured bank loan The secured bank loan of $260 (€199) bears interest at 2.7% and is repayable in monthly instalments of $8 over a 60-month period, expiring in 2016. Certain machinery and equipment are pledged as collateral for this loan. 61 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) d) Unsecured bank loan The unsecured bank loan of $1,332 (€1,018) bears interest at EURIBOR plus 1.35% and is repayable in quarterly instalments of $253 over a 36-month period, expiring in 2014. e) Unsecured bank loan The unsecured bank loan of $1,112 (€850) bears interest at 2.91% and is repayable in monthly instalments over a 120-month period, expiring in 2021. f) Unsecured bank loan The unsecured bank loan of $1,023 (€782) bears interest at 4.90% and is repayable in monthly instalments over a 108-month period, expiring in 2021. g) Unsecured state bank loan The unsecured state bank loan of $618 (€472) is non-interest bearing and is repayable in semi-annual instalments over an 84-month period, expiring in 2020. h) Secured finance lease obligations The secured finance lease obligations are repayable in fiscal 2013 and bear interest predominately at EURIBOR plus 0.714%. i) Secured Bank Loan The secured bank loan of $338 (KW336,500) bears interest at 2.25% and is repayable in 2015. Certain land, a building, and certain machinery and equipment are pledged as collateral for this loan. j) Included in Other is an amount of $3,608 (€2,758) (2012 – $3,100 (€2,308)) related to an unconditional put option held by a minority shareholder in one of the Company’s subsidiary companies. This is recognized as a liability instead of non-controlling interest. The liability is initially recognized as the non-controlling interest’s share of the net identifiable assets of the subsidiary or SPE. Subsequently, the liability is carried at the amount of the present value of estimated future cash flows discounted at the original effective rate. Adjustments to the carrying value are recorded as interest expense in the consolidated statement of income. 62 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) k) The following is a schedule of future debt payments: February 28, 2014 February 28, 2015 February 29, 2016 February 28, 2017 February 28, 2018 Subsequent years $ 10,463 6,356 5,860 1,669 344 2,158 26,850 The aggregate net book value of the assets pledged as collateral under long-term debt agreements amounted to $6,911 (2012 – $4,001). The aggregate net book value of the assets pledged as collateral under finance lease obligations amounted to $73 (2012 – $169). l) The carrying value of long-term debt approximates its fair value. 13 Share capital a) Authorized – in unlimited number Preferred Shares, issuable in series Subordinate Voting Shares Multiple Voting Shares (five votes per share), convertible into Subordinate Voting Shares b) Issued 6,357,201 Subordinate Voting Shares (February 29, 2012 – 6,582,401) (note 13(c)) 15,566,567 Multiple Voting Shares As at February 28, 2013 $ As at February 29, 2012 $ 69,188 7,126 76,314 71,638 7,126 78,764 63 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) c) Pursuant to its Normal Course Issuer Bid, the Company is entitled to repurchase for cancellation a maximum of 5% of the issued Subordinate Voting Shares outstanding as at October 12, 2012 during the ensuing 12-month period ending October 21, 2013. During the year ended February 28, 2013, 225,200 (2012 –46,600) Subordinate Voting Shares were purchased for a cash consideration of $2,633 (2012 – $605) and cancelled. The amount by which the repurchase amount is above the stated capital of the shares has been debited to contributed surplus. d) The Company established a fixed share option plan (the “Share Option Plan”) in 1996, amended in fiscal 2007, to allow for the purchase of Subordinate Voting Shares by certain of its full-time employees, directors, officers and consultants. The subscription price for Subordinate Voting Shares granted under options is the greater of (i) the weighted average trading price for such Subordinate Voting Shares for the five days preceding the date of grant during which the Subordinate Voting Shares were traded on the Toronto Stock Exchange (“TSX”) or (ii) the trading price for the Subordinate Voting Shares on the last day the Subordinate Voting Shares were traded on the TSX immediately preceding the date of grant. Under the Share Option Plan, the maximum number of Subordinate Voting Shares issuable from time to time is a fixed maximum percentage of 5% of the aggregate of the Multiple Voting Shares and the Subordinate Voting Shares issued and outstanding from time to time. The granting of options is at the discretion of the Board of Directors which, at the date of grant, establishes the term and vesting period. Vesting of options generally commences 12 months after the date of grant and accrues annually over the vesting period provided there is continuous employment. The maximum term permissible is 10 years. A compensation cost of $58 (2012 – $71) was recorded in the consolidated statement of income and credited to contributed surplus. The table below summarizes the status of the Share Option Plan. 64 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) Number of shares Weighted average exercise price Weighted average contractual life in months Outstanding – March 1, 2011 Granted Expired/forfeited Outstanding – February 29, 2012 Exercisable – February 29, 2012 Outstanding – March 1, 2012 Expired/forfeited Outstanding – February 28, 2013 Exercisable – February 28, 2013 190,000 50,000 (45,000) 195,000 145,000 195,000 (15,000) 180,000 146,667 $11.62 (CA$11.29) $14.30 (CA$14.15) $12.34 (CA$12.21) $11.94 (CA$11.81) $11.12 (CA$11.00) $11.94 (CA$11.81) $10.67 (CA$11.00) $11.51 (CA$11.88) $11.01 (CA$11.36) 27.4 53.0 - 28.1 28.1 - 16.8 14 Foreign exchange Foreign exchange gains (losses) realized on the translation of foreign currency balances, transactions and the fair value of foreign currency financial derivatives and embedded derivatives during the period are included in sales and cost of sales and amounted to: Sales Cost of sales 2013 $ 1,219 (1,566) 2012 $ 1,121 2,561 65 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 15 Cost of sales Change in inventories of finished goods and work in progress Raw materials and consumables used Employee benefit expense (note 17) Depreciation and amortization (note 20) Movement in inventory provision – net (note 6) Foreign exchange (note 14) Other production overhead costs 16 Administration costs Employee benefit expense (note 17) Commissions Freight to customers Professional fees Scientific research investment tax credit (note 19) Movement in bad debt provision Depreciation and amortization (note 20) Other 2013 $ 9,304 216,897 99,864 10,565 2,382 1,566 46,097 386,675 2013 $ 44,288 10,821 7,109 14,186 (3,684) 393 1,922 15,950 90,985 2012* $ (29,318) 233,271 92,370 10,830 4,592 (2,561) 40,689 349,873 2012* $ 42,236 7,321 6,266 11,799 (3,603) (842) 2,347 18,096 83,620 * Certain comparative figures have been reclassified to conform to the current year’s basis of presentation. 66 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 17 Employee benefit expense Wages and salaries Social security costs Scientific research investment tax credit (note 19) Share-based compensation (note 13(d)) Other 18 Finance income and costs Finance costs Interest expense Finance income Investment income Finance costs – net 19 Research expenses 2013 $ 103,049 34,652 (3,684) 58 6,393 2012* $ 95,527 32,485 (3,603) 71 6,522 140,468 131,002 2013 $ 2012 $ 3,191 1,669 631 2,560 318 1,351 Research expenses are included in cost of sales and administration costs and consist of the following: Research expenditures Less: Scientific research investment tax credit 2013 $ 9,238 3,684 5,554 2012 $ 8,468 3,603 4,865 * Certain comparative figures have been reclassified to conform to the current year’s basis of presentation. 67 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 29, 2012 and February 28, 2011 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 20 Depreciation and amortization costs Depreciation and amortization costs are included in cost of sales and administration costs and consist of the following: Depreciation of property, plant and equipment Amortization of intangible assets 21 Income tax Current tax: Current tax on profits for the year Adjustments in respect of prior years Deferred tax: Origination and reversal of timing differences Income tax expense 2013 $ 9,572 2,915 2012 $ 8,847 4,330 12,487 13,177 2013 $ 6,960 (351) 6,609 2012 $ 3,121 156 3,277 (1,325) (2,929) 5,284 348 68 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) The tax on the Company’s income before tax differs from the amount that would arise using the weighted average tax rate applicable to income of the consolidated entities as follows: 2013 $ 2012 $ Income before tax at statutory rate of 26.90% (2012 – 28.15%) 3,233 1,716 Tax effects of: Difference in statutory tax rates in foreign jurisdictions Non-deductible (taxable) foreign exchange loss (gain) Non-deductible goodwill impairment loss Non-deductible interest accretion of proceeds payable Non-taxable income on fair value adjustment of proceeds payable Benefit attributable to a financing structure Other Income tax expense The analysis of deferred tax assets and deferred tax liabilities is as follows: Deferred income tax assets: To be realized after more than 12 months To be realized within 12 months Deferred income tax liabilities: To be realized after more than 12 months To be realized within 12 months Net deferred income tax asset The movement of the net deferred income tax asset account is as follows: Balance – Beginning of year Recovery to consolidated statement of income Deferred tax liability arising on business acquisition (note 4) Exchange differences Balance – End of year 1,044 (314) 3,147 178 (657) (1,178) (169) 5,284 2013 $ 6,100 5,126 (7,742) (293) 3,191 2013 $ 1,882 1,325 - (16) 3,191 943 (401) - 266 (628) (1,105) (443) 348 2012 $ 4,895 5,257 (7,922) (348) 1,882 2012 $ 6,187 2,929 (7,871) 637 1,882 69 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) The significant components of the net deferred income tax asset are as follows: Property, plant and equipment Intangible assets Non-deductible provisions and reserves Investment tax credits Inventories Non-capital loss carryforwards Other 2013 $ (3,830) (5,512) 5,202 (394) 5,672 2,283 (230) 3,191 2012 $ (2,809) (6,322) 3,603 (366) 4,429 2,832 515 1,882 The Company did not recognize deferred income tax assets of $276 (2012 – $276) in respect of capital losses amounting to $2,051 (2012 – $2,051) that can be carried forward indefinitely against future taxable capital gains. Deferred tax liabilities of $6,412 (2012 – $5,673) have not been recognized for the withholding tax and other taxes that would be payable on the unremitted earnings of certain subsidiaries. Such amounts are not expected to reverse in the foreseeable future. Unremitted earnings as at February 28, 2013 totalled $268,515 (2012 – $253,520) 22 Earnings per share a) Basic Basic earnings per share is calculated by dividing the net income attributable to the Subordinate and Multiple Voting shareholders by the weighted average number of Subordinate and Multiple Voting Shares outstanding during the year. Net income attributable to Subordinate and Multiple Voting shareholders Weighted average number of Subordinate and Multiple Voting Shares outstanding Basic earnings per share 2013 2012 $6,169 $7,892 22,019,568 22,177,423 $0.28 $0.36 70 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) b) Diluted Diluted earnings per share is calculated by adjusting the weighted average number of Subordinate and Multiple Voting Shares outstanding to assume conversion of all dilutive potential Subordinate and Multiple Voting Shares. The Company has one category of dilutive potential Subordinate and Multiple Voting Shares: stock options. For the stock options, a calculation is done to determine the number of Subordinate and Multiple Voting Shares that could have been acquired at fair value (determined as the average market share price of the Company’s outstanding Subordinate and Multiple Voting Shares for the period), based on the exercise prices attached to the stock options. The number of Subordinate and Multiple Voting Shares calculated above is compared with the number of Subordinate and Multiple Voting Shares that would have been issued assuming exercise of the stock options. Net income attributable to Subordinate and Multiple Voting shareholders Weighted average number of Subordinate and Multiple Voting Shares outstanding Adjustments for stock options Weighted average number of Subordinate and Multiple Voting Shares for diluted earnings per share Diluted earnings per share 2013 2012 $6,169 $7,892 22,019,568 11,995 22,177,423 25,492 22,031,563 22,202,915 $0.28 $0.36 23 Commitments and contingencies a) In the normal course of business, the Company issues performance bond guarantees related to product warranty and on-time delivery as well as advance payment guarantees and bid bonds. As at February 28, 2013, the aggregate maximum value of these guarantees, if exercised, amounted to $84,762 (2012 – $73,322). The guarantees expire as follows: February 28, 2014 February 28, 2015 February 29, 2016 February 28, 2017 February 28, 2018 Subsequent years $ 35,797 15,253 6,347 9,824 9,403 8,138 84,762 b) The Company has outstanding purchase commitments with foreign suppliers, due within one year, amounting to $7,899 (2012 – $5,654), which are covered by letters of credit. 71 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) c) Future minimum payments under operating leases (related mainly to premises and machinery) are as follows: February 28, 2014 February 28, 2015 February 29, 2016 February 28, 2017 February 28, 2018 Subsequent years $ 1,053 933 786 738 743 1,606 5,859 d) Two of the Company’s U.S. subsidiaries have been named as defendants in a number of asbestos-related legal proceedings pertaining to products they formerly sold. Management believes it has a strong defence, and the subsidiaries have previously been dismissed from a number of similar cases. Because of the many uncertainties inherent in predicting the outcome of these proceedings, as well as the course of asbestos litigation in the United States, management believes that it is not possible to make an estimate of the subsidiaries’ asbestos liability. Accordingly, no provision has been set up in the accounts. During the year ended February 28, 2013, legal and related costs for these matters amounted to $8,763 (2012 – $6,920). e) Lawsuits and proceedings or claims arising from the normal course of operations are pending or threatened against the Company. Although at this time it is not possible to determine the outcome based on the facts currently known, the Company does not believe that the ultimate outcome will have a material adverse effect on its financial position, results of operations or liquidity. No provision has been set up in the accounts. 72 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 24 Related party transactions Transactions and balances with related parties occur in the ordinary course of business. Related party transactions and balances not otherwise disclosed separately in these consolidated financial statements are as follows: Affiliated company owned by certain relatives of controlling shareholder Purchases – Material components Sales – Material components Amounts charged by an affiliated company in which a relative of the controlling shareholder owns a 50% interest Computer consulting Amount charged by the controlling shareholder to one of the Company’s subsidiaries and certain of its executives Rent based on weekly usage Accounts receivable Affiliated companies Amount charged by minority shareholders of the Company’s Italian subsidiary Rent for manufacturing facilities Accounts payable and accrued liabilities Affiliated companies Controlling shareholder Key management1 compensation Salaries and other short-term benefits Share-based compensation CA$435 Non-interest-bearing short-term advance2 CA$500 Long-term advance2, bearing interest at prescribed rate, repayable in 2016 as a balloon payment Short-term loans payable to minority shareholders of the Company’s Italian subsidiary €1,071 Short term loans, bearing interest at 5%, repayable in May 2013 Accrued interest expense on short-term loans 2013 $ 1,909 168 17 25 9 680 296 4 3,581 58 - - 1,401 65 2012 $ 2,030 131 29 29 - 288 104 4 3,855 71 440 505 - - 1 Key management includes directors (executive and non-executive) and certain senior management. 2 Certain assets are pledged as collateral. 73 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 25 Segment reporting Geographic distribution of sales and assets: Canada $ United States $ France $ Italy $ Other $ February 28, 2013 Consolidation Adjustment Consolidated $ $ Sales Customers - Domestic Export Intercompany (export) 54,284 96,099 103,085 124,631 - 31,492 49,013 71,597 143 Total 253,468 156,123 120,753 Property, plant and equipment Intangible assets and goodwill Other identifiable assets 41,628 116 263,309 6,514 - 34,638 11,841 11,307 161,205 48 42,557 1,239 43,844 5,270 31,720 35,571 13,979 48,366 61,591 (197,550) 241,955 258,619 - 123,936 (197,550) 500,574 25,397 51 107,401 (20) - (116,174) 90,630 43,194 485,950 Total identifiable assets 305,053 41,152 184,353 72,561 132,849 (116,194) 619,774 Canada $ United States $ France $ Italy $ Other $ February 29, 2012 Consolidation Adjustment Consolidated $ $ Sales Customers - Domestic Export Intercompany (export) 39,406 80,469 88,878 121,516 - 20,198 55,741 74,727 1,029 Total 208,753 141,714 131,497 Property, plant and equipment Intangible assets and goodwill Other identifiable assets 34,697 312 234,989 3,909 - 65,373 10,546 11,831 164,203 3,304 17,491 765 21,560 4,998 46,679 41,505 13,743 30,738 45,866 90,347 18,842 23 66,886 233,710 203,425 - (156,736) (156,736) 437,135 (31) - (102,792) 72,961 58,845 470,164 Total identifiable assets 269,998 69,282 186,580 93,182 85,751 (102,823) 601,970 74 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 26 Financial risk management The Company’s activities expose it to a variety of financial risks: market risk (including currency risk, cash flow interest rate risk and fair value interest rate risk), credit risk and liquidity risk. The Company’s overall financial risk management program focuses on mitigating unpredictable financial market risks and their potential adverse effects on the Company’s financial performance. The Company’s financial risk management is generally carried out by the corporate finance team, based on policies approved by the Board of Directors. The identification, evaluation and hedging of the financial risks are the responsibility of the corporate finance team in conjunction with the finance teams of the Company’s subsidiary companies and SPEs. The Company uses derivative financial instruments to hedge certain risk exposures. Use of derivative financial instruments is subject to a policy which requires that no derivative transaction be entered into for the purpose of establishing a speculative or leveraged position (the corollary being that all derivative transactions are to be entered into for risk management purposes only). Overview The Company’s financial instruments and the nature of risks which they may be subject to are set out in the following table: Risks Market Financial instrument Currency Interest rate Credit Liquidity Cash and cash equivalents Short-term investments Accounts receivable Derivative assets Bank indebtedness Short-term bank loans Accounts payable and accrued liabilities Customer deposits Dividend payable Accrual for performance guarantees Derivative liabilities Long-term debt x x x x x x x x x x x x x x x x x x x x x x x x x x x x x Market risk Currency risk Currency risk on financial instruments is the risk that the fair value of future cash flows of a financial instrument will fluctuate because of changes in foreign exchange rates. The Company operates internationally and is exposed to foreign exchange risk arising from various currency exposures. Currency risk arises when future commercial transactions and recognized assets and liabilities are denominated in a currency other than a company’s functional currency. The Company has operations with different functional currencies, each of which will be exposed to currency risk based on its specific functional currency. 75 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) When possible, the Company matches cash receipts in a foreign currency with cash disbursements in that same currency. The remaining anticipated net exposure to foreign currencies is hedged. To hedge this exposure, the Company uses foreign currency derivatives, primarily foreign exchange forward contracts. These derivatives are not designated as hedges for accounting purposes. The amounts outstanding as at February 28, 2013 and February 29, 2012 are as follows: Range of exchange rates Gain (loss) (In thousands of U.S. dollars) Notional amount (In thousands of indicated currency) February 28, 2013 February 29, 2012 February 28, 2013 $ February 29, 2012 $ February 28, 2013 February 29, 2012 Foreign exchange forward contracts Sell US$ for CA$ – 0 to 12 months Sell US$ for € – 0 to 13 months Buy US$ for € – 0 to 12 months Buy ₤ for € – 0 to 12 months Sell US$ for ₤ – 0 to 21 months Sell US$ for KW – 0 to 12 months Sell € for US$ – 0 to 12 months Buy € for US$ – 0 to 12 months Buy £ for US$ – 0 to 12 months 0.97-1.04 1.28-1.43 1.28-1.41 - 1.52 - 1.25-1.35 1.26 1.51-1.61 0.97-1.04 1.28-1.42 1.28-1.41 0.80-0.89 - 1,197-1,202 1.30-1.42 - 1.56-1.62 (951) (192) 1 - (6) - 103 67 (62) (13) US$43,245 US$8,664 51 US$33 (9) 30 - US$1,485 - - 19 €30,693 1,095 €1,420 £889 30 US$42,000 US$13,921 US$1,437 £1,564 - US$333 €25,617 - £1,919 Foreign exchange forward contracts are contracts whereby the Company has the obligation to sell or buy the currencies at the strike price. The fair value of the foreign currency instruments is recorded in the consolidated statement of income and reflects the estimated amounts the Company would have paid or received to settle these contracts as at the financial position date. Gains are recorded as derivative assets and losses as derivative liabilities on the consolidated statement of financial position. Cash flow and fair value interest rate risk The Company’s exposure to interest rate risk is related primarily to its credit facilities, long-term debt and cash and cash equivalents. Items at variable rates expose the Company to cash flow interest rate risk, and items at fixed rates expose the Company to fair value interest rate risk. The Company’s long-term debt and credit facilities predominantly bear interest, and its cash and cash equivalents earn interest at variable rates. An assumed 0.5% change in interest rates would have no significant impact on the Company’s net income or cash flows. Credit risk Credit risk is the risk of an unexpected loss if a customer or counterparty to a financial instrument fails to meet its contractual obligations. Credit risk arises primarily from the Company’s trade accounts receivable. The Company’s credit risk related to its trade accounts receivable is concentrated. As at February 28, 2013, three (2012 – six) customers accounted for more than 5% each of its trade accounts receivable, of which one customer accounted for 6.2% (2012 – 10.9%), and the Company’s ten largest customers accounted for 43.1% (2012 – 62.8%). 76 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) In order to mitigate its credit risk, the Company performs a continual evaluation of its customers’ credit and performs specific evaluation procedures on all its new customers. In performing its evaluation, the Company analyzes the ageing of accounts receivable, historical payment patterns, customer creditworthiness and current economic trends. A specific credit limit is established for each customer and reviewed periodically. An allowance for doubtful accounts is recorded when, based on management’s evaluation, the collection of an account receivable is not reasonably certain. The Company is also exposed to credit risk relating to derivative financial instruments, cash and cash equivalents and short-term investments, which it manages by dealing with highly rated financial institutions. The Company’s primary credit risk is limited to the carrying value of the trade accounts receivable and gains on derivative assets. The table below summarizes the ageing of trade accounts receivable as at: Current Past due 0 to 30 days Past due 31 to 90 days Past due more than 90 days Less: Allowance for doubtful accounts Trade accounts receivable Other receivables Total accounts receivable As at February 28, 2013 $ As at February 29, 2012 $ 97,741 10,351 8,702 10,793 127,587 1,525 126,062 8,312 78,838 13,221 5,054 10,482 107,595 1,144 106,451 5,405 134,374 111,856 77 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) The table below summarizes the movements in the allowance for doubtful accounts: Balance – Beginning of year Bad debt expenses Recoveries of trade accounts receivable Write-off of trade accounts receivable Foreign exchange Balance – End of year Liquidity risk As at February 28, 2013 $ As at February 29, 2012 $ 1,144 916 (472) (50) (13) 1,525 1,661 331 (720) (453) 325 1,144 Liquidity risk is the risk that the Company will not be able to meet its financial obligations as they come due. The Company manages its liquidity risk by continually monitoring its future cash requirements. Cash flow forecasting is performed in the operating entities and aggregated by the Company’s corporate finance team. The Company’s policy is to maintain sufficient cash and cash equivalents and available credit facilities in order to meet its present and future operational needs. The following tables present the Company’s financial liabilities identified by type and future contractual dates of payment as at: As at February 28, 2013 Total $ Less than 1 year $ 1 to 3 Years $ 4 to 5 Years $ After 5 years $ Long-term debt Accounts payable and accrued liabilities Customer deposits Accrual for performance guarantees Bank indebtedness and short-term bank loans Derivative liabilities 26,850 10,463 12,216 2,013 2,158 78,431 76,682 28,525 50,864 1,380 78,431 76,682 28,525 50,864 1,380 - - - - - - - - - - - - - - - 78 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) As at February 29, 2012 Total $ Less than 1 year $ 1 to 3 Years $ 4 to 5 Years $ After 5 years $ 9,587 1,696 5,349 694 1,848 82,088 86,544 21,679 33,296 534 82,088 86,544 21,679 33,296 534 - - - - - - - - - - - - - - - Long-term debt Accounts payable and accrued liabilities Customer deposits Accrual for performance guarantees Bank indebtedness and short-term bank loans Derivative liabilities Fair value of financial instruments The fair value hierarchy has the following levels: • Level 1 – quoted market prices in active markets for identical assets or liabilities; • Level 2 – inputs other than quoted market prices included in Level 1 that are observable for the asset or liability, either directly (as prices) or indirectly (derived from prices); and • Level 3 – unobservable inputs such as inputs for the asset or liability that are not based on observable market data. The level in the fair value hierarchy within which the fair value measurement is categorized in its entirety is determined on the basis of the lowest level input that is significant to the fair value measurement in its entirety. The fair value of financial assets and financial liabilities measured on the consolidated statements of financial position are as follows: As at February 28, 2013 Financial position classification and nature Total $ Level 1 $ Level 2 $ Level 3 $ Assets Derivative assets Liabilities Derivative liabilities 340 1,380 - - 340 1,380 - - 79 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) As at February 29, 2012 Financial position classification and nature Total $ Level 1 $ Level 2 $ Level 3 $ Assets Derivative assets Liabilities Derivative liabilities 1,737 534 - - 1,737 534 - - Fair value measurements of the Company’s derivative assets and liabilities are classified under Level 2 because such measurements are determined using published market prices or estimates based on observable inputs such as interest rates, yield curves, and spot and future exchange rates. The carrying value of the Company’s financial instruments is considered to approximate fair value, unless otherwise indicated. 27 Capital management The Company’s capital management strategy is designed to maintain strong liquidity in order to pursue its organic growth strategy, undertake selective acquisitions and provide an appropriate investment return to its shareholders while taking a conservative approach to financial leveraging. The Company’s financial strategy is designed to meet the objectives stated above and to respond to changes in economic conditions and the risk characteristics of underlying assets. In order to maintain or adjust its capital structure, the Company may issue or repurchase shares, raise or repay debt, vary the amount of dividends paid to shareholders or undertake any other activities it considers appropriate under the circumstances. The Company monitors capital on the basis of its total debt-to-equity ratio. Total debt consists of all interest- bearing debt, and equity is defined as total equity. 80 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) The total debt-to-equity ratio was as follows: Bank indebtedness Short-term bank loans Current portion of long-term debt Long-term debt Total debt Equity Total debt-to-equity ratio As at February 28, 2013 $ As at February 29, 2012 $ 48,580 2,284 10,463 16,387 77,714 32,438 858 1,696 7,891 42,883 328,173 335,577 23.7% 12.8% The Company’s objective is to conservatively manage the total debt-to-equity ratio and to maintain funding capacity for potential opportunities. The Company’s financial objectives and strategy as described above have remained unchanged since the last reporting period. These objectives and strategies are reviewed annually or more frequently if the need arises. The Company is in compliance with all covenants related to its debt and credit facilities, and is not subject to any capital requirements imposed by a regulator. 28 Adjustments to reconcile net income to cash provided from operating activities 2013 $ 9,572 2,915 (1,325) 11,700 58 (134) 663 (2,444) (407) 2,169 622 2012 $ 8,847 4,330 (2,929) - 71 (14) 946 (2,230) (978) 1,649 684 23,389 10,376 Depreciation of property, plant and equipment Amortization of intangible assets Deferred income taxes Goodwill impairment loss (note 5) Share-based compensation expense Gain on disposal of property, plant and equipment Interest accretion on proceeds payable (note 4) Income from fair value adjustment of proceeds payable (note 4) Unrealized foreign exchange gain on proceeds payable (note 4) Net change in derivative assets and liabilities Net change in other liabilities 81 Velan Inc. Notes to the Consolidated Financial Statements For the years ended February 28, 2013 and February 29, 2012 (in thousands of U.S. dollars, excluding number of shares and per share amounts) 29 Changes in non-cash working capital items Accounts receivable Inventories Income taxes recoverable Deposits and prepaid expenses Accounts payable and accrued liabilities Income tax payable Customer deposits Provisions Accrual for performance guarantees 2013 $ 2012 $ (23,266) 11,313 1,943 156 (3,778) 335 (10,189) 1,156 6,619 (8,515) (38,421) (4,758) (1,903) 4,741 115 11,139 846 7,863 (15,711) (28,893) 82 Directors and officers Corporate directors A. K. Velan Founder and Executive Chairman of the Board I. C. Velan T. C. Velan G. Jellinek Director Director Director K. MacKinnon Director A. Martini W. Sheffield P. Velan Director Director Director Corporate officers A. K. Velan Founder and Executive Chairman of the Board T. C. Velan President and Chief Executive Officer I. C. Velan Executive Vice-President W. Maar J. D. Ball S. Cherlet Executive Vice-President, International Sales and Overseas Operations Chief Financial Officer Chief Operations Officer V. Apostolescu Vice-President, Quality Assurance S. Bruckert Vice-President, Human Resources and General Counsel, Corporate Secretary J. del Buey Vice-President, Severe Service Applications P. Dion P. Lee G. Perez C. Pogue Vice-President, Canadian Sales Vice-President, Sales - United States (Eastern Division) Vice-President, Engineering Vice-President, Sales - United States (Western Division) G. Sabourin Vice-President, Treasurer and Financial Systems A. Smith Vice-President, Procurement and Overseas Manufacturing R. Sossoyan Vice-President, Global Financial Reporting N. Tarfa Vice-President, Materials and Process Technologies G. Zarifah Vice-President, Global Capital Investments and Production Technology 83 Shareholder Information Head office 7007 Côte-de-Liesse Montreal, Quebec Canada H4T 1G2 Website www.velan.com Investor relations John D. Ball Chief Financial Officer 7007 Côte-de-Liesse, Montreal, Quebec Canada H4T 1G2 Tel.: (514) 748-7743, Ext. 5537 Fax: (514) 908-0180 Auditors PricewaterhouseCoopers LLP Transfer agent Canadian Stock Transfer Company Inc. (“CST”) as administrative agent for CIBC Mellon Trust Company Shares outstanding as at February 28, 2013 6,357,201 Subordinate Voting Shares 15,566,567 Multiple Voting Shares Listing Symbol: VLN Price range High Low $12.70 $10.96 Closing on February 28, 2013: $12.05 Annual meeting The Annual Meeting of Shareholders will be held July 11, 2013, at 11:00 a.m. in the Grand Salon of the: St. James Club 1145 Union Avenue Montreal, Quebec 84 Velan worldwide Head Office An extensive global network Montreal, Canada Velan Inc. Manufacturing - North America Plant 1 • 16 production facilities • 5 plants in North America • 6 plants in Europe • 5 plants in Asia • 5 stocking and distribution centers • Hundreds of distributors worldwide • Over 60 service shops worldwide Manufacturing - Europe Plant Manufacturing - Asia Plant 1 Distribution centers Stocking and distribution Montreal, Canada Velan Inc. Plant 2 and 7 Lyon, France Velan SAS Plant Ansan City, South Korea Velan Ltd. Willich, Germany Velan GmbH Plant 2 Stocking and distribution Montreal, Canada Velan Inc. Plant 4 and 6 Mennecy, France Segault SA Plant Ansan City, South Korea Velan Ltd. Granby, Canada VelCAN Plant Stocking and distribution Granby, Canada Velan Inc. Plant 5 Leicester, UK Velan Valves Ltd. Plant Taichung, Taiwan Velan-Valvac Plant Benicia, CA, USA VelCAL Stocking and distribution Montreal, Canada Velan Inc. Plant 3 Lisbon, Portugal Velan Valvulas Industriais, Lda. Suzhou, China Velan Valve (Suzhou) Co., Ltd. Marietta, GA, U.S.A. VelEAST Plant 1 Plant Stocking and distribution Williston, VT, USA Velan Valve Corp. Lucca, Italy Velan ABV S.p.A Plant 2 Coimbatore, India Velan Valves India Private Ltd. Houston, TX, U.S.A. VelTEX Lucca, Italy Velan ABV S.p.A A world leader in industrial valve design and manufacturing supplying to: • Fossil, nuclear, and cogeneration power • Oil and gas • Refining and petrochemicals • Chemicals • Pulp and paper • Subsea • LNG and cryogenics • Marine • Mining • HVAC • Water and wastewater Pour une version française de ce rapport annuel adressez-vous à: Velan inc. 7007, chemin de la Côte-de-Liesse, Montréal (Québec) H4T 1G2 Canada Tél. : +1 514-748-7743 Téléc. : +1 514-748-8635 www.velan.com 

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