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«Management Discussion and Analysis of Financial Position and Operating Results This management discussion and analysis (MD&A) is intended to provide ...»

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Management Discussion and Analysis

of Financial Position and Operating Results

This management discussion and analysis (MD&A) is intended to provide an overview

of how the financial position of Héroux-Devtek Inc. (“Héroux-Devtek” or “the Company”)

changed between March 31, 2005 and December 31, 2005. It also compares the

operating results and cash flows for the three-and nine-month periods ended December

31, 2005 to those for the same periods the previous year. It should be read in conjunction with the audited consolidated financial statements dated March 31, 2005 and the related MD&A, both available on the Company’s website at www.herouxdevtek.com, and with the interim consolidated financial statements to June 30, 2005, September 30, 2005 and December 31, 2005. Héroux-Devtek’s consolidated financial statements have been prepared in accordance with Canadian generally accepted accounting principles (“GAAP”). The Company reports its results in Canadian dollars. All amounts in this MD&A are in Canadian dollars unless otherwise indicated.

Forward-Looking Statements In the interest of providing shareholders and potential investors with information regarding Héroux-Devtek, including management’s assessment of future plans and operations, certain statements in this MD&A are forward-looking statements subject to risks, uncertainties and other important factors that could cause the Company’s actual performance to differ materially from those expressed in or implied by such statements.

Such factors include, but are not limited to: the impact of general economic conditions in Canada and the United States; industry conditions including changes in laws and regulations; increased competition; the lack of availability of qualified personnel or management; fluctuations in commodity prices or availability; foreign exchange and interest rates; stock market volatility; and the impact of accounting policies issued by Canadian and US standard setters. Some of these factors are further discussed under Risks and Uncertainties in the Company’s MD&A for the year ended March 31, 2005.

Although the Company believes that the expectations conveyed by the forward-looking statements are based on information available to it on the date such statements were made, there can be no assurance that such expectations will prove to be correct. All subsequent forward-looking statements, whether written or orally attributable to the Company or persons acting on its behalf, are expressly qualified in their entirety by these cautionary statements.

OVERVIEW

Héroux-Devtek designs, develops, manufactures and repairs systems and components for two main market segments: Aerospace and Industrial. The Aerospace segment

comprises the following:

landing gear products aerostructure products aircraft engine components 1

TheIndustrial segment includes:

industrial gas turbine products other industrial products On May 20, 2005, the Company concluded the sale of its Logistics and Defence Division, Diemaco, to Colt Defense LLC. Where required, last year figures were restated to reflect this transaction, which was accounted for as discontinued operations.

During the third quarter ended December 31, 2005, the economic and industry factors influencing Héroux-Devtek’s business remained essentially unchanged from those discussed at March 31, 2005, our last fiscal year-end, and at the end of our previous two quarters. Calendar year 2004 showed the first sign of a turnaround in the civil aerospace market. This recovery in the civil aerospace market is having a favourable impact on Héroux-Devtek’s sales for fiscal 2006, mainly in the large civil aircraft, business jets and turboprop (commuter) markets. The military aerospace market remains generally strong. On the industrial side, the downturn in the power generation market which was believed to have ended in calendar year 2004, has remained relatively flat and has not shown the modest growth anticipated. Finally, the strength of the Canadian dollar and tight supply and price increases of raw materials continued to have a significant negative impact on Héroux-Devtek’s results.

RESULTS OF OPERATIONS

Consolidated Sales Consolidated sales for the quarter ended December 31, 2005 grew by 17.1% to $66.9 million from $57.1 million for the same period last year.

The rise in third quarter sales was mainly due to improved sales for commercial products, consisting of landing gear products for large aircraft and business jets, as well as growth in military repair and overhaul and engineering sales. However, the strength of the Canadian dollar relative to the US dollar (US dollar denominated sales) reduced sales by $3.7 million or 6.4%.

Consolidated sales for the first nine months of the year stood at $183.1 million, up $16.5 million or 9.9% from $166.6 million last year. The increase mainly represents continued growth in sales of landing gear for larger aircraft and business jets since the beginning of the current year. This was partially offset by the stronger Canadian dollar, which had a negative impact of $11.4 million or 6.9% of sales.

–  –  –

For the third quarter ended December 31, 2005, overall sales for the Aerospace segment were up 18.8% to $61.8 million compared to $52.0 million for the same period last year.





During the third quarter, Landing Gear sales increased by $8.9 million or 30.3% compared to the same period last year, with continued growth in sales for large civil and business jets and military sales to civil customers, and the full quarter impact of the supply of materials under the US Air Force (USAF) repair and overhaul contract, which started last August.

Third quarter Aerostructure sales were slightly higher than last year. An increased built rate on business jet and turboprop (commuter) contracts, along with $1.5 million in sales catch-up from previous quarters for deliveries delayed because of raw material shortages, were offset by reduced regional jets sales due to the stoppage of the Bombardier RJ200 program, as well as the negative impact of the stronger Canadian

–  –  –

For the first nine months of the year, sales for this segment rose 10.2%, from $151.3 million last year to $166.7 million this year, essentially for the reasons explained above.

–  –  –

Third quarter sales for the Industrial segment totalled $5.1 million this year, about 1% lower than last year. A year-over-year decline of $1 million in Industrial Gas Turbine sales was partially offset by stronger Wind Energy market sales, which increased Other Industrial sales by approximately $1 million.

Year-to-date Industrial segment sales of $16.4 million were $1.1 million or 7.2% higher than last year.

–  –  –

The year-to-date increase in sales in Canada reflects improved commercial sales to Canadian customers relative to the same period last year.

4 Gross Profit For the third quarter ended December 31, 2005, consolidated gross profit as a percentage of sales was 9.4%, up from 3.4% last year in spite of a 1.6% negative impact attributable to the continued strength of the Canadian dollar relative the US currency.

In the third quarter, an insurance recovery of $1.8 million ($1.1 million or $0.04 per share net of income taxes) was recorded against the cost of sales. This recovery, which could have favourably impacted the fourth quarter of our last fiscal year and the first quarter of this fiscal year, could not be recognized earlier in accordance with Canadian Generally Accepted Accounting Principles (GAAP). However, this recovery was partially offset by a provision of $1.0 million ($0.7 million or $0.02 per share net of income taxes) for non-quality and certain terminated parts on aircraft engine components. Aircraft engine components sales have been impacted in prior quarters by ongoing delivery and quality issues at the Gas Turbine Components division that caused the termination of certain manufactured parts by the customer (see Note 7 to the interim financial statements).

At December 31, 2005, this situation has stabilized with improved deliveries and reduced non-quality costs.

Gross profit was also favourably impacted by improved pricing on certain contracts and by overall increased sales, which contributed to a better absorption of manufacturing overhead costs.

Year-to-date consolidated gross profit as a percentage of sales also increased yearover-year from 4.6% to 7.2%, in spite of the 1.4% negative impact of the stronger Canadian dollar.

Selling and Administrative Expenses

–  –  –

The increase in selling and administrative expenses in the third quarter of this year can be explained by higher variable costs, in line with the increased sales, and a gain on currency translation of approximately $0.6 million last year.

Year-to-date selling and administrative expenses of $11.8 million were at the same level as last year.

–  –  –

For the third quarter ended December 31, 2005, financial expenses were $1.0 million, $0.3 million lower than for the same period last year. Year to date, financial expenses were up $0.6 million from last year at $3.3 million. The slight increase in the interest expense reflects the general increase in US interest rates, but was partially offset by the reduction in interest expense due to the net capital repayments of $24.4 million on the Company’s long-term debt since the beginning of the current fiscal year. These net capital repayments were made following the sale of Diemaco in the first quarter and the treasury issue of 4.5 million common shares concluded on November 10, 2005.

On May 20, 2004, the Company designated its interest rate swap agreement as a hedging instrument to be recorded under the hedge accounting rules. This resulted in a gain of $411,000, representing the change in the fair value of the interest rate swap agreement between April 1, 2004 and May 20, 2004, net of the amortization of the related deferred loss recorded on April 1, 2004.

Provision for Income Taxes (Income Tax Recovery)

The effective tax rate for the third quarter and nine months ended December 31, 2005, differs from the statutory rate due mainly to the non-recognition of tax benefits relating to certain operating losses incurred by a Canadian subsidiary, which represented $227,000 for the third quarter and $942,000 for the first nine months of this fiscal year. It also reflects the favourable impact of the change in the Quebec provincial income tax rate on the Company’s net future income tax assets, which represented $388,000 both for this quarter and the year-to-date.

Discontinued Operations

On May 20, 2005, the Company concluded the sale of its Logistics & Defence Division, Diemaco, to Colt Defense LLC. The final total sale price was $19.0 million. All assets and liabilities related to Diemaco were reclassified as discontinued assets and liabilities in the consolidated balance sheets. Diemaco’s revenues, expenses and net income are shown under discontinued operations in the consolidated statements of income (loss), and the impact of Diemaco’s operations on the Company’s cash and cash equivalents is presented under discontinued operations in the consolidated statements of cash flows (see below and Note 3 to the interim consolidated financial statements).

A significant portion of the net proceeds from the sale of Diemaco was used to repay $15.3 million on the Company’s Secured Syndicated Revolving Credit Facilities.

–  –  –

The Company posted a net income for the quarter ended December 31, 2005, of $743,000 compared to a net loss of $887,000 for the same period last year.

Year-to-date net income stood at $6.9 million compared to a loss of $3.8 million last year. Net income from discontinued operations includes the $8.6 million gain on the sale of the Company’s Logistics and Defence Division (Diemaco), net of income taxes of $2.3 million, and Diemaco’s net income from operations of $0.2 million for the period from April 1, 2005 until May 20, 2005, the closing date of the sale transaction.

Earnings (loss) per share figures are based on weighted averages of 29,547,207 common shares outstanding for the third quarter of this year and 26,944,975 for the same period last year. The increase is essentially due to the treasury issue of 4.5 million common shares last November, and the issuance of common shares pursuant to the Company’s stock purchase and ownership incentive plan (see Note 6 to the interim consolidated financial statements).

On February 1st, 2006, the date of this MD&A, the Company had 31,482,578 common shares outstanding.

–  –  –

For the third quarter ended December 31, 2005, cash flows from continuing operations was $4.7 million, $2.2 million higher than for the same period last year due mainly to a $2.4 million improvement in net income.

For the third quarter ended December 31, 2005, the net change of $4.1 million in noncash items was mainly caused by a $3.5 million decrease in accounts receivable following improved accounts receivable collection, and a $1.5 million reduction in inventories, in line with our third quarter increase in deliveries.

For the nine months ended December 31, 2005, cash flows from continuing operations increased from $7.8 million last year to $12.2 million this year, due essentially to a $2.9 million improvement in net income and a $1.2 million increase in the non-cash future tax expense. The net change in non-cash items included an increase of $3.1 million in income taxes receivable due mainly to our income tax recovery related to the Company’s operating losses last year and for the first six months this year, and an increase of $2.6 million in inventories, in line with the overall increased business activity.



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