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«Management Discussion and Analysis of Financial Position and Operating Results The purpose of this management discussion and analysis (“MD&A”) is ...»

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In fiscal 2006, the Company issued 4.53 million common shares at a weighted-average price of $3.75 for a total net cash consideration of $15.8 million. This includes the 4.5 million common shares issued pursuant to the November 2005 public offering and 34,047 common shares issued under the Stock Purchase Plan.

In fiscal 2005, the Company issued 3.55 million common shares for a total net cash consideration of $16.4 million. Of these, 3.5 million common shares were issued at a price of $4.90 for a net cash consideration of $16.2 million in conjunction with the financing and closing of the Progressive acquisition. The remaining 52,993 common shares were issued under the Stock Purchase Plan (17,993 common shares) and pursuant to the exercise of stock options (35,000 common shares) for a total cash consideration of $0.2 million.

As of March 31, 2006, 873,021 stock options were issued and outstanding with weighted-average maturity of 4.2 years and a weighted-average exercise price of $5.72 (see Note 15 to the consolidated financial statements).

Changes to the Company’s Stock Option Plan On February 1, 2006, the Human Resources and Corporate Governance Committee recommended to the Board of Directors (the “Board”) the approval of certain changes to the Company’s stock option plan, which were approved the same day by the Board. The purpose of these changes is to increase the number of common shares that may be issued under the stock option plan and under the stock purchase plan from an aggregate of 2,277,118 common shares (of which 300,319 common shares remain available for future grants at March 31, 2006 and of which 90,000 are reserved for the stock purchase and ownership incentive plan) to 3,148,257 common shares (representing about 10% of the common shares outstanding at March 31, 2006 and of which 340,000 will be reserved for the stock purchase and ownership incentive plan).

These changes are subject to the approval of the Toronto Stock Exchange and by the shareholders of the Company at the next annual general meeting on August 3, 2006.

Foreign Exchange The Company is subject to foreign currency fluctuations from the translation of revenues (sales), expenses, assets and liabilities of its self-sustaining foreign operations and from transactions denominated in foreign currency. The year-end and average exchange rates were as follows at

March 31, 2006 and 2005 and for the fiscal years then ended:

–  –  –

The Company makes use of derivative contracts to hedge foreign currency fluctuation exposure or risks in an effort to mitigate these risks. At March 31, 2006, the Company had forward foreign exchange contracts totalling US $146.5 million at an average exchange rate of 1.2617 maturing over the next four fiscal years, the majority of which mature over the next two fiscal years. See off-balance sheet items and commitments below.

Consolidated Balance Sheets The following table itemizes and explains the significant changes in the consolidated balance

sheets between March 31, 2005 and March 31, 2006:

–  –  –

Future income taxes 3.6 Increase represents mainly the counter-part of the realization (long-term liabilities) of the income tax attributes explained above.

–  –  –

Off-Balance Sheet Items and Commitments The Company had entered into operating leases amounting to $11.7 million as at March 31, 2006, mainly for machinery and equipment. All these amounts are repayable over the next seven years (see Note 20 to the consolidated financial statements). At March 31, 2006, the Company also had machinery and equipment purchase commitments totalling $7.4 million (see Note 20 to the consolidated financial statements).

At March 31, 2006, the Company had forward foreign exchange contracts with Canadian chartered banks totalling US $146.5 million at an average exchange rate of 1.2617. These contracts relate mainly to its export sales, and mature at various dates between April 2006 and December 2009 (see Note 5 to the consolidated financial statements). This compares to US $128.0 million in forward foreign exchange contracts held at March 31, 2005 at an average exchange rate of 1.3308.

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- Design-to-manufacture contracts and major assembly manufacturing contracts The Company’s management uses estimates to value inventory and cost of sales related to design-to-manufacture contracts and major assembly manufacturing contracts. In fact, nonrecurring costs (development, pre-production and tooling costs) and the excess over production costs (production costs incurred in the early stage of a contract in excess of the average estimated production unit cost for the entire contract) are included in inventory.

Recovery of these costs is expected from related contract sales as production costs decline to below the average production unit cost.

Two major assumptions are made when capitalizing non-recurring costs and the excess over

production costs in inventory:

- Estimated average production unit cost; and

- Production accounting quantities.

The estimated average production unit cost includes raw materials, direct labour and manufacturing overhead cost, and is based on the learning curve concept. This anticipates a predictable decrease in direct labour costs as tasks and production techniques become more efficient through repetition. To evaluate the average production unit cost, management bases its analysis mainly on historical performance, economic trends, labour agreements and information provided by customers and suppliers. It also takes into consideration inflation rates, foreign exchange rates, labour productivity, employment levels and salaries.





Production accounting quantities for a particular contract are essentially established at the inception of the contract or contract date, and are based on management’s assessments of the anticipated demand for the related aircraft or product, taking into account mainly firm order and committed order backlog and options, as well as prevailing market and economic conditions.

Management reviews the major assumptions on a quarterly basis, and a more detailed review is made at fiscal year-end. The effect of any revision to the assumptions is accounted for by way of a cumulative catch-up adjustment in the period or year in which the revision takes place.

A 1% change in the estimated future costs to produce the remaining quantities on all designto-manufacture contracts and all major assembly manufacturing contracts would have an impact of approximately $0.7 million on the Company’s cost of sales, including $0.4 million relating to cumulative catch-up adjustments for prior years.

- Goodwill Goodwill is tested for impairment annually or more frequently if events or circumstances indicate that the asset might be impaired. The Company selected its fourth quarter as its annual testing period for its goodwill. A goodwill impairment charge is recorded when the discounted value of the expected future cash flows of the entire related reporting unit is less than its carrying value. Future cash flows are forecast based on the management’s best estimates of revenues, production costs, manufacturing overhead and other costs. These

–  –  –

- Pension plans and other employee post-retirement benefits Certain critical assumptions are used in the determination of pension plan and other employee post-retirement benefit costs and obligations. In particular, the discount rate and the expected long-term rate of return on plan assets are important assumptions used to measure these costs and obligations. Other assumptions include the rate of increase in employee compensation, as well as demographic factors such as employee retirement ages, mortality rates and turnover.

These assumptions are reviewed annually.

A lower discount rate increases benefit costs and obligations. A 1% change in the discount rate would have an impact of approximately $0.2 million and $4.0 million, respectively, on the Company’s pension plan expense and accrued benefit obligation.

A lower expected rate of return on pension plan assets also increases benefit costs. A 1% change in the return assumption would have an impact of approximately $156,000 on the Company’s pension plan expense.

- Income taxes The Company accounts for future income tax assets mainly from loss carry-forwards and deductible temporary differences. Company management assesses and reviews the realization of these future income tax assets at least annually, at year-end, to determine whether a valuation allowance is required. Based on that assessment, it is determined whether it is more likely than not that all or a portion of the future income tax assets will be realized. Factors taken into account include future income based on internal forecasts, losses in recent years and their expiry dates and a history of loss carry-forwards, as well as reasonable tax planning strategies.

FUTURE CHANGES IN ACCOUNTING POLICIES

The following standards may, when adopted, have a material impact on the Company

consolidated financial statements:

- Financial instruments – Recognition and measurement;

- Hedges; and

- Comprehensive income.

These standards will be effective for the Company for the first quarter of fiscal year 2008. The

principal impacts of the standards are summarized below:

Financial instruments – Recognition and measurement

- All derivative financial instruments, including embedded derivatives that are not closely related to the host contract, must be recorded on the balance sheet and measured at fair value.

- All financial assets must be classified as held for trading, available for sale, held to maturity or as loans and receivables, and measured either at fair value, cost or amortized cost.

21

- Gains and losses on financial instruments measured at fair value must be recognized in the income statement or in their comprehensive income.

Hedges Hedges can be designed as either fair value hedges, cash flow hedges or hedges of a net investment in a self-sustaining foreign operation. Gains and losses as a result of changes in the fair value of hedging instruments which quality for hedge accounting must be recognized to income, together with the offsetting gains or losses on the hedged risk in the change period or to other comprehensive income if certain criteria are met, with subsequent reclassification to income when the hedged item affects income.

Comprehensive income Comprehensive income is the change in equity (net assets) of an enterprise during a period from transactions and other events and circumstances from non-owner sources. Comprehensive income and its components must be presented in the consolidated financial statements with the same prominence as other financial statements that constitute the complete set of consolidated financial statements.

The Company is currently assessing the impact of these recommendations on its consolidated financial statements.

CERTIFICATION ON DISCLOSURE CONTROLS AND PROCEDURES, AND OTHER

CORPORATE GOVERNANCE POLICIES

At March 31, 2006 and 2005, Company management proceeded with the certification on disclosure controls and procedures by its Chief Executive Officer (CEO) and Chief Financial Officer (CFO).

Disclosure controls and procedures have the general objective of seeking to ensure that information disclosable by the Company in its reports, regulatory statements, filings and other communications is recorded, processed, summarized and reported on a timely basis. This information also includes controls to ensure compliance with Canadian disclosure requirements beyond the Company’s consolidated financial statements.

In that regard, in February 2005, the Company’s Human Resources and Corporate Governance Committee and the Board approved the creation of a disclosure management committee. This committee has the responsibility to ensure that management has access to all information that must be disclosed in the Company’s public reporting to provide accurate and complete information to security holders.

It also ensures that the Company’s CEO and CFO can evaluate the effectiveness of the design and operation of the Company’s disclosure controls and procedures for the purpose of improving them as necessary and disclosing the results of evaluation in the reports.

At March 31, 2006 an evaluation was carried out, under the supervision of the CEO and the CFO of the effectiveness of the Company’s disclosure controls and procedures as definited in Multilateral Instruments 52-109. Based on this evaluation, the Company’s CEO and CFO

–  –  –

The required certification on disclosure controls and procedures and their effectiveness will be filed on SEDAR on or before June 29, 2006.

The Human Resources and Corporate Governance Committee and the Board also approved the Company’s Code of Business Conduct in February 2005, which establishes a high standard for ethical behaviour throughout the Company, and the Company’s Whistleblower Policy in September 2004, which encourages and enables employees to raise any serious concerns, particularly in relation to the violation of laws within the Company, without fear of reprisal or discrimination.

RISKS AND UNCERTAINTIES

Héroux-Devtek operates in industry segments subject to various risks and uncertainties that could have a material adverse effect on the Company’s business, financial condition and results of operations. These risks and uncertainties include, but are not limited to, those mentioned below.

Reliance on Large Customers

The Company has exposure due to its reliance on certain large contracts and customers. The Company’s six largest customers account for approximately 64% of its sales. Any loss or delay in certain orders from any of these customers could have a negative impact on the Company’s results.

Availability and Cost of Raw Materials



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