UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM
20-F





oREGISTRATION STATEMENT
PURSUANT TO SECTION 12(b) OR (g)


OF THE
SECURITIES EXCHANGE ACT OF 1934; or





xANNUAL REPORT PURSUANT TO
SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934


For the
fiscal year ended August 31, 2008; or





oTRANSITION REPORT PURSUANT
TO SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934


For the
transition period ________ to ________; or





oSHELL COMPANY REPORT
PURSUANT TO SECTION 13 OR 15(d) OF


THE
SECURITIES EXCHANGE ACT OF 1934


Date of
event requiring this shell company report





For
the transition period from September 1, 2007 to August 31, 2008





Commission
File No. 0-30895





EXFO
ELECTRO-OPTICAL ENGINEERING INC. /


EXFO
INGÉNIERIE ÉLECTRO-OPTIQUE INC.


(Exact
name of registrant as specified in its charter)





Canada


(Jurisdiction
of Incorporation or organization)





400
Godin Avenue


Quebec,
Quebec, G1M 2K2, Canada


(418)
683-0211


(Address,
including zip code and telephone number, including area code, of registrant’s
principal executive offices)





Securities
registered or to be registered pursuant to Section 12(b) of the
Act:





Title
      of each class
            Name
      of each exchange on which registeredSubordinate
      Voting Shares without par value
            NASDAQSubordinate
      Voting Shares without par value
            TSX





Securities
registered or to be registered pursuant to Section 12(g) of the
Act:





None





Securities
for which there is a reporting obligation pursuant to Section 15(d) of the
Act:





None

















As of
November 3, 2008, the registrant had 30,606,791 Subordinate Voting Shares
outstanding.





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.





Yes o No x





If this
report is an annual report or transition report, indicate by check mark if the
registrant is not required to file reports pursuant to Section 13 or 15 (d) of
the Securities Exchange Act of 1934.





Yes oNo x





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.





Yes xNo o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of “accelerated
filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.
(Check one):





Large
      accelerated filer      o
            Accelerated
      filer      x
            Non-accelerated
      filer      o





Indicate
by check mark which basis of accounting the registrant has used to prepare the
financial statements included in this filing:





U.S.
      GAAP      o
            International
      Financial Reporting Standards as issued by
      the      o
              International
      Accounting Standards Board
            Other      x





If
“Other” has been checked in response to the previous question, indicate by check
mark which financial statement item the registrant has elected to
follow.


Item 17
oItem 18 x





If this
is an annual report, indicate by check mark whether the registrant is a shell
company (as defined in Rule 12b-2 of the Exchange Act).


Yeso        Nox





Indicate
by check mark whether the registrant has filed all documents and reports
required to be filed by Sections 12, 13 of 15 (d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under
a plan confirmed by a court.





Yeso        Nox













TABLE OF CONTENTS




PART I.




Item 1. Identity of
Directors, Senior Management and Advisors




Item 2. Offer Statistics and
Expected Timetable




Item 3. Key
Information


A. Selected
Financial Data


B. Capitalization and
Indebtedness


C. Reasons for
the Offer and Use of Proceeds


D. Risk
Factors




Item 4. Information on the
Company


A. History and
Development of the Company


B. Business
Overview


C. Organizational
Structure


D. Property,
Plant and Equipment




Item
4A.        Unresolved Staff
Comments




Item 5. Operating and
Financial Review and Prospects




Item 6. Directors, Senior
Management and Employees


A. Directors and
Senior Management


B. Compensation


C. Board
Practices


D. Employees


E. Share
Ownership




Item 7. Major Shareholders
and Related Party Transactions


A. Major
Shareholders


B. Related Party
Transactions




Item 8. Financial
Information


A. Consolidated
Statements and Other Financial Information


B. Dividend
Policy


C. Significant
Changes




Item 9. Offer and
Listing




Item 10.         
Additional Information


A. Share
Capital


B. Memorandum and
Articles of Association


C. Material
Contracts


D. Exchange
Controls


E. Taxation


F. Dividends and Paying
Agents


G. Statement by
Experts


H. Documents on
Display


I. Subsidiary
Information




Item 11.         
Qualitative and Quantitative Disclosures about Market Risk




Item 12.         
Description of Securities Other than Equity Securities




PART II.




Item 13.         
Defaults, Dividends Arrearages and Delinquencies




Item 14.         
Material Modifications to the Rights of Security Holders and User of
Proceeds




Item 15.         
Controls and Procedures




Item 16.         
[Reserved]




Item 16A.       Audit Committee
Financial Expert




Item 16B.       Code of
Ethics




Item 16C.       Principal Accountant
Fees and Services




Item 16D.       Exemptions from the
Listing Standards for Audit Committee




Item 16E.       Purchases of Equity
Securities by the Issuer and Affiliated Purchasers




PART III.




Item 17.         
Financial Statements




Item 18.         
Financial Statements




Item 19.         
Exhibits




Signatures







Table of Contents


DISCLOSURE
REGARDING FORWARD-LOOKING INFORMATION





This
annual report contains or incorporates by reference statements which constitute
forward-looking statements within the meaning of the U.S. Private Securities
Litigation Reform Act of 1995 and we intend that such forward-looking statements
be subject to the safe harbors created thereby. Forward-looking statements are
statements other than historical information or statements of current condition
that refer to expectations, projections or other characterizations of future
events and circumstances. They are not guarantees of future performance and
involve risks and uncertainties. Actual results may differ materially from those
in forward-looking statements due to various factors including those that are
discussed under “Risk Factors” set forth in Item 3D of this annual report.
Assumptions relating to forward-looking statements involve judgments and risks,
all of which are difficult or impossible to predict and many of which are beyond
our control. When used in this annual report, the words “believe”, “anticipate”,
“plan”, “expect”, “intend”, “estimate” or similar expressions are intended to
identify forward-looking statements, although not all forward-looking statements
contain such identifying words. We believe that the expectations reflected in
the forward-looking statements are reasonable based on information currently
available to us, but we cannot assure you that the expectations will prove to
have been correct. Accordingly, you should not place undue reliance on these
forward-looking statements. These statements speak only as of the date of this
document. Unless required by law or applicable regulations, we undertake no
obligation to revise or update any of them to reflect events or circumstances
that occur after the date of this document.





All
dollar amounts in this annual report are expressed in US dollars, except as
otherwise noted.











PART
I.





Item 1.
            Identity
      of Directors, Senior Management and
Advisors




Not
Applicable.








Item 2.
            Offer
      Statistics and Expected Timetable




Not
Applicable.








Item 3.
            Key
      Information




A.Selected
Financial Data




The
consolidated statements of earnings data for the years ended August 31, 2004 and
2005 and the consolidated balance sheets data as at August 31, 2004, 2005 and
2006 are derived from our audited consolidated financial statements not included
in this annual report.  The consolidated statements of earnings data
for each of the three years ended August 31, 2006, 2007 and 2008 and
the consolidated balance sheets data as at August 31, 2007 and 2008
are derived from our audited consolidated financial statements that are included
elsewhere in this annual report.





Our
consolidated financial statements are prepared in accordance with generally
accepted accounting principles in Canada (“Canadian GAAP”) and significant
differences in measurement and disclosure from generally accepted accounting
principles in United States (“U.S. GAAP”) are set out in note 19 to our
consolidated financial statements included elsewhere in this annual report. The
historical results below are not necessarily indicative of the results to be
expected for any future periods.





1
 Table of Contents





The
selected financial data should be read in conjunction with our audited
consolidated financial statements and the related notes included elsewhere in
this annual report, and “Item 5. Operating and Financial Review and Prospects”
of this annual report.




Years
      ended August 31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(in
      thousands of US dollars, except share and per share data)Consolidated
      Statements of Earnings Data:Amounts
      under Canadian GAAPSales
              
              $
              183,790
              
              
              $
              152,934
              
              
              $
              128,253
              
              
              $
              97,216
              
              
              $
              74,630Cost
      of sales (1)
              
              
              75,624
              
              
              
              65,136
              
              
              
              57,275
              
              
              
              44,059
              
              
              
              34,556Gross
      margin
              
              
              108,166
              
              
              
              87,798
              
              
              
              70,978
              
              
              
              53,157
              
              
              
              40,074Operating
      expensesSelling
      and administrative
              
              
              61,153
              
              
              
              49,580
              
              
              
              40,298
              
              
              
              31,782
              
              
              
              25,890Net
      research and development
              
              
              26,867
              
              
              
              16,668
              
              
              
              15,404
              
              
              
              12,190
              
              
              
              12,390Amortization
      of property, plant and equipment
              
              
              4,292
              
              
              
              2,983
              
              
              
              3,523
              
              
              
              4,256
              
              
              
              4,935Amortization
      of intangible assets
              
              
              3,871
              
              
              
              2,864
              
              
              
              4,394
              
              
              
              4,836
              
              
              
              5,080Impairment
      of long-lived assets
              
              
              −
              
              
              
              −
              
              
              
              604
              
              
              
              −
              
              
              
              620Government
      grants
              
              
              −
              
              
              
              (1,079
              )
              
              
              (1,307
              )
              
              
              −
              
              
              
              −Restructuring
      and other charges
              
              
              −
              
              
              
              −
              
              
              
              −
              
              
              
              292
              
              
              
              1,729Total
      operating expenses
              
              
              96,183
              
              
              
              71,016
              
              
              
              62,916
              
              
              
              53,356
              
              
              
              50,644Earnings
      (loss) from operations
              
              
              11,983
              
              
              
              16,782
              
              
              
              8,062
              
              
              
              (199
              )
              
              
              (10,570
              )Interest
      income
              
              
              4,639
              
              
              
              4,717
              
              
              
              3,253
              
              
              
              2,524
              
              
              
              1,438Foreign
      exchange gain (loss)
              
              
              442
              
              
              
              (49
              )
              
              
              (595
              )
              
              
              (1,336
              )
              
              
              (278
              )Earnings
      (loss) before income taxes and extraordinary gain
              
              
              17,064
              
              
              
              21,450
              
              
              
              10,720
              
              
              
              989
              
              
              
              (9,410
              )Income
      taxes
              
              
              1,676
              
              
              
              (20,825
              )
              
              
              2,585
              
              
              
              2,623
              
              
              
              (986
              )Earnings
      (loss) before extraordinary gain
              
              
              15,388
              
              
              
              42,275
              
              
              
              8,135
              
              
              
              (1,634
              )
              
              
              (8,424
              )Extraordinary
      gain
              
              
              3,036
              
              
              
              −
              
              
              
              −
              
              
              
              −
              
              
              
              −Net
      earnings (loss) for the year
              
              $
              18,424
              
              
              $
              42,275
              
              
              $
              8,135
              
              
              $
              (1,634
              )
              
              $
              (8,424
              )Basic
      and diluted earnings (loss) before extraordinary gain per
      share
              
              $
              0.22
              
              
              $
              0.61
              
              
              $
              0.12
              
              
              $
              (0.02
              )
              
              $
              (0.13
              )Basic
      and diluted earnings (loss) per share
              
              $
              0.27
              
              
              $
              0.61
              
              
              $
              0.12
              
              
              $
              (0.02
              )
              
              $
              (0.13
              )Basic
      weighted average number of shares used in per share calculations
      (000’s)
              
              
              68,767
              
              
              
              68,875
              
              
              
              68,643
              
              
              
              68,526
              
              
              
              66,020Diluted
      weighted average number of shares used in per share calculations
      (000’s)
              
              
              69,318
              
              
              
              69,555
              
              
              
              69,275
              
              
              
              68,981
              
              
              
              66,615Other
      consolidated statements of earnings data:Gross
      research and development
              
              $
              32,454
              
              
              $
              25,201
              
              
              $
              19,488
              
              
              $
              15,878
              
              
              $
              15,668Net
      research and development
              
              $
              26,867
              
              
              $
              16,668
              
              
              $
              15,404
              
              
              $
              12,190
              
              
              $
              12,390Amounts
      under U.S. GAAPNet
      earnings (loss) for the year
              
              $
              18,424
              
              
              $
              42,257
              
              
              $
              8,135
              
              
              $
              (2,920
              )
              
              $
              (9,571
              )Basic
      and diluted net earnings (loss) per share
              
              $
              0.27
              
              
              $
              0.61
              
              
              $
              0.12
              
              
              $
              (0.04
              )
              
              $
              (0.14
              )Basic
      weighted average number of shares used in per share calculations
      (000’s)
              
              
              68,767
              
              
              
              68,875
              
              
              
              68,643
              
              
              
              68,526
              
              
              
              66,020Diluted
      weighted average number of shares used in per share calculations
      (000’s)
              
              
              69,318
              
              
              
              69,555
              
              
              
              69,275
              
              
              
              68,981
              
              
              
              66,615As
      at August 31,2008
              
              
              2007
              
              
              2006
              
              
              2005
              
              
              2004(in
      thousands of US dollars)Consolidated
      Balance Sheets Data:Amounts
      under Canadian GAAPCash
              
              $
              5,914
              
              
              $
              5,541
              
              
              $
              6,853
              
              
              $
              7,119
              
              
              $
              5,159Short-term
      investments
              
              
              81,626
              
              
              
              124,217
              
              
              
              104,437
              
              
              
              104,883
              
              
              
              83,969Total
      assets
              
              
              293,066
              
              
              
              279,138
              
              
              
              219,159
              
              
              
              190,957
              
              
              
              172,791Long-term
      debt (excluding current portion)
              
              
              −
              
              
              
              −
              
              
              
              354
              
              
              
              198
              
              
              
              332Share
      capital
              
              
              142,786
              
              
              
              150,019
              
              
              
              148,921
              
              
              
              521,875
              
              
              
              521,733Shareholders’
      equity
              
              $
              259,515
              
              
              $
              250,165
              
              
              $
              196,234
              
              
              $
              173,400
              
              
              $
              157,327Amounts
      under U.S. GAAPCash
              
              $
              5,914
              
              
              $
              5,541
              
              
              $
              6,853
              
              
              $
              7,119
              
              
              $
              5,159Short-term
      investments
              
              
              81,626
              
              
              
              124,217
              
              
              
              104,437
              
              
              
              104,883
              
              
              
              83,969Total
      assets
              
              
              280,426
              
              
              
              268,389
              
              
              
              212,702
              
              
              
              182,852
              
              
              
              164,758Long-term
      debt (excluding current portion)
              
              
              −
              
              
              
              −
              
              
              
              354
              
              
              
              198
              
              
              
              332Share
      capital
              
              
              568,917
              
              
              
              599,519
              
              
              
              598,421
              
              
              
              597,664
              
              
              
              596,309Shareholders’
      equity
              
              $
              246,802
              
              
              $
              239,343
              
              
              $
              189,777
              
              
              $
              165,295
              
              
              $
              149,294




(1)
            The
      cost of sales is exclusive of amortization, shown
    separately.





2
 Table of Contents





B.Capitalization
and Indebtedness




Not
Applicable.





C.Reasons
for the Offer and Use of Proceeds





Not
Applicable.





D.Risk
Factors





We
must continue to overcome significant competition in our targeted industries in
order to gain market share and achieve our growth strategy.





The
market for our primary business activity ─ namely designing, manufacturing,
marketing and selling telecommunications test, measurement and service assurance
equipment ─ is rapidly evolving and is marked by intense competition and
technical innovation. Likewise, the market for our selected life sciences and
industrial solutions is very competitive. We anticipate the pace of change to
remain high or even accelerate for our targeted industries in the future. We
might see the emergence of new competitors or the consolidation of current
competitors, as the markets for telecommunications test, measurement and service
assurance equipment as well as for life sciences and industrial solutions might
evolve in response to technical innovations and economic conditions. Achieving a
compound annual growth rate of 20% for sales in the next three years, as defined
in our new corporate performance metrics, will largely depend on our ability to
gain market share by increasing sales of current products at existing accounts,
expanding into new accounts, introducing new products and product enhancements,
and exploiting new market opportunities.





During
the past few years, the telecommunications test, measurement and service
assurance industry has witnessed consolidation. Danaher Corporation acquired
Tektronix, Inc., in November 2007. Anritsu Corporation acquired NetTest A/S in
August 2005 and JDS Uniphase Corporation (JDSU) completed its acquisition
of Acterna Corporation during the same month. Agilent Technologies Inc. divested
itself of its semiconductor division to refocus its efforts on test and
measurement. With the exception of JDSU (which also sells optical components),
these competitors are global test, measurement and service assurance vendors who
complement their broad range of products with telecommunications test,
measurement and service assurance equipment. Similarly, Spirent plc. and
Yokagawa are global test, measurement and service assurance vendors who compete
against us. Other competitors, such as Digital Lightwave Inc., Fluke Networks
and Tektronix, operating divisions within Danaher Corporation, IXIA, Sunrise
Telecom Inc., and VeEX Inc. compete against us in separate niche markets. Some
competitors in both groups may have greater financial, technical and/or
marketing resources than us. Consequently, they may be able to devote
greater resources to the development, marketing, manufacturing, selling and
support of their products in order to capture market share.





Competitors
also may be better positioned than us to capture market share or to acquire
companies and new technologies that would potentially displace our products or
render them obsolete. We cannot predict whether current or future competitors
will develop or market products that offer higher performance, more features, or
are more cost-effective than our current or future products. To remain
competitive and achieve our growth strategy, we must increase our sales and
develop cost-effective products and product enhancements that offer higher
performance and more functionality, in current and new sectors, so that we can
increase our market share. Our failure to do so may harm our business,
results of operations and financial condition.








3
 Table of Contents





Fluctuations
in the exchange rates between the Canadian dollar, US dollar and other
currencies may adversely affect our operating results.





Most of
our sales are denominated in currencies other than the Canadian dollar
(principally US dollars and Euros). However, a large portion of our operating
expenses and capital expenditures are denominated in Canadian dollars. As a
result, even though we manage to some extent our exposure to currency risks with
forward-exchange contracts and certain operating expenses denominated in
currencies other than the Canadian dollar, we are exposed to fluctuations in the
exchange rates between the Canadian dollar on one hand and the US dollar
and Euro on the other. For example, the average exchange rate of the Canadian
dollar versus the US dollar was 1.0071 in fiscal 2008 compared to 1.1215 in
2007. During the period from September 1, 2008 to October 31, 2008, the Canadian
dollar fluctuated significantly, mainly due to the turmoil in financial markets.
Any increase in the value of the Canadian dollar relative to other currencies,
especially the US dollar, and any variance between the value of the Canadian
dollar and the contractual rate of our forward-exchange contracts, could have
a material adverse effect on our operating results and provide competitive
advantages to our competitors.





Our
business may be adversely affected by unfavorable general economic and market
conditions





Our
business is subject to the effects of general economic conditions in North
America and throughout the world and, more particularly, market conditions in
the telecommunications industry. During fiscal 2008, a weaker global
macro-economic environment prompted many network service providers to carefully
scrutinize their capital expenditures. Even if network service providers
(“NSPs”) reduce their capital expenditures amidst a challenging environment, we
believe that it will accelerate the fundamental shift in their capital
spending budgets from legacy to next-generation, IP networking as the
latter maximizes revenue-generating services and reduces operating costs. We
believe that we are very well positioned to enable the deployment of
next-generation, IP-based networks. It should be noted, however, that the
turmoil in financial markets has rendered it more difficult for NSPs to secure
financing for their deployments. In the past, our operating results were
adversely affected by reduced telecom capital spending in North America, Europe
and Asia and by general unfavorable economic conditions. In particular, sales
to network service providers in North America were significantly and
adversely affected by a downturn in 2001 in the telecommunications
industry. If there is a recession or slowdown in key geographic regions or
markets, we may experience a material adverse impact on our business, operating
results and financial condition.





One
of our customers has accounted for a high percentage of our sales in the past
several years, and any adverse factor affecting this customer or our
relationship with this customer could cause our sales
to decrease.





A Tier-1
carrier in the US accounted for 7.4% of our sales in fiscal 2008, 14.7% in
fiscal 2007, 13.8% in 2006 and 23.3% in 2005. Although we have reduced our
exposure to this customer in recent years, we may not be able to offset
lower sales at this particular account in the future. Even if this customer has
a supply contract with us, it could change its purchasing practice, force
us to renegotiate prices and is not obligated to purchase a specific amount of
products from us or provide us with binding purchase forecasts for any period.
In addition, our customers typically purchase our products under individual
purchase orders and may cancel or defer purchases on short notice without
significant penalties.





The loss
of such a customer or the reduction, delay, or cancellation of orders from this
customer or other significant customers could cause our sales and, therefore,
net earnings to decline.





We
have faced pricing pressure on our existing products and expect that this
pressure will continue. If we do not keep lowering our manufacturing costs or
introduce new products with higher margins, our gross margins may decrease and
our operating results may be adversely affected.





We
continue to implement measures to protect our gross margin, despite the negative
impact of the exchange rate between US and Canadian currencies. In addition,
since September 2007, we began transferring and ramping the manufacturing of our
higher-volume, lower-complexity telecom products at a wholly-owned production
facility in Shenzhen, China, with a goal of lowering our production costs.
However, increased competitiveness in the telecommunications test, measurement
and service assurance industry will likely result in continuing downward
pressure on average selling prices, which may in turn negatively affect our
gross margins. Pricing pressure can result from a number of factors such
as:





4
 Table of Contents





·
            increased
      competition for business;


·
            reduced
      demand;


·
            limited
      number of potential customers;


·
            competition
      from companies with lower production costs, including companies operating
      in lower cost environments;


·
            introduction
      of new products by competitors;


·
            greater
      economies of scale for higher-volume
  competitors;


·
            large
      customers, who buy in high volumes, can exert substantial negotiating
      leverage over us; and


·
            resale
      of used equipment.





In
addition, gross margins may also be negatively affected by increased costs of
raw materials as well as obsolescence and excess costs, product and
customer mix and under-absorption of fixed manufacturing costs.





As
pricing pressure will likely continue to affect our existing products, we may
have to increase the number of units sold to maintain our existing sales levels.
If we are unable to increase our sales levels, lower our manufacturing costs, or
introduce new products with higher margins, our gross margins may decline and
our operating results may suffer.





Our
products may have unforeseen defects that could harm our reputation, impede
market acceptance of our products and negatively impact our business, results of
operations and financial condition.





As a
result of their complexity, our products may contain undetected software or
hardware defects, inaccurate calibration or compatibility problems or regulatory
compliance issues, particularly when they are first introduced or when new
versions are released. There can be no assurance that, despite our testing and
diligent effort, defects will not be found in new products after they have been
fully deployed and operated under peak stress conditions or that customized
products meet customer sign-off acceptance requirements. If we are unable to fix
defects or other problems or meet custom requirements, we could experience,
among other things:





·
            costly
      repairs;


·
            product
      returns or recalls;


·
            damage
      to our brand reputation;


·
            loss
      of customers, failure to attract new customers or achieve market
      acceptance;


·
            diversion
      of development and engineering
resources;


·
            legal
      actions by our customers, including claims for consequential damages and
      loss of profits; and


·
            legal
      actions by governmental entities, including actions to impose product
      recalls and/or forfeitures.





The
occurrence of any one or more of the foregoing could seriously harm our
business, results of operations and financial condition.





We
may not be able to make the necessary acquisitions or strategic alliances needed
for the development of our business or, if we do make such acquisitions or
strategic alliances, we cannot assure you that we will successfully integrate
the businesses, products, technologies and personnel. In addition, such
acquisitions could distract management’s attention from our day-to-day business
and operations. Ultimately, the failure to make strategic acquisitions or the
inability to carry out effective integrations could disrupt our overall business
and harm our financial condition.





We intend
to carefully seek businesses, whose products and technologies are complementary
to ours, or which will enable us to expand our markets and/or our market
share. There can be no assurance that we will ultimately make any such
transactions. Our competitors may be in a better position to acquire the same
businesses, products and technologies that we wish to acquire. In addition, our
fluctuating stock price, our cash position or our ability to raise capital or
issue debt on favorable terms or at all at the time of an acquisition may affect
our ability to complete such an acquisition.





We made
two strategic acquisitions in fiscal 2008, namely of Navtel Communications and
Brix Networks, and we intend to continue making acquisitions of businesses,
products and technologies as part of our overall growth strategy. In the event
of any future acquisition, we could:







5
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·
            issue
      shares that would dilute individual shareholder percentage
      ownership;


·
            incur
      debt;


·
            assume
      liabilities and commitments;


·
            incur
      significant expenses related to amortization of additional intangible
      assets;


·
            incur
      significant impairment losses of goodwill and intangible assets related to
      such acquisitions; and


·
            incur
      losses from operations.





These
acquisitions also involve numerous risks, including:





·
            risk
      of not realizing the expected benefits or synergies of such
      acquisitions;


·
            problems
      integrating the acquired operations, technologies, products and
      personnel;


·
            risks
      associated with the transfer of acquired know-how and
      technology;


·
            unanticipated
      costs or liabilities;


·
            diversion
      of management’s attention from our core
  business;


·
            adverse
      effects on existing business relationships with suppliers and
      customers;


·
            risks
      associated with entering markets in which we have no or limited prior
      experience; and


·
            potential
      loss of key employees, particularly those of acquired
      organizations.





If
we fail to adapt appropriately to the challenges associated with operating
internationally, the expected growth of our business may be impeded and our
operating results may be affected.





For the
fiscal year ended August 31, 2008, customers outside of the United States and
Canada accounted for 49.0% of our sales. Our international sales will be limited
if we cannot establish and maintain relationships with international
distributors, set up additional foreign operations, expand international sales
channel management, hire additional personnel, develop relationships with
international service providers and operate adequate after-sales support
internationally.





In the
third quarter of fiscal 2007, we established a software development center in
Pune, India, to supplement the efforts of our R&D centers in Quebec
City, Canada, Montreal, Canada, Concord, Canada, and since the third quarter of
fiscal 2008, Boston, United States. We also began manufacturing high-volume,
low-complexity telecom products at our wholly-owned production facility in
Shenzhen, China, in the first quarter of fiscal 2008 with the goal of
lowering our manufacturing costs.





Even if
we are able to successfully expand our international operations, we may not be
able to maintain or increase international market demand for our products.
Our international operations are subject to a number of risks,
including:





·
            challenges
      in staffing and managing foreign operations due to the limited number of
      qualified candidates, employment laws and business practices in foreign
      countries, any of which could increase the cost and reduce the efficiency
      of operating in foreign countries;


·
            our
      inability to comply with import/export, environmental and other trade
      compliance regulations of the countries in which we do business,
      together with unexpected changes in such
  regulations;


·
            measures
      to ensure that we design, implement and maintain adequate controls over
      our financial processes and reporting in the future, especially in light
      of setting up new operating companies in India and China or the likely
      future acquisition of companies;


·
            failure
      to adhere to laws, regulations and contractual obligations relating to
      customer contracts in various
countries;


·
            difficulties
      in establishing and enforcing our intellectual property
      rights;


·
            inability
      to maintain a competitive list of distributors for indirect
      sales;


·
            tariffs
      and other trade barriers;


·
            economic
      instability in foreign markets;


·
            wars,
      acts of terrorism and political
unrest;


·
            language
      and cultural barriers;


·
            lack
      of integration of foreign
operations;


·
            currency
      fluctuations;






6
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·
            potential
      foreign and domestic tax
consequences;


·
            technology
      standards that differ from those on which our products are based, which
      could require expensive redesign and retention of personnel familiar with
      those standards;


·
            longer
      accounts receivable payment cycles and possible difficulties in collecting
      payments which may increase our operating costs and hurt our financial
      performance; and


·
            failure
      to meet certification requirements.





Any of
these factors could harm our international operations and negatively affect our
business, results of operations and financial condition. The recurrence of
weakness in these economies or of weakness in other foreign economies could have
a significant negative effect on our future operating results.





We
may make misjudgments in our strategic planning that could have material adverse
effects on our business, results of operations and financial
condition.





We devise
a three-year strategic business plan, which is prepared by management and
approved by our Board of Directors. This strategic plan, reviewed by management
on a regular basis, is mainly based on market research and analysis related to
future market trends and demands. In our strategic plan, we have made and will
continue to make judgments based on our analysis of future market trends and
requirements. These decisions may involve substantial investments in the
development of new product lines, diversification of our business
on a geographic basis, as well as expansion into new market segments —
either organically or through acquisitions. We may make misjudgments in our
strategic planning that could have material adverse effects on our business,
results of operations and financial condition.





Our
quarterly revenues and operating results are subject to significant fluctuations
and you should not rely on them as an indication of our future
performance.





Our sales
and operating results have fluctuated from quarter to quarter in the past and
significant fluctuations may occur in the future, especially following the
acquisition of Brix Networks (renamed EXFO Service Assurance Inc.). EXFO Service
Assurance Inc. offers service assurance systems that monitor next-generation,
converged IP networks. Given that these systems are more complex and
mission-critical than traditional test equipment, the orders are much larger and
the sales cycles are relatively longer.





In
addition, our sales and operating results generally depend on the volume and
timing of the orders we receive from customers as well as our ability to fulfill
received orders. Our operating expenses, which include manufacturing overhead
costs, selling and administrative, research and development, and amortization
expenses, are relatively fixed in the short term. If we sell fewer products than
anticipated, if there is a delay in the launch of new products, or if
prices for our products decline, we may not be able to quickly reduce our
operating expenses in response to lower sales. Factors that could affect
the amount and timing of our sales, and cause quarterly fluctuations in our
revenue and operating results include:





·
            length
      of the product sales cycle for certain products, especially those that are
      higher priced and more complex;


·
            timing
      of product launches and market acceptance of new products for us as well
      as our competitors;


·
            our
      ability to sustain product volumes and high levels of quality across all
      product lines;


·
            timing
      of shipments for large orders;


·
            effect
      of seasonality on sales and bookings;
and


·
            losing
      key accounts and not successfully developing new
  ones.





Our sales
and operating results could also be affected by the following factors, some of
which we have little or no control over:





·
            fluctuating
      demand for telecommunications test, measurement and service assurance
      equipment as well as life sciences and industrial
    solutions;


·
            changes
      in the capital spending and operating budgets of our customers, which may
      cause seasonal or other fluctuations in product mix, volume, timing
      and number of orders we receive from our
  customers;


·
            order
      cancellations or rescheduled delivery
dates;






7
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·
            pricing
      changes by our competitors or
suppliers;


·
            customer
      bankruptcies and difficulties in collecting accounts
      receivable;


·
            restructuring
      and impairment charges;


·
            foreign
      exchange rate fluctuations, as a portion of our operating expenses are
      denominated in Canadian dollars;
and


·
            general
      economic conditions, including a slowdown or
  recession.





We may in
the future choose to reduce prices, increase spending, or modify our product
portfolio in response to actions by competitors or as an effort to pursue new
market opportunities. These actions may also adversely affect our business and
operating results and may cause our quarterly results to be lower than the
results of previous quarters. Due to these factors, you should not rely on
quarter-to-quarter comparisons of our results of operations as an
indication of our future performance.





If
we are unable to adapt to current and future changes in technology or if we are
unable to introduce new and enhanced products on a timely basis, our
products may become obsolete, which could prevent us from achieving our growth
strategy and adversely affect our operating results.





The
industries that we target are characterized by rapidly evolving technology and
industry standards that result in frequent new product introductions. Any
failure by us to anticipate or respond to new technological developments,
customer requirements or evolving standards could have a material adverse effect
on our business, results of operations and financial condition. The development
of proprietary technology entails significant technical and business risks and
requires substantial expenditures and lead-time. The success of our new product
introductions will depend on several factors, including our ability
to:





·
            properly
      identify and anticipate customer
needs;


·
            innovate
      and develop new products;


·
            gain
      timely market acceptance for new
products;


·
            manufacture
      and deliver our new products on time, in sufficient volume and with
      adequate quality;


·
            price
      our products competitively;


·
            continue
      investing in our research and development programs;
  and


·
            anticipate
      competitors’ announcements of new
products.





Failure
to do the above could be exploited by our competitors. If we lose market share
as a result of lapses in our product development, our business would
suffer.





Our
intellectual property and proprietary technology are important to the continued
success of our business. Our failure to protect this proprietary technology may
significantly impair our competitive position.





Our
success and ability to compete depend to a significant extent on our proprietary
technology, with which we attempt to keep others from using the innovations that
are central to our existing and future products. We currently hold 41
actively-maintained granted patents from the United States (including one
“design” patent), seven from Canada, four from Germany (including one "Utility
Model"), four from the United Kingdom, three from France, and two from
China. In addition, EXFO has twenty US patent applications in
process, eleven Canadian patents applications in process, three
European applications in process, three in China, two direct national
entries (not via the European application) in Germany, and one in Russia, these
applications being either direct national or regional submissions or submissions
as applications under the Patent Cooperation Treaty. We also rely on a
combination of copyright and trademark laws, trade secrets, confidentiality
procedures, contractual provisions and license agreements to protect our
proprietary technology. We may have to engage in litigation in order to protect
our patents and other intellectual property rights, or to determine the validity
or scope of the proprietary rights of others. Such litigation can be
time-consuming and expensive, regardless of whether we win or lose.








8
 Table of Contents





The
process of seeking patent protection can be long and expensive and we cannot be
certain that any currently pending or future applications will actually result
in issued patents, or that, even if patents are issued, they will be of
sufficient scope or strength to provide meaningful protection or any commercial
advantage to us. We also rely on trade secret protection for our technology, in
part through confidentiality agreements with our employees, consultants,
distributors and third parties. However, these agreements may be breached or
otherwise not effective and we may not have adequate remedies for any breach or
shortfall of these agreements. In any case, others may come to know about our
trade secrets through a variety of methods. In addition, the laws of some
territories in which we sell our products may not protect our intellectual
property rights to the same extent as do the laws of Canada and the United
States.





Our
intellectual property rights, particularly our existing or future patents, may
be invalidated, circumvented, challenged or required to be licensed to others.
Furthermore, others may develop technologies that are similar or superior to our
technology, duplicate or reverse engineer our technology, or design around the
patents owned or licensed by us. We cannot be sure that the steps that we take
to protect our technology will prevent misappropriation or infringement. If we
fail to protect our technology so that others may copy or use it, we will
be less able to differentiate our products and our sales may
decline.





Others
may claim that our products infringe upon their intellectual property rights, or
they may infringe our intellectual property, and we may expend significant
resources enforcing or defending our rights or suffer competitive
injury.





Litigation
regarding intellectual property rights is common in the technology industry and
for this reason we expect that third-party infringement claims involving
technologies may increase. If an infringement claim is filed against us, we may
be prevented from using some of our technologies and may incur significant costs
to resolve the claim. Conversely, we may be required to spend significant
resources to monitor and enforce our intellectual property rights.





We could
incur substantial costs in defending ourselves and our customers against
infringement claims or in bringing infringement claims against others.
Litigation could also adversely affect sales of the challenged product or
technology and divert the efforts of our management and technical personnel. In
the event of an infringement claim, we may be required to obtain one
or more licenses from third parties. We cannot assure you that we, or our
customers, could obtain necessary licenses from third parties at a reasonable
cost or at all. If we fail to obtain a license where one is
required, we could incur substantial liabilities and be forced to suspend the
marketing of the challenged products.





If
customers fail to meet their financial commitments to us, it could have a
material adverse effect on our business, results of operations and
financial condition.





Some of
our customers may experience cash flow problems. Consequently, we may have
customers who delay payments or may not be able to meet their financial
commitments to us. Furthermore, they may not order as many products from us
as originally forecasted or they may cancel their orders outright. The failure
of customers to order products would result in decreased revenues for us. If
customers fail to meet their financial commitments to us, it could have a
material adverse effect on our business, results of operations and financial
condition.





As
our customers consolidate, they may reduce or halt purchases of our products,
which would harm our sales and operating results.





Consolidation
in the telecommunications industry could reduce the number of customers to which
our products are sold. Some of our customers have been subject to consolidation
and could obtain products from a vendor other than us, or demand more
favorable terms and conditions from us, which would harm our sales and operating
results. In addition, some customers may merge with or acquire our competitors
and discontinue their relationships with us.








9
 Table of Contents





If
we fail to predict our supply requirements accurately, we may have excess
inventory or insufficient inventory, either of which could cause us to incur
additional costs and/or experience manufacturing delays.





We
provide non-binding forecasts of our requirements to some of our suppliers up to
six months prior to scheduled delivery of products to our customers. If we
overestimate our forecasted requirements, we may have excess inventory, which
could harm our relationships with our suppliers due to reduced future orders,
increase our costs and require inventory write-offs. If we underestimate our
requirements, we may have an inadequate inventory of parts, which could
interrupt manufacturing of our products and result in shipment delays. The
likelihood of misjudging our inventory requirements increased in the past
year with the opening of a telecom manufacturing facility in Shenzhen, China,
for high-volume, low-complexity products. This manufacturing facility
complements the low-volume, high-complexity telecom products produced at our
plant in Quebec City, Canada. In addition, lead times for materials and parts
that we order may be long and depend on factors such as the procedures of, or
supply terms with, a specific supplier and demand for each part at a given
time.





We
depend on a single supplier or a limited number of suppliers for some key
components and materials in our products, which makes us susceptible to supply
shortages or price fluctuations that could adversely affect our operating
results.





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





If
we fail to maintain an effective system of internal controls, we may not be able
to accurately report our financial information or prevent fraud, which could
harm our operating results and cause investors to lose confidence in our
reported financial information.





Effective
internal controls are necessary for us to provide reliable and accurate
financial information and effectively prevent fraud. We devote significant
resources and time to comply with the internal control over financial reporting
requirements of the Sarbanes-Oxley Act of 2002. In addition, Section 404 of the
Sarbanes-Oxley Act of 2002 requires that we assess and our auditors attest to
the design and operating effectiveness of our controls over financial reporting.
Our compliance with the annual internal control report requirement for each
fiscal year will depend on the effectiveness of our financial reporting as well
as data systems and controls throughout our company and operating subsidiaries.
Furthermore, we cannot be certain that these measures will ensure that we
design, implement and maintain adequate controls over our financial processes
and reporting in the future, especially in light of having acquired Navtel
Communications and Brix Networks or the likely future acquisition of companies
that are not in compliance with Section 404 of the Sarbanes-Oxley Act of 2002.
As well, the complexity of our systems and controls may become more difficult to
manage as we transform our operating structure and continue to reduce
infrastructure costs. To effectively manage these changes, we will need to
continue to improve our operational, financial and management controls and our
reporting systems and procedures. Any failure to implement required new or
improved controls, difficulties encountered in their implementation or
operation, or difficulties in the assimilation of acquired businesses into our
control system could harm our operating results or cause it to fail to meet
our financial reporting obligations. Inferior internal controls could also cause
investors to lose confidence in our reported financial information, which
could have a negative effect on our share price and our access to
capital.








10
 Table of Contents





Regulatory
changes may cause us to incur increased costs.





Changes
in the laws and regulations affecting public companies may increase our expenses
as we may have to devote resources to respond to these new requirements. In
particular, we incurred and may incur additional general administrative expenses
to comply with Section 404 of the Sarbanes-Oxley Act, which requires management
to report on internal controls over financial reporting. In addition, the
process of moving from Canadian GAAP to IFRS, which will extend from fiscal
2009 to 2011, will require management’s time and attention, and cause our
general and administrative expenses to increase. Compliance with new rules could
require the further commitment of significant financial resources and result in
the diversion of management’s time and attention from revenue-generating
activities. Finally, the impact of these changes could make it more difficult
for us to attract and retain qualified persons to serve on our Board of
Directors or as executive officers, which could harm our business.





We
require employees and management resources who are knowledgeable about the
specialized nature of our business. If we are unable to attract and retain
sufficient numbers of highly skilled technical, sales, marketing, senior
management and other personnel, our operations and financial results will
suffer.





Due to
the specialized nature of our business, we are highly dependent on the continued
service of and on the ability to attract qualified engineering, sales,
marketing, senior management and other personnel. If we are unable to attract
and retain such qualified personnel, it could have a material adverse effect on
our business, results of operations and financial condition.





We must
also provide significant training for our employee base due to the highly
specialized nature of telecommunications test, measurement, and service
assurance as well as life sciences and industrial technologies. Our current
personnel may be inadequate and we may fail to assimilate and train new
employees. Highly skilled employees with the education and training that we
require – especially employees with significant experience and expertise,
international business development, product management, sales, engineering and
operation – may be difficult to find. Once trained, our employees may also be
hired by our competitors or leave the organization.





Our
insurance may not be sufficient to cover all potential liability. A successful
claim exceeding our policy limits will reduce our cash position, increase our
expenses and have a negative effect on our business, operating results and
financial condition.





Our
products are designed to help network service providers, cable operators and
manufacturers of optical networks and components ensure network reliability. We
also leverage our core telecom technologies for life sciences and industrial
applications. The failure of our products to perform to client expectations
could give rise to product liability and warranty claims. We carry
insurance for product liability and take accounting reserves for warranty claims
that we consider adequate in view of industry practice.





In
addition, we may face other types of claims by third parties in relation to the
conduct of our business; a successful claim against us for an amount
exceeding our policy limits would force us to use our own resources to pay
the claim, which could result in a reduction of our cash available for other
uses, increase our expenses and have a negative effect on our business, results
of operations and financial condition.





We
may become involved in costly and time-consuming litigation that may
substantially increase our costs and harm our business.





We may
from time to time become involved in various lawsuits and legal proceedings. For
example, we are a defendant in a putative securities class action filed in the
United States District Court for the Southern District of New York
involving approximately 300 other issuing companies. Litigation is subject to
inherent uncertainties, and an adverse result in these or other matters that may
arise from time to time could have a material adverse effect on our business,
results of operations or financial condition. Any litigation to which we are
subject could require significant involvement of our senior management and may
divert management attention from our business and operations.








11
 Table of Contents





If
we suffer loss to our factories or facilities, our operations could be seriously
harmed.





Our
factories and facilities are subject to catastrophic loss due to fire,
vandalism, terrorism or other natural or man-made disasters. We do not have
redundant multiple-site capacity and if any of our facilities or factories were
to experience a catastrophic loss, it would disrupt our operations, delay
production, shipments and revenue and result in large expenses, thereby harming
our results of operation.





Unexpected
declines in our research and development and other tax credits and grants may
have an adverse effect on our business.





Our
historical operating results reflect substantial benefits from programs
sponsored by federal and provincial governments for the support of research and
development activities, as well as in relation to other activities. For example,
research and development tax credits and grants represented 17.2% of our gross
research and development expenses for the year ended August 31,
2008.





If
unexpected changes in the laws or government policies terminate or adversely
modify the Canadian and Quebec government programs, under which we receive the
majority of our research and development and other tax credits and grants, or if
we unexpectedly become unable to participate in or take advantage of these
programs, then our net research and development and other expenses will
materially increase or we may decrease our research and development activities.
In addition, to the extent that we have increased our research and development
activities outside of Canada and Quebec, resulting from the hiring of additional
personnel at our software development center in Pune, India and acquisition of
Brix Networks, or potential future acquisitions, our increased R&D
activities may not be eligible for these programs. If we were required to
decrease our research and development activities, or were unable to benefit from
other tax credits and grants, this could have a material adverse effect on our
business, results of operations and financial condition.





Changes
in our effective tax rate or adverse outcomes resulting from tax audits may have
an adverse impact on our results.





As an
international corporation, we are subject to taxation in the various
jurisdictions in which we conduct business. Significant judgment is required in
the determination of our worldwide provision for income taxes and this
determination requires the interpretation and application of complex tax laws
and regulations. Our effective tax rate may be adversely impacted by the level
of earnings, by changes in the mix of earnings among companies and countries
which may have different statutory tax rates, by the valuation of our deferred
tax assets, and by changes in tax rules and regulations. We are also
subject to income tax audits and transfer pricing audits in the respective
jurisdictions in which we conduct business and we regularly assess the
likelihood of adverse outcomes resulting from these audits to ascertain the
adequacy of our provisions for income taxes and transfer pricing policies. There
can be no assurance that the outcomes of these tax audits will not have an
adverse impact on our result and financial condition.





Our
current principal stockholder has effective control over our
business.





As of
November 3, 2008, Germain Lamonde, our Chairman of the Board, President and
Chief Executive Officer, held 92.29% of the voting rights in our stock. By
virtue of such stock ownership, Mr. Lamonde has effective control over all
matters submitted to our stockholders, including the election of our Directors,
and exercises significant control over our policies and affairs. Such
concentration of voting power could have the effect of delaying, deterring or
preventing a change in control or other business combinations that might
otherwise be beneficial to our stockholders.








12
 Table of Contents





If
we complete major acquisitions of complementary businesses, products or
technologies, we may need additional capital, and may not be able to raise
additional capital on favorable terms or at all, which could limit our ability
to grow and could increase our costs.





Our
future liquidity and capital requirements are difficult to predict because they
depend on numerous factors, including the success of our existing and new
product offerings as well as competing technological and market developments. As
a result, we may not be able to generate sufficient cash flows from our
operations to meet additional working capital requirements, support additional
capital expenditures or take advantage of acquisition opportunities. In fiscal
2008, the acquisitions of Navtel Communications ($11.3 million) and Brix
Networks ($29.7 million), combined with $6.5 million in capital expenses,
exceeded the $13.8 million provided by cash flows from operations. As at August
31, 2008, we held $87.5 million in cash and short-term investments.





We may
need to raise additional capital in the future. Our ability to obtain additional
financing will be subject to a number of factors, including market
conditions, effects of the financial crisis, reduced access to credit facility
and our operations performance. These factors may render the timing, amount,
terms and conditions of additional financing unattractive for us. If we raise
additional funds by selling equity securities, the relative ownership of our
existing investors could be diluted or the new investors could obtain terms more
favorable than previous investors. If we raise funds through debt financing,
we could incur significant borrowing costs. If we are unable to raise
additional funds when needed or at terms satisfactory to us, our ability to
operate and grow our business could be impeded.





Our
business and operations would suffer in the event of a failure of our
information technology infrastructure.





We rely
upon the capacity, efficiency and security of our information technology
hardware and software infrastructures as well as our ability to expand and
update these infrastructures in response to our evolving needs. Any failure to
manage, expand or update our information technology infrastructures or any
failure in the operation of this infrastructure could harm our
business.





Our
information systems are vulnerable to damages from computer viruses, natural
disasters, unauthorized access and other similar disruptions. Any system
failure, accident or security breach could result in disruptions to our
operations. To the extent that any disruption or security breach results in a
loss or damage to our data, or inappropriate disclosure of our confidential
information, it could harm our business. In addition, these events may force us
to devote more money and resources in order to protect ourselves against damages
caused by these disruptions or security breaches in the future.







13
 Table of Contents




Item 4.
              Information
      on the Company
  A.History
and Development of the Company




Our legal
name and commercial name is EXFO Electro-Optical Engineering Inc. / EXFO
Ingénierie électro-optique inc. Our head office is located at 400 Godin Avenue,
Quebec, Quebec, Canada, G1M 2K2 and our main telephone number is (418) 683-0211.
Our e-mail address is info@EXFO.com and our website is www.EXFO.com.
Information on our website is not incorporated by reference in this annual
report. Our agent for service in the United States is CT Corporation
System, 111 Eighth Avenue, New York, New York 10011. Our Transfer Agent and
Registrar is CIBC Mellon Trust Company, 2001 University Street, Suite 1600,
Montreal, Quebec, Canada, H3A 2A6. This annual report contains trademarks
and registered trademarks of us and other companies.





We were
incorporated on September 18, 1985 pursuant to the Canada Business Corporations Act.Since that date, we have amended our articles on various occasions mainly
to modify our legal and corporate names and our share capital.





On
December 20, 2000, we acquired all of the shares of EXFO Burleigh Products Group
Inc. (formerly Burleigh Instruments, Inc.) (“EXFO Burleigh”), Burleigh
Instruments GmbH and Burleigh Instruments (U.K.) Ltd. for an aggregate purchase
price of US$189.3 million, comprised of 6,488,816 of our subordinate voting
shares and US$42.5 million in cash pursuant to the terms of an Agreement of
Merger and Plan of Reorganization among us, EXFO Sub, Inc. and the selling
shareholders, dated November 4, 2000, as amended on
December 20, 2000.  In April2002, the name of Burleigh
Instruments, Inc. was changed to EXFO Burleigh Products Group
Inc.  On November 12, 2002, Burleigh Instruments (UK) Ltd. was
dissolved. EXFO Burleigh is a U.S. company that manufactures precision
scientific instruments used in basic and applied research engineering and
production test applications in a variety of fields.





On March
15, 2001, we acquired all of the shares of EXFO Photonic Solutions Inc.
(formerly EFOS Inc.) (“EXFO Photonic”), a privately held company in Toronto,
Canada, for a total consideration of US$110.1 million, of which US$25.1 million
was paid in cash. We also issued 3,700,000 of our subordinate voting shares
in connection with the acquisition. In September 2001, the name EFOS Inc. was
changed to EXFO Photonic Solutions Inc.





EXFO
Photonic, operating since 1984, is a supplier of precision light-based adhesive
spot curing products as well as curing process control for the global optical
component manufacturing market and other non-telecom markets. Its products
deliver precise doses of the appropriate spectral light into photo-sensitive and
heat-cured adhesives to significantly reduce bonding time and increase
repeatability in optical component and other manufacturing activities. EXFO
Photonic light-based curing technologies are supported by an extensive
understanding of bonding and material sciences and by a broad intellectual
property portfolio. EXFO Photonic, as of November 3, 2008, has
26 patents and 8 patents pending.





Also on
March 16, 2001, our wholly owned subsidiary, Burleigh Automation Inc. (“Burleigh
Automation”), acquired substantially all the assets of Vanguard Technical
Solutions, Inc., a wholly owned subsidiary of DT Industries, Inc. for a purchase
price of US$600,000 paid in cash. Vanguard, an automation equipment manufacturer
in Tucson, Arizona, specialized in the design and manufacturing of
ultra-precision assembly equipment for sensitive process and critical assembly
challenges on the production floor.  This acquisition, which
complemented our acquisition of Burleigh, was planned to fit with our overall
strategy at that time of providing customers with a comprehensive solution for
the assembly, alignment and testing of optical components and subsystems. Since
September 2001, Burleigh Automation has ceased operations and we have
transferred all material intellectual property assets and most of the physical
assets of Burleigh Automation to EXFO Burleigh.





In
November 2001, we acquired all of the shares of Avantas Networks Corporation and
simultaneously changed the name of that company to EXFO Protocol Inc. (“EXFO
Protocol”).  We paid a total consideration of US$69.4 million (or
US$95.0 million for the equity minus US$25.6 million of cash in the hands of the
acquired company) to acquire EXFO Protocol. Consideration paid consisted of
4,374,573 of our subordinate voting shares and US$9.8 million in cash, net of
cash acquired.  EXFO Protocol, a company based in Montreal, Canada
operating since 1998 is a supplier of fiber-optic testing and optical network
performance management equipment that supports a wide range of protocols and
data transmission rates.






14
 Table of Contents





During
fiscal 2001, we were forced to align our cost structure to market conditions. On
June 27, 2001, we announced the reduction of non-customer-related expenses,
postponement of plans to build a new facility in the Quebec Metro High-Tech
Park, termination of non-cure operations of Nortech, a subsidiary that
specialized in manufacturing fiber-optic temperature sensors and reduction
of our work force by 15%. Our plan to build a new facility has been cancelled
since then.





During
fiscal 2002, we were forced tore-align our cost
structure to market conditions.  First, on December 5, 2001,
we announced the lowering of our operating expenses, a freeze in employee
salaries, and the reduction of our workforce by 10%.  Then, on
May 15, 2002, we announced a further 20% reduction of our global
workforce in an effort to lower our cost structure. In May 2002, we performed an
assessment of the carrying value of goodwill and intangible assets recorded in
conjunction with the three acquisitions made during the previous 18 months.
Considering the ongoing unfavorable market conditions, we recorded a charge of
US$222.2 million to write down a significant portion of goodwill and a
charge of US$23.7 million to write down a significant portion of acquired core
technology. Also, overall for fiscal 2002, we wrote off US$18.5 million in
excess and obsolete inventories.





In August
2002, EXFO Burleigh received confirmation of the extension of its contract with
the U.S. Air Force Research Laboratory into phase 2 of a project for the
development by EXFO Burleigh of new high-precision actuator
system.  The contract for phase 2 provided for an additional funding
of US$1.7 million and extended through the first quarter of 2005.





In
October 2002, our newly created, wholly owned subsidiary, EXFO Gnubi Products
Group Inc. (“EXFO Gnubi”), acquired substantially all the assets of gnubi communications L.P.,
including its technology, expertise, customer base, inventories and capital
assets.  Consideration paid consisted of US$1.9 million in cash and
1,479,290 of our subordinate voting shares.  Furthermore, an
additional cash amount of US$241,000, based on sales volumes, was paid in fiscal
2004 in accordance with earn out provisions. With the acquisition of these
assets, EXFO Gnubi, based in Dallas, Texas, continues the operations of gnubi communications, L.P.,
as a supplier of multi-channel telecom and datacom testing solutions serving
optical transport equipment manufacturers and research and development
laboratories.  At the time of the asset acquisition, 30 employees of
gnubi communications,
L.P. transferred to EXFO Gnubi.





During
fiscal 2003, we were required to implement further restructuring measures as a
result of depressed spending levels in the telecommunications industry and
economic uncertainty. We reduced our workforce by 30%, rationalized our business
activities and consolidated certain manufacturing operations. These measures
incurred charges of US$4.1 million. The rationalization and consolidation
initiatives involved the reorganization of our business into two new reportable
market segments: Telecom Division and Photonics and Life Sciences Division and
the exiting of the optical component manufacturing automation business. Our
Telecom Division consists of the former Portable and Monitoring and telecom
related Industrial and Scientific product lines. Our Photonics and Life Sciences
Division includes previous non-telecom Industrial and Scientific product lines.
Each division has been structured with its own sales, marketing, manufacturing,
research and development and management teams.





In May
2003, we performed our annual impairment test on goodwill recorded in
conjunction with the acquisitions of EXFO Burleigh, EXFO Photonic and EXFO
Protocol and also reviewed the carrying value of intangible assets related to
these acquisitions. As a result of this assessment, we concluded that the
carrying value of goodwill related to EXFO Burleigh and the carrying value of
intangible assets related to EXFO Burleigh and EXFO Photonic was impaired and we
recorded a charge of US$4.5 million to write down goodwill and a pre-tax charge
of US$2.9 million to write down acquired core technology. Of the total
impairment loss of US$7.4 million, US$6.9 million is related to EXFO
Burleigh for goodwill and acquired core technology and US$0.6 million is related
to EXFO Photonic for acquired core technology.





In
addition, in an effort to simplify our structure and stream-line our operations,
the operations of EXFO Protocol were merged with those of the Corporation as of
September 1, 2003 and effective December 1, 2003, the operations of
EXFO Gnubi were merged with those of EXFO America Inc.





In fiscal
2004, EXFO also closed a public offering of 5.2 million subordinate voting
shares to a syndicate of Canadian-based underwriters for net proceeds of US$29.2
million (CA$38.4 million).





Furthermore
in fiscal 2004, we consolidated our protocol test operations (EXFO Protocol and
EXFO Gnubi) in Montreal, Canada to improve efficiency and reduce
costs.






15
 Table of Contents





In March
2004, we renewed our collective bargaining agreement with unionized
manufacturing employees in Quebec City, Canada. Such agreement will expire in
February 2009.





During
fiscal 2005, our Photonics and Life Sciences Division was renamed the Life
Sciences and Industrial Division to better reflect its market
focus.





During
fiscal 2005, we completed the consolidation of our Life Sciences and Industrial
Division in Toronto, Canada and we recorded US$482,000 in restructuring
expenses. Altogether, we incurred US$2.5 million in restructuring and other
charges since the fourth quarter of 2004 in conjunction with this consolidation
process. Following this process all of the operating activities of EXFO Burleigh
were transferred mainly in Toronto, Canada.





In
January 2006, we acquired substantially all the assets of Consultronics Limited
(“Consultronics”), a leading supplier of test equipment for copper-based
broadband access networks. Consultronics is a privately held company based in
Toronto, Canada with subsidiaries in the United Kingdom and Hungary. We acquired
all of the subsidiaries’ respective issued and outstanding shares. Consultronics
specializes in x-Digital Subscriber Line (xDSL), Internet Protocol TV (IPTV) and
Voice-over-Internet Protocol (VoIP) test solutions for the broadband access
market. We paid consideration equal to approximately US$19.1 million, including
debt assumption and other acquisition-related costs.





In
November 2006, we incorporated EXFO Electro-Optical Engineering India Private
Limited as our wholly-owned subsidiary to establish a software development
center in Pune, India. In October 2007, we acquired substantially all of the
assets of JamBuster Technologies Private Limited, for an immaterial
consideration, a company duly incorporated in Pune, India which is engaged
in the business of software development services.





In April
2007, we established a wholly-owned foreign entity in Shenzhen China, EXFO
Telecom Equipment (Shenzhen) Co. Ltd. for manufacturing purposes. We started
ramping up manufacturing in September 2007 at our Chinese
facility.





On
November 5, 2007, the Board of Directors approved a share repurchase program, by
way of a normal course issuer bid on the open market of up to 9.9% of our public
float (as defined by the Toronto Stock Exchange), or 2,869,585 shares at the
prevailing market price. The period of the normal course issuer bid commenced on
November 8, 2007, and ended on November 7, 2008. We repurchased a
total of 1,859,835 shares. All shares repurchased under the bid were cancelled.
We shall provide to any person or company, upon request to our Secretary,
at 400 Godin Avenue, Quebec, Province of Quebec, Canada, G1M 2K2,
phone number (418) 683-0913 ext. 3704 or fax number (418) 683-9839 a copy
of the notice sent to the Toronto Stock Exchange (TSX) according to its normal
course issuer bid.





In March
2008, we acquired all the issued and outstanding shares of Navtel Communications
Inc. (“Navtel”), a leading provider of Internet Protocol Multimedia
Subsystem (IMS) and Voice-over-Internet Protocol (VoIP) test solutions for
Network Equipment Manufacturers (NEMs) and Network Service Provider (NSP) labs.
Navtel is a privately held company based in Toronto, Canada with subsidiaries in
the Province of Ontario, Canada, United States and Germany. We paid
consideration equal to approximately US$11,477,000, or US$11,332,000 net of
US$145,000 of cash acquired. The total consideration included
acquisition-related costs of US$172,000.





In April
2008, we acquired all the issued and outstanding shares of Brix Networks Inc.
(“Brix”), a global provider of open and extensible converged service
assurance solutions. Brix is a privately held company based near Boston, USA
with a subsidiary in the United Kingdom. We paid consideration equal to
approximately US$29,696,000, or US$29,684,000 net of US$12,000 of cash acquired,
plus a contingent cash consideration of up to a maximum of US$7,537,000, based
upon the achievement of a bookings volume exceeding US$16,000,000 up to
US$40,000,000 in the 12 months following this acquisition.








16
 Table of Contents





On
November 6, 2008 we announced the renewal of a share repurchase program, by way
of a normal course issuer bid on the open market of up to 10% of our public
float (as defined by the Toronto Stock Exchange), or 2,738,518 subordinate
voting shares at the prevailing market price. We expect to use cash, short-term
investments or future cash flow from operations to fund the repurchase of
shares. The normal course issuer bid will start on November 10, 2008, and end on
November 9, 2009, or on an earlier date if we repurchase the maximum
number of shares permitted under the bid. The program does not require that we
repurchase any specific number of shares, and it may be modified, suspended or
terminated at any time and without prior notice. All shares repurchased under
the bid will be cancelled. We shall provide to any person or company, upon
request to our Secretary, at 400 Godin Avenue, Quebec, Province of Quebec,
Canada, G1M 2K2, phone number (418) 683-0913 ext. 3704 or fax number (418)
683-9839 a copy of the notice sent to the Toronto Stock Exchange (TSX) according
to its normal course issuer bid.





On
November 10, 2008 we announced a substantial issuer bid (the “Offer”) to
purchase for cancellation up to 8,823,529 shares for an aggregate purchase
price not to exceed CA$30 million. The Offer is being made by way of a
“modified Dutch Auction” pursuant to which shareholders may tender all or a
portion of their shares (i) at a price not less than CA$3.40 per share and
not more than CA$3.90 per share, in increments of CA$0.05 per share, or
(ii) without specifying a purchase price, in which case their shares will
be purchased at the purchase price determined in accordance with the Offer. The
Offer will expire at 5 p.m. (Eastern time) on December 16, 2008, unless
withdrawn, extended or varied by us. We expect to use cash, short-term
investments or future cash flow from operations to fund the repurchase of
shares. The Offer is not conditional upon any minimum number of shares being
tendered, but it is subject to certain other conditions. A complete description
of the terms and conditions of the Offer is contained in the Offer to Purchase
and Issuer Bid Circular and related documents filed with the applicable
securities regulatory authorities in Canada and the United States and mailed to
holders of shares on or about November 10, 2008. We shall provide to any person
or company, upon request to our Secretary, at 400 Godin Avenue, Quebec,
Province of Quebec, Canada, G1M 2K2, phone number (418) 683-0913 ext. 3704
or fax number (418) 683-9839 a copy of such documentation sent to the
Toronto Stock Exchange (TSX) according to its normal course issuer
bid.





Upon the
approval of the Offer, we suspended the normal course issuer bid that we had
renewed on November 6, 2008 referred above, until 20 business days after
the expiration of the Offer.







B.
            Business
      Overview




Company
Overview




EXFO is a
leading provider of testing, measuring and monitoring solutions for network
service providers and equipment manufacturers in the global telecommunications
industry. The Telecom Division, which represents more than 85% of our business,
offers a wide range of innovative solutions extending across the full technology
lifecycle― from
design to technology deployment and onto service assurance―and covering all the
layers of a network infrastructure to enable triple-play services and
next-generation, converged IP networking. The Life Sciences and Industrial
Division offers solutions in medical-device and opto-electronics assembly,
fluorescence microscopy, UV printing ink curing and other life sciences
sectors.




We were
founded in 1985 in Quebec City, Canada. Our original products were focused on
the needs of installers and operators of fiber-optic networks. Customers use
these field-portable testing products for the installation, maintenance,
monitoring and troubleshooting of optical networks. In 1996, we supplemented our
product portfolio with an extensive line of high-end products that are mainly
dedicated to research and development as well as manufacturing activities
of optical component manufacturers and system vendors.




Over the
past several years, we have enhanced our competitive position and breadth of
products through the acquisition of companies that specialize in transport and
data communications testing higherlayer protocol testing and emulation,
copper/xDSL testing and network communications service assurance.







17
 Table of Contents





In April
2008, we acquired all issued and outstanding shares of Brix Networks Inc.
(renamed EXFO Service Assurance Inc.), for a cash consideration of US$29.7
million, plus a contingent cash consideration of up to a maximum of US$7.5
million, based on booking levels exceeding US$16 million up to US$40 million in
the 12 months following the closing of the deal. Brix Networks, a privately
held company located in the Boston (MA) area, offers VoIP and IPTV service
assurance solutions across the three areas most affecting the success of a
real-time service: signaling quality (signaling path performance), delivery
quality (media transport performance) and content quality (overall quality
of experience). Brix Networks’ service assurance solutions are mainly
designed for network service providers (NSPs) and large
enterprises.




In March
2008, we acquired all issued and outstanding shares of Navtel Communications
Inc., for a cash consideration of US$11.3 million. Navtel Communications, a
privately held company in Toronto, Canada, is a leading provider of IMS and
VoIP(based on SIP Protocol) test solutions  for network equipment
manufacturers (NEMs) and NSP labs. Navtel Communications specializes in testing
next-generation IP networks that are increasingly combining wireline and
wireless technologies. Subsequent to the acquisition, Navtel Communications was
merged into the parent company.




In fiscal
2008, we opened our own telecom manufacturing facilities in Shenzhen, China. We
now have two main manufacturing sites for our Telecom Division and one smaller
plant for our Life Sciences and Industrial Division. Over time, low-volume,
high-complexity telecom products will be manufactured in Quebec City, whereas
high-volume, low-complexity telecom products will be manufactured in
Shenzhen.




In fiscal
2008, we accelerated the deployment of a software development center in Pune,
India, to supplement the research and development capabilities of our R&D
labs in Boston, Toronto, Montreal and Quebec City. This will enable us to
benefit from the wealth of IP expertise in India, to accelerate product
development―especially for our
software-intensive protocol test solutions―to take advantage
of a lower cost structure.




In
January 2006, we acquired substantially all the assets of Consultronics Limited,
a leading supplier of test equipment for copper-based broadband access networks,
for a total cash consideration of US$19.1 million. Above and beyond copper/xDSL
test solutions, Consultronics had a rich product portfolio for testing
next-generation technologies, such as IPTV and VoIP, which are critical for NSPs
in their deployment of triple-play services (voice, data, video) over optical
and copper links in access networks. This acquisition was a strategic initiative
to position EXFO as a strong supplier of broadband access and triple-play
testing because it complemented our market leadership in the optical FTTx
test market.




In
November 2001, we acquired Avantas Networks Corporation (renamed EXFO Protocol
Inc. and which has since been merged with EXFO), a supplier of transport and
datacom testing equipment for NSPs. This transaction enabled us to combine
optical and protocol test modules inside a single field-portable test platform
in order to help our customers increase revenues and reduce operating costs. In
October 2002, our wholly-owned subsidiary, EXFO Gnubi, purchased substantially
all the assets of gnubi
communications, L.P., a supplier of multichannel telecom and datacom
testing solutions for the system manufacturer market. These strategic
acquisitions―which were consolidated in Montreal, Canada, in fiscal
2004―enabled us to more than double our addressable market, as we
expanded from optical testing to transport and datacom (Layers 1-3) testing
applications, and to offer a more complete line of test solutions to our
customers.




Previously,
we had completed two acquisitions to bolster growth in the optical component
manufacturing market. We acquired Burleigh Instruments, Inc. (renamed EXFO
Burleigh Products Group Inc.) in December 2000 for its wavelength measurement
instruments and nanopositioning alignment systems. We also added EFOS Inc.
(renamed EXFO Photonic Solutions Inc.) in March 2001 for its precision
light-based, adhesive spot-curing technology. We have since exited the
optical component manufacturing automation business, and the remaining
operations of EXFO Burleigh have mostly been consolidated with those of
EXFO Photonic Solutions in Toronto, Canada. These consolidated businesses now
fall under our Life Sciences and Industrial Division.







18
 Table of Contents





We
launched 27 new products in fiscal 2008, including seven in the fourth quarter,
compared to 20 in fiscal 2007. Key product introductions in fiscal 2008 included
among others a multiservice, multimedium modular handheld platform for
characterizing and troubleshooting access networks (AXS-200 SharpTESTER) along
with related DSL, copper access, Ethernet and optical test modules; a compact
multiservice transport test set that combines next-generation SONET/SDH and
Ethernet testing inside a single module (FTB-8120NGE/FTB-8130NGE Power Blazer);
40/43 Gbit/s SONET/SDH field and lab oriented solutions (FTB-8140/IQS-8140
Transport Blazer) for high-speed optical networks; an all-in-one chromatic
dispersion (CD) and polarization mode dispersion (PMD) analyzer (FTB-5700
Single-Ended Dispersion Analyzer) that requires only one technician to
characterize a link from a single end; a triple-play test set (AXS-200/630
VDSL, ADSL2+ and IP Triple-Play Test Set) for the deployment and troubleshooting
of ADSL2+/VDSL2 networks; and the advanced IQS-600 Integrated Qualification
System, a next-generation, modular test platform for R&D and manufacturing
applications. Following the year-end, we introduced an enhanced version of
Navtel’s InterWatch platform that simulates up to 256,000 unique IPv6 subscriber
addresses per chassis, and new software features on the Transport Blazer test
modules for characterizing 40G/43G SONET/SDH networks. Sales from products that
have been on the market two years or less accounted for 34.6% for the fiscal
year, while our published goal is 30%.




Overall
for fiscal 2008, we increased sales 20.2% to $183.8 million from $152.9 million
in 2007. Global sales for fiscal 2008 included $5.4 million from newly
acquired Brix Networks and Navtel Communications since their acquisitions in the
third quarter of 2008. GAAP net earnings reached $18.4 million, or $0.27 per
diluted share, including $5.3 million for the recognition of previously
unrecognized future income tax assets in the United States, $2.7 million for
income tax recovery following the review of our tax strategy related to recently
substantively enacted income tax rates in Canada, $1.5 million of income tax
expense to account for the recently substantively enacted income tax rate on our
future income tax assets in Canada, an extraordinary gain of $3.0 million
related to the negative goodwill on the Navtel acquisition, as well as
$3.0 million in after-tax amortization of intangible assets and $1.3
million in stock-based compensation costs. In 2007, GAAP net earnings reached
$42.3 million, or $0.61 per diluted share, including $24.6 million in
recognition of previously unrecognized future income taxes, $3.2 million in
recognition of previously unrecognized research and development tax credits,
$2.9 million in amortization of intangible assets, $1.1 million from a
government grant recovery and $1.0 million in stock-based compensation
costs.




In fiscal
2008, we faced a substantial and sudden increase in the value of the Canadian
dollar versus the US dollar. The average value of the Canadian dollar increased
11.4% in fiscal 2008, compared to the same period last year. Given that most of
our sales are denominated in US dollars but a significant portion of our
expenses are denominated in Canadian dollars, our financial results were
negatively affected.


On
November 5, 2007, the Board of Directors approved a share repurchase program, by
way of normal course issuer bid on the open market, up to 9.9% of our public
float (as defined by the Toronto Stock Exchange), or 2.9 million
of subordinate voting shares, at the prevailing market price. The period of
the normal course issuer bid commenced on November 8, 2007 and ended on
November 7, 2008. All shares repurchased under the bid were cancelled. We
redeemed 1.9 million subordinate voting shares for a total consideration
of $8.5 million under that program.




On
November 6, 2008, we announced a renewal of our share repurchase program, by way
of a normal course issuer bid on the open market, of up to 10% of our
public float (as defined by the Toronto Stock Exchange), or 2,738,518
subordinate voting shares, at the prevailing market price. We expect to use
cash, short-term investments or future cash flows from operations to fund the
repurchase of shares. The period of the normal course issuer bid starts on
November 10, 2008, and will end on November 9, 2009, or on an earlier
date if we repurchase the maximum number of shares permitted under the bid. The
program does not require that we repurchase any specific number of shares, and
it may be modified, suspended or terminated at any time and without prior
notice. All shares repurchased under the bid will be cancelled.







19
 Table of Contents





On
November 10, 2008, we announced a substantial issuer bid (the “Offer”) to
purchase for cancellation up to 8.8 million subordinate voting shares for an
aggregate purchase price not to exceed CA$30 million. The Offer is being
made by way of a “modified Dutch Auction” pursuant to which shareholders may
tender all or a portion of their shares (i) at a price not less than
CA$3.40 per share and not more than CA$3.90 per share, in increments of
CA$0.05 per share, or (ii) without specifying a purchase price, in which case
their shares will be purchased at the purchase price determined in
accordance with the Offer. The Offer will expire
on December 16, 2008, unless withdrawn, extended or varied. We
expect to use cash, short-term investments or future cash flows from
operations to fund the repurchase of shares. The Offer is not conditional upon
any minimum number of shares being tendered, but it is subject to certain other
conditions.




Upon the
approval of the Offer, we suspended the normal course issuer bid referred to
above, until 20 business days following the expiration of the
Offer.




Key
Industry Trends




The basic
fundamentals of the global telecom industry remain solid for the moment.
However, it is still unknown what impact the financial crisis might have on the
global economy and the telecom industry in particular, especially in the United
States where a severe economic slowdown could potentially reduce investments and
affect other parts of the world. Fundamental telecom business drivers are based
on exponential growth in bandwidth demand, coupled with intense competition
between telecom operators (telcos) and cable companies (cablecos). Both classes
of companies are funding massive investments in converged, next-generation
Internet protocol (IP) networks to capitalize on significant operational
efficiencies and to attract/retain subscribers and increase revenues through
improved service offerings.




Global
Internet bandwidth demand is growing very rapidly, due to a myriad of
applications like video, Web gaming, etc. TeleGeography Research estimated that
bandwidth demand has grown at a compound annual growth rate (CAGR) of 54% from
2004 to 2008. This trend is likely to remain steady in the years to come with
the upcoming deployments of IPTV (Internet protocol television), HD-IPTV
(high-definition Internet protocol television) and increased online video
streaming, since these applications, among others, will consume a colossal
amount of additional bandwidth. As a result, telcos and cablecos are investing
substantially in their access networks in order to provide differentiated,
revenue-generating services to attract and retain consumers who are
increasingly relying on broadband network services for their work, entertainment
and everyday activities. From a telco perspective, it is likely that
fiber-to-the-home (FTTH) will become the access network architecture of choice
that will allow them to meet heightened bandwidth requirements and future-proof
their access networks, as residential bandwidth requirements are growing from
the 1 to 5 Mbit/s (megabits per second) of the past to the 30 to 100 Mbit/s
required in the long-term. Hybrid architectures, combining copper and fiber
(fiber-to-the-curb, or FTTC, and fiber-to-the-node, or FTTN), will continue
expanding in the short term, since they are less-expensive methods to increase
bandwidth and can be mass-deployed faster.




These
investment decisions are applicable not only to green-field deployments and
high-rise buildings, but also to larger-scale rollouts as long-term operating
costs are less than FTTC and FTTN. The cost of deploying FTTH has been
decreasing over the last few years as volume increased and deployment tools,
like those we offer, are making the task increasingly simple and efficient.
Networks are in the early stages of fiber deployments in access networks in
both the Americas and around the world. In addition, Western Europe and
China have become increasingly committed to deploying FTTH networks, given their
high population density. Both Japan and South Korea have already adopted fiber
to the home as a mainstream method of broadband residential
service.




As
bandwidth growth in access networks continues to increase it has begun placing a
strain on metro rings and core networks. It is also driving the need for
higher-speed technologies; for example, 43 Gbit/s(gigabits per
second)SONET/SDH
is now increasingly deployed and becoming mainstream, while 100 Gbit/s Ethernet
is in early field trials. The deployment of these solutions is expected to be
significantly more economical if it alleviates the need for trenches need to be
dug in order to deploy new fiber in metro or long-distance routes.







20
 Table of Contents





As
telecommunication networks are being transformed to provide IP-based voice,
video and data capabilities, legacy SONET/SDH standards, which were first
established in the mid-1980s and implemented until 2005, do not have the payload
flexibility to seamlessly and efficiently mix and transport video with voice and
data. These networks will not be capable of efficiently carrying emerging
IP-based services, since they are designed for public switched telephone network
(PSTN), point-to-point voice transmission. As a result, with new SONET/SDH
standards, which are part of what the industry is labeling next-gen networks, telcos
operators are increasingly turning to next-generation, IP-based networks to
allow for more flexible and efficient transport of applications and services,
and to offer customers higher-margin triple-playservices―and even
quadruple-play services―as wireline and wireless technologies become
increasingly interconnected. Finally, as subscribers of these new services reach
a critical mass, telcos are relying on service assurance solutions to ensure
that the quality of service (QoS) and quality of experience (QoE)
demanded by users are optimal in the post-deployment phase.




These
market dynamics positively affected telecom test, measurement and service
assurance suppliers in fiscal 2008; however, deteriorating macro-economic
conditions in the United States could instigate a slowdown in capital spending
among customers, which would necessarily reduce demand for our test, measurement
and service assurance solutions.




In terms
of our Life Sciences and Industrial Division, key market trends for the niche
markets that we serve include:




·
            Industrial
      UV Spot-Curing: The end-markets for precision assembled products
      manufactured with UV curing remains healthy, especially for the assembly
      of medical devices, despite weaker economic conditions. The market in
      Asia, dominated by high volume opto-electronics manufacturing, is
      increasingly adopting LED (light emitting diode) UV spot curing
      equipment.


·
            Life
      Sciences: The fluorescence microscopy market continues to increase
      steadily with the majority of the growth happening in live cell and
      quantitative imaging applications.


·
            Industrial
      UV Digital Print Ink Curing: The digital print markets that we target are
      exhibiting strong growth as printing press equipment continues to make the
      transition from analog to digital
technology.




Three-Year
Corporate Objectives




Our
vision is to become a strong market leader in the global telecom test,
measurement and service assurance industry―offering market-driven solutions
mainly for network service providers and increasingly covering the service and
application layers of the network infrastructure―to enable triple-play services
and next-generation, converged IP networking.




We do not
intend to become a one-stop shop for our customers, but rather continue to be a
strong player in selected, high-growth and synergistic markets. We will follow
this roadmap by offering best-in-class solutions that anticipate market needs,
while focusing on the highest level of customer satisfaction.




To
achieve our long-term vision, we plan to expand our leadership position in the
portable Optical segment, while growing our Transport and Data communications
testing (Protocol) business even faster to surpass the Optical segment in terms
of sales. This plan is based first and foremost on organic growth, but it will
be supported by strategic acquisitions of small to mid-size companies with
best-in-class technologies in nascent, high-growth markets that are
complementary to us. We also intend to improve our competitive position through
strategic alliances and partnerships.




Following
our practice of benchmarking performance, we have established three corporate
performance objectives to measure the success of our three-year plan ending at
the close of fiscal 2011. These long-term objectives are intended to replace the
performance goals that the company provided on an annual basis. These new
objectives reflect the clear direction management is taking towards long-term
value creation.







21
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Objective
            Three-Year
      MetricIncrease
      sales significantly faster than the industry growth rate
            20%
      CAGRGrow
      EBITDA* in
      dollars faster than sales
            >20%
      CAGRContinue
      raising gross margin
            62%





*
            EBITDA
      is defined as net earnings before interest, income taxes, amortization of
      property, plant and equipment, amortization of intangible assets, and
      extraordinary gain.





The
EXFO Solution




We offer
an extensive range of test, measurement and service assurance solutions to the
global telecommunications industry. Our success has been largely predicated on
our core expertise in producing test equipment for optical telecommunications.
We also leverage this expertise to develop products for life sciences and
high-precision assembly applications. Our solution is based on the following key
attributes:




Modular System
Design. In 1996, we established an industry-first by launching the
original modular optical test platform. This system design consists of a
PC-based, MS Windows-driven platform that can accommodate several test modules
performing various types of measurements. We have since developed additional
compatible test platforms and extended our test module offering for both NSPs
and system manufacturers based on the same modular design. Our modular product
design provides the following advantages:




·
            unlike
      stand-alone units, new test modules can be rapidly developed to address
      changing industry requirements;


·
            as
      customers’ testing requirements change, they can purchase additional
      modules that are compatible with their previously purchased platforms,
      thus protecting their initial
investments;


·
            our
      standard graphical user interface reduces training costs because customers
      are familiar with previously acquired software
  products;


·
            the
      flexibility of our systems allows customers to develop customized and
      automated solutions for their specific test
  requirements;


·
            our
      test platforms are PC-based and MS Windows-driven, thus they can support
      third-party software solutions.




High Degree of
Technological Innovation. We have established a strong reputation for
technological innovation over the last 23 years. In fact, we believe this
attribute represents a key differentiator for us within a competitive
marketplace. Following are some of our industry firsts:




·
            the
      first PC-based modular test platform for field
    applications;


·
            the
      first all-in-one optical loss test set combining several
      instruments;


·
            the
      first portable polarization mode dispersion (PMD)
  analyzer;


·
            the
      first modular platform to combine optical and protocol test
      solutions;


·
            the
      first line of portable test instruments designed for FTTx testing;
      and


·
            the
      first fully integrated Ethernet-over-SONET test
  solution.




High-Quality
Products.  Product quality is an integral part of our solution.
Our Quebec City, Canada, operations have maintained ISO 9001 certification since
1994 and they are now certified to the new 2000 edition of the standard. Our
manufacturing plant in Shenzhen, China, which started operations in September
2007, is responsible for the production of high-volume, low-complexity telecom
products. Quality-control responsibilities for products manufactured in China
will remain in Quebec City until the Shenzhen facility obtains full ISO-9000
certification. All of our products meet required industry standards, and some of
our products meet additional voluntary standards, such as those set by
Telcordia, formerly Bellcore, IEC, IETF, ETSI and other industry-leading
standards bodies. During manufacturing, each product has a related
quality-assurance plan, with rigorous checkpoints, to ensure product conformity.
Various tasks in the quality assurance process include quality control,
conformity testing, product documentation, product improvement, regulatory
compliance, metrology and calibration.







22
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Our
product designs comply with Directive 2002/96/EC, a legislation enacted by the
European Union regarding the disposal of waste electrical and electronic
equipment (WEEE), for all products exported to Europe. In regard to the
Directive 2002/96/EC (RoHs), test and measurement manufacturers have been
provided a limited exemption until 2012.




Products




Our test
platforms, namely the AXS-200 SharpTESTER, FTB-200 Compact Platform, FTB-400
Universal Test System (UTS), and IQS-600 Intelligent Test System (ITS), are at
the core of our product portfolio. The AXS-200 SharpTESTER, which was launched
in September 2007, is a multi-service, multi-medium handheld test platform
designed for characterizing and troubleshooting commercial and residential
access networks. It can easily be configured for copper/DSL/triple-play,
Ethernet or optical testing applications. The FTB-200 Compact Platform is a
two-slot portable test unit optimized for multi-technology, multi-application
characterization of metro and access networks. The FTB-400 field-testing
platform provides network service providers with a simple, yet efficient way to
perform multiple, advanced test operations for installation, maintenance and
troubleshooting applications. Our IQS-600 ITS, which was launched in the second
quarter of 2008, is designed for manufacturing and R&D applications. It
tests optical as well as transport and data communications technologies
increasingly based on IP. All platforms and related test modules are supported
by integrated and highly intuitive graphical user interfaces (GUIs), enabling
the user to easily store, handle and retrieve test results and measurement data.
In addition, EXFO offers a number of handheld and benchtop test and measurement
products, some of which are modular in nature.




Following
the acquisition of Navtel Communications in March 2008, we offer the InterWatch
platform series, a line of advanced hardware and software-based test systems
that enable network equipment manufacturers and network service provider labs to
fully test their complex digital telecommunications equipment and services more
quickly and cost-effectively, while helping to ensure interoperability and
reliability. These advanced software and hardware solutions assist customers in
the design, integration, installation and acceptance testing of a broad range of
Internet Protocol Multimedia Subsystem (IMS)/Next-Generation Network (NGN)
telecommunications equipment and services by performing a variety of test
functions:




·
            Design
      and feature verification;


·
            Interoperability
      testing;


·
            Load
      and stress testing; and


·
            Monitoring
      and analysis.




Following
the acquisition of Brix Networks in April 2008, we also offer various Brix
Solutions, a comprehensive service assurance and performance monitoring systems
for advanced IP services such as IPTV, voice-over-IP, virtual private networks
(VPNs), video on demand, and video conferencing. The Brix System, a family of
integrated software and hardware components, proactively monitors quality by
providing complete visibility across all IP services, throughout the lifecycle
of the service, and across the entire network.




In the
Brix Solutions, advanced performance management applications, running on a
central-site software engine, called BrixWorx, analyze and display performance
data collected from the measurement sources, Brix Verifiers, deployed throughout
the network being monitored. Brix Verifiers execute protocol-specific tests to
precisely calculate crucial availability and performance metrics through
proactive testing, ongoing monitoring, and the collection of data directly from
infrastructure devices.




BrixWorx
provides all performance data analysis, configuration, and management for the
distributed Brix System, while test suites offer broad and deep visibility into
the performance of converged network services.




Furthermore,
EXFO offers network monitoring systems and test probes used in third-party
network monitoring solutions.







23
 Table of Contents





The
following table summarizes the principal types of test instruments for the
telecommunications industry, typical applications and the formats in which we
offer them:




Instrument
      Type
            Typical
      Application
            NSP
      Market
            Manufacturer
              /R&D
      MarketFTB
      400 Modules
            FTB
      200 Modules
            AXS
      200 Modules
            Handhelds
            IQS-600
                Modules
            Bench
      top InstrumentsADSL/ADSL2+
      Service Verification Tool
            Based
      on a DSL “golden modem”, these units are used to test the function, speed
      and quality of a DSL service at the subscriber premises.
            
            
            X
            XBroadband
      source
            Used
      for testing wavelength-dependent behavior of fiber cables and dense
      wavelength division multiplexing (DWDM) optical
components.
            
            
            
            
            X
            XChromatic
      dispersion analyzer
            Measures
      increasing levels of chromatic dispersion in high-capacity optical
      networks.  Chromatic dispersion is a physical phenomenon
      inherent to optical fiber and optical components that causes information
      bits to spread along a network.  This degrades the quality of
      the transmission signal and, in turn, limits the transmission speed
      carried by optical networks.
            XClip-on
      coupling device
            Clips
      to an optical fiber and allows non-invasive testing.
            
            
            
            XFibre
      Channel tester
            Brings
      FC-0, FC-1 and FC-2 logical layer Fibre Channel testing to services
      delivered via transport protocols, such as dense wavelength division
      multiplexing (DWDM), SONET/SDH and dark fiber. It provides valuable timing
      information and buffer credit estimation for Fibre Channel network
      deployment.
            X
            X
            
            
            XGigabit
      Ethernet tester
            Measures
      data integrity for high-speed Internet protocol telecommunications in
      metro and edge networks.
            X
            X
            X
            
            X10
      Gigabit Ethernet tester
            Benchmarks
      and verifies high-speed 10 Gbit/s Ethernet network performance and
      service-level agreements.
            X
            X
            
            
            XHDTV,
      SDTV and IPTV service test instrument
            Used
      to test the quality and functionality of standard and high definition
      television signals that are delivered over higher-rate ADSL, ADSL2+ and
      VDSL2 transmission technologies.
            
            
            
            XLaser
      spectrum analyzer
            Performs
      high-resolution, spectral characterization of continuous CW laser
      sources
            
            
            
            
            
            XTelephone
      for traditional voice and VoIP service testing
            Used
      by telephone line and DSL installers to test the proper functioning of
      both traditional and next-generation voice and data communication
      services.
            
            
            
            XLive
      fiber detector
            Clips
      on to a fiber and is used to detect the presence and direction of a signal
      without interrupting the traffic.
            
            
            
            XLoss
      test set
            Integrates
      a power meter and a light source to manually or automatically measure the
      loss of optical signal along a fiber.
            X
            X
            X
            X
            X
            XNarrowly
      tunable laser
            A
      laser that can be precisely tuned to simulate a DWDM light
      sources.  Used primarily for testing optical
      amplifiers.
            
            
            
            
            XNext-generation
      SONET/SDH analyzer
            Full
      SONET/SDH protocol testing functionality, including support for generic
      framing procedure (GFP), virtual concatenation (VCAT), and link-capacity
      adjustment scheme (LCAS) next generation enhancements.
            X
            
            
            
            XOptical
      coupler
            Used
      in test system to combine sources or signals.  Also uses as
      splitters to monitor signals.
            
            
            
            
            XOptical
      power meter
            Measures
      the power of an optical signal.  It is the basic tool for the
      verification of transmitters, amplifiers and optical transmission path
      integrity.
            X
            X
            
            X
            X
            XOptical
      power reference module
            Provides
      a highly accurate and traceable measurement of power for the calibration
      or verification of other power measurement instruments.
            
            
            
            
            X








24
 Table of Contents




Instrument
      Type
            Typical
      Application
            NSP
      Market
            Manufacturer
              /R&D
      MarketFTB
      400 Modules
            FTB
      200 Modules
            AXS
      200 Modules
            Handhelds
            IQS-600
                Modules
            Bench
      top InstrumentsOptical
      return loss meter
            Combines
      a laser and a power meter to measure the amount of potentially degrading
      back reflection.
            X
            X
            
            X
            XOptical
      spectrum analyzer
            Produces
      a graphical representation of power versus wavelength for an optical
      signal. Useful for measuring the drift, power and signal-to-noise ratio
      for each wavelength in a DWDM system.
            XOptical
      switch
            Provides
      switching between fibers. Used to provide flexible and automated test
      setups such as the measurement of multiple fibers or components with
      multiple ports with one instrument.
            X
            
            
            
            XOptical
      time domain reflectometer
              (OTDR)
            Like
      a radar, it measures the time of arrival of reflections of an optical
      signal to determine the distance to the breaks or points of excessive loss
      in a fiber network.
            X
            X
            
            XPassive
      component analyzer
            Characterizes
      passive wavelength-selective devices, such as multiplexers, demultiplexers
      and add/drop filters, with respect to absolute wavelength in order to
      guarantee their performance within dense wavelength division multiplexing
      (DWDM) systems.
            
            
            
            
            
            XPassive
      optical network (PON) power meter
            Determines
      the power level of various signal types, including continuous (e.g., TV
      signal at 1550 nm) and framed (e.g., ATM or Ethernet at 1490 nm or 1310
      nm) within a passive optical network. Various baud rates are covered,
      ranging from 155 Mbit/s to 2.5 Gbit/s, for both synchronous and
      non-synchronous signals.
            
            
            
            XPolarization-dependent
      loss meter
            Measures
      the difference in loss of power for the different states of
      polarization.
            
            
            
            
            XPolarization
      mode dispersion analyzer
            Measures
      the dispersion of light that is caused by polarization. Generally used to
      determine the speed-distance limitation of fiber and
    cables.
            XSONET/
      SDH analyzer
            Provides
      accurate bit-error rate and performance analysis of SONET/SDH overhead
      format that reflects the quality of a transmission system.
            X
            X
            
            
            XStable
      light source
            Emitting
      diode or lasers used in connection with a power meter to measure signal
      loss.
            X
            
            
            X
            X
            XSynchronization
      analyzer
            Portable,
      stand-alone tester for network synchronization analysis and wander
      measurement in wireless and wireline transport networks.
            
            
            
            
            
            XTalk
      set
            A
      device that attaches to an optical fiber and serves as a temporary voice
      link facilitating coordination of work among installation
      crews.
            X
            
            
            XTelephone
      wire analyzer
            Used
      by telecommunications service providers that have networks that are
      comprised mostly or partially of twisted-pair local loops to ensure that
      those loops are of sufficient quality to carry higher-frequency signals
      required for DSL.
            
            
            
            XVariable
      optical attenuator
            Used
      in network simulation setups to provide calibrated variable reduction of
      the strength of an optical signal.
            
            
            
            X
            X
            XVisual
      fault locator
            A
      visible laser that can be connected to an optical fiber network to help
      locate breaks or points of excessive loss.
            X
            X
            
            XWidely
      tunable laser
            Can
      produce laser light across a broad range of wavelengths. Used to test DWDM
      components and value-added optical modules.
            
            
            
            
            X
            X







25
 Table of Contents





Products
for Network Service Providers




Test
Equipment




We offer
an extensive range of field-portable test, measurement and monitoring solutions
that are mainly used by network service providers that can also be utilized by
network equipment manufacturers. These products are available as handheld test
instruments, portable platforms with related modules, and as rack-mount chassis
with related modules. Our handheld instruments are durable, compact and easy to
use. Our AXS-200 SharpTESTER platform, which is designed for entry-level field
technicians in access networks, can easily be configured for
copper/DSL/triple-play, Ethernet or optical testing applications. We released
Ethernet/IP and ADSL2+ triple-play test modules for the AXS-200 SharpTESTER in
fiscal 2008, while several others modules and applications will be introduced in
upcoming months. Our FTB-200 Compact Platform, designed for the “super field
technician”, holds up to two interchangeable modules that are fully compatible
with the highly entrenched FTB-400 platform. Test technologies well-suited for
the FTB-200 Compact Platform include a wide range of singlemode and multimode
optical time-domain reflectometers (OTDRs), automated optical loss test sets
(OLTSs), SONET/SDH analyzers from DS0 up to OC-192, as well as Gigabit Ethernet
(GigE) and 10 Gigabit Ethernet testers. Our second-generation field-testing
platform, the FTB-400 UTS, is available in four configurations: the two-slot
model is ideal for OTDR, OLTS and Gigabit Ethernet applications; the four-slot
model offers a high-speed bus, ideal for extensive datacom testing and dedicated
OTDR, optical loss and Ethernet (up to 10 Gigabit) testing; the seven-slot model
is used for dispersion characterization (PMD and CD), DWDM testing (OSA and MWM)
and protocol (SONET/SDH/datacom) testing. Finally, the eight-slot model is a
high-performance, multiple-protocol configuration that allows users to combine
next-generation SONET/SDH functions with Ethernet, Fibre Channel and
optical-layer testing capabilities. Our portable platforms are PC-centric,
Windows-based, highly flexible and fully scalable. Their large robust
touchscreens are very practical for field use.




Service
Assurance Systems




We also
offer a family of service assurance and performance monitoring solutions,
collectively known as the Brix System, to network service provider labs and
large enterprises. The following describes the software and hardware elements of
the Brix System:




Centralized
Management and Correlation -- BrixWorx




BrixWorx
represents the core of the Brix System.BrixWorx
provides network- and service-wide control, visibility, and analysis for the
fully integrated Brix System. Using the BrixWorx Operations Center user
interface, administrators remotely control each component of the system and can
easily configure and modify all aspects of the geographically distributed
network of Verifiers and third-party measurement sources, including: choosing
the desired performance tests and configuring their parameters, threshold
values, and schedules.




The
BrixWorx unified correlation engine quickly turns data into actionable
information through a visualization layer for service-level agreement (SLA)
conformance, root-cause analysis, troubleshooting, usage patterns, and
trending.




The
highly scalable BrixWorx architecture easily accommodates hundreds of thousands
of Brix Verifier test points and third-party measurement sources.




Visualisation
and Business Intelligence -- BrixView




Seamlessly
integrated with the BrixWorx correlation engine, BrixView enables the flexible
presentation of performance and quality information to all decision makers. With
interactive dashboard views, customizable reporting packages, and individual
content portals, BrixView delivers fast, simple access to information when it is
needed and in the format it is needed for all levels of users across an
organization.




BrixView
produces visualization and reports of varying levels to allow a broad audience
to take the appropriate actions. With the appropriate information, network
operators spend less time working with static charts and spreadsheets, and
business owners and executives have the information and insights they need to
make intelligent decisions and drive business value for the
organization.







26
 Table of Contents





Testing
Across the Entire Network -- Brix Verifiers




Installed
at customer premise locations, the Brix Verifiers’ various interfaces include
Ethernet, ATM, and Euro/ISDN PRI. Similarly, Verifier test capacity scales from
the modest requirements of an enterprise branch office running hundreds of tests
to a network core running hundreds of thousands of tests.




In
addition to Brix Verifiers, the Brix System also supports selected third-party
measurement sources. Brix Verifiers are designed for long-term 24x7 deployments
in the lights-out, production networks of service providers and enterprises.
Once a Brix Verifier is deployed, administrators do not need to locally access
it again.




End-to-End
IP Service Assurance:  BrixNGN




The
network core is the heart of the service delivery network, and where successful
providers’ service assurance strategies start. To effectively guarantee
end-to-end SLAs and meet customers’ requirements, providers must implement a
service assurance solution that provides visibility from the provider edge and
to end-users, while allowing segmented views of service quality for problem
isolation. By continually monitoring the performance and quality of real-time IP
services, and not just the physical network devices, BrixNGN provides the most
effective service assurance solution.




With
BrixNGN, providers can continuously collect, correlate, analyze, and visualize
critical quality of service (QoS) and quality of experience (QoE) data from the
network core to the customer endpoint for capacity planning, verifying service
turn-ups, and identifying, diagnosing, and quickly resolving network and service
performance issues before customers are impacted—thereby guaranteeing
quality.




The
BrixNGN software module performs proactive monitoring of the network core,
extended Ethernet and IP networks between partners and customers, and data
services, including E-mail, web-based applications, file transfers, and
more.  BrixNGN enables early detection and quick resolution of service
affecting issues.




Performance
Monitoring for IP Video: BrixVision




The
BrixVision product line is a family of IPTV service assurance products that
measure the end-to-end quality of IP-based video services and validate
performance of broadcast and on-demand channel quality. The BrixVision product
line provides full service lifecycle performance monitoring for IP Video
services such as broadcast TV, video on demand, gaming, and videoconferencing.
BrixVision provides visibility into service performance using a combination of
proactive testing and user transaction generation, passive monitoring, and the
collection of performance metrics from service delivery or home network
devices.




Voice
over IP Testing and Monitoring: BrixCall




BrixCall
provides comprehensive visibility into the performance of live VoIP traffic to
ensure call quality from the network core to customer care.  Deployed
in conjunction with the Brix family of Verifiers, BrixCall is an integrated
component of EXFO Service Assurance’s live call monitoring solution and employs
Brix Verifiers to monitor call signaling and media traffic throughout the
network with the advanced BrixCall stream correlation and analysis
engine.  The solution delivers a single detailed Call Quality Report
for each call monitored as well as visibility across all monitored
calls.




In
addition, the BrixCall dashboard presents critical information about the current
state of the service, including all performance threshold violations, call
disposition, average Mean Opinion Score (MOS), peak call volume and bandwidth
utilization, answer seizure and network efficiency ratios, and call duration
information.




BrixCall
features the unique Brix Tri-Q Analysis, and graphically displays the impact of
each of the elements that contribute to a user’s satisfaction with a call —
signaling quality, delivery quality, and call quality.







27
 Table of Contents





The
following table summarizes the principal service assurance solutions we provide
as well as their typical applications:




Service
      Assurance SolutionsProduct
      Type
            Product
            Typical
      ApplicationSoftware
      Products
            BrixWorx
            Central
      site operations centerBrixCall
            Advanced
      analysis and correlation of VoIP callsBrixVision
            Advanced
      analysis and correlation of live video sessionsBrixNGN
            Network
      core and MPLS analysis, correlation and reportingBrix
      Verifier
            Brix
      100M Verifier
            Customer
      premise end point monitoringBrix
      1000 Verifier
            Network
      edge and lower capacity monitoringBrix
      2500 Verifier
            Network
      core, at a higher capacityBrix
      3500T Verifier
            PSTN
      monitoringBrix
      4100 Verifier family
            In-network
      live voice or video monitoring





Products
for Network Equipment/Component Manufacturers




Test
Equipment




Our
network equipment/component vendor solutions, mainly built around our IQS-600
ITS, are available as test modules or stand-alone benchtop instruments. The
next-generation IQS-600 platform can efficiently run as many as 100 optical test
modules using a single controller unit. The IQS-600 platform is equipped with
the software and hardware technology to support single-button operation for
automated testing. Its system-based approach – one box, several test
modules – combined with an open architecture (PXI, Windows, LabVIEWTM,
etc.) and ease of programming, produces a highly flexible test
environment.




The
IQS-600 also provides backward compatibility with recent IQ-generation test
modules, while delivering all the power and advantages of a next-generation
platform. EXFO’s wide selection of high-performance test modules includes
high-speed power meters, light sources, WDM laser sources, tunable laser
sources, variable attenuators, multi-wavelength meters, polarization-dependent
loss (PDL) and optical return loss (ORL) meters, polarization controllers and
optical switches.




As
demonstrated by the release of our IQS-12001B Cable Assembly and Component Test
System in fiscal 2007, our system/component vendor solutions also address
testing issues that cannot be handled by standard test modules or stand-alone
benchtop instruments. We have developed a number of integrated test systems and
offer them as off-the-shelf solutions to suit a wide range of customer needs. In
addition, we have created a software development kit for developers who prefer
writing their own programs for our instruments. Following is a list of
integrated test systems that we provide for characterizing optical components,
subsystems and networks:




·CWDM/FTTH
      passive optical component test
              system
            Used
      to automatically characterize all critical specifications, including
      spectral insertion loss, polarization-dependent loss and optical return
      loss of a CWDM passive component or a FTTH splitter with a high degree of
      accuracy, ease of use and speed.·Cable
      assembly and component test system
            Used
      to perform insertion loss and mandrel-free reflection measurements with
      the highest degree of accuracy and repeatability on short fiber assemblies
      (including multifiber patchcords, hybrids and fan-out patchcords) and
      components like PLC splitters and fiber arrays.·DWDM
      passive component test system
            Used
      to automatically characterize all critical specifications, including
      spectral insertion loss, polarization-dependent loss and optical return
      loss of a DWDM passive component with a high degree of accuracy, ease of
      use and speed.







28
 Table of Contents





IMS/VoIP
Test Systems




InterWatch
Product Line


In
addition, we offer a line of hardware modules and SolarisTM
software-based telecommunications test products operating on a common hardware
platform range. This product line consists of the InterWatch R14 system,
originally introduced in 2005 and since extensively upgraded, and the M7 system,
introduced in 2004. Our products simulate both network subscribers and network
elements used in emerging IMS and NGN networks.


We
maintain an extensive library of software modules that provide test support for
a large number of industry standard protocols and variants thereon. Our emphasis
is on testing complex, high-level and emerging protocols,
including:


·
              IP
      Multimedia Subsystem (IMS);


·
              IP
      Telephony (Voice over IP or
VoIP);


·
              Asynchronous
      Transfer Mode (ATM);


·
              Packetcable;


·
              ISUP.


Our
extensive technical know-how and proprietary software development tools enable
us to implement test support for new protocols and protocol variants rapidly in
response to customer needs. With their extensive libraries of software protocol
test modules, large selection of proprietary hardware physical interfaces and
versatile range of hardware platforms, our products are easily configured to
support a wide variety of digital testing functions, thereby reducing a
customer’s need for multiple test systems. In addition, the systems’
multi-protocol, multi-user capabilities allow multiple complex testing
operations to be performed simultaneously, helping our customers to accelerate
their product development cycles.


Our
InterWatch test systems consist of advanced proprietary software together with
our proprietary hardware interface and co-processor cards. When acquiring a
system, customers typically license one or more software modules and purchase
hardware and ongoing software support. Customers may upgrade their systems by
purchasing additional software protocol test modules and additional hardware
interfaces to meet future testing needs. Prices for our systems vary widely
depending upon the overall system configuration parameters, including the number
and type of software protocol modules and the number of physical interfaces
required by the customer.


Applications


The
principal applications of our InterWatch test systems are:


Feature
Verification.  Our systems are used to perform feature
verification by simulating one or more network devices and testing a wide
variety of possible scenarios to establish if the device under test can handle
all features specified by the protocol. Users are able to initiate multiple
simultaneous calls across one or many links, create correct call scenarios, send
messages out of sequence to verify error response mechanisms and verify a voice
or data path.


Interoperability
Testing.  Our systems are used to simulate one or more network
devices, emulating their actions and responses. By simulating various network
devices, such as digital switches, wireless base stations, network access nodes
and network databases, our products assist engineers with the cost-effective
development of equipment that will be compatible with other devices in the
networks within which they will be deployed. This helps ensure that network
equipment will interoperate reliably, thereby reducing costly failures after
installation.


Load and Stress
Testing.  Our systems are used to verify that a device under
test can successfully handle its designed traffic capacity and that its
performance will degrade gracefully, rather than fail completely, when stressed
beyond its specifications. The scalable architectures of the systems
significantly improve our ability to address our customers’ growing need to
generate and maintain high traffic volumes for load testing.







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Monitoring and
Analysis.  Our systems are used in development laboratories to
monitor network links and store network activity information for future
analysis, typically without affecting network traffic. By collecting and
analyzing traffic, our systems help ensure that the links have been brought into
service and that the devices connected by the links are functioning
properly.


Products
for life sciences and industrial applications




Over the
years, we have developed and acquired a number of core technologies that we
leverage in selected high-precision assembly and life sciences markets. For
example, we offer several light-based curing solutions for optical component
manufacturing applications and have adapted our approach for other industries,
such as semiconductor, microelectronic, and medical device manufacturing, in
order to maximize revenues. Our Omnicure® systems
deliver precise doses of the appropriate spectral light onto photosensitive
adhesives to significantly reduce bonding time and increase repeatability. These
light-based curing systems, supported by patented optical feedback, thermal
control and radiometry technology, produce a high-quality bonding solution. Our
technology and application knowledge place us at the forefront of this
market.




Another
key product line is the X-Cite fluorescence illumination systems for microscope
manufacturers.  X-Cite systems deliver excellent image quality and at least
2000 hours of lamp life, which is over 60% longer than previous models and up to
10 times longer than conventional illumination systems.




X-Cite
systems are self-contained illumination units separate from a microscope. 
A simple light guide attachment through custom-coupling optics ensures a
uniformly illuminated field of view with no heat from the lamp being transferred
to the microscope.  Models range from the basic X-Cite 120XL for routine
imaging applications to the full-featured X-Cite Exacte, designed to provide
maximum illumination stability and control for the most advanced live cell
research.




The
following table summarizes the principal types of high-precision assembly and
life science solutions we provide as well as their typical
applications:




Light
      Sources and AccessoriesProduct
      Type
            Product
            Typical
      ApplicationUV
      Light Sources
            Omnicure®
      S1000
              Omnicure®
      S2000
            Used
      to initiate photo chemical reactions in polymer-based materials for a
      variety of end use applications. Examples include adhesive curing for
      manufacturing of high value-added items such as medical devices,
      micro-electronic and opto-electronic components, displays, and data
      storage devices.Fluorescent
      Light Sources
            X-Cite®
      120XL
              X-Cite®
      120 PC
              X-Cite®
      exacte
            Fluorescence
      light source that attaches directly to most microscopes currently sold by
      major microscopes manufacturers.Optical
      Accessories
            
            Optional
      custom delivery optics used with EXFO UV light sources to tailor the
      properties of light beams to end-user applications.High
      Power Fiber Light Guide
            
            Provides
      an equal distribution of light energy to multiple cure sites with 50% more
      throughput than standard fiber
guides.








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OpticalInstrumentsProduct
      Type
            Product
            Typical
      ApplicationRadiometer
            R5000
              R2000
              X-Cite®
      Radiometer
            Handheld,
      broadband optical radiometers used in conjunction with EXFO UV light
      sources to ensure process quality control at the end-user
      location.Cure-Site
      Radiometer
            
            Attachments
      for the R2000 and R5000 radiometers that enable optical measurements under
      customer specific configurations. Examples include the cure-ring
      radiometer, which measures the output power of light from an EXFO cure
      ring; ideal for applications that requires a uniform 360°
      exposure.Precision
      Positioning InstrumentsProduct
      Type
            Product
      Line
            Typical
      ApplicationMicromanipulators
            PCS-6000
      Micromanipulators
            Electrophysiology
      research such as patch clamp recording experiments on cells from the brain
      and central nervous system.PCS-5000
      MicromanipulatorsMicroscope
      Platforms
            Gibraltar
      Platform/Stage
            Stable
      mechanical platforms that facilitate cellular research with
      micropositioning and microinjection systems.Microinjection
      Systems
            MIS-5000
      Microinjection manipulator
            Microinjection
      and nuclear transfer for genetics and reproductive sciences
      research.





Research
and Development




We
believe that our future success largely depends on our ability to maintain and
enhance our core technologies and product functionality. To keep developing new
products and enhancements, it is important that we retain and recruit highly
skilled personnel. Our Telecom Division’s research and development department is
headed by a Vice-President of Research and Development, while our Life Sciences
and Industrial Division has a Director of Research and Development.




In fiscal
2008, we accelerated our software development capabilities at our R&D center
in India at a lower cost. We had initially acquired a small outsourcing company
based in Pune, India.




As of
November 3, 2008, our research and development departments included
359 full-time engineers, scientists and technicians, of who 62 hold
post-graduate degrees. Gross research and development expenditures in fiscal
2008 reached $32.5 million, compared to $25.2 million in 2007 and
$19.5 million in 2006. We launched 27 new products in fiscal 2008
compared to 20 in 2007 and 18 in 2006. Approximately 35% of sales in fiscal 2008
originated from products that have been on the market two years or less compared
to 34% in 2007 and 37% in 2006.




Through
market-oriented product portfolio review processes at our telecom sites in
Quebec City, Canada, Montreal, Canada, Concord, Canada, Chelmsford, USA, and
Pune, India, we ensure that our investments in research and development are
aligned with our market opportunities and customers’ needs. This process enables
us to maximize our returns on R&D investments by focusing our resources on
prioritized projects. Quarterly product portfolio review meetings enable us to
select a realistic, balanced mix of new products and allocate the necessary
resources for their development. All our projects, including those already
underway, are reviewed, given a priority rating and allocated budgets and
resources. Our existing projects can be stopped or substantially redefined if
there have been significant changes in market conditions, or if the project
development schedule or budget have significantly changed.







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To manage
our research projects once they are underway, we use a structured management
process known as the stage-gate approach. The stage-gate approach is based on a
systematic review of a project’s progress at various stages of its life cycle.
The following are the key review stages of the stage-gate approach:




·
            market
      study and research feasibility;


·
            product
      definition;


·
            development
      feasibility;


·
            development;


·
            qualification;
      and


·
            transfer
      to production.




At each
stage, we review our project risks, costs and estimated completion time. We
compare our design to anticipated market needs and ensure that our new product
development is synchronized with other internal departments and external
industry events. Adherence to these inter-related portfolio review and
stage-gate processes enabled us to be named winners of the Outstanding Corporate
Innovator Award in 2000 by the U.S.-based Product Development and Management
Association.




We also
maintain research and development programs for our life sciences and industrial
activities in Toronto, Canada. The product development process is managed using
a similar stage-gate process, and projects are reviewed and approved through a
quarterly portfolio review. The future success of our life sciences and
industrial operations largely depends on our ability to maintain and enhance our
core technology in light-based curing, fluorescence illumination systems and
piezoelectric positioning.




Strong
R&D capabilities at our Life Sciences and Industrial Division site in
Toronto, Canada have made it possible to bring a number of successful new
products to market quickly and retain customer intimacy. In the process, it has
enhanced our ability to customize products for special applications and to
develop original equipment manufacturing (OEM) products under partnerships and
exclusive contracts. Outside consultants are often used for added support in
areas like software development, mechanical design and rapid
prototyping.




Customers




Our
global and diversified telecom customer base relies on our test, measurement and
service assurance solutions to enable optical networks to perform impeccably
during their complete life cycles: research, development, manufacturing,
installation, maintenance and monitoring. We also have selected customers in
high-precision assembly and life science sectors that require our solutions to
render them more efficient in their respective fields. Our telecom customers
include network service providers, cable television companies, public utilities,
private network operators, third-party installers, equipment rental companies,
large enterprises, network equipment manufacturers, component vendors and
laboratory researchers. Our life science and industrial customers consist of
major manufacturers of medical devices, microelectronics, optical displays,
electronic storage systems, photonic components and microscopes, as well as
universities, medical schools, governments, and private and industrial research
laboratories. In fiscal 2008, our top customer accounted for 7.4% of our
sales and our top three customers represented 13.1% of our sales. In comparison,
in 2007 our top customer accounted for 14.7% of sales and our top three
customers represented 19.6%, while in 2006, our top customer accounted for 13.8%
of sales and our top three customers represented 19.4%.




With
regard to geographic distribution, sales to customers in the Americas (US,
Canada and Central & South America) represented 56% of our sales in fiscal
2008, while sales to customers in EMEA (Europe, Middle East and Africa) and
Asia-Pacific accounted for 28% and 16% of sales, respectively. In comparison,
the Americas, EMEA and Asia-Pacific accounted for 59%, 27% and 14% of sales,
respectively, in 2007, and 60%, 25% and 15%, respectively, in 2006.







32
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Sales




We sell
our telecom test, measurement and service assurance solutions through direct and
indirect sales channels in the Americas (US, Canada, Central & South
America) and around the world.




In the
Americas, we use a hybrid model, combining key account management with direct
and indirect sales coverage. We typically use key account managers to serve
large customers that generate high sales volumes or might potentially represent
high sales volumes in the future. These key account managers are supplemented by
regional sales managers, sales engineers, sales representatives and distributors
in US as well as Central and South American metropolitan areas, and regional
sales managers in Canada.




We opt
for a direct sales approach when selling higher-end, highly technical products
to sophisticated buyers. Sales of low- to medium-level complexity products to
less stringent technical buyers are usually done through a manufacturer
representative organization supported by regional sales managers. Our main sales
offices and service centers in the Americas are located in Plano, Texas, Quebec
City, Canada, and Concord, Canada. They are supplemented by a regional presence
in cities across the US, Central and South America, as well as
Canada.




On the
international front, we have sales personnel covering strategic areas such as
EMEA (Europe, Middle-East and Africa) and APAC (Asia-Pacific region). Our sales
network in EMEA is supported by a main office and service center in Southampton,
UK, which maintains our head of European sales operations and also provides
repair and calibration services for our EMEA customers. We also have additional
sales offices in multiple countries across EMEA to serve and support our various
customers and distributors.




As for
APAC, our main sales offices for South East Asia is located in Singapore, while
our main sales representative offices for mainland China are located in Shenzhen
and Beijing, which also acts as a service center to better serve our customer
base in that geographic area. In addition, we have other sales offices in
strategic locations around the world to support our network of distributors and
various customers.




We rely
on a network of more than 90 distributors worldwide to work with us in
supporting mostly our international sales and to participate in a large number
of our international events. We believe that the local presence and cultural
attributes of our distributors allow us to better serve our global
markets.




Our
direct telecom sales team consists of a Vice-President of Sales for the Americas
and a Vice-President of International Sales. They are supported by nine regional
sales directors that are leading a widely distributed team of more than 112
people acting as key account managers, regional sales managers, sales engineers
and application engineers. Our sales people are located throughout major
metropolitan areas around the world. This group of sales professionals has on
average more than 14 years of experience in the fields of telecommunications,
fiber optics, or test and measurement. We also have an in-house Customer Service
Group to meet the needs of existing and new customers. This group is responsible
for providing quotations to customers, supporting our sales force, managing
demonstration units, order management, technical support and training as well as
calibration and repair services.




Following
the acquisitions of Navtel Communications and Brix Networks (renamed EXFO
Service Assurance Inc.) in the third quarter of fiscal 2008, sales
responsibilities within our Telecom Division were modified. Navtel
Communications’ sales team was fully integrated within the Telecom Division,
while EXFO Service Assurance’s sales force remained stand-alone as its systems
are more complex than traditional test equipment and require longer sales
cycles. EXFO Service Assurance, with its main sales office located in
Chelmsford, MA, USA, consists of regionally based account executives and sales
engineers that target carriers, service providers and cable MSOs. Regional sales
offices are located in Southampton, England, Singapore and Beijing,
China.




EXFO
Service Assurance sells its solutions mainly through direct channels in the
Americas (US, Canada, Central and South America) and around the world. In the
EMEA and Asia/Pac regions, its sales teams work with resellers that have a
strong local presence.







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The main
office for our Life Sciences and Industrial Division is located in Toronto,
Canada. We use mixed sales channels to serve various markets supported by this
division, depending on product line and geography. Optical light sources and
related accessories used for industrial applications are sold in North America
through a network of more than 10 manufacturer representatives and,
internationally, through a network of more than 20 distributors. The X-Cite
120 and Exacte Fluorescence Illumination Systems are sold through value-added
reseller agreements with major microscope companies and system integrators in
North America and Europe. Positioning products are sold directly to customers in
North America, which includes the United States and Canada, and internationally
through a network of technical distributors. To gain additional access to the
positioning life science research market in the United States and Canada,
distributor agreements are in place with major microscope manufacturers, which
include Leica, Nikon, Olympus and Zeiss. These companies often combine the sale
of their microscopes with our product.




Product
Management, Marketing/Communications and Customer Support




Product
Management




Our
telecom Product Management Group consists of one Vice-President responsible for
our Optical, Protocol, Copper Access, and Systems product lines – as well as
directors and product managers who have various degrees in engineering, science
and business administration. Directors and product managers, under the direction
of the Vice-President, are responsible for all aspects of our telecom marketing
program including product strategy, new product introductions, definition of new
features and functions, pricing, product launches and advertising campaigns. We
follow up our marketing initiatives by attending industry trade shows.
Furthermore, we have a customer relationship management (CRM) system to
compile market and customer information including forecasts, opportunities,
leads and competitive data. We use this information to make strategic business
decisions. Finally, strategic marketing specialists analyze our markets of
interests, compile competitive information and identify macro-trends in our
sector.




Following
the acquisitions of Navtel Communications and Brix Networks in the third quarter
of fiscal 2008, product management responsibilities have remained within their
respective groups. Under the direction of a Vice-President/General Manager for
each group, directors and product managers are responsible for product strategy,
new product introductions, definition of new features and functions, pricing,
product launches and advertising campaigns.




Our Life
Sciences and Industrial Group consists of a Director – responsible for both life
sciences and precision assembly sectors – as well as product managers who have
various degrees in engineering, science and business administration. Product
managers, under the direction of the Director, are responsible for all aspects
of their business line marketing programs including product strategy, new
product introductions, definition of new features and functions, pricing,
product launches and advertising campaigns.




The
Telecom Division product management group and the Life Sciences and Industrial
Division product management group include 34 and 4 employees,
respectively.




Marketing/Communications




The
Telecom Division’s Marketing-Communications team, which consists mainly of
project managers, marketing writers, translators and graphic artists, supports
our Product Management Group by producing marketing and corporate documentation.
Literature includes specification sheets, application notes, product catalogues,
advertising copy and an electronic corporate newsletter. This
Marketing-Communications team is also responsible for all sales tools required
by our worldwide sales force and for updating the marketing contents of our
Website. This team falls under the responsibility of the Vice-President, Telecom
Product Management and Marketing.







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The Life
Sciences & Industrial Division’s Marketing-Communications team shares a
variety of marketing initiatives.  This group is assisted by product
managers, who provide the technical data and collaborative support required to
produce product specification sheets, catalogues, application notes and
multimedia marketing tools. This Marketing-Communications team is responsible
for all advertising material, Website updates, events planning (including trade
shows) and direct promotional marketing such as mass mailings and
telemarketing.  This team also provides the sales tools required by the
Life Sciences and Industrial Division’s worldwide sales channels, including
maintaining our elite partner program. This team falls under the responsibility
of the Director of Marketing for the Life Sciences and Industrial
Division.




Customer
Support




Customer
support is deemed a corporate mandate at EXFO. As such, our Customer Support
Group handles requests from customers worldwide. We aim to anticipate our
customers’ needs, offering Inside Sales, Technical Support and After-Sales
Service. EXFO Customer Service Department offers customer support in French,
English, Chinese, German, Spanish, Portuguese, Italian, Russian and
Japanese.




Our
employees in the Inside Sales Team are mainly responsible for guiding customers
in purchasing the correct equipment for their respective applications, issuing
quotations and promoting our Flexcare extended warranty service and support
program. In order to provide customers with one central point of contact, our
service representatives work with the customer from purchasing equipment to
helping them service the equipment, if necessary.




Within
our Technical Support team, we have agents who provide troubleshooting support
to our customers as well as trainers and installers who offer on-site servicing
for more complex equipment.




To offer
superior after-sales service worldwide, we have service centers in North
America, Europe and Asia. These support centers provide technical support, order
processing, inside sales, calibration and repairs for our
customers.




To ensure
that we exceed customer satisfaction and continue to improve our service, we
measure our performance by sending surveys and logging customer
feedbacks.




Manufacturing




Our
telecom manufacturing operations consist mainly of material planning,
procurement, sub-assembly, final assembly and test, software loading,
calibration, quality assurance, shipping, billing and customs management. As of
November 3, 2008, we had 310 employees involved in our telecom
manufacturing operations. Most of our telecom manufacturing activities, which
occupy a total of approximately 115,000 square feet, are spread among four
buildings: two in Quebec City, Canada, one in Shenzhen, China, and one in
Chelmsford, MA, USA.




These
manufacturing operations include the following responsibilities:




·
            Production.  From
      production planning to product shipment, our production department is
      responsible for manufacturing high-quality products on time. Factories are
      organized in work cells; each cell consists of specialized technicians and
      equipment and has full responsibility over a product family. Technicians
      are cross-trained and versatile enough, so that they can carry out
      specific functions in more than one cell. This allows shorter lead times
      by alleviating bottlenecks.




·
            Product
      Engineering and Quality.  This department, which supports
      our production cells, acts like a gatekeeper to ensure the quality of
      our products and the effectiveness of our manufacturing processes. It is
      responsible for the transfer of products from research and development to
      manufacturing, product improvement, documentation, metrology, and the
      quality assurance and regulatory compliance process. Quality assurance
      represents a key element in our manufacturing operations. Quality is
      assured through product testing at numerous stages in the manufacturing
      process to ensure that our products meet stringent industry requirements
      and our customers’ performance
requirements.







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·
            Supply-Chain
      Management.  This department is responsible for sales
      forecasting, raw material procurement, material-cost reduction and vendor
      performance management. Our products consist of optical, electronic and
      mechanical parts, which are purchased from suppliers around the world.
      Approximately one-third of our parts are manufactured to our
      specifications. Materials represent the biggest portion of our cost of
      goods. Our performance is tightly linked to vendor performance, requiring
      greater emphasis on this critical aspect of our
  business.




Our Life
Sciences and Industrial Division’s manufacturing operations occupy 8,000 square
feet in Toronto, Canada. This group manufactures light sources and related
accessories, fluorescence illumination systems and precise positioning equipment
for the life sciences and high-precision assembly markets. Operations consist
of manufacturing, procurement, warehousing, quality control and document
control managed by various elements of the ISO 9001 certified quality
system. Recognizing the importance of reduced time-to-market for our solutions,
we have focused efforts on designing products with an emphasis on
standardization, modularity, as well as ease of fabrication and assembly.
Following are key manufacturing responsibilities in Toronto,
Canada:




Manufacturing– consists
primarily of assembly and test capabilities in which all major manufacturing
elements are subcontracted to various key suppliers. These components are
integrated into assemblies and tested in order to ensure all operating
specifications have been met for each product manufactured. Cross-training
of assembly technicians for each product group ensures scalability of
manufacturing to meet customer demand. In addition, this group is
responsible for capacity and production planning, which are necessary on an
on-going basis to ensure that adequate resources are available to meet
forecasted and actual demand.




Supply Chain Management– is
responsible for the planning of materials required by manufacturing and
developing key-supplier relationships to ensure materials have been manufactured
to our specifications. This group’s main focus is to work with our worldwide
supplier base to find effective manufacturing and logistic solutions in order
reduce costs and cycle time. Paramount to this process is an effective
communication system that provides timely feedback to our suppliers and forms an
important element of our supplier evaluation system.




Manufacturing Engineering and Quality
Assurance – is responsible for product integrity throughout the
manufacturing cycle. From the release of new products, through our new product
introduction process, and configuration management to manage engineering change,
we ensure consistent manufacturing processes throughout the product life cycle.
In conjunction with the above process, quality is maintained by performing
quality tests at incoming receiving and final product verification. The
responsibility for product quality is shared by all team members throughout the
company and does not reside solely with the quality group.




Competition




The
telecommunications test, measurement and monitoring industry is highly
competitive and subject to rapid change as a result of technological
developments and market conditions. We compete with many different companies,
depending on product family and geographical market. We believe that the main
competitive factors in the industry include the following:




·
            product
      performance and reliability;


·
            price;


·
            level
      of technological innovation;


·
            product
      lead times;


·
            breadth
      of product offerings;


·
            ease
      of use;


·
            brand-name
      recognition;


·
            customer
      service and technical support;


·
            strength
      of sales and distribution relationships;
and


·
            financial
      stability.







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Generally,
competitors fall into two categories. The first category consists of global test
and measurement vendors, who complement their broad range of products with
telecom test, measurement and service assurance equipment. These companies
include Agilent Technologies, Inc., Anritsu Corporation, Danaher Corporation
(Tektronix), JDS Uniphase Corporation, Spirent plc, and Yokogawa.




The
second category refers to niche companies in the telecom test, measurement and
service assurance industry. These companies typically have limited product lines
and in some cases may be geographically limited in their customer base. Such
companies include Digital Lightwave Inc., Empirix, Inc., IneoQuest Technologies,
Inc., IXIA, Sunrise Telecom Inc., and VeEX Inc.




Competition
for our life sciences and industrial solutions is quite varied, depending upon
product line. Competitors that sell light-based curing products include Dymax,
Henkle-Loctite in North America and Europe as well as Hamamatsu, Ushio and
Matsushita (Panasonic) in Asia. With regard to our X-Cite 120 Fluorescence
Illumination System, main competitors consist of microscope manufacturers who
have developed lamp housings for low-wattage mercury burners in-house. Finally,
our motion control Life Science instruments, which are designed for various life
science applications, compete against products from companies such as Sutter
Instruments and Narishige.




Regulatory
Environment




In most
countries where our products are sold, our products must comply with the
regulations of one or more governmental entities. These regulations often are
complex and vary from country to country. Depending upon the country and the
relevant product, the applicable regulations may require product testing,
approval, registration, marking and unique design restrictions. Accordingly, we
have appointed a team of engineers who are responsible for ensuring that our
products comply with all applicable regulations.




In the
United States, our products must comply with the regulations of several agencies
of the U.S. federal government, including the Federal Communications Commission
(FCC), the Food and Drug Administration (FDA) and the Occupational Safety and
Health Administration (OSHA). Under the FCC’s regulations, our products must
comply with certain electro magnetic compatibility (EMC) requirements to insure
they do not generate and are immune from electrical noise which could possibly
cause undesirable operation, as well as affect other surrounding devices.
Depending upon the product, compliance with these rules may necessitate applying
for and obtaining an FCC equipment authorization prior to importing into the
United States, or marketing, any units of the relevant product. Additionally,
some of our products must comply with the FDA’s non-medicalperformance standards
and related rules concerning light-emitting products, such as lasers. The FDA’s
regulations are intended to promote safety by limiting human exposure to harmful
non-iodizing radiation. Similarly, our products must comply with safety
standards adopted by OSHA. Furthermore, for our Life Science and Industrial
Division, certain U.S. states require mandatory product registration and
reporting of Mercury-added products being imported. This registration is
controlled by the Interstate Mercury Education and Reduction Clearinghouse
(IMERC).




Similar
regulations apply in other countries. For example, in Canada our products must
comply with the applicable standards adopted by the Standards Council of Canada
(SCC). These include product safety standards developed by the Canadian
Standards association as well as EMC requirements adopted by Industry Canada.
Countries in the European Union require product compliance as dictated by an
applicable directive, often referred to as CE marking. This includes testing to
ensure compliance with harmonized European Norm (EN) standards for both product
safety and EMC requirements.




In
Europe, with the implementation of the WEEE directives for recycling of
electronic products in selected European Countries (2002-96-CE), we have
appointed a task force committee consisting of our management and employees,
distributors and other partners as the case may be, to ensure full compliance
with regulations and oversee the management, logistics, recycling rate, disposal
services and activities related to recycling of electronic equipment and
products within the member states.




Additionally,
to address the issue of environmental compliance, the European Union has
mandated the Restriction of the Use of Certain Hazardous Substances or "RoHS"
Directive, which applies to all products included within the scope of WEEE
directive with the exception of Categories 8 (Medical devices) and 9 (Monitoring
and control instruments). Mandatory product compliance includes the ban of
certain substances within specified concentrations, unless formally exempted by
the directive. To ensure compliance to this directive, a formal restricted
substances control (RSC) program was implemented for our products included
within the scope of WEEE. This program ensures the design, procurement and
manufacturing of affected products prevents the inclusion of the banned
substances as specified by the RoHS directive.







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Other
significant types of regulations not described in this annual report also may
apply, depending upon the relevant product and country of
destination.





Intellectual
Property





Our
success and ability to compete are dependent in part on our ability to develop
and protect our proprietary technology. We file U.S. and international
applications to protect technology, inventions and improvements important to the
development of our business. We also rely on a combination of copyright,
trademark, trade secret rights, licensing and confidentiality
agreements.





As of
August 31, 2008, we held 41 actively maintained granted patents from the U.S.
(including one “design” patent), seven from Canada, four from Germany (including
one “Utility Model”), four from the United Kingdom, three from France, and
two from China.  In addition, we have 20 US patent applications in
process, eleven Canadian patent applications in process, three European
applications in process, three applications in China, two direct national
entry in Germany (not via the European application) and one in Russia, these
applications being either direct national or regional submissions or submissions
as applications under the Patent Cooperation Treaty. The expiration dates of our
issued patents range from October 3, 2008 to January 13, 2026.





We
consider eight of our inventions for which patents have either been granted or
are pending to be material. These inventions are:





·
            a
      method and apparatus for “non-intrusive” live-fiber detection and
      monitoring. This invention permits a fiber “clip-on” device to be attached
      to a cabled fiber, essentially guaranteeing that the induced bending
      loss to a live-traffic link will never exceed 1 dB.  This
      is a key invention for our LFD-250, LFD-300, and TG-300
      product;





·
            the
      measurement of attenuation of optical fibers using bidirectional
      transmission of information via the fiber,  which forms the
      basis of our FOT-930 and FTB-3920
products;





·
            a
      method and apparatus for characterizing optical power levels in
      three-wavelength, bidirectional fiber-to-the-home systems. This invention
      describes how the optical power can be measured at the two-downstream and
      one upstream wavelengths used to connect a residence or business customer,
      while maintaining the signal continuity necessary to keep the home-based
      Optical Network Terminal operating.  This invention underlies
      the two-port version of our PPM-350B PON Power
  Meter;





·
            an
      optical spectrum analyzer using optical fibers as input and output
      “slits”.  This invention forms the basis of our FTB-5240,
      FTB-5240B and IQ-5250 products;





·
            a
      light-curing system with closed-loop control and work-piece recording
      which is at the heart of the spot-curing systems manufactured by EXFO
      Photonic Solutions;





·
            a
      special optical design used in some of the X-Cite adaptors to prevent
      structure in the beam from reducing the uniformity of illumination at the
      microscope objective plane, which is a key patent for our X-Cite
      fluorescent illumination system;





·
            a
      method and apparatus to determine the theoretical and practical data rates
      for a cable under test. This invention forms the basis of the EXFO
      CableSHARK product, describing how two test devices,
      communicating with each other via the cable under test, can predict the
      performance of a pair of ADSL (Asymmetric Digital Subscriber Line) modems,
      and in case of problems, analyze the cause of the modems failing to
      synchronize;





·
            a
      method and system for hardware time stamping packetized data to provide
      sub-microsecond accuracy in test measurements, which is embedded in the
      Brix100M, Brix1000, and Brix2500 Series
  Verifiers.





Confidentiality
and proprietary information agreements with our senior management, employees and
others generally stipulate that all confidential information developed or made
known to these individuals by us during the course of their relationship is to
be kept confidential and not disclosed to third parties, except in specific
circumstances. The agreements also generally provide that all intellectual
property developed by the individual in the course of rendering services to us
belongs exclusively to us. These efforts afford only limited
protection.







38
 Table of Contents




C.
              Organizational
      Structure


As of
November 3, 2008, the following chart presents our corporate structure, the
jurisdiction of incorporation of our subsidiaries and the percentage of
shares that we hold in those subsidiaries.












39
 Table of Contents




D.
              Property,
      Plant and Equipment





Our head
offices and facilities are located in Quebec City, Province of Quebec, Canada
where we occupy two buildings. These buildings house our executive and
administrative offices, research and development facilities and production
facilities. We also have facilities in Montreal, Province of Quebec, Canada
(formerly EXFO Protocol), in Concord, Ontario, Canada (formerly Consultronics
Limited), in Markham, Ontario, Canada (formerly Navtel Communications Inc.), in
Mississauga, Ontario, Canada (EXFO Photonic), in Chelmsford, Massachusetts,
United States (EXFO Service Assurance Inc.), in Eastleigh, Hampshire, United
Kingdom (EXFO Europe), in Shenzhen, China (EXFO Telecom Equipment (Shenzhen) Co.
Ltd.) and in Pune, India (EXFO India). EXFO Burleigh’s facilities located in
Victor, New York, were sold on August 31, 2006.





In
addition, we maintain sales offices and/or have regional sales managers located
in China, Czech Republic, France, Germany, Great Britain, Mexico, Singapore,
Spain, United Arab Emirates and the United States.





In
September 2002, we obtained ownership of one of the buildings housing production
facilities in Quebec City that was previously leased from a company controlled
by EXFO’s president and chief executive officer. In September 2003, due to
down-sizing efforts, we were able to move all of our Quebec City activities into
two buildings, rather that three. Though we no longer occupy the facilities at
465 Godin Avenue in Quebec City, we remain bounded by the lease until
November 30, 2006. However, on September 1, 2004, we were released from our
obligations under the lease with a final payment of $194,000
(CA$250,000).





The
following table sets forth information with respect to the main facilities that
we occupy as of November 3, 2008.





Location
            Use
      of Space
            Square
      Footage
            Type
      of Interest436
      Nolin Street
              Quebec
      (Quebec)
              G1M 1E7
            Partially
      occupied for manufacturing of telecom products
            44,164
      (1)
            Owned400
      Godin Avenue
              Quebec
      (Quebec)
              G1M 2K2
            Fully
      occupied for research and development, manufacturing, management and
      administration
            128,800 (2)
            Owned2260
      Argentia Road
              Mississauga
      (Ontario)
              L5N 6H7
            Partially
      occupied for research and development, manufacturing of life science and
      industrial products, management and administration
            25,328
      (3)
            Leased2650
      Marie-Curie
              St-Laurent (Quebec)
              H4S 2C3
            Fully
      occupied for research and development, management  and
      administration
            26,000
            Leased160
      Drumlin Circle
              Concord
      (Ontario)
              L4K 3E5
            Partially
      occupied for research and development, product management and
      administration
            23,500
      (4)
            Owned55
      Renfrew Drive, Suite 100
              Markham
      (Ontario)
              L3R
      8H3
            Unoccupied,
      lease expired on April 30, 2009
            26,690
            Leased285
      Mill Road
              Chelmsford,
      MA 01824
              United
      States
            Partially
      occupied for research and development, manufacturing, management and
      administration
            23,052
      (5)
            Leased






40
 Table of Contents




Location
            Use
      of Space
            Square
      Footage
            Type
      of InterestOmega
      Enterprise Park
              Electron
      Way, Chandlers Ford,
              Eastleigh,
      Hampshire S053 4SE
              United
      Kingdom
            Fully
      occupied for European customer service, sales management and
      administration
            10,000
            LeasedHua
      Chuang Da Industrial Park
              Bldg
      D, 2/F, Hangcheng Blvd,
              Gushu,
      Xixiang
              Shenzhen
      518126
              China
            Partially
      occupied for manufacturing of telecom products
            40,000
      (6)
            Leased113/1,
      Lane 4A
              Koregaon
      Park
              Pune
      411001
              India
            Fully
      occupied for research and development
            5,986
            LeasedOffice
      No 701, Building 1
              The
      Cerebrum IT Park
              Wadgaon
      Sheri, Pune 411014
              India
            Fully
      occupied for research and development
            16,840
            Leased





(1)
            Approximately
      5% of these premises are not
occupied.


(2)
            Including
      the warehouse space. Premises without the warehouse are approximately
      115,000 square feet.


(3)
            9,792
      square feet have been subleased to a third party. The total square footage
      leased is 36,000.


(4)
            Approximately
      1/3 of these premises are not
occupied.


(5)
            7,950
      square feet have been subleased to a third party. The total square footage
      leased is 31,002.


(6)
            Approximately
      35% of these premises are occupied.





Item 4A.
                Unresolved
      Staff Comments


Not
applicable.







41
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Item 5.
                Operating
      and Financial Review and Prospects
 This
discussion and analysis contains forward-looking statements within the meaning
of the U.S. Private Securities Litigation Reform Act of 1995, and we intend that
such forward-looking statements be subject to the safe harbors created thereby.
Forward-looking statements are statements other than historical information or
statements of current condition. Words such as may, will, expect, believe,
anticipate, intend, could, estimate, continue, or the negative or comparable
terminology are intended to identify forward-looking statements. In addition,
any statements that refer to expectations, projections or other
characterizations of future events and circumstances are considered
forward-looking statements. They are not guarantees of future performance and
involve risks and uncertainties. Actual results may differ materially from those
in forward-looking statements due to various factors including consolidation in
the global telecommunications test, measurement and monitoring industry; capital
spending levels in the telecommunications, life sciences and high-precision
assembly sectors; concentration of sales; fluctuating exchange rates and our
ability to execute in these uncertain conditions; the effects of the additional
actions we have taken in response to such economic uncertainty (including our
ability to quickly adapt cost structures with anticipated levels of business,
ability to manage inventory levels with market demand); market acceptance of our
new products and other upcoming products; limited visibility with regards to
customer orders and the timing of such orders; our ability to successfully
integrate our acquired and to-be-acquired businesses; our ability to
successfully expand international operations; the retention of key technical and
management personnel; and future economic, competitive, financial and market
conditions, including any slow-down or recession in the global economy.
Assumptions relating to the foregoing involve judgments and risks, all of which
are difficult or impossible to predict and many of which are beyond our control.
Other risk factors that may affect our future performance and operations are
detailed in our Annual Report, on Form 20-F, and our other filings with the U.S.
Securities and Exchange Commission and the Canadian securities commissions. We
believe that the expectations reflected in the forward-looking statements are
reasonable based on information currently available to us, but we cannot assure
you that the expectations will prove to have been correct. Accordingly, you
should not place undue reliance on these forward-looking statements. These
statements speak only as of the date of this document. Unless required by law
or applicable regulations, we undertake no obligation to revise or
update any of them to reflect events or circumstances that occur after the
date of this document.
 
 The
following discussion and analysis of the consolidated financial condition and
results of operations of EXFO Electro-Optical Engineering Inc. for the
fiscal years ended August 31, 2006, 2007 and 2008, should be read in
conjunction with our consolidated financial statements and the related notes
included elsewhere in this Annual Report. Our consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
in Canada, or Canadian GAAP. Significant differences in measurement and
disclosure from generally accepted accounting principles in the United States,
or U.S. GAAP, are set out in note 19 to our consolidated financial statements.
Our measurement currency is the Canadian dollar although we report our financial
statements in US dollars.
 
 The
following discussion and analysis of financial condition and results of
operations is dated November 3, 2008, except as indicated
herein.
 
 All
dollar amounts are expressed in US dollars, except as otherwise
noted.
 
 INDUSTRY
OVERVIEW
  The basic
fundamentals of the global telecom industry remain solid for the moment.
However, it is still unknown what impacts the current financial crisis might
have on the global economy particularly in the United States, where
a severe economic slowdown could potentially reduce investments and affect
other parts of the world. The main fundamental telecom drivers are based upon
exponential growth in bandwidth demand, as well as on the intense competition
between telecom operators (telcos) and cable companies (cablecos), who are
pushing massive investments in Internet protocol (IP) converged next-generation
networks to capitalize on significant operational efficiencies and service
revenues.
 
  42
 Table of Contents
  Global
Internet bandwidth demand is growing very rapidly, due to a wide range of
applications like video, webgaming, etc. TeleGeography Research has estimated
its compound annual growth rate (CAGR) at 54% from 2004 to 2008. This trend is
likely to remain steady in the years to come, with the upcoming deployments of
Internet protocol television (IPTV), high-definition Internet protocol
television (HD-IPTV) and increased online video streaming, since these
applications, among others, will consume a colossal amount of additional
bandwidth. As a result, telcos and cablecos are investing
substantially in their access networks in order to provide differentiated,
revenue-generating services to attract and retain consumers, who are
increasingly relying on broadband network services for their work, entertainment
and everyday activities. From a telco perspective, it is now clear that
fiber-to-the-home (FTTH) will become the access network architecture of choice,
which will allow them to meet heightened bandwidth requirements and future-proof
their access networks, as residential bandwidth requirements are growing from
the 1 to 5 Mbit/s (megabits per second) of the past to the 30 to 100 Mbit/s
required in the long-term to assure multiple HD-IPTV channels, online gaming,
high-speed content-rich Internet, VoIP (voice-over-Internet protocol) telephony
and a myriad of other IP-based applications. Hybrid architectures,
combining copper and fiber (fiber-to-the-curb, or FTTC, and
fiber-to-the-node, or FTTN), will also keep expanding in the short term, since
they are less-expensive methods to increase bandwidth and can be mass-deployed
faster.
 
 These
investment decisions are applicable not only to green-field deployments and
high-rise buildings, but also to larger-scale rollouts as long-term
operating costs are less than FTTC and FTTN. It is important to mention that the
cost of deploying FTTH has largely fallen over the last three years as volume
increased and deployment tools, like those we offer, are making the task
increasingly simple and efficient. We are at the early stages of fiber
deployments in access networks, both in the Americas and around the world.
Western Europe and China have become increasingly committed to deploying FTTH
networks, given their high population density.
 
 As
bandwidth growth in access networks continues to increase, it has begun placing
a strain on metro rings and core networks. It is also driving the need for
higher-speed technologies; for example, 43 Gbit/s(gigabits per
second)SONET/SDH
is now seeing early deployments and becoming mainstream, while the upcoming 100
Gbit/s Ethernet is in early field trials. The deployment of these solutions is
expected to be significantly more economical, especially if trenches need to be
dug in order to deploy new fiber in metro or long-distance routes.
 
 As
telecommunication networks are being transformed to provide IP-based voice,
video and data capabilities, legacy SONET/SDH standards, which were first
established in the mid-1980s and implemented until 2005, do not have the payload
flexibility to seamlessly and efficiently mix and transport video with voice and
data. These networks will not be capable of efficiently carrying these emerging
IP-based services as they are designed for public switched telephone network
(PSTN), point-to-point voice transmission only. As a result, with new SONET/SDH
standards, which are part of what the industry is calling next-gen networks, telco
operators are increasingly turning to next-generation, IP-based networks to
allow for more
flexible and efficient transport of applications and services, and to offer
customers higher-margin triple-play services―and even quadruple-play services―as
wireline and wireless technologies become increasingly interconnected. Finally,
as subscribers of these new services reach a critical mass, telcos are
relying on service assurance solutions to ensure that the quality of service
(QoS) and quality of experience (QoE) demanded by users are optimal in the
post-deployment phase.
 
 These
market dynamics positively affected telecom test and monitoring suppliers in
fiscal 2008; however, deteriorating macro-economic conditions in the United
States could instigate a slowdown in capital spending among customers, which
would necessarily reduce demand for our test and monitoring
solutions.
 
 
 COMPANY
OVERVIEW
 
 EXFO is a
leading provider of test and monitoring solutions for network service providers
and equipment manufacturers in the global telecommunications industry. The
Telecom Division, which represents more than 85% of our business,
offers a wide range of innovative solutions extending across the full technology
lifecycle― from design to technology deployment and onto service assurance―and
covering all the layers of a network infrastructure to enable triple-play
services and next-generation, converged IP networking. The Life Sciences and
Industrial Division offers solutions in medical-device and opto-electronics
assembly, fluorescence microscopy and other life sciences sectors.
 
  43
 Table of Contents
  We were
founded in 1985 in Quebec City, Canada. Our original products were focused on
the needs of installers and operators of fiber-optic networks. Customers use
these field-portable testing products for the installation, maintenance,
monitoring and troubleshooting of optical networks. In 1996, we supplemented our
product portfolio with an extensive line of high-end products that are mainly
dedicated to research and development as well as manufacturing activities
of optical component manufacturers and system vendors.
 
 Over the
past several years, we have enhanced our competitive position through
acquisitions of protocol, copper/xDSL and service assurance test
businesses.
 
 In April
2008, we acquired all issued and outstanding shares of Brix Networks Inc.
(renamed EXFO Service Assurance Inc.), for a cash consideration of $29.7
million, plus a contingent cash consideration of up to a maximum of $7.5
million, based on booking levels exceeding $16 million up to $40 million in the
12 months following the closing of the deal. Brix Networks, a privately held
company located in the Boston (MA) area, offers VoIP and IPTV service assurance
solutions across the three areas most affecting the success of a real-time
service: signaling quality (signaling path performance), delivery quality (media
transport performance) and content quality (overall quality of experience).
Brix Networks’ service assurance solutions are mainly designed for network
service providers (NSPs) and large enterprises.
 
 In March
2008, we acquired all issued and outstanding shares of Navtel Communications
Inc., for a cash consideration of $11.3 million. Navtel Communications, a
privately held company in Toronto, Canada, is a leading provider of Internet
protocol multimedia subsystem (IMS) and VoIP test solutions for network
equipment manufacturers (NEMs) and NSP labs. Navtel Communications specializes
in testing next-generation IP networks that are increasingly combining wireline
and wireless technologies. Subsequent to the acquisition, Navtel Communications
was merged into the parent company.
 
 In fiscal
2008, we opened our own telecom manufacturing facilities in Shenzhen, China. We
now have two main manufacturing sites for our Telecom Division and one plant for
our Life Sciences Division. Over time, low-volume, high-complexity telecom
products will be manufactured in Quebec City, whereas high-volume,
low-complexity telecom products will be manufactured in Shenzhen.
 
 In fiscal
2008, we accelerated the deployment of a software development center in Pune,
India, to supplement the research and development capabilities of our labs in
Boston, Toronto, Montreal and Quebec City. This will enable us to benefit from
the wealth of IP expertise in India, to accelerate product development―especially for our
software-intensive protocol test solutions―to take advantage
of a lower cost structure.
 
 In
January 2006, we acquired substantially all the assets of Consultronics Limited,
(now merged with the parent company) a leading supplier of test equipment for
copper-based broadband access networks, for a total cash consideration of $19.1
million. Above and beyond copper/xDSL test solutions, Consultronics had a rich
product portfolio for testing next-generation technologies, such as IPTV and
VoIP, which are critical for NSPs in their deployment of triple-play services
(voice, data, video) over optical and copper links in access networks. This
acquisition was a strategic initiative to position EXFO as a genuine one-stop
shop for broadband access and triple-play testing, since it complemented our
market leadership in the optical FTTx test market.
 
 In
November 2001, we acquired Avantas Networks Corporation (renamed EXFO Protocol
Inc. and now merged with the parent company), a supplier of protocol-testing and
optical-network performance management equipment for NSPs. This transaction
enabled us to combine optical and protocol test modules inside a single
field-portable test platform in order to help our customers increase revenues
and reduce operating costs. In October 2002, our wholly-owned subsidiary, EXFO
Gnubi, purchased substantially all the assets of gnubi communications, L.P., a
supplier of multichannel telecom and datacom testing solutions for the
system manufacturer market. These strategic acquisitions―which were
consolidated in Montreal, Canada, in fiscal 2004―enabled us to more than double
our addressable market, as we expanded from optical testing to protocol testing
applications, and to offer a more complete line of test solutions to our
customers.
 
  44
 Table of Contents
  Previously,
we had completed two acquisitions to bolster growth in the optical component
manufacturing market. We acquired Burleigh Instruments, Inc. (renamed EXFO
Burleigh Products Group Inc.) in December 2000 for its wavelength measurement
instruments and nanopositioning alignment systems. We also added EFOS Inc.
(renamed EXFO Photonic Solutions Inc.) in March 2001 for its precision
light-based, adhesive spot-curing technology. We have since exited the
optical component manufacturing automation business, and the remaining
operations of EXFO Burleigh have mostly been consolidated with those of
EXFO Photonic Solutions in Toronto, Canada.
 
 We
launched 27 new products in fiscal 2008, including seven in the fourth quarter,
compared to 20 in fiscal 2007. Key product introductions in fiscal 2008 included
among others a multiservice, multimedium modular handheld platform for
characterizing and troubleshooting access networks (AXS-200 SharpTESTER) with
related copper access, protocol and optical test modules; a compact multiservice
transport test set that combines next-generation SONET/SDH and Ethernet testing
inside a single module (FTB-8120NGE/FTB-8130NGE Power Blazer);
a 40/43 Gbit/s SONET/SDH field-test solution (FTB-8140 Transport
Blazer) for high-speed optical networks; an all-in-one chromatic dispersion (CD)
and polarization mode dispersion (PMD) analyzer (FTB-5700 Single-Ended
Dispersion Analyzer) that requires only one technician to characterize a link
from a single end; a triple-play test set (AXS-200/630 VDSL, ADSL2+ and IP
Triple-Play Test Set) for the deployment and troubleshooting
of ADSL2+/VDSL2 networks; and the advanced IQS-600 Integrated Qualification
System, a next-generation, modular test platform for R&D and manufacturing
applications. Following the year-end, we introduced an enhanced version of
Navtel’s InterWatch platform that simulates up to 256,000 unique IPv6 subscriber
addresses per chassis, and new software features on the Transport Blazer test
modules for characterizing 40G/43G SONET/SDH networks. Sales from products that
have been on the market two years or less accounted for 34.6% for the fiscal
year, while our published goal is 30%.
 
 Overall
for fiscal 2008, we increased sales 20.2% to $183.8 million from $152.9 million
in 2007. Global sales for fiscal 2008 included $5.4 million from newly
acquired Brix Networks and Navtel Communications since their acquisitions in the
third quarter of 2008. GAAP net earnings reached $18.4 million, or $0.27 per
diluted share, including $5.3 million for the recognition of previously
unrecognized future income tax assets in the United States, $2.7 million for
income tax recovery following the review of our tax strategy related to recently
substantively enacted income tax rates in Canada, $1.5 million of income tax
expense to account for the recently substantively enacted income tax rate on our
future income tax assets in Canada, an extraordinary gain of $3.0 million
related to the negative goodwill on the Navtel acquisition, as well as
$3.0 million in after-tax amortization of intangible assets and $1.3
million in stock-based compensation costs. In 2007, GAAP net earnings reached
$42.3 million, or $0.61 per diluted share, including $24.6 million in
recognition of previously unrecognized future income taxes, $3.2 million in
recognition of previously unrecognized research and development tax credits,
$2.9 million in amortization of intangible assets, $1.1 million from a
government grant recovery and $1.0 million in stock-based compensation
costs.
 
 In fiscal
2008, we faced a substantial and sudden increase in the value of the Canadian
dollar versus the US dollar. The average value of the Canadian dollar increased
11.4% in fiscal 2008, compared to the same period last year. Given that most of
our sales are denominated in US dollars but a significant portion of our
expenses are denominated in Canadian dollars, our financial results were
negatively affected.
 
 On
November 5, 2007, the Board of Directors approved a share repurchase program, by
way of normal course issuer bid on the open market, up to 9.9% of our public
float (as defined by the Toronto Stock Exchange), or 2.9 million
of subordinate voting shares, at the prevailing market price. The period of
the normal course issuer bid commenced on November 8, 2007, and ended on
November 7, 2008. All shares repurchased under the bid were cancelled.
We redeemed 1.9 million subordinate voting shares for a total consideration
of $8.5 million under that program.
 
  45
 Table of Contents
  On
November 6, 2008, the Board of Directors approved a renewal of our share
repurchase program, by way of a normal course issuer bid on the open
market, of up to 10% of our public float (as defined by the Toronto Stock
Exchange), or 2.7 million subordinate voting shares, at the prevailing market
price. We expect to use cash, short-term investments or future cash flows from
operations to fund the repurchase of shares. The period of the normal course
issuer bid starts on November 10, 2008, and will end on
November 9, 2009, or on an earlier date if we repurchase the maximum
number of shares permitted under the bid. The program does not require that we
repurchase any specific number of shares, and it may be modified, suspended or
terminated at any time and without prior notice. All shares repurchased under
the bid will be cancelled.
 
 On
November 10, 2008, the Board of Directors approved a substantial issuer bid (the
“Offer”) to purchase for cancellation up to 8.8 million subordinate voting
shares for an aggregate purchase price not to exceed CA$30 million. The
Offer is being made by way of a “modified Dutch Auction” pursuant to which
shareholders may tender all or a portion of their shares (i) at a
price not less than CA$3.40 per share and not more than CA$3.90 per share,
in increments of CA$0.05 per share, or (ii) without specifying a purchase
price, in which case their shares will be purchased at the purchase price
determined in accordance with the Offer. The Offer will expire
on December 16, 2008, unless withdrawn, extended or varied. We
expect to use cash, short-term investments or future cash flows from
operations to fund the repurchase of shares. The Offer is not conditional upon
any minimum number of shares being tendered, but it is subject to certain other
conditions.
 
 Upon the
approval of the Offer, we suspended the normal course issuer bid referred to
above, until 20 business days following the expiration of the
Offer.
 
 Sales
 
 We sell
our products to a diversified customer base in approximately 95 countries
through our direct sales force and channel partners like sales representatives
and distributors. Most of our sales are denominated in US dollars and
Euros.
 
 In fiscal
2008, no customer accounted for more than 10% of our global sales, with our top
customer representing 7.4% of our global sales. In fiscal 2006 and 2007, our top
customer accounted for 13.8% and 14.7% of global sales, respectively. The
significant sales concentration with this Tier-1 carrier in fiscal 2006 and 2007
was largely due to our leadership position in the FTTx test market and the
fact that we benefited from aggressive FTTH rollouts from this customer. This
sales concentration significantly decreased in fiscal 2008. However, we do
not believe that we have lost market share with this particular customer in
fiscal 2008 as the sales level with this customer may fluctuate year-over-year,
based on the amount of budget available, the allocation of such budget and the
timing and scope of projects. It should also be noted that over the last three
years, we significantly increased our business with several other accounts
around the globe. Although we maintained our leadership position with this
customer, we reduced our customer concentration to a lower level with this
customer while increasing our penetration with other accounts.
 
 We
believe that we have varied product lines, a diversified customer base, and a
market for our products that is spread across geographical areas, which we
believe helps protect us against concentration of sales and credit
risk.
 
 Cost
of Sales
 
 Cost of
sales includes raw materials, salaries and related expenses for direct and
indirect manufacturing personnel (net of government grants) as well as overhead
costs. Excess, obsolete and scrapped materials are also included in cost of
sales. However, cost of sales is exclusive of amortization, which is shown
separately in the statements of earnings.
 
 Operating
Expenses
 
 We
classify our operating expenses into three main categories: selling and
administrative expenses, research and development expenses and amortization
expenses.
 
  46
 Table of Contents
  Selling
and administrative expenses consist primarily of salaries and related expenses
for personnel, sales commissions, travel expenses, marketing programs,
professional services, information systems, human resources and other corporate
expenses.
 
 Gross
research and development expenses consist primarily of salaries and related
expenses for engineers and other technical personnel, material component costs
as well as fees paid to third-party consultants. We are eligible to receive
research and development tax credits and government grants on research and
development activities carried out in Canada. All related research and
development tax credits and government grants are recorded
as a reduction of gross research and development
expenses.
 
 
 OUR
STRATEGY, KEY PERFORMANCE INDICATORS AND CAPABILITY TO DELIVER
RESULTS
 
 Strategic
Objectives for Fiscal 2008
 
 In our
fiscal 2007 Annual Report, we established three strategic objectives for fiscal
2008. We planned to increase sales through market-share gains, maximize
profitability and focus on innovation. The following section reviews our
strategic objectives for fiscal 2008 and the results achieved for each of these
objectives.
 
 Increase
sales through market-share gains
 
 We
increased our annual sales 20.2% to $183.8 million in fiscal 2008, while our
corporate metric for the fiscal year was 20%. In fiscal 2008, our Telecom
Division generated a sales growth of 24.0% year-over-year, including 97.4%
growth for our protocol test business. It should be noted that Brix Networks and
Navtel Communications, which were acquired in the third quarter of 2008,
contributed $5.4 million to our protocol test sales in 2008. We also expanded
our international presence in Europe, Middle-East and Africa (26.3% sales growth
year-over-year) and in the Asia-Pacific region (40.1% sales growth
year-over-year). On the other hand, sales from our copper access test business
(3.9% decrease year-over-year), optical test business (12.7% growth
year-over-year) as well as in the Americas region (12.8% growth year-over-year)
fell short of our plans. With regard to the modest growth in our optical test
business and Americas region, it is largely attributable to reduced spending by
our top customer in fiscal 2008, compared to 2007. We do not believe that we
lost market share with this customer, but this Tier-1 network service provider
reduced its capital expenditures in fiscal 2008. The decline in our copper
access business is mainly due to the fact that we integrated Consultronics’
products into a new modular platform (AXS-200 SharpTESTER) in fiscal 2008,
and we anticipate returning to a growth mode in 2009.
 
 Maximize
profitability
 
 We
generated GAAP earnings from operations of 6.5% in fiscal 2008, while our
published metric was 8%. Our GAAP earnings from operations in fiscal 2008
included the negative contribution from newly acquired Brix Networks and Navtel
Communications, which was not initially forecasted in our corporate metric.
Excluding the negative contribution from these acquisitions, our earnings from
operations would have been above 8%.
 
 Focus
on innovation
 
 Sales
from new products (on the market two years or less) accounted for 34.6% of total
sales in 2008, compared to our stated goal of 30%.
 
 Three-year
Strategic Objectives
 
 Our goal is to
become a strong market leader in the global telecom test and service
assurance industry―offering market-driven solutions mainly to NSPs and
increasingly covering the service and application layers on a network
infrastructure―to enable triple-play services and next-generation, converged
IP networking.
 
  47
 Table of Contents
  To
achieve our long-term vision, we plan to expand our leadership position in the
portable optical segment, while growing our protocol business even faster to
surpass optical in terms of sales. This plan is based first and foremost on
organic growth, but it will be supported by strategic acquisitions of small to
mid-size companies with best-of-class technologies in nascent, high-growth
markets complementary to EXFO’s. We also intend to improve our competitive
position through strategic alliances and partnerships.
 
 Following
our practice of benchmarking performance, we have established three corporate
performance objectives to gauge the success of our overall plan over the
next three years:
 
 o
                Increase
      sales significantly faster than the industry growth rate (20%
      CAGR)
 o
                Grow
      EBITDA* in dollars faster than sales (>20%
  CAGR)
 o
                Continue
      raising gross margin (62%)
 
 *
                EBITDA
      is defined as net earnings before interest, income taxes, amortization of
      property, plant and equipment, amortization of intangible assets and
      extraordinary gain.
 
 These
three-year objectives will guide our actions in upcoming years as we are
committed to maximizing shareholder value. They are meant to replace the
performance goals that we have been providing on an annual basis. Hopefully,
this new information will draw attention to our long-term potential and offer
investors a more complete picture of our investment proposition.
 
 
 CRITICAL
ACCOUNTING POLICIES AND ESTIMATES
 
 Management’s
discussion and analysis of financial conditions and results of operations is
based on our consolidated financial statements included elsewhere in this Annual
Report. As previously mentioned, they have been prepared in accordance with
Canadian GAAP. The preparation of financial statements in accordance with GAAP
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosures of contingent assets and
liabilities at the date of the financial statements, as well as the reported
amounts of revenues and expenses during the reporting years. On an ongoing
basis, we evaluate these estimates and assumptions, including those related to
the fair value of financial instruments, the allowance for doubtful accounts
receivable, the amount of tax credits recoverable, the provision for excess and
obsolete inventories, the useful lives of capital assets, the valuation
of long-lived assets, the valuation allowance of future income tax assets,
the amount of certain accrued liabilities and deferred revenue as well as
stock-based compensation costs. We base our estimates and assumptions on
historical experience and on other factors that we believe to be reasonable
under the circumstances, the result of which form the basis for making judgments
about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results could differ from these
estimates.
 
 The
following summarizes our critical accounting policies as well as other policies
that require the most significant judgment and estimates in the preparation of
our consolidated financial statements.
 
 Revenue recognition. For
products in which software is incidental, we recognize revenue when persuasive
evidence of an arrangement exists, the product has been delivered, the price is
fixed or determinable and collection of the resulting receivable is reasonably
assured. In addition, provisions are made for estimated returns, warranties and
support obligations.
 
 For
products in which software is not incidental, revenues are separated into two
categories: product and post-contract customer support (PCS) revenues, based
upon vendor-specific objective evidence of fair value. Product revenues for
these sales are recognized as described above. PCS revenues are deferred and
recognized ratably over the years of the support arrangement. PCS revenues are
recognized at the time the product is delivered when provided substantially
within one year of delivery, the costs of providing this support are
insignificant (and accrued at the time of delivery) and no (or infrequent)
software upgrades or enhancements are provided.
 
  48
 Table of Contents
  Maintenance
contracts generally include the right to unspecified upgrades and enhancements
on a when-and-if available basis and ongoing customer support. Revenue from
these contracts is recognized ratably over the terms of the maintenance
contracts on a straight-line basis.
 
 Revenue
for extended warranties is recognized on a straight-line basis over the warranty
period.
 
 For all
sales, we use a binding purchase order as evidence that a sales arrangement
exists.
 
 Delivery
generally occurs when the product is handed over to a transporter for
shipment.
 
 At the
time of the transaction, we assess whether the price associated with our revenue
transaction is fixed or determinable, and whether or not collection is
reasonably assured. We assess whether the price is fixed or determinable
based on the payment terms associated with the transaction. We assess collection
based on a number of factors, including past transaction history and the
creditworthiness of the customer. Generally, collateral or other security is not
requested from customers.
 
 Most
sales arrangements do not generally include acceptance clauses. However, if a
sales arrangement does include an acceptance provision, acceptance occurs upon
the earliest of the receipt of a written customer acceptance or the expiration
of the acceptance period. For these sales arrangements, the sale is recognized
when acceptance occurs.
 
 Allowance for doubtful
accounts. We estimate collectibility of accounts receivable on an ongoing
basis by reviewing balances outstanding over a certain period of time. We
determine our allowance for doubtful accounts receivable based on our historical
accounts receivable collection experience and on the information that we have
about the status of our accounts receivable balances. If the financial
conditions of our customers deteriorate, resulting in an impairment of
their ability to make required payments, additional allowance may be required,
which could adversely affect our future results.
 
 Reserve for excess and obsolete
inventories. We state our inventories at the lower of cost, determined on
an average cost basis, and replacement cost or net realizable value, and we
provide reserves for excess and obsolete inventories. We determine our reserves
for excess and obsolete inventories based on the quantities we have on hand
versus expected needs for these inventories, so as to support future sales of
our products. It is possible that additional inventory reserves may occur if
future sales are less than our forecasts or if there is a significant shift in
product mix compared to our forecasts, which could adversely affect our future
results.
 
 Research and development tax credits
and government grants. We record research and development tax credits and
government grants based on our interpretation of tax laws and grant programs,
especially regarding related eligible projects and expenses, and when there is
reasonable assurance that we have complied and will continue to comply with all
conditions and laws. Also, our judgment and estimates are based on historical
experience. It is possible, however, that the tax authorities or the sponsors of
the grant programs have a different interpretation of laws and application of
conditions related to the programs or that we do not comply with all conditions
related to grants in the future, which could adversely affect our future
results. Furthermore, a significant part of our research and development tax
credits are refundable against income taxes payable, causing their ultimate
realization to be dependent upon the generation of taxable income. If
we obtain information that causes our forecast of future taxable income to
change or if actual taxable income differs from our forecast, we may have to
revise the carrying value of these tax credits, which would affect our results
in the period in which the change was made.
 
 Impairment of long-lived assets and
goodwill. We assess impairment of long-lived assets when events
or circumstances indicate that costs may not be recoverable. Impairment
exists when the carrying value of an asset, or a group of assets, is greater
than the pre-tax undiscounted future cash flows expected to be provided by the
asset or the group of assets. The amount of impairment loss, if any, is the
excess of the carrying value over the fair value. We assess fair value of
long-lived assets based on discounted future cash flows.
 
  49
 Table of Contents
  We assess
impairment of goodwill on an annual basis, or more frequently, if events or
circumstances indicate that it might be impaired. Recoverability of
goodwill is determined at the reporting-unit level using a two-step approach.
First, the carrying value of a reporting unit is compared to its fair value,
which is determined based on a combination of discounted future cash flows and a
market approach. If the carrying value of a reporting unit exceeds its fair
value, the second step is performed. In this step, the amount of impairment
loss, if any, represents the excess of the carrying value of goodwill over its
fair value and the loss is charged to earnings in the period in which it is
incurred. For the purposes of this impairment test, the fair value of goodwill
is estimated in the same way as goodwill is determined in business
combinations; that is, the excess of the fair value of a reporting unit over the
estimated fair value of its net identifiable assets.
 
 Future income taxes. We
account for income taxes using the liability method of tax allocation. Under
this method, future income tax assets and liabilities are determined based on
deductible or taxable temporary differences between financial statement values
and tax values of assets and liabilities as well as the carryforward of unused
tax losses and deductions, using substantively enacted income tax rates for the
years in which the assets are expected to be realized or the liabilities to
be settled. In assessing the recoverability of our future income tax assets,
we consider whether it is more likely than not that some or all of the
future income tax assets will not be realized. The ultimate realization of our
future income tax assets is dependent upon the generation of sufficient future
taxable income during the periods in which those assets are expected to be
realized.
 
 Stock-based compensation
costs. We account for all forms of employee stock-based compensation
using the fair value-based method. This method requires that we make estimates
about the expected volatility of our shares, the expected life of the
awards and the forfeiture rate.
 
 Adopted
in fiscal 2008
 
 On
September 1, 2007, we adopted the Canadian Institute of Chartered Accountants
(CICA) Handbook Section 1530, “Comprehensive Income”, Section 3251, “Equity”,
Section 3855, “Financial Instruments – Recognition and Measurement”, and Section
3865, “Hedges”. Sections 3251 and 3865 have been adopted prospectively, while
Section 3855 has been applied retroactively, without restatement of prior years’
financial statements and Section 1530 has been applied retroactively with
restatement of prior years’ financial statements.
 
 Following
the adoption of Section 3855, we classified our financial instruments as
follows:
 
 Cash
 
 Cash is
classified as a financial asset held for trading and is carried at fair value in
the balance sheet, and any changes in its fair value are reflected in the
statements of earnings.
 
 Short-term
investments
 
 We
elected to classify our short-term investments as available-for-sale securities;
therefore, they are carried at fair value in the balance sheet, and any changes
in their fair value are reflected in comprehensive income. Upon the disposal or
maturity of these assets, accumulated changes in their fair value are
reclassified in the statements of earnings. Also, upon the adoption of this
new standard, unrealized losses on short-term investments
as of August 31, 2007, in the amount of $55,000 (previously
recorded in the statements of earnings), have been reclassified from the opening
balance of retained earnings to the opening balance of accumulated other
comprehensive income for the year ended August 31, 2008.
 
 Interest
income on short-term investments is recorded in interest income in the
statements of earnings and in cash flows from operating activities in the
statements of cash flows.
 
 Accounts
receivable
 
 Accounts
receivable are classified as loans and receivable. After their initial
measurement at fair value, they are carried at amortized cost, which generally
corresponds to nominal amount due to their short-term maturity.
 
  50
 Table of Contents
  Accounts
payable and accrued liabilities
 
 Accounts
payable and accrued liabilities are classified as other financial liabilities.
They are initially measured at their fair value. Subsequent measurements
are at amortized cost, using the effective interest rate method. For us, that
value corresponds to nominal amount as a result of their short-term
maturity.
 
 Forward
exchange contracts
 
 Our
forward exchange contracts, which qualify for hedge accounting, are used to
hedge anticipated US-dollar-denominated sales and the related accounts
receivable. They are recorded at fair value in the balance sheet with changes in
their fair value being reported in comprehensive income. Upon the recognition
of related hedged sales, accumulated changes in fair value are reclassified
in the statements of earnings. Unrecognized gains on forward exchange contracts
as of August 31, 2007, in the amount of $1.9 million, net of future
income taxes of $916,000, have been reflected as an adjustment to the
opening balance of accumulated other comprehensive income for the year ended
August 31, 2008.
 
 Cumulative
foreign currency translation adjustment
 
 The
cumulative foreign currency translation adjustment, which is solely the result
of the translation of our consolidated financial statements in US dollars (our
reporting currency), has been reclassified to be presented
as a component of accumulated other comprehensive income for all years
presented.
 
 Transition
 
 We
elected to use September 1, 2002, as the transition date for embedded
derivatives.
 
 Other
than the adjustments described above for the short-term investments and the
forward exchange contracts, the recognition, derecognition and measurement
methods used to prepare the consolidated financial statements have not changed
from the methods of periods prior to the effective date of the new standards.
Consequently, there were no further adjustments to record on
transition.
 
 Section
1506, “Accounting Changes”
 
 On
September 1, 2007, we adopted Section 1506, “Accounting Changes”. This section
establishes criteria for changes in accounting policies, accounting treatment
and disclosures regarding changes in accounting policies, estimates and
corrections of errors. In particular, this section allows for voluntary changes
in accounting policy only when they result in the financial statements providing
reliable and more relevant information. Furthermore, this section requires
disclosure of when an entity has not applied a new source of GAAP that has been
issued but is not yet effective. The adoption of this section had no effects on
our consolidated financial statements for the year ended August 31,
2008.
 
 To
be adopted after fiscal 2008
 
 In
December 2006, the CICA issued three new sections, which provide a complete set
of disclosure and presentation requirements for financial instruments: Section
3862, “Financial Instruments − Disclosures”; Section 3863, “Financial
Instruments − Presentation”; and Section 1535, “Capital
Disclosures”.
 
 Section
3862 replaces the disclosure portion of Section 3861, “Financial
Instruments − Disclosure and Presentation”. The new standard places
increased emphasis on disclosures regarding risks associated with both
recognized and unrecognized financial instruments and how these risks are
managed. It is also intended to remove any duplicate disclosures and simplify
the disclosures about concentrations of risk, credit risk, liquidity risk and
price risk currently found in Section 3861.
 
 Section
3863 carries forward the presentation requirements from Section 3861,
unchanged.
 
  51
 Table of Contents
  Section
1535 applies to all entities, regardless of whether they have financial
instruments and are subject to external capital requirements. The new section
requires disclosure of information about an entity’s objectives, policies and
processes for managing capital, as well as quantitative data about capital and
whether the entity has complied with any capital requirements.
 
 Sections
1535, 3862 and 3863 apply to fiscal years beginning on or after October 1, 2007.
We will adopt these new standards on September 1, 2008, and are currently
assessing the disclosure effects these new standards will have on our
consolidated financial statements.
 
 In June
2007, the CICA issued Section 3031, “Inventories”. This standard requires the
measurement of inventories at the lower of cost and net realizable value and
includes guidance on the determination of cost, including allocation of
overheads and other costs to inventory. The standard also requires the
consistent use of either first-in, first-out (FIFO) or weighted average cost
formula to measure the cost of inventories and requires the reversal of previous
write-downs to net realizable value when there is a subsequent increase in the
value of inventories. The new standard applies to fiscal years beginning on or
after January 1, 2008. We will adopt this new standard on September 1,
2008, and its adoption will have no significant effect on our consolidated
financial statements.
 
 In June
2007, the CICA amended Section 1400, “General Standards of Financial Statement
Presentation”, to include new requirements regarding an entity’s ability to
continue as a going concern. These amendments apply to fiscal years beginning on
or after January 1, 2008. We will adopt these amendments on September 1, 2008,
and their adoption will have no effect on our consolidated financial
statements.
 
 In
February 2008, the CICA issued Section 3064, “Goodwill and intangible assets”,
which supersedes Section 3062, “Goodwill and other intangible assets” and
Section 3450, “Research and development costs”. Various changes have been made
to other sections of the CICA Handbook for consistency purposes. Section 3064
establishes standards for the recognition, measurement, presentation and
disclosure of goodwill subsequent to its initial recognition and
of intangible assets by profit-oriented enterprises. Standards concerning
goodwill remain unchanged from the standards included in the previous Section
3062. This new section applies to fiscal years beginning on or after
October 1, 2008. We will adopt this new standard on September 1, 2009,
and have not yet determined the effects its adoption will have on our
consolidated financial statements.
 52
 Table of Contents
 
 RESULTS
OF OPERATIONS
 
 The
following table sets forth certain Canadian GAAP consolidated financial
statements data in thousands of US dollars, except per share data, and
as a percentage of sales for the years indicated:
 
 Consolidated
      statements of earnings data:
              
              2008
              
              
              2007
              
              
              2006
              
              
              2008
              
              
              2007
              
              
              2006Sales
              
              $
              183,790
              
              
              $
              152,934
              
              
              $
              128,253
              
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %Cost
      of sales (1)
              
              
              75,624
              
              
              
              65,136
              
              
              
              57,275
              
              
              
              41.1
              
              
              
              42.6
              
              
              
              44.7Gross
      margin
              
              
              108,166
              
              
              
              87,798
              
              
              
              70,978
              
              
              
              58.9
              
              
              
              57.4
              
              
              
              55.3Operating
      expensesSelling
      and administrative
              
              
              61,153
              
              
              
              49,580
              
              
              
              40,298
              
              
              
              33.3
              
              
              
              32.4
              
              
              
              31.4Net
      research and development (2)
              
              
              26,867
              
              
              
              16,668
              
              
              
              15,404
              
              
              
              14.6
              
              
              
              10.9
              
              
              
              12.0Amortization
      of property, plant and equipment
              
              
              4,292
              
              
              
              2,983
              
              
              
              3,523
              
              
              
              2.4
              
              
              
              1.9
              
              
              
              2.7Amortization
      of intangible assets
              
              
              3,871
              
              
              
              2,864
              
              
              
              4,394
              
              
              
              2.1
              
              
              
              1.9
              
              
              
              3.4Impairment
      of long-lived assets
              
              
              −
              
              
              
              −
              
              
              
              604
              
              
              
              −
              
              
              
              −
              
              
              
              0.5Government
      grants
              
              
              −
              
              
              
              (1,079
              )
              
              
              (1,307
              )
              
              
              −
              
              
              
              (0.7
              )
              
              
              (1.0
              )Total
      operating expenses
              
              
              96,183
              
              
              
              71,016
              
              
              
              62,916
              
              
              
              52.4
              
              
              
              46.4
              
              
              
              49.0Earnings
      from operations
              
              
              11,983
              
              
              
              16,782
              
              
              
              8,062
              
              
              
              6.5
              
              
              
              11.0
              
              
              
              6.3Interest
      income
              
              
              4,639
              
              
              
              4,717
              
              
              
              3,253
              
              
              
              2.5
              
              
              
              3.0
              
              
              
              2.5Foreign
      exchange gain (loss)
              
              
              442
              
              
              
              (49
              )
              
              
              (595
              )
              
              
              0.3
              
              
              
              −
              
              
              
              (0.5
              )Earnings
      before income taxes and extraordinary gain
              
              
              17,064
              
              
              
              21,450
              
              
              
              10,720
              
              
              
              9.3
              
              
              
              14.0
              
              
              
              8.3Income
      taxesCurrent
              
              
              (7,094
              )
              
              
              3,741
              
              
              
              2,585
              
              
              
              (3.9
              )
              
              
              2.4
              
              
              
              2.0Future
              
              
              14,094
              
              
              
              −
              
              
              
              −
              
              
              
              7.7
              
              
              
              −
              
              
              
              −Recognition
      of previously unrecognizedfuture
      income tax
      assets
              
              
              (5,324
              )
              
              
              (24,566
              )
              
              
              −
              
              
              
              (2.9
              )
              
              
              (16.0
              )
              
              
              −1,676
              
              
              
              (20,825
              )
              
              
              2,585
              
              
              
              0.9
              
              
              
              (13.6
              )
              
              
              2.0Earnings
      before extraordinary gain
              
              
              15,388
              
              
              
              42,275
              
              
              
              8,135
              
              
              
              8.4
              
              
              
              27.6
              
              
              
              6.3Extraordinary
      gain
              
              
              3,036
              
              
              
              −
              
              
              
              −
              
              
              
              1.6
              
              
              
              −
              
              
              
              −Net
      earnings for the period
              
              $
              18,424
              
              
              $
              42,275
              
              
              $
              8,135
              
              
              
              10.0
              %
              
              
              27.6
              %
              
              
              6.3
              %Basic
      and diluted earnings before extraordinary gain per share
              
              $
              0.22
              
              
              $
              0.61
              
              
              $
              0.12Basic
      and diluted net earnings per share
              
              $
              0.27
              
              
              $
              0.61
              
              
              $
              0.12Segment
      informationSales:Telecom
      Division
              
              $
              160,981
              
              
              $
              129,839
              
              
              $
              107,376
              
              
              
              87.6
              %
              
              
              84.9
              %
              
              
              83.7
              %Life
      Sciences and Industrial Division
              
              
              22,809
              
              
              
              23,095
              
              
              
              20,877
              
              
              
              12.4
              
              
              
              15.1
              
              
              
              16.3$
              183,790
              
              
              $
              152,934
              
              
              $
              128,253
              
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %Earnings
      from operations:Telecom
      Division
              
              $
              9,524
              
              
              $
              13,132
              
              
              $
              6,679
              
              
              
              5.2
              %
              
              
              8.6
              %
              
              
              5.2
              %Life
      Sciences and Industrial Division
              
              
              2,459
              
              
              
              3,650
              
              
              
              1,383
              
              
              
              1.3
              
              
              
              2.4
              
              
              
              1.1$
              11,983
              
              
              $
              16,782
              
              
              $
              8,062
              
              
              
              6.5
              %
              
              
              11.0
              %
              
              
              6.3
              %Research
      and development data:Gross
      research and development
              
              $
              32,454
              
              
              $
              25,201
              
              
              $
              19,488
              
              
              
              17.7
              %
              
              
              16.5
              %
              
              
              15.2
              %Net
      research and development(2)
              
              $
              26,867
              
              
              $
              16,668
              
              
              $
              15,404
              
              
              
              14.6
              %
              
              
              10.9
              %
              
              
              12.0
              %Consolidated
      balance sheets data:Total
      assets
              
              $
              293,066
              
              
              $
              279,138
              
              
              $
              219,159
  (1)
              The
      cost of sales is exclusive of amortization, shown
    separately.
 (2)
              Net
      research and development expenses for the year ended August 31, 2007
      include recognition of previously unrecognized research and development
      tax credits of $3,162, or 2.1% of
sales.
   53
 Table of Contents
  SALES
 
 Fiscal
2008 vs. 2007
 
 In fiscal
2008, our global sales increased 20.2% to $183.8 million from
$152.9 million for the same period last year, with an 88%–12% split in
favor of our Telecom Division (85%–15% in 2007).
 
 Telecom
Division
 
 In fiscal
2008, sales of our Telecom Division increased 24.0% to $161.0 million from
$129.8 million in 2007.
 
 In fiscal
2008, we posted sales growth due to the market acceptance of our next-generation
IP test solutions and continued market-share gains in optical test solutions;
due to revenue fromnewly acquired Brix
Networks and Navtel Communications; and due to continued spending in access
networks fuelled by the competitive dynamic between telephone and cable
companies.
 
 In fiscal
2008, sales of our optical test solutions increased 12.7% to $115.1 million,
from $102.1 million in 2007. In addition, in fiscal 2008, we posted
record-high sales and bookings of protocol test solutions, including
next-generation IP test solutions and product lines of newly acquired Brix
Networks and Navtel Communications. Protocol test solutions represented our
fastest-growing product line with a year-over-year sales increase of 97.4%
(organic growth of 65.6% excluding sales of $5.4 million from our new
acquisitions of fiscal year 2008) as they reached $33.7 million in 2008,
compared to $17.1 million in 2007. Also, they represented more than 20% of our
telecom sales in 2008 (more than 10% in 2007). With these two acquisitions as
well as the recent launches of significant strategic protocol test
solutions—namely, a compact multiservice transport test set that combines
next-generation SONET/SDH and Ethernet testing inside a single module
(FTB-8120NGE/FTB-8130NGE Power Blazer), a 40/43 Gbit/s SONET/SDH field-test
solution for high-speed optical networks (FTB-8140 Transport Blazer) as well as
the advanced IQS-600 Integrated Qualification System, a highly scalable modular
test platform for R&D and manufacturing applications—we have a much
more comprehensive offering in this market segment, which provides us with a
significant competitive advantage; we believe this should help us further
increase our market share and sales in the upcoming quarters.
 
 However,
in fiscal 2008, we posted a year-over-year sales decrease of 3.9% ($7.4 million
in fiscal 2008, compared to $7.7 million in 2007) for our copper-access test
solutions given that our highly competitive new product offering is only just
starting to establish itself on the market and that large-scale IPTV deployments
have been delayed, which affected our sales in fiscal 2008 to some extent.
During fiscal 2008, we launched new added-value products that integrate
Consultronics (copper-access) core knowledge and intellectual property, such as
the new AXS-200 SharpTESTER. Also in 2008, we launched a new test module housed
inside the AXS-200 SharpTESTER platform, which differentiates our access network
offering from those of other vendors. The AXS-200/630 Triple-Play Test Set,
which leverages the benefits of Broadcom’s customer premises equipment (CPE)
multimode VDSL2 chipset, enables the installation and troubleshooting of ADSL2+
and VDSL2 access networks with the highest level of interoperability. These
new, innovative products have yet to contribute to our sales for this market
segment. A large portion of our sales of copper-access products in fiscal
2007 were made to a Tier-1 carrier in the United States. In fiscal 2008, sales
of copper-access test solutions made to this customer significantly decreased
compared to 2007, which means that we were able to diversify our customer base
year-over-year.
 
 It should
be noted however that in fiscal 2007, we benefited from aggressive FTTH rollouts
from our top customer, and sales to this customer represented 17.3% ($22.5
million) of our telecom sales in fiscal 2007, compared to 8.4%
($13.6 million) this year. Excluding sales to this customer, our telecom
sales would have increased 37.3% in fiscal 2008, compared to 2007; we
believe this shows that we have properly diversified our customer base
year-over-year.
 
 In fiscal
2008, foreign exchange gains on our forward exchange contracts, which are
included in our telecom sales, amounted to $4.2 million, compared to $1.3
million in 2007. In fiscal 2008, the average value of the Canadian dollar
increased 11.4% versus the US dollar compared to 2007, which contributed to
the increase in the foreign exchange gains on our forward exchange contracts
year-over-year.







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Life
Sciences and Industrial Division





In fiscal
2008, sales of our Life Sciences and Industrial Division decreased 1.2%
year-over-year at $22.8 million from $23.1 million in 2007.





A
significant portion of sales of that division are conducted through original
equipment manufacturer (OEM) agreements. Consequently, we are dependent, to some
extent, on the buying pattern of our customers. In particular, one of our major
OEM customers significantly reduced its purchases of our products following the
launch of its own solution that competes against our products. Excluding sales
to this customer, sales of this division would have increased 3.5%
year-over-year.





Net
Bookings





Overall,
for the two divisions, net accepted orders increased 17.8% year-over-year to a
record-high $184.6 million in fiscal 2008 from $156.7 million in 2007,
for a book-to-bill ratio of 1.00 (excluding the backlog of Brix Networks and
Navtel Communications) in fiscal 2008. Our 17.8% increase in net accepted orders
in fiscal 2008, compared to the same period last year, is mainly due to the
increased demand for our next-generation IP and optical test solutions, and the
contribution of Brix Networks and Navtel Communications since their
acquisitions.





Fiscal
2007 vs. 2006





In fiscal
2007, our global sales increased 19.2% to $152.9 million from $128.3 million in
2006, with an 85%–15% split in favor of our Telecom Division (84%–16% in
2006).





Telecom
Division





In fiscal
2007, sales of our Telecom Division increased 20.9% to $129.8 million from
$107.4 million in 2006.





In fiscal
2007, we posted organic sales growth due to market-share gains in optical
testing and next-generation IP test solutions and due to continued spending
in access networks fueled by the competitive dynamic between telephone and cable
companies. In fiscal 2007, sales of our optical test solutions increased 19.9%
to $102.1 million ($85.2 million in 2006), and we earned our fourth
consecutive Growth Strategy Leadership Award from Frost & Sullivan for
largest market-share gains in optical testing. Also, during fiscal 2007,
protocol test solutions were our fastest-growing product line with a sales
increase of 48.2% year-over-year as they reached $17.1 million, compared to
$11.5 million in 2006. These products represented more than 10% of our Telecom
sales in 2007.





In
addition, during fiscal 2007, sales of our copper-access test solutions
increased 15.5% to $7.7 million, compared to $6.7 million in 2006. It should be
noted however that Consultronics (acquired in January 2006) contributed to
our sales during the whole period compared to about seven months in 2006, which
contributed to the increase in our sales year-over-year.This business unit did
not perform as well as expected in 2007, as large-scale IPTV deployments were
delayed. A large portion of our sales of copper-access products in fiscal 2007
were made to a Tier-1 carrier in the United States.





During
fiscal 2007, we faced increased pricing pressure, especially in the Asia-Pacific
region, which prevented us from further increasing our sales
year-over-year.





Life
Sciences and Industrial Division





In fiscal
2007, sales of our Life Sciences and Industrial Division increased 10.6% to
$23.1 million from $20.9 million in 2006. The increase in sales in
fiscal 2007, compared to 2006, is mainly due to increased sales activities in
the curing market as well as market-share gains in the fluorescence illumination
market, following our efforts to expand international markets, mainly Europe and
Asia.







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Geographic
distribution





Fiscal
2008 vs. 2007





In fiscal
2008, sales to the Americas, Europe, Middle-East and Africa (EMEA) and
Asia-Pacific (APAC) accounted for 56%, 28% and 16% of global sales,
respectively, compared to 59%, 27% and 14%, respectively in 2007.





In fiscal
2008, we reported sales increases (in dollars) in every geographic area. In
fact, sales to the Americas, EMEA and APAC increased (in dollars) 12.8%, 26.3%
and 40.1%, respectively, which resulted in a larger percentage of sales coming
from international markets.





In the
Americas, the increase in sales in fiscal 2008, compared to the same period
last year, comes from every region; we posted a sales growth of 47.8%, 7.9% and
16.7% in Canada, United States and Latin America, respectively. In the
United States, despite the decrease in sales to our top customer year-over-year,
we were able to increase our sales in this region. Additionally, Brix
Networks and Navtel Communications contributed to the increase in sales in the
United States and in Canada year-over-year as most of their sales are made in
these two countries. As mentioned above, during fiscal 2007, we benefited from
aggressive FTTH rollouts from our top customer, and sales to this customer
represented 14.7% ($22.5 million) of our global sales in fiscal 2007, compared
to 7.4% ($13.6 million) this year. We believe that we did not lose market share
with this particular customer in fiscal 2008; in fact, we believe we
have expanded market share as we successfully got additional product-line
approvals to partially offset the decline in optical business. Excluding sales
to this customer, sales to the United States would have increased 28.7% in
dollars year-over-year; this shows that, overall, we have diversified our
customer base year-over-year in this region. Finally, sales to Latin
America fluctuate depending on the timing and scope of our customers’
projects.





The
increase in sales in the EMEA market, in dollars, in fiscal 2008, compared to
2007, is a result of our continued strategy to aggressively develop this
market in the past several years, to consistently invest in sales resources, and
to develop stronger support and service operations in this region. In
addition, many Tier-1 carriers in EMEA are migrating their traditional
circuit-switched core networks to higher-speed, dense wavelength-division
multiplexing (DWDM) and next-generation packet-based architectures, which is
creating a market demand for our protocol test solutions as well as our
DWDM, ROADM and fiber characterization test kits. Furthermore, we are leveraging
our FTTx leadership gained in the United States to provide consultancy with
many of the early adopters in this field in EMEA.





In the
APAC market, we are seeing the continued return on investment of some specific
optical, protocol as well as life sciences and industrial products
developed and targeted for this important market. This increasingly competitive
range, coupled with our steadily expanding market presence, is responsible for
the higher sales in this region in fiscal 2008, compared to
2007.





Fiscal
2007 vs. 2006





In fiscal
2007, sales to the Americas, Europe, Middle-East and Africa (EMEA) and
Asia-Pacific (APAC) accounted for 59%, 27% and 14% of global sales,
respectively, compared to 60%, 25% and 15%, respectively in 2006.





In fiscal
2007, we reported sales increases in dollars in every geographic area. In fact,
sales to the Americas, EMEA and APAC increased (in dollars) 18.7%, 27.5% and
7.8% year-over-year, respectively.





In the
Americas, the increase in sales in dollars in fiscal 2007, compared to the same
period last year, comes from the United States and Canada, where we witnessed an
increase in sales of our optical and protocol test solutions. In the United
States, we continue leveraging our dominant FTTx market position to increase our
sales. In addition, sales to our top customer, who is located in the United
States, increased in dollars in fiscal 2007, compared to 2006. Sales to this
customer represented $22.5 million, or 14.7% of global sales in 2007, compared
to $17.7 million, or 13.8% of our global sales in 2006, representing
an increase of 27.0% year-over-year. In Latin America, we reported a slight
decrease in sales in fiscal 2007 compared to 2006.






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The
significant increase in sales in the EMEA market, in dollars, in fiscal 2007,
compared to 2006, is apparent in the results for all our product lines,
following our efforts to aggressively develop this market in the past several
years, and our continued investment to increase our sales presence as well as
our initiatives to develop stronger support and service operations in this
region. Many Tier-1 carriers in EMEA are migrating their traditional
circuit-switched core networks to higher-speed, DWDM and next-generation
packet-based architectures, which is creating a market demand for our
protocol test solutions and fiber characterization test kits. In addition, we
are leveraging our FTTx leadership gained in the United States to provide
consultancy with many of the early adopters in this field
in EMEA.





In the
APAC market, we started to see the impact of the introduction of some specific
optical, protocol and life sciences and industrial products as we steadily
increase our market presence in this growth region; this explains the increase
in sales in this region in fiscal 2007, compared to the corresponding period
last year. However, although we reported sales growth year-over-year in
this region, we are facing significant competitive pricing pressure, which
prevented us from reaching expected sales growth. In addition, a significant
portion of our sales to this market are made through tenders, which vary in
number and importance year-over-year.





Through
our two divisions, we sell our products to a broad range of customers, including
network service providers, network equipment manufacturers, wireless operators,
cable TV operators, optical system and component manufacturers, as well as
customers in the life sciences and high-precision assembly sectors. In fiscal
2008, no customer accounted for more than 10% of our global sales, and our
top three customers accounted for 13.1% of our global sales. In fiscal
2007, our top customer accounted for 14.7% ($22.5 million) of our global sales,
and our top three customers accounted for 19.6% of our global
sales.








GROSS
MARGIN





Gross
margin amounted to 58.9%, 57.4% and 55.3% of sales in fiscal 2008, 2007 and
2006, respectively.





Fiscal
2008 vs. 2007





Fiscal
2008 marked the sixth consecutive year that the company raised its gross margin
as it reached its highest level since fiscal 2001. The increase in our gross
margin in fiscal 2008, compared to 2007, can be explained by the following
factors. First, in fiscal 2008, our gross margin was positively affected by the
significant increase in sales of our protocol test solutions year-over-year,
including those of Brix Networks and Navtel Communications, as these
products have better margins than our other test solutions. In addition, the
significant increase in global sales, year-over-year, resulted in an increase in
manufacturing activities, allowing us to better absorb our fixed manufacturing
costs. Furthermore, we were able to reduce our cost of goods sold by better
leveraging our supplier base and by developing innovative new products with
cost-effective design. Also, our cost of goods was positively affected by lower
costs for raw material due to the significant increase in the value of the
Canadian dollar, compared to the US dollar in previous quarters, as most of
these costs are incurred in US dollars.





However,
the shift in sales between the Americas in favor of APAC had a negative impact
on our gross margin year-over-year. In fact, sales to APAC tend to have lower
margins than sales to the Americas since we are facing higher pricing pressure
in the APAC region. In addition, we are facing continued aggressive pricing
pressure worldwide. Furthermore, in fiscal 2008, a stronger Canadian dollar,
compared to the US dollar year-over-year, prevented us from further
improving our gross margin as most of our overhead costs and a portion of
our raw material purchases are denominated in Canadian dollars. Finally, the
startup of our own manufacturing activities in China, over the last few months,
resulted in additional expenses, which reduced our gross margin in fiscal
2008, compared to 2007.





On an
ongoing basis and when technically possible, we adjust the design of our
products to reuse excess inventory; over the past few years, we experienced
higher sales than expected on some product lines and consumed such excess
inventory. Consequently, we were able to reuse excess inventories that were
written off in previous years. Excess inventory reuse accounted for
approximately $1.2 million, or 0.7% of sales in fiscal 2008, compared
to approximately $1.7 million, or 1.1% of sales in 2007 and approximately
$1.2 million, or 0.9% of sales in 2006.








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Fiscal
2007 vs. 2006





Despite
the increased strength of the Canadian dollar, compared to the US dollar in
fiscal 2007 versus 2006, and the intense competitive pressure on selling prices
that we faced in 2007, we were able to significantly increase our gross margin
(2.1%) year-over-year.





This
increase in our gross margin in fiscal 2007, compared to 2006, can be explained
by several factors. First, the increase in sales year-over-year resulted in an
increase in manufacturing activities, allowing us to better absorb our fixed
manufacturing costs. In addition, sales of our protocol test solutions increased
in dollars and as a percentage of sales year-over-year; this had a positive
impact on our gross margin, as these products are more software-intensive and
tend to have better gross margins than our optical test solutions. Furthermore,
we were able to reduce our cost of goods sold by better leveraging our supplier
base and by developing innovative new products with cost-effective design.
Finally, our initiative to outsource the manufacturing of some product lines to
China in fiscal 2007 helped us to improve our gross margin
year-over-year.





However,
we are facing continued aggressive pricing pressure worldwide, which negatively
affected the gross margin in fiscal 2007. In addition, in 2007, a stronger
Canadian dollar, compared to the US dollar year-over-year, prevented us
from further improving our gross margin, as some cost of sales items are
denominated in Canadian dollars. Furthermore, the transfer, in fiscal 2007, of
our protocol and copper access manufacturing operations from Montreal and
Concord to our Quebec City plant resulted in one-time charges, which negatively
affected our gross margin during that period. Finally, the setup of our own
manufacturing activities in China late in fiscal 2007 resulted in
additional one-time costs in 2007, thus reducing the gross margin of that
year.





Outlook
for Fiscal 2009





Considering
our expectations of sales growth in fiscal 2009, our expectations of increase in
sales of protocol products and the full contribution of Brix Networks and Navtel
Communications (which historically have generated higher margins than our own
product lines), the cost-effective design of our products, our manufacturing
activities in China and our tight control on operating costs, while no assurance
can be given, we expect our gross margin to improve in the next few years.
However, our gross margin may fluctuate quarter-over-quarter as our sales may
fluctuate. Furthermore, our gross margin can be negatively affected by increased
competitive pricing pressure, customer concentration and/or consolidation,
increased obsolescence costs, shifts in customer and product mix,
under-absorption of fixed manufacturing costs, challenges encountered in the
ramp-up of our manufacturing facilities in China and increases in product
offerings by other suppliers in our industry. Finally, any increase in the
strength of the Canadian dollar, compared to the US dollar, would have a
negative impact on our gross margin in fiscal 2009 and beyond.








SELLING
AND ADMINISTRATIVE





Selling
and administrative expenses were $61.2 million, $49.6 million and $40.3 million
for fiscal 2008, 2007 and 2006, respectively. As a percentage of sales, selling
and administrative expenses amounted to 33.3%, 32.4% and 31.4% for fiscal 2008,
2007 and 2006, respectively.

















Fiscal
2008 vs. 2007











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In
addition, the setup in 2008 of manufacturing facilities in China and
a software development center in India contributed to an increase in our
administrative expenses year-over-year.








However,
in fiscal 2007, we had large orders sold directly to international customers,
for which we still had to pay commissions to distributors instead of selling
through our distributors at a discounted price; this did not occur at the same
extent in 2008, resulting in higher selling expenses for 2007, compared to
2008.





In fiscal
2008, and despite an increase in sales, our selling and administrative expenses
increased in percentage of sales compared to 2007. The significant
increase in the average value of the Canadian dollar compared to the
US dollar year-over-year, the setup of our manufacturing facilities in
China and R&D center in India, as well as the impacts of the acquisitions of
Brix Networks and Navtel Communications—whose selling expenses tend
to be higher as their products deliver better margins compared to the
rest of our product lines—contributed to the increase in these expenses
as a percentage of sales.





Fiscal
2007 vs. 2006





In fiscal
2007, we intensified our sales and marketing activities to develop our markets
and leverage the significant research and development investments of the prior
years; this resulted in higher sales and marketing expenditures (including the
number of employees), compared to 2006.





In
addition, our overall commission expenses increased in fiscal 2007, compared to
the corresponding period last year, due to the increase in sales year-over-year
and the shift in customer mix. In fact, in fiscal 2007, we had large orders sold
directly to international customers for which we still had to pay commissions to
distributors instead of selling through our distributors at a discounted
price, which increased our selling expenses year-over-year, but had, to some
extent, a positive impact on our gross margin.





Furthermore,
Consultronics, acquired in January 2006, contributed to our selling and
administrative expenses throughout the entire period, compared to about seven
months in 2006, thus increasing these expenses year-over-year.





Also, a
stronger Canadian dollar on average for the period, compared to the US dollar
during fiscal 2007 versus 2006, caused our selling and administrative expenses
to increase year-over-year, as more than half of these expenses are denominated
in Canadian dollars.





In
addition, late in fiscal 2007, the setup of manufacturing facilities in China
and a software development center in India contributed to an increase
in our administrative expenses year-over-year.





Finally,
in fiscal 2007, and despite an increase in sales, our selling and administrative
expenses increased in percentage of sales compared to the corresponding
period last year. Larger commissions on international sales as well as our
efforts to develop international markets and operations contributed to the
increase in these expenses as a percentage of sales.





Outlook
for Fiscal 2009





For
fiscal 2009, considering the significant impacts of the acquisitions of Brix
Networks and Navtel Communications on our selling and administrative
expenses—whose selling expenses tend to be higher, as their products deliver
better margins compared to the rest of our product lines—we expect our
selling and administrative expenses to increase in dollars and range between 32%
and 34%. In particular, in fiscal 2009, we expect our commission expenses
to increase as sales volume increases. Furthermore, considering our goal of
becoming the leading player in the telecom test, measurement and monitoring
space, we plan to continue intensifying our sales and marketing efforts, both
domestic and international, which will also cause our expenses to rise. Finally,
any increase in the strength of the Canadian dollar would also cause our selling
and administrative expenses to increase, as more than half of these expenses are
incurred in Canadian dollars.







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RESEARCH
AND DEVELOPMENT





Gross
research and development expenses





Gross
research and development expenses totaled $32.5 million, $25.2 million and $19.5
million for fiscal 2008, 2007 and 2006, respectively. As a percentage of sales,
gross research and development expenses amounted to 17.7%, 16.5% and 15.2%
for fiscal 2008, 2007 and 2006, respectively, while net research and development
expenses accounted for 14.6%, 10.9% and 12.0% of sales for these respective
periods. Net research and development expenses for fiscal 2007 included the
recognition of non-refundable research and development tax credits in the amount
of $3.2 million that were written off in fiscal 2003 following the downturn in
the telecommunications industry; this represented 2.1% of sales.





Fiscal 2008 vs.
2007





In fiscal 2008, the
significant increase in the average value of the Canadian dollar, compared to
the US dollar year-over-year, had a significant and negative effect on our gross
research and development expenses as a significant portion of these expenses are
denominated in Canadian dollars and also because these expenses increased
year-over-year.In
addition, we intensified our research and development activities, including
additional employees, which resulted in more gross research and development
expenses in both divisions in fiscal 2008, compared to 2007. Furthermore, Brix Networks and Navtel
Communications contributed about four months and five months, respectively, in
fiscal 2008, which caused our gross research and development expenses to
increase compared to 2007. It should be noted that Brix Networks and Navtel
Communications tend to incur a higher percentage of sales for research and
development expenses compared to our other product lines as their products are
more software-intensive; but they deliver higher margins than most of our other
product lines. Also, weestablished a research and development
center focused on software development in Pune, India, which resulted in
increased expenses year-over-year.  Finally, in fiscal 2008, we closed
down our R&D operations in Budapest, Hungary, and certain R&D projects,
which resulted in severance expenses during that year and caused our fiscal 2008
expenses to increase year-over-year.





The
increase in our gross research and development expenses as a percentage of sales
year-over-year is mainly due to the negative effect of the increased value
of the Canadian dollar versus the US dollar year-over-year, the impact of the
acquisitions of Brix Networks and Navtel Communications as well as the severance
expenses incurred in fiscal 2008.





Fiscal
2007 vs. 2006





In fiscal
2007, we intensified our research and development activities in both divisions,
which resulted in higher gross research and development expenses, including
additional employees, compared to 2006. In addition, in fiscal 2007,
we subcontracted a larger portion of our research and development projects in
Canada and India, compared to the corresponding period last year, which
resulted in an increase in our gross research and development expenses
year-over-year.





Furthermore,
Consultronics contributed to our research and development expenses during the
whole period this year, compared to about seven months in 2006, thus increasing
these expenses year-over-year. Finally, in fiscal 2007, the increased strength
of the Canadian dollar, on average, compared to the US dollar year-over-year,
contributed to the increase in our gross research and development expenses, as
most of these are denominated in Canadian dollars.





The
above-mentioned factors explain the increase of our gross research and
development expenses as a percentage of sales in fiscal 2007, compared to
2006.





Tax
      credits





In fiscal
2008, tax credits from the Canadian federal and provincial governments for
research and development activities were $5.6 million, $8.5 million and
$4.1 million for fiscal 2008, 2007 and 2006, respectively.
As a percentage of gross research and development expenses, tax
credits and grants reached 17.2%, 33.9% and 21.0% for fiscal 2008, 2007 and
2006, respectively.







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Fiscal
2008 vs. 2007





In fiscal
2007, and as explained below, tax credits included $3.2 million, or 12.5% of
gross research and development expenses, for the recognition of non-refundable
research and development tax credits that were written off in fiscal 2003
following the downturn in the telecommunications industry. Excluding this
one-time revenue, tax credits would have increased $216,000 in fiscal 2008,
compared to 2007.





This
increase in the dollar amount of our tax credits in fiscal 2008, compared to
2007, is due to the increased strength of the Canadian dollar, compared to the
US dollar year-over-year, since these credits are solely earned on research
and development expenses incurred in Canada. However, the decrease
in research and development tax credits as a percentage of gross research
and development expenses is mainly due to the fact that since the beginning
of fiscal 2008, the portion of gross research and development incurred in
Canada, where we are entitled to tax credits, was lower than in fiscal 2007
following the establishment of our new software development center in India
as well as the acquisition of Brix Networks, which is located in the United
States. Our research and development activities conducted outside Canada are not
entitled to tax credits.





Fiscal
2007 vs. 2006





During
fiscal 2003, following the downturn in the telecommunications industry and after
being in a cumulative loss position, we wrote off deferred non-refundable
research and development tax credits of our parent company because it was more
likely than not that these assets would not be realized.





In fiscal
2007, after reviewing both available positive and negative evidence, and because
we were in a cumulative profit position in the parent company at the Canadian
federal level, and also because we expect to generate sufficient taxable income
in future years, we concluded that is was more likely than not that deferred
non-refundable income tax credits of our parent company would be realized.
Consequently, in fiscal 2007, we recorded previously unrecognized non-refundable
research and development tax credits in the amount of $3.2 million, or
12.5% of gross research and development expenses. These non-refundable tax
credits of $3.2 million recognized in fiscal 2007 can be carried forward
against future years’ Canadian federal income taxes payable and expire between
2011 and 2014.





In
addition to this one-time tax credit, our tax credits increased in dollars in
fiscal 2007, compared to 2006, for several reasons. First, the increase in gross
research and development expenses in Canada in 2007, compared to 2006,
resulted in more expenses being eligible for tax credits as we were entitled to
similar grant programs and tax credits year-over-year. In addition, the
increased strength of the Canadian dollar, compared to the US dollar
year-over-year, resulted in higher tax credits since these credits are solely
earned on research and development expenses incurred in Canada.





Also, due
to the one-time recognition of non-refundable tax credits from prior years, our
tax credits significantly increased as a percentage of gross research and
development expenses. Had prior years’ credits not been recognized, our tax
credits would have been flat year-over-year as a percentage of gross research
and development expenses, as we incurred most of our expenses in Canada and
were entitled to the same grant programs and tax credits.





Outlook
for Fiscal 2009





For
fiscal 2009, we expect that our research and development expenses will increase
in dollars, and range between 14% and 16% of sales, given our focus on
innovation, the addition of Brix Networks and Navtel Communications, whose
products are software-intensive, the addition of software features in our
products, our desire to gain market share and our goal to exceed customer needs
and expectations. Also, we are increasingly taking advantage of talent pools
around the world with the establishment of a research and development center
focused on software development in Pune, India. Finally, any increase in
the strength of the Canadian dollar in the upcoming quarters would cause
our net research and development expenses to increase, as most of these are
incurred in Canadian dollars.








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AMORTIZATION
OF PROPERTY, PLANT AND EQUIPMENT





In fiscal
2008, amortization of property, plant and equipment was $4.3 million, compared
to $3.0 million in 2007 and $3.5 million in 2006.





Fiscal
2008 vs. 2007




The recent startup
ofour own manufacturing and research and development facilities in
China and India, the upgrade of our IT systems, and the impact of the
acquisition of Brix Networks and Navtel Communications, which contributed about
four months and five months in fiscal 2008, respectively, resulted
in an increase in our amortization expenses in fiscal 2008 compared to
last year. In addition, the increase in the average
value of the Canadian dollar versus the US dollar in fiscal 2008, compared to
2007, contributed to the increase in our amortization expenses
year-over-year as most of these expenses are denominated in Canadian
dollars.





Fiscal
2007 vs. 2006





The
decrease in amortization expenses in fiscal 2007, compared to 2006, despite the
increase in the strength of the Canadian dollar, compared to the US dollar, as
well as the acquisition of Consultronics in January 2006, is mainly due to
the fact that some of our property, plant and equipment became fully amortized
in 2007 and 2006.





Outlook
for Fiscal 2009





For
fiscal 2009, we expect the amortization of property, plant and equipment to
increase in dollars due to the upgrade of our IT systems in fiscal 2008, the
full impact of the acquisitions of Brix Networks and Navtel Communications, and,
more importantly, the expansion of our own manufacturing and research and
development facilities in China and India. Also, any increase in the strength of
the Canadian dollar in the upcoming quarters would cause our amortization of
property, plant and equipment to increase, as most of these are denominated
in Canadian dollars.








AMORTIZATION
OF INTANGIBLE ASSETS





In
conjunction with the business combinations we completed over the past several
years, we recorded intangible assets, primarily consisting of core technology.
These intangible assets resulted in amortization expenses
of $3.9 million, $2.9 million and $4.4 million for fiscal 2008, 2007
and 2006, respectively.





Fiscal
2008 vs. 2007





The
increase in amortization expenses in fiscal 2008, compared to 2007, is mainly
due to the acquisition of Brix Networks core technology, acquired in the third
quarter of 2008 and the increased strength of the Canadian dollar compared to
the US dollar.





Fiscal
2007 vs. 2006





The
decrease in amortization expenses in fiscal 2007, compared to 2006, despite
the increased strength of the Canadian dollar compared to the US dollar, and the
acquisition of Consultronics in January 2006 is mainly due to the fact that
some of our core technologies became fully amortized during fiscal 2005 and
2006; namely, those related to the acquisition of EXFO Burleigh, EXFO Photonics
Solutions and EXFO Protocol.





Outlook
for Fiscal 2009





For
fiscal 2009, we expect the amortization of intangible assets to increase because
we will have the full impact of the acquisition of Brix
Networks.








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IMPAIRMENT
OF LONG-LIVED ASSETS





Fiscal
2006





In June
2006, we entered into an agreement to sell one of our buildings (located in
Rochester, NY) along with some equipment, and we recorded an impairment charge
of $604,000 in the third quarter of fiscal 2006. The impairment charge
represented the excess of the carrying value of these assets over the expected
net selling price of $1.2 million. The sale of these assets was finalized in the
fourth quarter of 2006 for the expected net selling price. These assets were
related to the Life Sciences and Industrial Division.








GOVERNMENT
GRANTS





During
1998, we entered into an agreement with the Quebec Minister of Industry,
Commerce, Science and Technology (“The Minister”). Pursuant to this agreement,
the Minister agreed to contribute, in the form of grants, up to CA$2.2
million over the period from January 1, 1998, through December 31, 2002, payable
based on the number of full-time jobs created during that period.





The above
grants were subject to the condition that jobs created pursuant to the agreement
be maintained for a period of at least five years from the date of
creation. Since the beginning of the program, we deferred CA$1.5 million
(US$1.3 million) in the balance sheet until we received the final approval
by the sponsor of the program related to jobs created. In fiscal 2006, the
sponsor of the program granted us with its final approval and we recorded
CA$1.5 million (US$1.3 million) in the earnings from operations in the
statement of earnings of fiscal 2006.





Furthermore,
until December 31, 2006, companies operating in the Quebec City area
were eligible for a refundable credit granted by the Quebec provincial
government. This credit was earned based on the increase of eligible production
and marketing salaries incurred in the Quebec City area at a rate of 40%. From
the total amount we claimed under this program, a sum of CA$1.1 million
(US$1.1 million) was deferred in the balance sheet until we received the final
approval of eligible salaries by the sponsor of the program. In fiscal 2007, the
sponsor of the program granted us its final approval, and we recorded CA$1.1
million (US$1.1 million) in the earnings from operations in the statement of
earnings of fiscal 2007.





As at
August, 31, 2007 and 2008, we were not part of any significant grant
programs.








INTEREST
INCOME





Our
interest income mainly resulted from our short-term investments, less interests
and bank charges. Interest income amounted to $4.6 million, $4.7 million and
$3.3 million for fiscal 2008, 2007 and 2006, respectively.





Fiscal
2008 vs. 2007





The
slight decrease in interest income in fiscal 2008, compared to 2007, is mainly
due to the decrease of our cash and short-term investments following the cash
payment of $41.0 million for the acquisitions of Brix Networks and Navtel
Communications, the redemption of share capital for $8.1 million in accordance
with our share buy-back program as well as the general reduction in interest
rates year-over-year. However, the significant increase in the average value of
the Canadian dollar, compared to the US dollar year-over-year, contributed to
the increase in our interest income in fiscal 2008, compared to 2007, as it is
denominated in Canadian dollars. In addition, in fiscal 2008, we received
interest of $241,000 by the Canadian tax authorities following the recovery
during that period of prior years’ income tax receivable.





Fiscal
2007 vs. 2006





The
increase in our interest income in fiscal 2007, compared to 2006, is mainly due
to the increase in interest rates year-over-year. Also, our average cash
position increased in fiscal 2007 due to cash flows from operating activities,
which contributed to the further increase in interest revenue
year-over-year.







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Outlook
for Fiscal 2009





Assuming
no acquisitions paid in cash are made in fiscal 2009 and relative stability in
interest rates, we expect our interest income to decrease in 2009 as our average
cash position is expected to be lower in fiscal 2009, considering the impact of
our share repurchase programs and the cash used in fiscal 2008, namely for the
consideration paid for the acquisitions of Brix Networks and Navtel
Communications, the redemption of share capital and the additions of capital
assets. This should be slightly mitigated by cash flows from operating
activities in 2009.








FOREIGN
EXCHANGE GAIN (LOSS)





Foreign
exchange gains and losses are mainly the result of the translation of operating
activities denominated in currencies other than the Canadian
dollar.





Our
foreign exchange gain amounted to $442,000 in fiscal 2008, compared to foreign
exchange losses of $49,000 and $595,000 for 2007 and 2006,
respectively.





In fiscal
2008, we witnessed instability in the value of the Canadian dollar as it
fluctuated compared to the US dollar, which overall, resulted in a foreign
exchange gain of $442,000. The average exchange rate was CA$1.0071 = US$1.00 in
fiscal 2008, compared to a year-end exchange rate of CA$1.0564 = US$1.00 as at
August 31, 2007, and CA$1.0626 = US$1.00 as at August 31,
2008.





In fiscal
2007, we also witnessed instability in the value of the Canadian dollar as it
fluctuated compared to the US dollar, which overall, resulted in a small
foreign exchange loss of $49,000. The average exchange rate was CA$1.1215 =
US$1.00 in fiscal 2007, compared to a year-end exchange rate of CA$1.1066 =
US$1.00 as at August 31, 2006, and CA$1.0564 = US$1.00 as at August 31,
2007.





It should
be noted that foreign exchange rate fluctuations also flow through P&L line
items as a significant portion of our operating items are denominated in
Canadian dollars and we report our results in US dollars. Consequently, the
significant increase in the average value of the Canadian dollar in fiscal 2008,
compared to 2007, resulted in a significant and negative impact on our financial
results. This was amplified by the fact that our operating activities incurred
in Canadian dollars increased year-over-year. In fact, the average value of the
Canadian dollar in fiscal 2008 was CA$1.0071 = US$1.00 versus CA$1.1215 =
US$1.00 in 2007, representing an increase of 11.4% in the average value of the
Canadian dollar year-over-year. In fiscal 2007, the average value of the
Canadian dollar was CA$1.1215 = US$1.00 versus CA$1.1481 = US$1.00 in 2006,
representing an increase of 2.4% in the average value of the Canadian dollar
year-over-year.




We manage
our exposure to currency risks with forward exchange contracts. In addition,
some of our Canadian entities’ operating activities are denominated in US
dollars or other currencies, which further hedges these risks. However, any
increase in the value of the Canadian dollar, compared to the US dollar, would
have a negative impact on our operating results.








INCOME
TAXES





We
recorded an income tax expense of $1.7 million in fiscal 2008, compared to an
income tax recovery of $20.8 million in 2007, and an income tax
expense of $2.6 million in 2006.





Fiscal
2006





Since
fiscal 2003, we have maintained a full valuation allowance against our
consolidated future income tax assets. In fiscal 2006, we recorded an income tax
expense of $2.6 million. Most of this expense represented income taxes payable
at the Canadian federal level, which were reduced by research and development
tax credits that were recorded against gross research and development expenses
in the statement of earnings of that year.








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Fiscal
2007





During
fiscal 2007, after reviewing both available positive and negative evidence, and
because we were in a cumulative profit position in the parent company
(Canadian federal and provinces levels) and in one of our subsidiaries, located
in the United States, and also because we expected to generate sufficient
taxable income in future years, we concluded that it was more likely than
not that future income tax assets and deferred non-refundable research and
development tax credits of the parent company and a portion of our future income
tax assets in the United States would be realizable. Consequently, we reversed a
portion of our valuation allowance against future income tax assets in the
amount of $24.6 million. From this amount, $16.2 million was related to the
Canadian federal level, $3.2 million was related to the Canadian provincial
levels and $5.2 million was related to the United States level. Future income
tax assets recognized in 2007 were recorded in the income tax provision
in the statement of earnings for that year.





However,
in the United States (federal level), based on available positive and negative
evidence as at August 31, 2007, as well as the level and the
nature of cumulative and expected profits, we maintained a valuation allowance
of $7.6 million on a portion of our future income tax assets in this
tax jurisdiction because it was more likely than not that these assets would not
be recovered. These future income tax assets consisted of operating losses
carried forward.





In other
tax jurisdictions where we have future income tax assets, we were still in a
cumulative loss position as at August 31, 2007, and available negative evidence
outweighed positive evidence. Consequently, for these tax jurisdictions, we
maintained a full valuation allowance against our future income tax assets. As
at August 31, 2007, the valuation allowance recorded for these tax
jurisdictions amounted to $4.9 million and mainly related to deferred operating
losses.





Except
for the reversal of the valuation allowance in fiscal 2007, most of the income
tax expenses recorded in fiscal 2007 represent income taxes payable at the
Canadian federal level, which are reduced by research and development tax
credits that are recorded against gross research and development expenses in the
statements of earnings.





Fiscal
2008





During fiscal 2008, reductions to the
Canadian federal statutory tax rate were substantively enacted. Therefore,
Canadian federal future income tax assets decreased by $1.5 million and
generated a future income tax expense in the same amount during the
year.





In addition, during fiscal 2008, taking
into account these new Canadian federal substantively enacted tax rates,
we reviewed our tax strategy for the future use of our Canadian federal
operating losses, research and development expenses, certain timing differences
and research and development tax credits to minimize income taxes payable
on future years’ taxable income. Consequently, we amended our prior year’s
income tax returns to generate a net operating loss to be carried back to prior
years, which reinstated previously used research and development tax credits.
This resulted in an increase of $2.7 million in both our tax-related assets in
the balance sheet and future income tax recovery in the statement of earnings
for the year ended August 31, 2008.





Finally,
during fiscal 2008, considering the expected positive impacts the acquisitions
of Navtel Communications and Brix Networks will have on future years’ taxable
income at the United States federal level and because actual taxable income in
the United States is greater than initially expected, we concluded that it was
more likely than not that all future income tax assets of our existing
consolidated US group would be recovered. Consequently, we reversed our
valuation allowance against future income tax assets in the amount of $7.6
million. The portions of the valuation allowance that were reversed, and that
were attributable to the effects of the Navtel Communications and Brix Networks
acquisitions—in the amount of $652,000 and $1.6 million, respectively—were
included in the purchase price allocation of the related acquired businesses.
The remainder of the reversal, in the amount of $5.3 million, has been
recorded in income taxes in the statement of earnings for the year ended
August 31, 2008.








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As at
August 31, 2008, our net future income tax assets amounted to $24.7 million, and
our non-refundable research and development tax credits amounted to $20.7
million. In order to realize these future income tax assets and non-refundable
research and development tax credits, we need to generate approximately $174
million in pretax earnings at the Canadian federal level, approximately $33
million at the Canadian provincial levels, and approximately $37 million at
the United States federal level.





Based on
the existing and expected levels of pretax earnings in these tax jurisdictions,
we believe that we should be able to recover our income tax assets at the
Canadian federal level, at the Canadian provincial levels, and at the United
States federal level over the next seven years, four years and nine years,
respectively.





Valuation
allowance





As at
August 31, 2008, we were still in a cumulative loss position in certain of our
subsidiaries and negative evidence outweighed positive evidence. For these
subsidiaries, we maintained a full valuation allowance against our future income
tax assets. As at August 31, 2008, the valuation allowance for these
subsidiaries amounted to $15.5 million and mainly related to operating
losses and research and development expenses carried forward. Of the global
valuation allowance of $15.5 million, $8.2 million related to Brix Networks. In
the event that we reverse a portion of or all the valuation allowance,
the amount of such reversal would reduce the amount of goodwill recognized
for this acquisition.





Please
refer to note 15 of our consolidated financial statements included elsewhere in
this Annual Report for more details on income taxes and a full reconciliation of
the income tax provision.








EXTRAORDINARY
GAIN





In
conjunction with the acquisition of Navtel Communications, we recorded negative
goodwill in the amount of $3.0 million. This negative goodwill has
been recorded as an extraordinary gain in the statement of earnings for fiscal
2008.








LIQUIDITY
AND CAPITAL RESOURCES





Cash Requirements
and Capital Resources





As at
August 31, 2008, cash and short-term investments totalled $87.5 million, while
our working capital was at $144.6 million. Our cash and short-term
investments decreased $42.2 million in fiscal 2008, compared to 2007, mainly due
to the cash payments of $41.0 million, $6.5 million and $8.1 million for the
acquisitions of Brix Networks and Navtel Communications, the purchases of
capital assets and the redemption of share capital, respectively. On the other
hand, operating activities generated cash flows of $13.8 million. We also
recorded an unrealized foreign exchange gain on our cash and short-term
investments of $0.4 million. This unrealized foreign exchange gain resulted from
the translation, in US dollars, of our Canadian-dollar-denominated cash and
short-term investments and was included in the accumulated other comprehensive
income in the balance sheet.





Our
short-term investments consist of commercial paper issued by ten (seven
as at August 31, 2007) high-credit quality corporations and trusts;
therefore, we consider the risk of non-performance of these financial
instruments to be limited. None of these debt instruments are expected to
be affected by a liquidity risk; and none of them represents asset-backed
commercial paper.For the purposes of
managing our cash position, we have established a cash management policy,
which we follow and monitor on a regular basis. These short-term investments
will be used for working capital and other general corporate purposes,
including other potential acquisitions and our share repurchase
programs.








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We
believe that our cash balances and short-term investments will be sufficient to
meet our liquidity and capital requirements for the foreseeable future,
including the cash contingent consideration payable for the acquisition
of Brix Networks and the effect of our share repurchase programs. In
addition to these assets, we have unused available lines of credit totaling
$10.5 million for working capital and other general corporate purposes and
unused lines of credit of $18.5 million for foreign currency exposure
related to forward exchange contracts. However, possible operating losses and/or
possible investments in or acquisitions of complementary businesses, products or
technologies may require additional financing. There can be no assurance that
additional debt or equity financing will be available when required or,
if available, that it can be secured on satisfactory terms. Our lines of
credit bear interest at prime rate.





As at
August 31, 2008, our commitments under operating leases amounted to $3.6 million
in 2009, $3.1 million in 2010, $1.5 million in 2011, $629,000 in 2012 and
$57,000 in 2013 and after, for total commitments
of $8.9 million.





Sources
and Uses of Cash





We
finance our operations and meet our capital expenditure requirements mainly
through cash flows from operating activities, the use of our cash and short-term
investments as well as the issuance of subordinate voting shares.





Operating
Activities





Cash
flows provided by operating activities were $13.8 million in fiscal 2008,
compared to $14.4 million in 2007 and $12.3 million in 2006.





Fiscal
2008 vs. 2007





Cash
flows provided by operating activities in fiscal 2008 were attributable to the
net earnings after items not affecting cash of $34.7 million, offset in
part by the negative net change in non-cash operating items
of $20.9 million. The negative net change in non-cash operating
items was mainly due to the negative effect on cash of the increase of $4.3
million of our accounts receivable, the negative effect on cash of the increase
of $12.8 million of our income tax and tax credits recoverable, the negative
effect on cash of the increase of $2.2 million of our inventories as well
as the negative effect on cash of the decrease of $1.4 million of our accounts
payable and accrued liabilities. The increase of our accounts receivable is
directly attributable to the increase in sales year-over-year. The increase
in our income taxes and tax credits is mainly due to the increase in our tax
credits recoverable that were earned during the year but not yet recovered as
well as the effect of the change in our tax strategy, explained elsewhere in
this document. This increase was mostly offset by the positive effect on cash of
the decrease of our future income tax assets (in items not affecting cash),
which also resulted from the change in the tax strategy. The increase in
our inventories resulted from expected increased sales activities for the next
quarters. The decrease in our accounts payable and accrued liabilities is
due to the timing of certain purchases and payments.





Fiscal
2007 vs. 2006





Cash
flows provided by operating activities in fiscal 2007 were attributable to the
net earnings after items not affecting cash of $24.6 million, less the
negative net change in non-cash operating items of $10.2 million.
Our accounts receivable, our income taxes and tax credits recoverable as
well as our inventories increased in fiscal 2007, resulting in negative effects
on cash flows of $5.5 million, $3.4 million and $5.5 million, respectively.
However, our accounts payable and accrued liabilities increased during fiscal
2007, resulting in a positive effect on cash flows of $4.1
million. The increase in sales year-over-year explains the increase
in accounts receivable. Also, one-time recognition of prior years’
non-refundable tax credits of $3.2 million explains most of the increase
in our income taxes and tax credits recoverable year-over-year.
Furthermore, increased sales activities in fiscal 2007 resulted in higher
inventory levels in 2007 in order to sustain these additional sales activities.
However, increased levels of activities in fiscal 2007, compared to 2006,
resulted in an increase in our accounts payable and accrued liabilities
year-over-year.








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Investing
Activities





Cash
flows used by investing activities amounted to $4.2 million in fiscal 2008,
compared to $16.1 million in 2007 and $13.2 million in 2006.





Fiscal
2008 vs. 2007





In fiscal
2008, we disposed (net of acquisitions) of $43.3 million worth of
short-term investments to pay for the cash consideration of $41.0 million
for the two business combinations closed during the year. Also, we paid $6.5
million for the purchase of capital assets.





Fiscal
2007 vs. 2006





In fiscal
2007, we acquired (net of sales) $13.6 million worth of short-term investments
and paid $5.6 million for the purchase of capital assets. On the other
hand, in fiscal 2007, we received net proceeds of $3.1 million from the disposal
of capital assets.





Financing
activities





Cash
flows used by financing activities amounted to $8.0 million in fiscal 2008,
compared to cash flows provided of $330,000 in 2007 and of $142,000 in
2006.





Fiscal
2008 vs. 2007





In fiscal
2008, we redeemed share capital for a cash consideration of $8.1 million.
However, during that year, exercise of stock options generated $61,000 ($557,000
and $802,000 in fiscal 2006 and 2007, respectively).








FORWARD
EXCHANGE CONTRACTS





We
utilize forward exchange contracts to manage our foreign currency exposure. Our
policy is not to utilize those derivative financial instruments for trading or
speculative purposes.





Our
forward exchange contracts, which are used to hedge anticipated
US-dollar-denominated sales, qualify for hedge accounting; therefore, foreign
exchange translation gains and losses on these contracts are recognized
as an adjustment of the revenues when the corresponding sales are
recorded.





As at
August 31, 2008, we held forward exchange contracts to sell US dollars at
various forward rates, which are summarized as follows:




Expiry
      dates
            
            Contractual
      amounts
            
            Weighted
      averagecontractual
                forward
      ratesSeptember
      2008 to August 2009
            
            $36,600,000
            
            1.0686September
      2009 to August 2010
            
            $17,400,000
            
            1.0535September
      2010 to August 2011
            
            $2,400,000
            
            1.0619





As at
August 31, 2008, the fair value of our forward exchange contracts, which
represents the amount we would receive or pay to settle the contracts based
on the forward exchange rate at year end, represented net gains of $62,000
($3.4 million as at August 31, 2007).
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  CONTINGENCY
 
 On
November 27, 2001, a class-action suit was filed in the United States District
Court for the Southern District of New York against EXFO, four of the
underwriters of our Initial Public Offering and some of our executive officers
pursuant to the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
thereunder and Sections 11, 12 and 16 of the Securities Act of 1933. This class
action alleges that EXFO’s registration statement and prospectus filed with the
Securities and Exchange Commission on June 29, 2000, contained material
misrepresentations and/or omissions resulting from (i) the underwriters
allegedly soliciting and receiving additional, excessive and undisclosed
commissions from certain investors in exchange for which they allocated material
portions of the shares issued in connection with EXFO’s Initial Public
Offering; and (ii) the underwriters allegedly entering into agreements with
customers whereby shares issued in connection with EXFO’s Initial Public
Offering would be allocated to those customers in exchange for which customers
agreed to purchase additional amounts of shares in the after-market
at predetermined prices.
 
 On April
19, 2002, the plaintiffs filed an amended complaint containing master
allegations against all of the underwriters in all of the 310 cases included in
this class action and also filed an amended complaint containing allegations
specific to four of EXFO’s underwriters, EXFO and two of our executive officers.
In addition to the allegations mentioned above, the amended complaint alleges
that the underwriters (i) used their analysts to manipulate the stock
market; and (ii) implemented schemes that allowed issuer insiders to sell
their shares rapidly after an initial public offering and benefit from high
market prices. As concerns EXFO and our two executive officers in particular,
the amended complaint alleges that (i) EXFO’s registration statement was
materially false and misleading because it failed to disclose the additional
commissions and compensation to be received by underwriters; (ii) the two
named executive officers learned of or recklessly disregarded the alleged
misconduct of the underwriters; (iii) the two named executive officers had
motive and opportunity to engage in alleged wrongful conduct due to personal
holdings of EXFO’s stock and the fact that an alleged artificially inflated
stock price could be used as currency for acquisitions; and (iv) the two named
executive officers, by virtue of their positions with EXFO, controlled it and
the contents of the registration statement and had the ability to prevent its
issuance or cause it to be corrected. The plaintiffs in this suit seek an
unspecified amount for damages suffered.
 
 In July
2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint
and a decision was rendered on February 19, 2003. Only one of the
claims against EXFO was dismissed. On October 8, 2002, the claims against
its officers were dismissed pursuant to the terms of Reservation of Rights and
Tolling Agreements entered into with the plaintiffs.
 
 In June
2004, an agreement of partial settlement was submitted to the court for
preliminary approval. The proposed partial settlement was between the
plaintiffs, the issuer defendants in the consolidated actions, the issuer
officers and directors named as defendants, and the issuers’ insurance
companies. The court granted the preliminary approval motion on
February 15, 2005, subject to certain modifications. On August 31,
2005, the court issued a preliminary order further approving the modifications
to the settlement and certifying the settlement classes. The court also
appointed the notice administrator for the settlement and ordered that notice of
the settlement be distributed to all settlement class members by
January 15, 2006. The settlement fairness hearing occurred on
April 24, 2006, and the court reserved decision at that time.
 
 While the
partial settlement was pending approval, the plaintiffs continued to litigate
against the underwriter defendants.  The district court directed that the
litigation proceed within a number of “focus cases” rather than in all of the
310 cases that have been consolidated.  EXFO's case is not one of
these focus cases.  On October 13, 2004, the district court certified
the focus cases as class actions.  The underwriter defendants appealed
that ruling, and on December 5, 2006, the Court of Appeals for the Second
Circuit reversed the district court’s class certification
decision.
 
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 Table of Contents
  On April
6, 2007, the Second Circuit denied the plaintiffs’ petition for rehearing of
that decision and, on May 18, 2007, the Second Circuit denied the
plaintiffs’ petition for rehearing en banc.  In light
of the Second Circuit’s opinion, liaison counsel for all issuer defendants,
including EXFO, informed the court that this settlement cannot be approved,
because the defined settlement class, like the litigation class, cannot be
certified.  On June 25, 2007, the district court
entered an order terminating the settlement agreement.  On August 14,
2007, the plaintiffs filed their second consolidated amended class-action
complaints against the focus cases and, on September 27, 2007, again moved for
class certification. On November 12, 2007, certain of the
defendants in the focus cases moved to dismiss the second consolidated amended
class-action complaints. On March 26, 2008, the district court denied the
motions to dismiss, except as to Section 11 claims raised by those plaintiffs
who sold their securities for a price in excess of the initial offering
price and those who purchased outside of the previously certified class period.
Briefing on the class certification motion was completed in May
2008.
 
 Due to
the inherent uncertainties of litigation, it is not possible to predict the
final outcome of the case, nor to determine the amount of any possible
losses. We will continue to defend our position in this litigation that the
claims against EXFO, and our officers, are without merit. Accordingly, no
provision for this case has been made in the consolidated financial
statements as at August 31, 2008.
 
 
 SHARE
CAPITAL AND STOCK-BASED COMPENSATION PLANS
 
 Share
Capital
 
 As at
November 3, 2008, EXFO had 36,643,000 multiple voting shares outstanding,
entitling to ten votes each and 30,606,791 subordinate voting shares
outstanding. The multiple voting shares and the subordinate voting shares are
unlimited as to number and without par value. In fiscal 2008, we redeemed
1,682,921 subordinated voting shares for a total consideration of $8.1
million based on our share buy-back program.
 
 Long-Term
Incentive Plan and Deferred Share Unit Plan
 
 The
aggregate number of subordinate voting shares covered by stock options,
restricted share units (RSUs) and deferred share units (DSUs) granted under the
Long-Term Incentive Plan and the Deferred Share Unit Plan was 2,748,457 as at
August 31, 2008. The maximum number of subordinate voting shares issuable under
these two plans cannot exceed 6,306,153 shares. The following tables summarize
information about stock options, RSUs and DSUs granted to the members of the
Board of Directors and to Management and Corporate Officers of the company and
its subsidiaries as at August 31, 2008:





Stock Options
            
            Number
            
            %
      of issued and outstanding
            
            Weighted
      average exercise priceChairman
      of the Board, President and CEO(one
      individual)
            
            179,642
            
            10%
            
            $9.05Board
      of Directors (five individuals)
            
            194,375
            
            11%
            
            $6.23Management
      and Corporate Officers(eight
      individuals)
            
            212,139
            
            11%
            
            $14.49586,156
            
            32%
            
            $10.08





Restricted Share Units
      (RSUs)
            
            Number
            
            %
      of issued and outstandingChairman
      of the Board, President and CEO(one
      individual)
            
            85,460
            
            10%Management
      and Corporate Officers(ten
      individuals)
            
            238,069
            
            28%323,529
            
            38%






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Deferred Share Units
      (DSUs)
            
            Number
            
            %
      of issued and outstandingBoard
      of Directors (four individuals)
            
            79,185
            
            100%




OFF-BALANCE
SHEET ARRANGEMENTS
 
 As at
August 31, 2008, our off-balance sheet arrangements consisted of letters of
guarantee and forward exchange contracts. As at August 31, 2008, our letters of
guarantee amounted to $5.7 million; these letters of guarantee expire at various
dates through fiscal 2010. From this amount, we had $1.5 million worth of
letters of guarantee for our own selling and purchase requirements, which were
reserved from one of our lines of credit. The remainder in the amount of $4.2
million was used to secure our line of credit in Chinese currency. This line of
credit was unused as at August 31, 2008. These letters of guarantee
were secured by short-term investments. Our forward exchange contracts are
described above.
   VARIABLE
INTEREST ENTITY
 
 As of
August 31, 2008, we did not have interests in any variable interest
entities.





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Item 6.
                  Directors,
      Senior Management and Employees


A.
            Directors
      and Senior Management




The
following table sets forth information about our executive officers, senior
managers and Directors as of November 3, 2008.





Name
      and Municipality of Residence
            
            Positions
      with EXFOPIERRE-PAUL
      ALLARD
              Pleasanton,
      California
            
            Independent
      DirectorJON
      BRADLEY
              Worminghall,
      United Kingdom
            
            Vice-President,
      Telecom Sales - InternationalSTEPHEN
      BULL
              Quebec
      City, Quebec
            
            Vice-President,
      Research and Development, Telecom DivisionNORMAND
      DUROCHER
              St-Sauveur,
      Quebec
            
            Vice-President,
      Human ResourcesALLAN
      FIRHOJ
              Georgestown,
      Ontario
            
            Vice-President
      and General Manager, Life Sciences and Industrial
  DivisionROBERT
      FITTS
              Minesing,
      Ontario
            
            Vice-President,
      Corporate DevelopmentÉTIENNE
      GAGNON
              Quebec
      City, Quebec
            
            Vice-President,
      Telecom Product Management and MarketingLUC
      GAGNON
              St-Augustin-de-Desmaures,
      Quebec
            
            Vice-President,
      Telecom Manufacturing Operations and Customer ServiceVIVIAN
      HUDSON
              Beaconsfield,
      Quebec
            
            Vice-President
      and General Manager, EXFO Service Assurance Business
  UnitGERMAIN
      LAMONDE
              St-Augustin-de-Desmaures,
      Quebec
            
            Chairman
      of the Board, President and Chief Executive OfficerPIERRE
      MARCOUILLER
              Magog,
      Quebec
            
            Independent
      DirectorGUY
      MARIER
              Lakefield
      Gore, Quebec
            
            Independent
      Lead DirectorPIERRE
      PLAMONDON
              Quebec
      City, Quebec
            
            Vice-President,
      Finance and Chief Financial OfficerBENOIT
      RINGUETTE
              Boischatel,
      Quebec
            
            General
      Counsel and Corporate SecretaryJOSEPH
      SUTHERLAND
              Apsley,
      Ontario
            
            Vice-President
      and General Manager, Navtel Product GroupDAVID
      A. THOMPSON
              Newton,
      North Carolina
            
            Independent
      DirectorANDRÉ
      TREMBLAY
              Outremont,
      Quebec
            
            Independent
      DirectorDANA
      YEARIAN
              Lake
      Forest, Illinois
            
            Vice-President,
      Telecom Sales - Americas





The
address of each of our executive officers, senior managers and Directors is c/o
EXFO Electro-Optical Engineering Inc., 400 Godin Avenue, Quebec, Quebec, Canada.
The following is a brief biography of each of our executive officers, senior
managers and Directors.






72
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Pierre-Paul Allardwas
appointed a member of EXFO’s Board of Directors in September 2008 and has been a
board member of many other technology companies in Canada and in the US. Today,
he is also an active philanthropist for l’Institut de Cardiologie de
Québec. Mr. Allard is presently Area Vice-President, Sales for Cisco
Systems Inc., where he has held several management positions over the years.
Currently, he is responsible for sales and field operations of Cisco’s Global
Enterprise Client segment, focusing on new market opportunities, accelerated
revenue growth and increased customer satisfaction. Prior to joining Cisco, Mr.
Allard worked for IBM Canada for 12 years. In 2002, Mr. Allard co-chaired the
Canadian e-Business Initiative, a private-public partnership aiming to measure
the role e-Business plays in increasing productivity levels, job creation and
competitive position. In 1998, he was the laureate of the Arista-Sunlife Award,
for Top Young Entrepreneur in Large Enterprise, by the Montreal Chamber of
Commerce. In 2003, he received the Queen’s Golden Jubilee Medal, which
highlights significant contributions to Canada. In the same year, he was also
awarded the prestigious Trudeau Medal from the University of Ottawa, School of
Management. Pierre-Paul Allard holds a bachelor’s and masters’ degree in
Business Administration from the University of Ottawa, School of Management, in
Canada.





Jon Bradleywas appointed
Vice-President, Telecom Sales - International for EXFO in March 2007.
He is responsible for managing telecom sales, both direct and
indirect, and for the execution of sales strategies in the international arena.
He manages an accomplished and diverse sales and distribution team. As a member
of the Strategy and Management Committees, he also develops corporate strategy
for EXFO. Prior to his appointment as Vice-President, International Telecom
Sales, Dr. Bradley held the position of Sales Director for the Europe, Middle
East and Africa (EMEA) territory from 2003 to 2007, and Regional Sales Manager
from 1999 to 2003. Before joining EXFO in 1999, Dr. Bradley was employed as
Sales and Marketing Director by Queensgate Instruments (UK) from 1997 to 1999
and as Sales Engineer by Lambda Photometrics (UK) from September 1993
to September 1997. Dr. Bradley holds an honors degree in chemistry, as
well as a Ph.D. in Raman spectroscopy from the University of Durham in the
United Kingdom.





Stephen Bullwas appointed
our Vice-President, Research and Development, Telecom Division
in December 1999. He joined us in July 1995 and held the positions of
Assistant Director-Engineering from September 1997 to December 1999 and Group
Leader (Engineering Management) from July 1995 to September 1997. From June 1990
to March 1995, Mr. Bull held the position of General Manager and Managing
Director for Space Research Corporation, a military engineering company in
Belgium. Mr. Bull holds a bachelor’s degree in Electrical Engineering from
Laval University in Quebec City, Canada.





Normand Durocherwas
appointed Vice-President of Human Resources in April 2004. In addition to
managing our human resources team, his main responsibility is to develop and
implement a human resources plan that supports EXFO’s business strategy. Mr.
Durocher began his career in labor relations in the Cable division of Nortel and
then took on several key roles at Nortel Networks and Nordx/CDT, all relating to
human resources and operations. Since then, Normand Durocher has accumulated
more than 25 years’ experience in operations and human resources management
within the telecommunications industry. Prior to joining EXFO, Mr. Durocher
ran his own human resources consulting business. Normand Durocher holds a
Bachelor of Science from the University de Montreal and also completed the
Advanced Human Resources program at Dalhousie University in Halifax,
Nova Scotia, Canada.





Allan Firhoj was appointed
Vice-President and General Manager, Life Sciences and Industrial Division in
July 2003. Prior to that, he held the position of General Manager of EXFO
Photonic Solutions Inc. since November 2001. He is responsible for the
overall strategic direction and management of the Life Sciences and Industrial
Division. Mr. Firhoj joined EFOS Inc. in 1996, where he was responsible for
Sales, Marketing and Business Development of the Dental Curing-Products
Division. Following the sale of this division to Dentsply International in 1997,
he was appointed Director of Marketing and Business Development. Mr. Firhoj
continued in this capacity until being appointed to the position of General
Manager of EXFO Photonic Solutions Inc. Prior to joining us, Mr. Firhoj
spent six years with The Horn Group, a plastics business involved in medical
devices/instrumentation and office communication equipment. He successively held
the positions of ISO 9000 Implementation Manager, Technical Sales Manager as
well as Marketing and Business Development Manager. In this latter role, he
successfully contributed to increasing sales in their medical market by an
annual average of 60% during a three-year period. Mr. Firhoj holds a
bachelor’s degree in Political Science from Bishop’s University in Lennoxville,
Quebec.








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Robert Fitts was nominated
Vice-President, Corporate Development in May 2007. His main role is to seek out
new business opportunities (such as strategic alliances, OEM agreements and
acquisitions), which will allow the company to enhance its competitive position
in the telecom test and measurement market. Prior to this appointment, Mr. Fitts
acted as Vice-President, Product Management - Copper Access Products, since our
acquisition of Consultronics in January 2006. Before taking on this position,
Mr. Fitts was Executive Vice-President at Consultronics, where he began his
career more than 20 years earlier. He therefore has extensive experience in the
telecommunications testing industry and, more specifically, has been an active
participant in the field of local-loop testing, DSL, IPTV and VoIP. Robert Fitts
attended the University of Guelph in Ontario, Canada, and has a degree in
electrical engineering (computer option) technology from Fleming College,
near Toronto, Canada. Mr. Fitts is also a graduate of the executive program
given by Queens University School of Business, located in Kingston,
Ontario.





Étienne Gagnon was appointed
Vice-President, Telecom Product Management and Marketing in May 2003 and,
in May 2007, he took on the responsibility of all our telecom business units –
Optical; Transport and Datacom; and Access. As such, he is responsible for
EXFO’s general marketing direction on both the product level and communications
level. Mr. Étienne Gagnon is not related to Mr. Luc Gagnon. For nearly three
years, before returning to EXFO in early 2003, Mr. Gagnon was Vice-President of
Sales and Marketing at TeraXion, an optical component manufacturer based in
Quebec City. Mr. Gagnon began his career as a design engineer for
Bombardier/Canadair, where he worked on the Canadian Regional Jet project
between 1990 and 1993. Later, he held the position of Business Development
Manager for France Telecom in Hungary. In 1994, he joined EXFO’s European office
as a Regional Sales Manager, and in 1996, he was brought back to Quebec City to
head the OSP marketing group. Mr. Gagnon then went on to become the director of
our Outside Plant division in 1998, and remained in that function until he
joined TeraXion in 2000. Etienne Gagnon holds a bachelor’s degree in
mechanical engineering from the University of Montreal’s School of Engineering,
and a master’s degree in European business from the Ecole nationale supérieure des
télécommunications in France.





Luc Gagnon was appointed
Vice-President, Telecom Manufacturing Operations in May 2003 and,
in May 2007, he also took on the vice-presidency of the Customer
Services department. Mr. Luc Gagnon is not related to Mr. Étienne
Gagnon. He is responsible for ensuring the smooth operation of all manufacturing
activities, which include production, purchasing, product engineering, quality
assurance, planning, manufacturing engineering, product configuration,
transportation and customs, as well as material resources. In addition, he
maintains an ongoing and efficient relation between the manufacturing
process and the end customer. Prior to his nomination in 2003, Mr. Gagnon
held the position of Production Director since 2000. Before joining EXFO, he had
similar roles in several other high-technology companies. He worked for Mendes
from 1999 to 2000, for C-MAC from 1997 to 1999, for STERIS from 1993 to
1997 and for MITEL from 1991 to 1993. Luc Gagnon holds a bachelor’s degree in
electrical engineering and master’s degree in engineering, both from the Université de Sherbrooke, in
Canada.





Vivian Hudsonwas nominated
Vice-President and General Manager for EXFO’s Service Assurance business unit in
September 2008. Prior to joining EXFO, Ms. Hudson held various general
management positions at Nortel, including those of General Manager for the
Systems Integration unit for the Microsoft-Nortel Innovative Communications
Alliance; the GSM business in France; and the High-Capacity Optical Networks
group. Ms. Hudson first began at Nortel in 1990 and worked through the
ranks, namely in European Marketing (based in the UK and in France), Optical
Product Management, Wireless Operations, as well as Optical and Wireless General
Management. Prior to this, she held positions at Bell Canada as a
business/services planner, at Canadian Pacific as a telecommunications
networking end user, and at DMR as a telecommunications consultant. A recognized
global high-tech business leader, Ms. Hudson has also pursued sustainable
development activities in the telecommunications area and serves on several
boards. Namely, she is a governor of Carleton University’s Board of Governors
and sits on the board of Shad International. She also holds the ICD.D
designation from the Institute of Corporate Directors of Canada. Vivian Hudson
holds a Bachelor of Science from Université Laval in Quebec
City, and a Master of Business Administration from McGill University in
Montreal.








74
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Germain Lamonde, a company
founder, has been Chairman of the Board, President and CEO of EXFO since its
inception in his apartment in 1985. Mr. Lamonde, who is responsible for the
overall management and strategic direction of EXFO and its subsidiaries and
divisions, has grown the company from the ground up into global leader in the
telecommunications test and measurement industry. Mr. Lamonde has served on
the boards of several organizations such as the Canadian Institute for Photonic
Innovations, the Pole QCA Economic Development Corporation and the National
Optics Institute of Canada to name a few. Germain Lamonde holds
a bachelor’s degree in physics engineering from the University of
Montreal’s School of Engineering (École Polytechnique), a master’s degree in
optics from Laval University, and is also a graduate of the Ivey Executive
Program offered by the University of Western Ontario.





Pierre Marcouillerhas served
as our Director since May 2000. Mr. Marcouiller is Chairman of the Board and CEO
of Camoplast Inc., an industrial manufacturer specializing in rubber tracks,
molded composites, thermoplastic components and off-road tracked vehicles. Prior
to joining Camoplast, Mr. Marcouiller was President and General Manager of
Venmar Ventilation Inc. (1988-1996), where he was the controlling shareholder
from 1991 to 1996. Mr. Marcouiller is also a Director of Canam Group Inc., an
industrial company specialized in the design and fabrication of construction
products and solutionsin the commercial,
industrial, institutional, residential, and bridge and highway infrastructures
markets. Mr. Marcouiller also holds directorships in other privately held
companies. Pierre Marcouiller holds a bachelor’s degree in business
administration from the Université du Québec
à Trois-Rivièresand an MBA from the Université de
Sherbrooke.





Guy Marierhas served as our
Director since January 2004. Formerly President of Bell Québec (1999 to 2003),
Guy Marier completed his successful 33-year career at Bell as Executive
Vice-President of the Project Management Office, before retiring at the end of
2003. From 1988 to 1990, Mr. Marier headed Bell Canada International’s
investments and projects in Saudi Arabia and, for the three following years,
served as President of Télébec. He then returned to the parent company to hold
various senior management positions. Guy Marier holds a Bachelor of Arts
from the University of Montreal and a Bachelor of Business Administration from
the Université du Québec à
Montréal.





Pierre Plamondonhas been our
Vice-President, Finance and Chief Financial Officer since January 1996. Prior to
joining us, Mr. Plamondon served as Senior Manager for Price Waterhouse,
now PricewaterhouseCoopers LLP, from September 1981 to December 1995 in Canada
and France. Pierre Plamondon holds a bachelor’s degree in business
administration and a license in accounting, both from Laval University in Quebec
City, Canada. Mr. Plamondon has been a member of the Canadian Institute of
Chartered Accountants since 1983 and a member of the Board of Directors of SOVAR
Inc. (Société de valorisation des applications de la recherche de l’Université
Laval) since December 2000.





Benoit Ringuette has
been our in-house Legal Counsel and Corporate Secretary since April
2004. Prior to joining EXFO, Mr. Ringuette practiced mainly in
commercial, corporate and securities law from 1998 to 2003 as an associate in
the law firms of O’Brien, Flynn Rivard in Quebec City and Desjardins Ducharme
Stein Monast in Quebec City. Mr. Ringuette has been a member of the
Quebec Bar since 1998. Mr. Ringuette holds a bachelor’s degree in Civil Law and
a master’s degree in Business Administration (MBA) from Laval University in
Quebec City, Canada.





Joseph Sutherland was
appointed Vice-President and General Manager of Navtel Product Group in March
2008, following EXFO’s acquisition of Navtel Communications Inc., an
Ontario-based, communications software company. Mr. Sutherland was President of
Navtel Communications Inc. from 2005 to 2008, and from 1976 to 1998. In this
role, he was responsible for growing the company from inception to over $40
million in revenue with several hundred employees. During his tenure at Navtel,
Mr. Sutherland raised significant venture capital, conducted several
acquisitions and successfully divested Navtel to a large European public
company. After divesture, he continued on as Divisional President of GN Nettest
and was part of the executive management team, participating in numerous
acquisition and strategy development activities until his retirement in 1998.
Prior to resuming his functions as President of Navtel in 2005, Mr. Sutherland
served on several boards. Namely, from 1998 until his successful exit in 2004,
he was Chairman of the Board of Toogood Financial Systems, a financial software
company based in Richmond Hill, Ontario Mr. Sutherland completed an Executive
Management Program in Marketing and Sales Management at the University of
British Columbia in Canada.







75
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David A. Thompsonhas served
as our Director since June 2000. Dr. David A. Thompson is currently
Vice-President and Director of Hardware & Equipment Technology at Corning
Cable Systems, where he has held this position since January 2006. Prior to
this, he was Vice President and Director of Hardware & Equipment Technology
Strategy for Corning Cable Systems from January 2002 to December 2005.
Dr. Thompson first joined Corning Incorporated in 1976 as a Senior Chemist
in glass research.  He then took on several technology Directorships
and strategic planning roles for Corning’s Component and Photonics Technologies
Division between 1988 and 1998; and in 1999, he was appointed technical leader
for the creation of the new Samsung-Corning Micro-Optics joint
venture.  His last position at Corning prior to transferring to
Corning Cable Systems in January 2002 was Division Vice-President for the
Strategic Planning & Innovation Effectiveness in Research, Development and
Engineering.  David A. Thompson holds a Bachelor of Science in
chemistry from Ohio State University and a doctorate in inorganic chemistry
from the University of Michigan.




André Tremblayhas served as
our Director since June 2000.Mr. Tremblay is a
Founder and Managing Partner of Trio Capital Inc, a private equity fund
management company.  He has more than 20 years experience in the
telecommunications industry, having been actively involved in the conception,
financing and management of several companies. As a special advisor to the
President of Telesystem Ltd., and as President of Telesystem Enterprises Ltd.
from 1992 to 1998, he managed a portfolio of telecommunication companies. For
almost 10 years, he served as President and Chief Executive Officer of Microcell
Telecommunications, a wireless network and service provider, which he led from
its inception on through the different phases of its evolution. During that
time, he has also provided early-stage financing, along with strategic advice
and direction, for start-up technology firms. In 2005, he was appointed by
Canada’s Industry Minister as member of the Telecommunications Policy Review
Panel to make recommendations on how to modernize Canada’s telecommunication
policies and regulatory framework. Mr. Tremblay holds bachelor’s degrees in
management and in accounting from Laval University, a master’s degree in
taxation from Université de Sherbrooke, and is also a graduate of Harvard
Business School’s Advanced Management Program.





Dana Yearian was appointed
our Vice President, Telecom Sales - Americas in March 2007. Prior to this
appointment, Mr. Yearian held the position of Vice-President, Telecom Sales −
North America. He is responsible for managing telecom sales, both direct and
indirect, and the execution of sales strategies across North, Central and South
America. Mr. Yearian oversees all sales-related functions for the EXFO sales
organization throughout this territory, including sales operations, global
account management and partner programs. As a member of the Strategy and
Management committees, he also helps develop corporate strategy. Prior to
joining EXFO, Mr. Yearian held senior executive sales positions at Spirent
Communications Service Assurance Division and Acterna Corp. Mr. Yearian
also held various executive positions; namely, at Toshiba America, Silicon
Sensors (Advanced Photonix, Inc.), and Impell Corporation (ABB Ltd.). Mr.
Yearian holds a bachelor's degree in electrical engineering from the Illinois
Institute of Technology in Chicago and has completed MBA course work at
DePaul University, also in Chicago, Illinois, USA.





Term
of Executive Officers





Executive
officers are appointed annually by the Board of Directors and serve until their
successors are appointed and qualified or until earlier resignation or
removal.







76
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B.
              Compensation


Director
Compensation





In the
financial year ended August 31, 2008, each director who was not an employee of
the Corporation or any of its subsidiaries received the level of compensation
set forth in the table below as annual compensation payable in a combination of
cash and Deferred Share Units (“DSUs”) as chosen by the Director pursuant to the
Deferred Share Unit Plan.




Annual
      Retainer for Directors (1)
              CA$50,000 (2)
              US$49,648 (3)Annual
      Retainer for Lead Director
              CA$5,000
              US$4,965 (3)Annual
      Retainer for Committee Chairman
              CA$5,000
              US$4,965 (3)Annual
      Retainer for Committee Members
              CA$3,000
              US$2,979 (3)Fees
      for all Meetings Attended per day in Person
              CA$1,000
              US$993 (3)Fees
      for all Meetings Attended per day by Telephone
              CA$500
              US$496 (3)
 
 (1)
              All
      the Directors elected to receive 50% of their Annual Retainer in form of
      Deferred Share Units except Mr. André Tremblay who elected to receive
      100% of his Annual Retainer in form of Deferred Share
    Units.
 (2)
              The
      Annual Retainer for Mr. David A. Thompson is US$50,000 (CA$50,355). The
      Annual Retainer for Mr. Pierre-Paul Allard will also be in
      US$.
 (3)
              The
      compensation information has been converted from Canadian dollars to U.S.
      dollars based upon an average foreign exchange rate of CA$1.0071 = US$1.00
      for the financial year ending August 31,
2008.


In the
financial year ended August 31, 2008 and as of November 3, 2008, the Directors
who were not employees received the following compensation in the form
indicated:




Name
              Annual
      Compensation
                Paid
      in Cash (US$) (1)
              Annual
      Compensation
                Paid
      in DSUs (#) (2)
              Estimated
      Value of DSUs at
                the
      time of grant (US$) (3)
              Total
      Attendance Fees
                Paid
      in Cash (US$) (1)Pierre-Paul
      Allard
              –
              –
              –
              –Pierre
      Marcouiller (4)
              30,781
              5,174
              24,824
              5,461Guy
      Marier (5)
              35,746
              5,174
              24,824
              8,440Dr.
      David A. Thompson (6)
              29,217
              5,228
              25,000
              6,951André
      Tremblay (7)
              7,944
              10,349
              49,648
              7,944Michael
      Unger (8)
              28,655
              3,760
              18,618
              6,454
 
 (1)
              The
      compensation information has been converted from Canadian dollars to U.S.
      dollars based upon an average foreign exchange rate of CA$1.0071 = US$1.00
      for the financial year ending August 31, 2008 except for Mr. David A.
      Thompson who is paid in U.S. dollar for the portion of his annual retainer
      for Director.  The Annual Compensation includes, as the case may
      be, the retainer for Director, Lead Director, Committee Members and
      Committee Chairman.
 (2)
              Indicates
      the number of Subordinate Voting Shares granted under the Deferred Share
      Unit Plan. A DSU is converted in a Subordinate Voting Share when
      a Director ceases to be a member of the
Board.
 (3)
              The
      estimated value at the time of grant of a DSU is determined based on the
      highest of the closing prices of the Subordinate Voting Shares on the
      Toronto Stock Exchange and the NASDAQ National Market on the last trading
      day preceding the grant date, using the noon buying rate of the Federal
      Reserve Bank of New York on the grant date to convert the NASDAQ National
      Market closing price to Canadian dollars, as required. The value at
      vesting of a DSU is equivalent to the market value of a Subordinate Voting
      Share when a DSU is converted to such Subordinate Voting
      Share.
 (4)
              Member
      of the Audit Committee and the Human Resources
  Committee.
 (5)
              Member
      of the Audit Committee and the Human Resources Committee, Lead Director
      and Chairman of the Human Resources Committee per interim in replacement
      of Mr. Unger and starting October 2008, he was confirmed as
      Chairman.
 (6)
              Member
      of the Human Resources Committee and the Audit Committee since April
      2008.
 (7)
              Member
      of the Human Resources Committee and Chairman of the Audit
      Committee.
 (8)
              Member
      of the Audit Committee and Chairman of the Human Resources Committee until
      his resignation that was effective on
    June 26, 2008.





77
 Table of Contents





Executive
Compensation




The table
below shows compensation information during the three most recently completed
financial years for Mr. Germain Lamonde, the Chairman of the Board,
President and Chief Executive Officer of the Corporation, Mr. Pierre
Plamondon, the Vice-President Finance and Chief Financial Officer and the three
other most highly compensated executive officers of the Corporation and its
subsidiaries who were serving the Corporation at the end of the financial year,
(collectively, the "Named Executive Officers"). This information includes the
U.S. dollar value of base salaries, bonus awards and Long-Term Incentive
Plan grants, the number of options or Restricted Share Units granted, and other
compensation, if any, whether paid or deferred.




Name
      and Principal
                Position
              Financial
                Years
              Salary
      (1)
      ($)
              Bonus
      (2)($)
              Other
      Annual Compensation
                ($)
      (3)
              Securities
                Under
                Options
      (4)
      (#)
              Restricted
                Share Units(5)
                (#)
              All
      Other
                Compensation
                ($)Germain
      Lamonde,
                President
      and Chief Executive Officer
              2008
              347,533
      (US)
                350,000
      (CA)
              198,848
      (US)
                200,260 (CA)
              -
              -
              29,910
              -2007
              294,334
      (US)
                330,096
      (CA)
              131,145
      (US)
                147,080
      (CA)
              -
              -
              25,347
              -2006
              271,753
      (US)
                312,000
      (CA)
              147,558
      (US)
                169,412
      (CA)
              -
              11,218
              21,477
              -Pierre
      Plamondon,
                Vice-President
      Finance and Chief Financial Officer
              2008
              201,569
      (US)
                203,000
      (CA)
              71,047 (US)
                71,551 (CA)
              -
              -
              9,637
              5,240 (US)
      (6)
                5,278 (CA)2007
              173,862
      (US)
                194,986
      (CA)
              56,906 (US)
                63,820 (CA)
              -
              -
              12,930
              4,836
      (US)
      (6)
                5,423
      (CA)2006
              165,691
      (US)
                190,230
      (CA)
              60,167 (US)
                69,078 (CA)
              -
              3,653
              6,994
              4,283
      (US)
      (6)
                4,918
      (CA)Dana
      Yearian,
                Vice-President,
      Telecom Sales - Americas
              2008
              289,219
      (US)
                291,272
      (CA)
              4,826 (US)
                4,861 (CA)
              -
              -
              7,225
              7,401 (US)
      (6)
                7,453 (CA)2007
              250,592
      (US)
                281,039
      (CA)
              8,326 (US)
                9,338 (CA)
              -
              -
              6,645
              566 (US)
      (6)
                634 (CA)2006
              7,851 (US)
      (7)
                9,014 (CA)
              -
                -
              -
              -
              5,000
              236 (US)
      (6)
                270 (CA)Jon
      Bradley,
                Vice-President,
      Telecom Sales - International
              2008
              296,960
      (US)
                299,069
      (CA)
                149,276
      (£)(8)
              34,940(US)
                35,188 (CA)
                17,563 (£)(8)
              -
              -
              6,122
              -2007
              226,991
      (US)
                254,571
      (CA)
                116,011
      (£)(8)
              19,470 (US)
                21,836 (CA)
                9,951 (£)(8)
              -
              -
              -
              -2006
              194,908
      (US)
                223,774
      (CA)
                108,778
      (£)(8)
              12,684 (US)
                14,563 (CA)
                7,079 (£)(8)
              -
              -
              2,500
              -Stephen
      Bull,
                Vice-President.
      Research and Development, Telecom Division
              2008
              173,369
      (US)
                174,600
      (CA)
              49,835 (US)
                50,189 (CA)
              -
              -
              7,340
              4,235 (US)
      (6)
                4,265 (CA)2007
              141,891
      (US)
                159,131
      (CA)
              35,399 (US)
                39,700 (CA)
              -
              -
              15,905
              3,657 (US)
      (6)
                4,102 (CA)2006
              133,917
      (US)
                153,750
      (CA)
              33,144 (US)
                38,053 (CA)
              -
              1,803
              4,602
              3,330 (US)
      (6)
                3,823 (CA)
 
 (1)
              The
      compensation information for Canadian residents has been converted from
      Canadian dollars to U.S. dollars based upon an average foreign exchange
      rate of CA$1.0071 = US$1.00 for the financial year ending August 31, 2008,
      CA$1.1215 = US$1.00 for the financial year ending August 31, 2007 and
      CA$1.1481 = US$1.00 for the financial year ending
      August 31, 2006. The currency conversions cause these reported
      salaries to fluctuate from year-to-year because of the fluctuation in
      exchange rate.
 (2)
              A
      portion of the bonus amounts is paid in cash in the year for which they
      are awarded and the balance is paid in cash in the year following the
      financial year for which they are
awarded.
 (3)
              Indicates
      only an aggregate amount if such amount is equivalent or greater than
      $50,000 and 10% of the total of the annual salary and bonus of the Named
      Executive Officer for the financial year ended August 31,
      2008.
 (4)
              Indicates
      the number of Subordinate Voting Shares underlying the options granted
      under the Long-Term Incentive Plan during the financial year
      indicated.
   78
 Table of Contents
  (5)
              Indicates
      the number of Restricted Share Units granted under the Long-Term Incentive
      Plan during the financial year
indicated.
 (6)
              Indicates
      the amount contributed by the Corporation during the financial year
      indicated to the Deferred Profit Sharing Plan or 401K Plan, as applicable,
      for the benefit of the Named Executive Officer. Mr. Lamonde is not
      eligible to participate in the Deferred Profit Sharing Plan and Mr.
      Bradley did not participate.
 (7)
              This
      amount represents the salary paid to Mr. Yearian from August 14, 2006
      until August 31, 2006 which is based on an annual salary
      amounted to US$173,424 (CA$199,109) for the financial year ended August
      31, 2006.
 (8)
              The
      compensation information for UK resident has been converted from British
      Pound to U.S. dollars based upon an average foreign exchange rate of
      £1.9893 = US$1.00 for the financial year ended August 31, 2008, £1.9566 =
      US$1.00 for the financial year ended August 31, 2007 and £1.7918 = US$1.00
      for the financial year ended August 31, 2006. For the conversion from U.S.
      dollars to Canadian dollars, please refer to note 1 above. The currency
      conversions cause these reported salaries to fluctuate from year-to-year
      because of the fluctuation in exchange
rate.
 Employment
Agreements





We have
an employment agreement with Mr. Germain Lamonde. The agreement is for an
indeterminate period and the compensation is reviewed annually. In the event of
the termination of Mr. Lamonde’s employment without cause, Mr. Lamonde will
be entitled to severance payments (in no case exceeding 24 months
of remuneration) and the immediate vesting of all stock options and
RSUs.  In addition, in the event that Mr. Lamonde’s employment is
terminated following a merger or an acquisition by a third party of
substantially all of the Corporation’s assets or of the majority of its share
capital, he will be entitled to severance payments (in no case exceeding 24
months remuneration plus health benefits) and to the immediate vesting of all
stock options and RSUs. If Mr. Lamonde voluntarily resigns, he will be entitled
to immediate vesting of all stock options and RSUs.





We have
an employment agreement with Mr. Pierre Plamondon, our Vice-President, Finance
and Chief Financial Officer. The agreement is for an indeterminate period and
the compensation is reviewed annually. In the event of termination of Mr.
Plamondon’s employment without cause, Mr. Plamondon will be entitled to
severance payments (in no case exceeding 12 months of the current base salary).
In addition, in the event Mr. Plamondon’s employment is terminated following a
merger or an acquisition by a third party of substantially all of the
Corporation’s assets or of the majority of its share capital, he will be
entitled to severance payments (in no case exceeding 18 months remuneration plus
health benefits) and to the immediate vesting of all stock options
and RSUs.





We have
an employment agreement with Mr. Dana Yearian, our Vice-President, Telecom Sales
- Americas. The agreement is for an indeterminate period and the compensation is
reviewed annually. In the event of termination of Mr. Yearian’s employment
without cause, Mr. Yearian will be entitled to severance payments (in no
case exceeding 12 months of the current base salary). In addition, in the event
Mr. Yearian’s employment is terminated following a merger or an acquisition
by a third party of substantially all of the our assets or of the majority of
our share capital, he will be entitled to severance payments (in no case
exceeding 18 months remuneration plus health benefits) and to the immediate
vesting of all stock options and RSUs.





We have
an employment agreement with Mr. Jon Bradley, our Vice-President, Telecom Sales
- International. The agreement is for an indeterminate period and the
compensation is reviewed annually. In the event of termination of Mr.
Bradley’s employment without cause, Mr. Bradley will be entitled to
severance payments (in no case exceeding 12 months of the current base
salary). In addition, in the event Mr. Bradley’s employment
is terminated following a merger or an acquisition by a third party of
substantially all of the our assets or of the majority of our share capital, he
will be entitled to severance payments (in no case exceeding 18 months
remuneration plus health benefits) and to the immediate vesting of all stock
options and RSUs.





We have
an employment agreement with Mr. Stephen Bull, the Corporation’s Vice-President,
Research and Development, Telecom Division. The agreement is for an
indeterminate period and the compensation is reviewed annually. In the event of
termination of Mr. Bull’s employment without cause, Mr. Bull will be entitled to
severance payments (in no case exceeding 12 months of the current base salary).
In addition, in the event Mr. Bull’s employment is terminated following a merger
or an acquisition by a third party of substantially all of the Corporation’s
assets or of the majority of its share capital, he will be entitled to severance
payments (in no case exceeding 18 months remuneration plus health benefits) and
to the immediate vesting of all stock options and RSUs.








79
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Key
Elements and Policies for Compensation of Executive Officers





Our
executive compensation plans are designed to attract, retain and motivate key
executives who directly impact our long-term success and the creation of
shareholder value. In determining executive compensation, the Committee
considers the following four principles:





·
            Performance-based:
      Executive compensation levels reflect both corporation and individual
      results based on specific quantitative and qualitative objectives
      established at the start of each financial year in keeping with our
      long-term strategic objectives.




·
            Aligned with shareholder
      interests: A significant proportion of incentive compensation for
      executives is composed of equity awards to ensure that executives are
      aligned with the principles of sustained long-term shareholder value
      growth.





·
            Market competitive:
      Compensation of executives is designed to be externally competitive when
      compared against executives of comparable peer companies, and in
      consideration of our results relative to the results of
    peers.





·
            Individually equitable:
      Compensation levels are also designed to reflect individual factors such
      as scope of responsibility, experience, and performance against individual
      measures.





The key
elements of our 2008 executive compensation program were Base salary, the Short
Term Incentive Plan, and stock-based incentive compensation delivered through
the Long Term Incentive Plan.  To determine appropriate
compensation levels for each pay component, the Committee considered all
elements of the executive compensation program. The Committee did not assign
specific weightings to any key element of our 2008 executive compensation
program.





Base
Salaries




In
establishing the base salaries of senior officers, including the President and
Chief Executive Officer, we take into consideration responsibilities, job
descriptions and salaries paid by other similar Canadian organizations for
positions similar in magnitude, scope and complexity. The Committee’s objective
is to align executive compensation levels with the median compensation offered
within a reference group of comparable companies that are similar in size to the
Corporation, with a particular focus on those within the
high-technology/telecommunications and manufacturing-durable goods industries.
The Committee reviews the base salary of each senior officer on an annual basis
and recommends that our Board approve appropriate adjustments, if required,
within the salary range in order to maintain a competitive position within the
market place.





Short-Term
Incentive Compensation




The
short-term incentive plan (“STIP”) provides senior executives with the
opportunity to earn annual bonuses based on our financial performance and the
achievement of strategic corporate and business unit objectives established on a
yearly basis.





Target
payout levels for Named Executive Officers eligible for incentive bonuses in the
year ended August 31, 2008 were established to be in line with
the objective of the Committee to align compensation with the median
compensation offered in the reference group. The minimum, target and maximum
payouts to senior officers under the STIP (expressed as a percentage of their
base salary) for the financial year ending August 31, 2008 were as
follows:




Our
President and Chief Executive Officer, Mr. Germain Lamonde, has a short term
incentive target of 55% of his annual base salary. That bonus is based on
the achievement of financial, strategic and individual objectives as shown in
the following table.




Our Chief
Financial Officer, Mr. Pierre Plamondon, has a short term incentive target of
35% of his annual base salary. That bonus is based on the achievement of
financial, strategic and individual objectives as shown in the following
table.







80
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Our
Vice-President, Research and Development, Telecom Division, Mr. Stephen Bull,
has a short term incentive target of 30% of his annual base salary. That
bonus is based on the achievement of financial, strategic and individual
objectives as shown in the following table.




Measure
      (1)
              Weighting
      Mr. Lamonde, Mr. Plamondon and Mr. BullSales
              35%Earnings
              15%Gross
      margin
              25%Customer
      satisfaction (quality and on time delivery)
              25%Growth
      metrics
              10%Personal
      objectives (multiplier)
              0%
      - 125%
 
 (1)
              Sales,
      Earnings, Gross margin and Customer satisfaction measures are established
      to provide a metric from 0% to 150% and such a metric is multiplied by the
      personal objectives measure. This result is then multiplied by the short
      term incentive target % of the individual annual base
    salary.


Our
Vice-President, Telecom Sales - International, Mr. Jon Bradley, and
Vice-President, Telecom Sales - Americas, Mr. Dana Yearian, do not participate
in the short term incentive plan that is available to the company’s other senior
executives. Instead, Mr. Bradley and Mr. Yearian participate in the
company’s sales incentive plan (SIP). Under the SIP, Mr. Bradley and Mr. Yearian
have target incentives of 40% of their annual base salaries. The SIP is based
40% on the achievement of revenue targets (billings), 40% on margin targets
and 20% on management objectives.




Long-Term
Incentive Compensation





Long-Term
Incentive Plan





We have a
Long-Term Incentive Plan for our Directors, executive officers, employees and
consultants and those of our subsidiaries as determined by our Board of
Directors, to attract and retain competent Directors, executive officers,
employees and consultants motivated to work toward ensuring our success and to
encourage them to acquire our shares. A copy of the Long-Term Incentive Plan has
been filed as exhibit 4.35 to our fiscal year 2005 annual report.





The
principal component of the long-term incentive compensation that we offer is
made up of the Long-Term Incentive Plan for directors, officers, employees and
consultants of us and our subsidiaries.





Introduced
in May 2000, amended in October 2004 and effective in January 2005, the
Long-Term Incentive Plan is designed to provide directors, officers, employees
and consultants with an incentive to create value and accordingly ensures that
their interests are aligned with those of our shareholders. The LTIP is subject
to Human Resources Committee review to ensure maintenance of its market
competitiveness. Our Board has full and complete authority to interpret the Plan
and to establish the rules and regulations applying to it and to make all other
determinations it deems necessary or useful for the administration of the Plan,
provided that such interpretations, rules, regulations and determinations are
consistent with the rules of all stock exchanges on which our securities are
then traded and with all relevant securities legislation.





The
Long-Term Incentive Plan provides for the issuance of options to purchase
Subordinate Voting Shares and the issuance of Restricted Share Units (“RSUs”)
redeemable for actual Subordinate Voting Shares or the equivalent in cash to
directors, officers, employees and consultants. Our Board of Directors, upon
recommendation of the Human Resources Committee, designates the recipients of
options or RSUs and determines the number of Subordinate Voting Shares covered
by each option or RSU, the dates of vesting, the expiry date and any other
conditions relating to these options or RSUs, in each case in accordance with
the applicable legislation of the securities regulatory authorities. During the
financial year ended August 31, 2008, target awards for eligible officers
under the LTIP were established to be in line with the objective of the
Committee to align compensation with the median compensation offered in the
reference group. A portion of the target RSU awards are fixed, in order to
encourage executive retention over the longer term, and the balance
are made at, above, or below target levels based on merit, as determined by
each executive's individual performance over the previous year.







81
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The
exercise price of the options is determined by our Board of Directors at the
time of granting the options, subject to compliance with the rules of all stock
exchanges on which the Subordinate Voting Shares are listed and with all
relevant securities legislation.  In any event, the price at which the
Subordinate Voting Shares may be purchased may not be lower than the highest of
the closing prices of the Subordinate Voting Shares on the Toronto Stock
Exchange and the NASDAQ National Market on the last trading day preceding the
grant date, using the noon buying rate of the Federal Reserve Bank of New York
on the grant date to convert the NASDAQ National Market closing price to
Canadian dollars.  Any option issued is non-transferable. At the end
of our financial year ended August 31, 2008, there were a total of 1,821,481
options granted and outstanding pursuant to the Long-Term Incentive Plan having
a weighted average exercise price of US$13.83 (CA$20.66).





The fair
value at the time of grant of a RSU is equal to the market value of Subordinate
Voting Shares at the time RSUs are granted. At the end of financial year ended
August 31, 2008, there were a total of 847,791 RSUs granted and outstanding
pursuant to the Long-Term Incentive Plan having a weighted average fair value at
the time of grant of US$5.62 (CA$6.05) per RSU.





The
maximum number of Subordinate Voting Shares that are issuable under the Plan
shall not exceed 6,306,153 Subordinate Voting Shares, which represents 9.4%
of our issued and outstanding voting shares as of November 3, 2008. The maximum
number of Subordinate Voting Shares that may be granted to any one individual
shall not exceed 5% of the number of outstanding Subordinate Voting
Shares.





Some
options granted to Directors and employees vest on the first anniversary date of
their grant. Some options granted in the financial year ended August 31, 2004
and 2005 vest at a rate of 12.5% six (6) months after the date of grant, 12.5%
twelve (12) months after the date of grant and 25% annually thereafter
commencing on the second anniversary date of the grant in October 2005.
Otherwise all options vest a rate of 25% annually commencing on the first
anniversary date of the grant. All options may be exercised in whole or in part
once vested. All of the options that are granted under the Plan must be
exercised within a maximum period of ten (10) years following the date of their
grant or they will be forfeited.





All RSUs
first vesting cannot be earlier than the third anniversary date of their grant.
Some RSUs granted in the financial year ended August 31, 2008, vest at a rate of
1/2 annually commencing on the third anniversary date of the grants in October
2007, January 2008, April 2008 and July 2008. Some RSUs granted in the financial
year ended August 31, 2007, vest at a rate of 1/2 annually commencing on the
third anniversary date of the grants in September 2006, January 2007 and July
2007 and others at a rate of 1/3 annually on the third, fourth and fifth
anniversary dates of the grants in September 2006, October 2006 and January
2007. Some RSUs granted in the financial year ended August 31, 2006
vest at a rate of 1/2 annually commencing on the third anniversary date of the
grant in February 2006 and in June 2006 and others at a rate of 1/3 annually
commencing on the third anniversary date of the grant in August 2006. Some RSUs
granted in the financial year ended August 31, 2005 vest at a rate of 1/3
annually commencing on the third anniversary date of the grant in February 2005
and others at a rate of 55%, 35% and 10%, on the third, fourth and fifth
anniversary dates of the grant in January 2005. Some RSUs granted during the
last four financial years vest on the fifth anniversary date of each grant
respectively in October 2007, October 2006, December 2005 and in January
2005. However, these RSUs are subject to early vesting on the third and fourth
anniversary dates of the grant on the attainment of performance objectives,
namely related to long term growth of revenue and profitability, as determined
by the Board of Directors of the Corporation. Accordingly, subject to the
attainment of performance objectives, the first early vesting is up to 1/3 of
the units on the third anniversary date of the grant and the second early
vesting is up to 50% of the remaining units on the fourth anniversary date of
the grant. If such vesting date falls into any black-out period or any other
restrictive period during which the RSU holder is not entitled to trade the
Corporation’s Subordinate Voting Shares, then the units shall vest on the first
trading day the RSU holder is entitled to trade after such black-out period or
restrictive period.




Any
option granted pursuant to the Long-Term Incentive Plan will lapse (i)
immediately upon the termination of the relationship with us or one of our
subsidiaries for a good and sufficient cause for employees or officers or at the
date on which an employee or an officer resigns or leaves his employment with us
or one of our subsidiaries (or within 30 days if the holder’s employment is
terminated for reasons not related to cause); and (ii) 30 days after a
Director ceases to be a member of our Board of Directors or one of our
subsidiaries. In the event of retirement or disability, any option held by an
employee lapses 30 days after the date of any such disability or
retirement.  In the event of death, any option held by the optionee
lapses 6 months after the date of death.







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 Table of Contents





Any RSU
granted pursuant to the Long-Term Incentive Plan will lapse (i) immediately,
where vesting of a unit is subject to the attainment of performance
objectives, if such performance objectives have not been attained
(or postponed at a further vesting date as determined by our Board of
Directors.); (ii) immediately, whether or not subject to attainment of
performance objectives, upon the termination of the relationship with us or one
of our subsidiaries for a good and sufficient cause for employees or officers or
at the date on which an employee or an officer resigns or leaves his employment
with us or one of our subsidiaries.





Any RSU
granted pursuant to the Long-Term Incentive Plan will vest immediately, to a
certain proportion as determined by the Plan, upon the termination of the
relationship of an employee or officer with us or one of our subsidiaries (i)
for reasons not related to cause; (ii) because of death or permanent disability
and (iii) retirement.





The
following table summarizes information about stock options granted to the
members of our Board of Directors, and to Management and Corporate Officers of
us and our subsidiaries as at August 31, 2008:




Number
      of
                Options
              %
      of Issued and
                Outstanding
      Options
              Weighted
      Average Exercise Price ($US/Security)President
      and CEO (one individual)
              179,642
              9.86%
              9.05Board
      of Directors (five individuals)
              194,375
              10.67%
              6.23Management
      and Corporate Officers (eight individuals)
              212,139
              11.65%
              14.49
 The
following table summarizes information about RSUs granted to the members of our
Board of Directors and to Management and Corporate Officers of us and our
subsidiaries as at August 31, 2008:
 Number
      of
                RSUs
              %
      of Issued and
                Outstanding
      RSUs
              Weighted
      Average Fair Value  at
                the
      Time of Grant $US/RSUPresident
      and CEO (one individual)
              85,460
              10.08%
              5.66Board
      of Directors (five individuals)
              -
              -
              -Management
      and Corporate Officers (ten individuals)
              238,069
              28.08%
              5.62


Option
Grants in Last Financial Year




There
were no options to purchase the Corporation’s Subordinate Voting Shares granted
during the financial year ended August 31, 2008. At the end of the
financial year ended August 31, 2008, there were a total
of 1,821 481 Subordinate Voting Shares covered by options granted
and outstanding pursuant to the Long-Term Incentive Plan having a weighted
average exercise price of US$13.83 (CA$20.66). See “Report on Executive
Compensation by the Human Resources Committee - Long-Term Incentive
Compensation” for a description of the Long-Term Incentive Plan.





Aggregated
Option Exercises in Last Financial Year and Financial Year End Option
Values





The
following table summarizes, for each of the Named Executive Officers, the number
of stock options, if any, exercised during the financial year ended August
31, 2008, the aggregate value realized upon exercise and the total number of
unexercised options, if any, held at August 31, 2008. Value realized
upon exercise is the difference between the market value of the underlying
Subordinate Voting Shares on the exercise date and the exercise or base price of
the option. The value of unexercised in-the-money options at financial year-end
is the difference between its exercise or base price and the market value of the
underlying Subordinate Voting Shares on August 29, 2008, which was US$4.20
(CA$4.47) per share. These values, unlike the amounts set forth in the column
“Aggregate Value Realized,” have not been, and may never be, realized. The
underlying options have not been, and may never be exercised, and actual gains,
if any, on exercise will depend on the value of the Subordinate Voting Shares on
the date of exercise. There can be no assurance that these values will be
realized. Unexercisable options are those that have been held for less than the
time required for vesting.






83
 Table of Contents




Name
              Securities
      Acquired on Exercise (#)
              Aggregate
                Value
      Realized
                (US$)(1)
      (4)
              Unexercised
      Options
                at
      August 31, 2008
              Value
      of Unexercised
                “In-the-Money”
      Options at
                August 31, 2008(2) (3)
      (4)Exercisable
                (#)
              Unexercisable
      (#)
              Exercisable
                (US$)
              Unexercisable
                (US$)Germain
      Lamonde
              -
              -
              169,549
              10,093
              92,654
              -Pierre
      Plamondon
              -
              -
              77,804
              3,172
              37,061
              -Dana
      Yearian
              -
              -
              -
              -
              -
              -Jon
      Bradley
              -
              -
              25,500
              1,000
              -
              -Stephen
      Bull
              -
              -
              25,328
              2,100
              -
              -
 
 (1)
              The
      aggregate value realized is equivalent to the difference between the
      market value of the securities underlying the options at exercise and the
      exercise price of the options. This value, as the case maybe, has been
      converted from Canadian dollars to U.S. Dollars based upon the
      average foreign exchange rate on the day of the
  exercise.
 (2)
              “In-the-money”
      options are options for which the market value of the underlying
      securities is higher than the price at which such securities may be bought
      from the Corporation.
 (3)
              The
      value of unexercisable “in-the-money” options is calculated using the
      highest of the closing prices of the Subordinate Voting Shares on the
      Toronto Stock Exchange and on the NASDAQ National Market on August 29,
      2008 using the noon buying rate of the Federal Reserve Bank of New York to
      convert the NASDAQ National Market closing price to Canadian dollars, as
      required, less the exercise price of “in-the-money”
    options.
 (4)
              This
      value has been converted from Canadian to US dollars based upon the
      foreign exchange rate on August 29, 2008
  of 1.0631.


Compensation
of Chief Executive Officer





In
establishing Mr. Lamonde’s compensation for the year ending August 31, 2008, the
Corporation relied on a study completed by an independent consulting firm
(Mercer Human Resource Consulting). Such study indicated average salaries and
bonuses, median salaries and bonuses and maximum salaries and bonuses paid to
chief executive officers by Canadian and American computer hardware and software
companies as well as by a specific group of companies active in the fiber
optics industry identified by the Corporation that it considers to be the best
available comparisons. It was decided that Mr. Lamonde’s compensation
should reflect the median of Canadian computer hardware and software companies
and of the specific group of companies in fiber optics identified by the
Corporation. In the financial year ended August 31, 2008, Mr.
Lamonde’s compensation was adjusted accordingly.





In the
financial year ended August 31, 2008, the bonus portion of Mr. Lamonde’s
compensation was tied to the financial and strategic objectives of the
Corporation based on the following factors:




Measure
      (1)
              Weighting
      ALLSales
              35%Earnings
              15%Gross
      margin
              25%Customer
      satisfaction (quality and on time delivery)
              25%Growth
      metrics
              10%Personal
      objectives (multiplier)
              0%
      - 125%
 
 (1)
              Sales,
      Earnings, Gross margin and Customer satisfaction measures are established
      to provide a metric from 0% to 150% and such a metric is multiplied by the
      personal objectives measure. This result is then multiplied by the short
      term incentive target % of the individual annual base
    salary.


Mr. Lamonde’s
bonus is payable in the same proportion at which the Corporation attains such
objectives. When the objectives are exceeded, the bonus is higher; when
objectives are not met, the bonus is lower.








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Deferred
Share Unit Plan





Introduced
in October 2004 and effective as of January 2005, the Deferred Share Unit Plan
is designed to align more closely the interests of its non-employee Directors
with those of our shareholders. A copy of the Deferred Share Unit Plan has been
filed as exhibit 4.36 to our fiscal year 2005 annual report.





Under the
Deferred Share Unit Plan, non-employee Directors shall receive up to 100 % of
their retainer fees in the form of Deferred Share Units (“DSUs”), each of which
has a fair value at the time of grant equal to the market value of a Subordinate
Voting Share at the time DSUs are credited to the Directors.  The
value of a DSU, when converted to Subordinate Voting Shares, is equivalent to
the market value of a Subordinate Voting Share at the time the conversion takes
place. DSUs attract dividends in the form of additional DSUs at the same rate as
dividends on Subordinate Voting Share.  When a Director ceases to be a
member of our Board of Directors, the DSUs are either converted and paid in
Subordinate Voting Shares purchased on the open market or issued by us. Such
Subordinate Voting Shares issued by us will be issued from the same pool of
Subordinate Voting Shares reserved for issuance pursuant to the Long-Term
Incentive Plan, which is 9.4% of the total issued and outstanding voting
shares.





The
following table summarizes information about DSUs granted to the non-employee
members of our Board of Directors as at November 3, 2008:




Number
      of DSUs
              %
      of Issued and
                Outstanding
      DSUs
              Weighted
      Average Estimated Value
                at
      the Time of Grant $US/DSUBoard
      of Directors (five individuals)
              79,185
              100%
              5.26
 The
following table summarizes information about DSUs converted and paid in
Subordinate Voting Shares when a director ceased to be a member of the Board as
at November 3, 2008:
 Name
              Number
      of DSUs converted
              Aggregate
      Value Realized (US$) (1)Michael
      Unger
              20,695
              88,894
 
 (1)
              The
      aggregate value realized is equivalent to the market value of the
      securities underlying the DSUs at conversion. This value, as the case
      maybe, has been converted from Canadian dollars to U.S. dollars based upon
      the average foreign exchange rate on the day of
  conversion.




Deferred
Share Unit Grants in Last Financial Year





The
aggregate number of Deferred Share Units (“DSUs”) credited to non-employee
directors during the financial year ended August 31, 2008 and as of
November 3, 2008 was 35,162. The estimated value at the time of grant of a DSU
is determined based on the highest of the closing prices of the Subordinate
Voting Shares on the Toronto Stock Exchange and the NASDAQ National Market on
the last trading day preceding the grant date, using the noon buying rate of the
Federal Reserve Bank of New York on the grant date to convert the NASDAQ
National Market closing price to Canadian dollars, as required. The value at
vesting of a DSU is equivalent to the market value of a Subordinate Voting Share
when a DSU is converted to such Subordinate Voting Share. As of
November 3, 2008, there were a total of 79,185 DSUs credited
to directors pursuant to the Deferred Share Unit Plan having an estimated value
at the time of grant of US$416,640 (CA$461,587).





DSUs
attract dividends in the form of additional DSUs at the same rate as dividends
on Subordinate Voting Shares. The DSUs are converted and paid in Subordinate
Voting Shares at the time a director ceases to be a member of our
Board.





Therefore,
the value at vesting of a DSU, when converted to Subordinate Voting Shares, is
equivalent to the market value of a Subordinate Voting Share at the time the
conversion takes place. The table below shows information regarding DSU grants
made under the Deferred Share Unit Plan during the financial year ended
August 31, 2008 and as of November 3, 2008.








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During
the financial year ended August 31, 2008 and as of November 3, 2008, the
following DSUs were granted to the directors:




DSUs
      #
              Weighted
      Average Estimated Value  at the
                Time
      of Grant US$/DSU
              Vesting35,162
              5.14
              At
      the time director cease to be a member of the Board of the
      Corporation


Restricted
Share Unit Grants in Last Financial Year





The
aggregate number of Restricted Share Units (RSUs) granted during the financial
year ended August 31, 2008 was 469,847 having a weighted average fair
value at the time of grant of US$5.46 (CA$5.43) per RSU. The fair value at the
time of grant of a RSU is equal to the market value of Subordinate Voting Shares
at the time RSUs are granted. At the end of the financial year ended
August 31, 2008, there were a total of 847,791 RSUs granted and
outstanding pursuant to the Long-Term Incentive Plan having a weighted average
fair value at the time of grant of US$5.62 (CA$6.05) per RSU. All RSUs first
vesting cannot be earlier than the third anniversary date of their grant. Some
RSUs granted in the financial year ended August 31, 2008, vest at a rate of 1/2
annually commencing on the third anniversary date of the grants in October 2007,
January 2008, April 2008 and July 2008. Some RSUs granted in the financial year
ended August 31, 2007, vest at a rate of 1/2 annually commencing on the third
anniversary date of the grants in September 2006, January 2007 and July 2007 and
others at a rate of 1/3 annually on the third, fourth and fifth anniversary
dates of the grants in September 2006, October 2006 and January 2007. Some RSUs
granted in the financial year ended August 31, 2006, vest at a rate of 1/2
annually commencing on the third anniversary date of the grant in February 2006
and in June 2006 and others at a rate of 1/3 annually on the third, fourth
and fifth anniversary dates of the grant in August 2006. Some RSUs granted in
the financial year ended August 31, 2005 vest at a rate of 1/3 annually
commencing on the third anniversary date of the grant in February 2005 and
others at a rate of 55%, 35% and 10%, on the third, fourth and fifth anniversary
dates of the grant in January 2005. Some RSUs granted during the last four
financial years vest on the fifth anniversary date of each grant respectively in
October 2007, October 2006, December 2005 and in January 2005. However, these
RSUs are subject to early vesting on the third and fourth anniversary dates of
the grant on the attainment of performance objectives, namely related to long
term growth of revenue and profitability, as determined by the Board of
Directors of the Corporation. Accordingly, subject to the attainment of
performance objectives, the first early vesting is up to 1/3 of the units on the
third anniversary date of the grant and the second early vesting is up to 50% of
the remaining units on the fourth anniversary date of the grant.




The RSUs
are redeemed for actual Subordinate Voting Shares or the equivalent in cash at
the discretion of the Board of Directors of the Corporation on the vesting dates
established by the Board of Directors of the Corporation at the time of grant in
its sole discretion.




Therefore,
the value at vesting of a RSU, when converted to Subordinate Voting Shares, is
equivalent to the market value of a Subordinate Voting Share at the time the
conversion takes place. The table below shows information regarding RSU grants
made under the Long-Term Incentive Plan during the financial year ended August
31, 2008. See “Report on Executive Compensation by the Human Resources Committee
– Long-Term Incentive Compensation – Long-Term Incentive Plan” for a description
of the Long-Term Incentive Plan.







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During
the financial year ended August 31, 2008, the following RSUs were
granted:




RSUs
      #
              Fair
      Value at the Time of
                Grant
      US$/RSU
              Vesting (1)29,000
              6.28
              50%
      on the third and fourth anniversary dates of the grant in October 2007
      (2)86,167
              6.28
              100%
      on the fifth anniversary date of the grant in October 2007 subject to
      early vesting up to 1/3 on the third anniversary date of the grant and up
      to 50% of the remaining units on the fourth anniversary date of the grant
      if the performance objectives are fully attained (3)76,200
              4.16
              50%
      on the third and fourth anniversary dates of the grant in January 2008
      (4)21,600
              6.09
              50%
      on the third and fourth anniversary dates of the grant in April 2008 (5)185,570
              5.82
              50%
      on the third and fourth anniversary dates of the grant in April 2008 (6)71,310
              4.39
              50%
      on the third and fourth anniversary dates of the grant in July 2008 (7)
 
 (1)
              All
      RSUs first vesting cannot be earlier than the third anniversary date of
      their grant.
 (2)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest at a rate of
      1/2 annually commencing on the third anniversary date of the grant in
      October 2007.
 (3)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest on the fifth
      anniversary date of the grant in October 2007 but are subject to
      early vesting on the third and fourth anniversary dates of the grant on
      the attainment of performance objectives, namely related to long term
      growth of revenue and profitability, as determined by the Board
      of Directors of the Corporation. Accordingly, subject to the
      attainment of performance objectives, the first early vesting is up
      to 1/3 of the units on the third anniversary date of the grant and the
      second early vesting is up to 50% of the remaining units on the fourth
      anniversary date of the grant.
 (4)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest at a rate of
      1/2 annually commencing on the third anniversary date of the grant in
      January 2008.
 (5)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest at a rate of
      1/2 annually commencing on the third anniversary date of the grant in
      April 2008.
 (6)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest at a rate of
      1/2 annually commencing on the third anniversary date of the grant in
      April 2008.
 (7)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest at a rate of
      1/2 annually commencing on the third anniversary date of the grant in July
      2008.
 During
the financial year ended August 31, 2008, the following RSUs were granted to the
following Named Executive Officers:
 Name
              RSUs
      #
              Percentage
      of Net
                Total
      of RSUs
                Granted
      to Employees
                in
      Financial Year
                (%)
              Fair
      Value at
                the
      Time of
                Grant
                US$/RSU
              Vesting(1)Germain
      Lamonde
              29,910
              6.37
              6.28
              100%
      on the fifth anniversary date of the grant in October 2007 subject to
      early vesting up to 1/3 on the third anniversary date of the grant and up
      to 50% of the remaining units on the fourth anniversary date of the grant
      if the performance objectives are fully attained (2)Pierre
      Plamondon
              9,637
              2.05
              6.28
              100%
      on the fifth anniversary date of the grant in October 2007 subject to
      early vesting up to 1/3 on the third anniversary date of the grant and up
      to 50% of the remaining units on the fourth anniversary date of the grant
      if the performance objectives are fully attained (2)
 Dana
      Yearian
              7,225
              1.54
              6.28
              100%
      on the fifth anniversary date of the grant in October 2007 subject to
      early vesting up to 1/3 on the third anniversary date of the grant and up
      to 50% of the remaining units on the fourth anniversary date of the grant
      if the performance objectives are fully attained (2)
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 Table of Contents
  Name
              RSUs
      #
              Percentage
      of Net
                Total
      of RSUs
                Granted
      to Employees
                in
      Financial Year
                (%)
              Fair
      Value at
                the
      Time of
                Grant
                US$/RSU
              Vesting(1)
 Jon
      Bradley
              6,122
              1.30
              6.28
              100%
      on the fifth anniversary date of the grant in October 2007 subject to
      early vesting up to 1/3 on the third anniversary date of the grant and up
      to 50% of the remaining units on the fourth anniversary date of the grant
      if the performance objectives are fully attained (2)Stephen
      Bull
              7,340
              1.56
              6.28
              100%
      on the fifth anniversary date of the grant in October 2007 subject to
      early vesting up to 1/3 on the third anniversary date of the grant and up
      to 50% of the remaining units on the fourth anniversary date of the grant
      if the performance objectives are fully attained (2)
 
 (1)
              All
      RSUs first vesting cannot be earlier than the third anniversary date of
      their grant.
 (2)
              Those
      RSUs granted in the financial year ended August 31, 2008 vest on the fifth
      anniversary date of the grant in October 2007 but are subject to
      early vesting on the third and fourth anniversary date of the grant on the
      attainment of performance objectives, namely related to long term
      growth of revenue and profitability, as determined by the Board
      of Directors of the Corporation. Accordingly, subject to the
      attainment of performance objectives, the first early vesting is up
      to 1/3 of the units on the third anniversary date of the grant and the
      second early vesting is up to 50% of the remaining units on the fourth
      anniversary date of the grant.


Aggregated
RSUs vested in Last Financial Year and Financial Year-End RSU
Values





The
following table summarizes, for each of the Named Executive Officers, the number
of RSUs, if any, vested during the financial year ended August 31, 2008, the
aggregate value realized upon vesting and the total number of unvested RSUs, if
any, held at August 31, 2008. Value realized upon vesting is the
market value of the Subordinate Voting Shares on the vesting date. The value of
unvested RSUs at financial year-end is the market value of the Subordinate
Voting Shares on August 29, 2008, which was US$4.20 per share. These values,
unlike the amounts set forth in the column "Aggregate Value Realized", have not
been and may never be realized. The actual gains on vesting will depend on the
value of the Subordinate Voting Shares on the date of vesting. There can be no
assurance that these values will be realized.




Name
              Securities
      Acquired
                on
      Vesting (#)
              Aggregate Value
      Realized
                (US$)(1)
              Unvested
      RSUs
                at
      August 31, 2008 (#)
              Value
      of Unvested RSUs
                at August 31, 2008 (US$)(2)
      (3)Germain
      Lamonde
              4,363
              18,805
              85,460
              358,932Pierre
      Plamondon
              17,809
              76,757
              45,679
              191,852Dana
      Yearian
              -
              -
              18,870
              79,254Jon
      Bradley
              667
              3,663
              9,955
              41,811Stephen
      Bull
              17,373
              95,402
              43,092
              180,986
 
 (1)
              The
      aggregate value realized is equivalent to the market value of the
      securities underlying the RSUs at vesting. This value, as the case maybe,
      has been converted from Canadian dollars to U.S. dollars based upon the
      average foreign exchange rate on the day of
  vesting.
 (2)
              The
      value of RSUs is calculated using the highest of the closing prices of the
      Subordinate Voting Shares on the Toronto Stock Exchange and on the NASDAQ
      National Market on August 29, 2008 using the noon buying rate of the
      Federal Reserve Bank of New York to convert the NASDAQ National Market
      closing price to Canadian dollars, as
required.
 (3)
              The
      actual gains on vesting will depend on the value of the Subordinate Voting
      Shares on the date of vesting. There can be no assurance that these
      values will be realized.





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Number
of Subordinate Voting Shares reserved for future issuance





During
the financial year ended August 31, 2008, 35,162 Deferred Share Units and
469,847 Restricted Share Units were granted to directors, officers and
employees. Such awards were issued from the same pool of Subordinate Voting
Shares reserved for issuance pursuant to the Long-Term Incentive Plan of which
the maximum number of Subordinate Voting Shares issuable shall not exceed
6,306,153 Subordinate Voting Shares, which represents 9.4% of the Corporation’s
issued and outstanding voting shares as of November 3, 2008.
As of November 3, 2008, the number of Subordinate Voting
Shares reserved for future issuance is 2,440,302.




Stock
Appreciation Rights Plan





On August
4, 2001, the Corporation established a Stock Appreciation Rights Plan (“SAR
Plan”) for the benefit of certain employees residing in countries where the
granting of options under the Long-Term Incentive Plan is not feasible in the
opinion of the Corporation.  The Board has full and complete authority
to interpret the SAR Plan and to establish the rules and regulations applying to
it and to make all other determinations it deems necessary or useful for the
administration of the SAR Plan.





Under the
SAR Plan, eligible employees are entitled to receive a cash amount equivalent to
the difference between the market price of the Subordinate Voting Shares on the
date of exercise and the exercise price determined on the date of
grant.  No Subordinate Voting Shares are issuable under the SAR
Plan.





The Board
of Directors has delegated to Management the task of designating the recipients
of stock appreciation rights, the date of vesting, the expiry date and other
conditions.  Under the terms of the SAR Plan, the exercise price of
the stock appreciation rights may not be lower than the highest of the closing
prices of the Subordinate Voting Shares on the Toronto Stock Exchange and on the
NASDAQ National Market on the last trading day preceding the grant date, using
the noon buying rate of the Federal Reserve Bank of New York on the grant date
to convert the NASDAQ National Market closing price to Canadian
dollars.  Stock appreciation rights are non-transferable.





The stock
appreciation rights vest over a four-year period, with 25% vesting annually
commencing on the first anniversary date of the date of grant. However, since
October 2007, some stock appreciation rights vest at a rate of 50% annually
commencing on the third anniversary date of the grants in October 2007 and
October 2008. Once vested, stock appreciation rights may be exercised between
the second and the fifteenth business day following each release of the
Corporation’s quarterly financial results.  All of the stock
appreciation rights that are granted under the SAR Plan may be exercised within
a maximum period of 10 years following the date of their
grant.  Any stock appreciation rights granted under the SAR Plan will
lapse immediately upon the termination of the relationship with the Corporation
or one of its subsidiaries for a good and sufficient cause or at the date on
which an employee resigns or leaves his employment with the Corporation or one
of its subsidiaries (or within 30 days if the holder is dismissed without
cause).  In the event of retirement or disability, any stock
appreciation right held by an employee lapses 30 days after the date of any
such disability or retirement.  In the event of death, any stock
appreciation right lapses 6 months after the date of death.





As of
November 3, 2008, there were 40,374 SAR’s outstanding.





Deferred
Profit Sharing Plan





We
maintain a plan for certain eligible Canadian resident employees, under which
the Corporation may elect to contribute an amount equal to 2% of an employee’s
gross salary, provided that the employee has contributed at least 2% of his
gross salary to a tax-deferred registered retirement savings plan. Cash
contributions to this plan and expenses for the years ended August 31, 2006,
2007 and 2008, amounted to US$316,000, US$419,000 and US$531,000,
respectively.








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401(k)
Plan





We
maintain a 401(k) plan for eligible United States resident employees of our
subsidiaries. Employees become eligible to participate in the 401(k) plan on the
first day of the month following the completion of three months of continuous
service. Employees may elect to defer their current compensation up to the
lesser of 1% of eligible compensation or the statutorily prescribed annual limit
and have the deferral contributed to the 401(k) plan. The 401(k) plan permits,
but does not require us to make additional matching contributions to the 401(k)
plan on behalf of the eligible participants, subject to a maximum of 50% of the
first 6% of the participant’s current compensation subject to certain legislated
maximum contribution limits. In the years ended August 31, 2006, 2007 and 2008,
we made an aggregate of US$126,000, US$166,000 and US$216,000 respectively, in
matching contributions to the 401(k) plan. Contributions by employees or by us
to the 401(k) plan and income earned on plan contributions are generally not
taxable to the employees until withdrawn and contributions by us are generally
deductible by us when made. At the direction of each participant, the trustees
of the 401(k) plan invest the assets of the 401(k) plan in selected investment
options. As of August 31, 2008, we made an aggregate of US$1,742,000
in matching contributions to the 401(k) plan.





Indemnification
of Directors and Executive Officers and Limitation of Liability





Our
by-laws require us, subject to the limitations provided by law, to indemnify our
present or former Directors and officers or any persons who act or acted at our
request as Directors or officers of a body corporatefor all costs, losses,
charges and expenses that arose or may arise by reason of their status as
Directors or officers of us or such body corporate. A policy of Directors’ and
officers’ liability insurance is maintained by us, which insures our Directors
and officers and those of our subsidiaries against liability incurred by,
arising from or against them for certain of their acts, errors or omissions.
Accordingly, we maintain insurance protection against liability incurred by our
officers and Directors as well as those of our subsidiaries in the performance
of their duties. The entire premium, amounting to US$165,000 from
September 30, 2008 to September 30, 2009, is paid by us. The aggregate
limit of liability in respect of any and all claims is US$10 million per year.
The policy provides for the indemnification of Directors and officers in the
case of claims for which we have not indemnified or are not permitted by law to
indemnify them, and for the reimbursement of us, subject to a deductible of
US$250,000.


C.
                Board
      Practices





Board
of Directors





Our
Directors are elected at the annual meeting of shareholders for one-year terms
and serve until their successors are elected or appointed, unless they resign or
are removed earlier. Our articles of incorporation provide for a Board of
Directors of a minimum of three (3) and a maximum of twelve (12) Directors. Our
Board of Directors presently consists of six Directors. Under the Canada Business Corporations
Act, twenty-five percent of the Directors and of the members of any
committee of the Board of Directors must be resident Canadians. We have no
arrangements with any of our Directors providing for the payment of benefits
upon their termination of service as Director except for the vesting of their
respective Deferred Share Units as detailed above.





The
following table and notes set out the name of each of the individuals who served
as a director of the Corporation during the last year term, all other positions
and offices with the Corporation and its subsidiaries now held by each such
individual, if any, the principal occupation or employment of each such
individual, their respective period of service as a director.




Name
      and Position or Office
                with
      the Corporation
              Principal
      Occupation or
                Employment
              Residence
              Director
      Since
              Number
      of
                Subordinate
                Voting
      Shares
              Number
      of
                Multiple
      Voting
                SharesPierre-Paul
      Allard (1)
                Independent
      Director
              Area
      Vice-President, Sales
                Cisco
      Systems Inc.
              Pleasanton,
      California, USA
              September
      2008 (2)
              -
              -Germain
      Lamonde
                Chairman
      of the Board, President and Chief Executive Officer
              Chairman
      of the Board, President and Chief Executive Officer, EXFO Electro-Optical
      Engineering Inc.
              St-Augustin-de-Desmaures,
                Quebec,Canada
              September
      1985
              4,363
              36,643,000
      (3)
 
 
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 Table of Contents
  Name
      and Position or Office
                with
      the Corporation
              Principal
      Occupation or
                Employment
              Residence
              Director
      Since
              Number
      of
                Subordinate
                Voting
      Shares
              Number
      of
                Multiple
      Voting
                SharesPierre
      Marcouiller (4)
      (5)
                Independent
      Director
              Chairman
      of the Board and Chief Executive Officer,
                Camoplast
      Inc. (6)
              Magog,
      Quebec,
                Canada
              May
      2000
              5,000
              -Guy
      Marier (4)
      (7)
                Independent
      Lead Director
              Executive
      Consultant
              Lakefield
      Gore, Quebec,
                Canada
              January
      2004
              1,000
              -Dr.
      David A. Thompson, Ph.D.(5)
      (8)
                Independent
      Director
              Vice-President
      & Director,  Hardware & Equipment Technology, Corning
      Cable Systems (9)
              Newton,
                North
      Carolina,
                USA
              June
      2000
              2,100
              -
 André
      Tremblay (5)
      (10)
                Independent
      Director
              Founder
      and Managing Partner, Trio Capital Inc.,  a private equity
      fund
              Outremont,
      Quebec,
                Canada
              May
      2000
              6,650 (11)
              -
 
 (1)
              Mr.
      Pierre-Paul Allard is presently Area Vice-President, Sales for Cisco
      Systems Inc. In this role, Mr. Allard is responsible for sales and field
      operations of Cisco’s Global Enterprise Client Segment. From January 2003
      to January 2007, Mr. Allard was Vice-President of Worldwide
      Enterprise Marketing where his primary responsibility was to develop
      Cisco’s global enterprise market. Cisco Systems Inc. is a leading network
      equipment manufacturer in the global telecommunications
      industry.
 (2)
              Named
      pursuant to a Board resolution in accordance with the Corporation’s
      by-laws.
 (3)
              Mr.
      Lamonde exercises control over this number of Multiple Voting Shares
      through G. Lamonde Investissements Financiers inc., a company
      controlled by Mr. Lamonde and through Fiducie Germain Lamonde, a
      family trust for the benefit of Mr. Lamonde’s
      family.
 (4)
              Member
      of the Audit Committee.
 (5)
              Member
      of the Human Resources Committee.
 (6)
              Camoplast
      Inc. designs, develops and manufactures specialized components,
      sub-systems and assemblies for the world leading original equipment
      manufacturers (OEMs) of both on- and off-road vehicles in a variety of
      markets including automotive, agricultural, construction and industrial,
      defense and powersports.
 (7)
              Chairman
      of the Human Resources Committee since October
  2008.
 (8)
              Member
      of the Audit Committee since April
2008.
 (9)
              Corning
      Incorporated is a diversified technology company that concentrates its
      efforts on high-impact growth opportunities. Corning combines its
      expertise in specialty glass, ceramic materials, polymers and the
      manipulation of the properties of light, with strong process and
      manufacturing capabilities to develop, engineer and commercialize
      significant innovative products for the telecommunications, flat panel
      display, environmental, semiconductor, and life sciences
      industries.
 (10)
              Chairman
      of the Audit Committee.
 (11)
              Mr.
      Tremblay exercises control over this number of Subordinate Voting Shares
      through 9104-5559 Quebec inc., a company controlled by Mr.
      Tremblay.


Since
September 1, 2007 until November 3, 2008, the Board met a total of fourteen (14)
times. Attendance at all meetings was satisfactory, except Mr. Pierre
Marcouiller who was absent four (4) times, Mr. David A. Thompson who was absent
two (2) times and Mr. Pierre-Paul Allard, Mr. André Tremblay and
Mr. Michael Unger who were absent one time.





Committees
of the Board of Directors





Our Board
of Directors has established an audit committee, a human resources committee and
a disclosure committee.








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Our audit
committee will recommend a firm to be appointed as independent auditors to audit
financial statements and to perform services related to the audit, review the
scope and results of the audit with the independent auditors, review with
management and the independent auditors our annual operating results and
consider the adequacy of the internal accounting procedures and the effect of
the procedures relating to the auditors’ independence. Further to changes to
NASDAQ corporate governance rules and Securities and Exchange rules flowing from
the adoption of the Sarbanes-Oxley Act, our audit
committee charter is being revised every financial year to ensure that we comply
with all new requirements.  Accordingly, in March 2005, the Board
updated and adopted an Audit Committee Charter. A copy of this Audit Committee
Charter has been filed as Exhibit 11.6 to our fiscal year 2005 annual report and
is also readily available from EXFO’s website at www.EXFO.com. The audit
committee revised such Charter in October 2008 but no amendment was required.
The audit committee is composed of four independent Directors: André Tremblay,
Guy Marier, Pierre Marcouiller and Mr. David A. Thompson since April 2008 in
replacement of Mr. Unger. The chairperson of the audit committee is André
Tremblay.





During
the fiscal year ended August 31, 2008, the Audit Committee met a total of four
(4) times and attendance was satisfactory at all meetings, except Mr. Pierre
Marcouiller who was absent two (2) times and Mr. Michael Unger who
were absent one time.





Our human
resources committee will evaluate, review and supervise our procedures with
regards to human resources and will assess the performance of our executive
officers and the chief executive officer. This committee will also review
annually the remuneration of the Directors and will recommend to the Board of
Directors general remuneration policies regarding salaries, bonuses and other
forms of remuneration for our Directors, executive officers and employees as a
whole. Finally, the human resources committee will review our organizational
structure annually and the development and maintenance of a succession plan.
Accordingly, in March 2005, the Board updated and adopted a Human Resources
Committee Charter which integrates the Compensation Committee Charter and the
Nominating and Governance Committee Charter. A copy of this Human Resources
Committee Charter has been filed as Exhibit 11.7 to our fiscal year 2005 annual
report and is also readily available from EXFO’s website at www.EXFO.com. The
human resources committee is composed of four independent Directors: Pierre
Marcouiller, Guy Marier, David A. Thompson and André Tremblay. Mr. Michael
Unger was also a member of the Human Resources Committee until his resignation
effective in June 2008. The chairperson of the Human Resources Committee
is Mr. Guy Marier.





During
the fiscal year ended August 31, 2008, the Human Resources committee met a total
of four (4) times and attendance was satisfactory at all meetings, except Mr.
Pierre Marcouiller who was absent two (2) times and Mr. David A. Thompson,
Mr. André Tremblay and Mr. Michael Unger who were absent one time.





The
disclosure committee is responsible for overseeing our disclosure practices.
This committee consists of the chief executive officer, the chief financial
officer, the manager of investor relations, the manager of financial reporting
and accounting as well as our legal counsel and corporate
secretary.





In
addition, in order to deal with issues arising from our implication in the IPO
class action suit, in October 2002, our Board of Directors appointed a
litigation committee composed of four of our independent Directors.





Furthermore,
our independent Directors hold regularly scheduled meetings at which
non-independent directors and members of management are not in attendance. The
independent Directors hold as many meeting, as needed, annually and any Director
may request such meeting at any time. Since September 1, 2007 and prior to
November 3, 2008, four (4) meetings of independent Directors without
management occurred.




D.
                  Employees




We have
fostered a corporate culture where growth and change are strongly encouraged. In
fact, employees are constantly evolving with the rapid pace of technology to
meet new challenges and realities. We believe that we possess a good
cross-section of experience and youth to handle these inevitable changes in the
industry.








92
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As of
November 3, 2008, we had a total of 1,174 employees, up from a total of 1,046 on
November 1, 2007. We have 888 employees in Canada, primarily
based in Quebec, and 286 employees based outside of Canada. 419 are
involved in research and development, 372 in manufacturing, 198 in sales and
marketing, 98 in general administrative positions and 87 in communications and
customer support. We have agreements with almost all of our employees covering
confidentiality and non-competition. Only manufacturing employees based in
Quebec City plants are represented by a collective bargaining agreement, which
expires in 2009. We have never experienced a work stoppage. We believe that
relations with our employees and bargaining unit are good.




E.
                  Share
      Ownership




The
following table presents information regarding the ownership of Subordinate
Voting Shares, Exercisable “in-the-money” and “out-the-money” options and the
beneficial ownership of our share capital as of November 3, 2008 by our Chief
Executive Officer, Chief Financial Officer, our Directors, our three other most
highly compensated executive officers, our other executive officers as a group,
all of our Directors and executive officers as a group.





Each
multiple voting share is convertible at the option of the holder into one
subordinate voting share. Holders of our subordinate voting shares are entitled
to one (1) vote per share and holders of our multiple voting shares are entitled
to ten (10) votes per share.





Name
            Subordinate
      Voting
              Shares
      Owned
            Currently
      Exercisable Options Owned
              as
      of November 3, 2008
            Total
      Subordinate
              Voting
      Shares
              Beneficially
      Owned (3)
            Multiple
      Voting
              Shares
      Beneficially
              Owned
      (3)
            Total
      Percentage
              of
      Voting PowerIn-the-money
      (1)
            Out-the-money
      (2)Number
            Percent
            Number
            Percent
            Number
            Percent
            Number
            Percent
            Number
            Percent
            PercentGermain
      Lamonde
            4,363
            *
            50,000
            2.75%
            119,549
            6.57%
            173,912
            *
            36,643,000
      (4)
            100
            92,33Pierre
      Plamondon
            52,336 (5)
            *
            20,000
            1.10%
            59,150
            3.25%
            131,486
            *
            –
            –
            *Pierre-Paul
      Allard
            –
            *
            –
            *
            –
            *
            –
            *
            –
            –
            *Pierre
      Marcouiller
            5,000
            *
            12,500
            *
            36,382
            2.00%
            53,882
            *
            –
            –
            *Guy
      Marier
            1,000
            *
            –
            *
            12,500
            *
            13,500
            *
            –
            –
            *David
      A. Thompson
            2,100
            *
            12,500
            *
            30,234
            1.66%
            44,834
            *
            –
            –
            *André
      Tremblay
            6,650 (6)
            *
            12,500
            *
            32,191
            1.77%
            51,341
            *
            –
            –
            *Dana
      Yearian
            –
            *
            –
            *
            –
            *
            –
            *
            –
            –
            *Jon
      Bradley
            –
            *
            –
            *
            25,500
            1.40%
            25,500
            *
            –
            –
            *Stephen
      Bull
            30,389
            *
            –
            *
            26,226
            1.44%
            56,615
            *
            –
            –
            *Other
      executive officers as a group
            18,866
            *
            15,000
            *
            57,372
            3.15%
            91,238
            *
            –
            –
            *All
      of our Directors and executive officers as a group
            120,704
            *
            122,500
            6.73%
            399,104
            21.94%
            642,308
            2.06%
            36,643,000
            100
            92.45


*
            Less
      than 1%.


(1)
            “In-the-money”
      options are options for which the market value of the underlying
      securities is higher than the price at which such securities may be bought
      from the Corporation. As of November 3, 2008 the market value of a
      Subordinate Voting Share was
US$2.80.


(2)
            “Out-the-money”
      options are options for which the market value of the underlying
      securities is lower than the price of which such securities may be bought
      from the Corporation.


(3)
            Beneficial
      ownership is determined in accordance with the rules of the SEC and
      generally includes voting or investment power with respect to securities.
      Options that are currently exercisable (including options that have an
      exercise price above the market price) are deemed to be outstanding and to
      be beneficially owned by the person holding such options for the purpose
      of computing the percentage ownership of such person, but are not treated
      as outstanding for the purpose of computing the percentage ownership of
      any other person. Accordingly, DSUs and RSUs are not
    included.


(4)
            The
      number of shares held by Germain Lamonde includes 1,900,000 multiple
      voting shares held of record by Fiducie Germain Lamonde and 34,743,000
      multiple voting shares held of record by G. Lamonde Investissements
      Financiers inc.


(5)
            The
      number of shares held by Pierre Plamondon includes 6,874 subordinate
      voting shares held of record by Fiducie Pierre
  Plamondon.


(6)
            The
      number of subordinate voting shares held of record by André Tremblay is
      held by 9104-5559 Québec Inc, a company controlled by Mr.
      Tremblay.






93
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The
following table presents information regarding stock options held as of
November 3, 2008by our Chief Executive
Officer, Chief Financial Officer, our Directors, our three other most highly
compensated executive officers and our other executive officers as a
group.





Name
            Securities
      Under Options
                Granted
      (1)
      (#)
            Exercise
      Price (2)
                (US$/Security)
            Expiration
      DateGermain
      Lamonde
            25,402
              5,080
              70,000
              50,000
              17,942
              11,218
            $26.00
              $22.25
              $9.13
              $1.58
              $4.51
              $4.76
            June
      29, 2010
              January
      10, 2011
              October
      10, 2011
              September
      25, 2012
              February
      1, 2015
              December
      6, 2015Pierre
      Plamondon
            8,700
              10,000
              5,000
              9,240
              19,000
              20,000
              5,383
              3,653
            $26.00
              $45.94
              $34.07
              $22.25
              $9.13
              $1.58
              $5.13
              $4.76
            June
      29, 2010
              September
      13, 2010
              October
      11, 2010
              January
      10, 2011
              October
      10, 2011
              September
      25, 2012
              October
      26, 2014
              December
      6, 2015Pierre-Paul
      Allard
            −
            −
            −Pierre
      Marcouiller
            2,000
              400
              17,966
              1,037
              2,479
              12,500
              12,500
            $26.00
              $22.25
              $9.13
              $12.69
              $5.65
              $1.58
              $3.51
            June
      29, 2010
              January
      10, 2011
              October
      10, 2011
              December
      1, 2011
              March
      1, 2012
              September
      25, 2012
              October
      27, 2013Guy
      Marier
            12,500
            $4.65
            March
      24, 2014David
      A. Thompson
            2,000
              400
              15,334
              12,500
              12,500
            $26.00
              $22.25
              $9.13
              $1.58
              $3.51
            June
      29, 2010
              January
      10, 2011
              October
      10, 2011
              September
      25, 2012
              October
      27, 2013André
      Tremblay
            2,000
              400
              17,291
              12,500
              12,500
            $26.00
              $22.25
              $9.13
              $1.58
              $3.51
            June
      29, 2010
              January
      10, 2011
              October
      10, 2011
              September
      25, 2012
              October
      27, 2013Dana
      Yearian
            −
            −
            −Jon
      Bradley
            5,000
              5,000
              1,000
              1,500
              10,000
              4,000
            $45.94
              $22.25
              $12.22
              $3.19
              $3.50
              $4.51
            September
      13, 2010
              January
      10, 2011
              January
      3, 2012
              January
      7, 2013
              December
      17, 2013
              February
      1, 2015Stephen
      Bull
            900
              5,000
              2,930
              15,000
              1,795
              1,803
            $26.00
              $45.94
              $22.25
              $9.13
              $5.13
              $4.76
            June
      29, 2010
              September
      13, 2010
              January
      10, 2011
              October
      10, 2011
              October
      26, 2014
              December
      6, 2015








94
 Table of Contents








Name
            Securities
      Under Options
                Granted
      (1)
      (#)
            Exercise
      Price (2)
                (US$/Security)
            Expiration
      DateOther
      Executive Officers as a group
            3,000
              4,000
              3,250
              10,000
              18,000
              15,000
              5,000
              9,259
              2,000
              7,726
            $45.94
              $34.07
              $22.25
              $23.40
              $9.13
              $1.58
              $3.19
              $5.13
              $4.51
              $4.76
            September
      13, 2010
              October
      11, 2010
              January
      10, 2011
              March
      15, 2011
              October
      10, 2011
              September
      25, 2012
              January
      7, 2013
              October
      26, 2014
              February
      1, 2015
              December
      6, 2015





(1)
            Underlying
      securities: subordinate voting
shares


(2)
            The
      exercise price of options granted is determined based on the highest of
      the closing prices of the subordinate voting shares on the Toronto Stock
      Exchange and the NASDAQ National Market on the last trading day preceding
      the grant date, using the noon buying rate of the Federal Reserve Bank of
      New York on the grant date to convert the NASDAQ National Market closing
      price to Canadian dollars, as
required.





The
following table presents information regarding Deferred Share Units and
Restricted Share Units held by our Chief Executive Officer, our Chief Financial
Officer, our Directors, our three other most highly compensated executive
officers, our other executive officers as a group, all of our Directors and
executive officers as a group, as of November 3, 2008.




Name
              DSUs
              RSUsNumber
              Percentage
              Estimated
      Average
                Value
      at the time of
                grant
      US$/DSU (1)
              Number
              Percentage
              Fair
      Value at the time of grant US$/RSU (2)Germain
      Lamonde
              –
              –
              –
              8,726 (3)
              0.72%
              4.69–
              –
              –
              21,477 (4)
              1.76%
              4.76–
              –
              –
              25,347 (5)
              2.08%
              6.02–
              –
              –
              29,910 (6)
              2.46%
              6.28–
              –
              –
              65,254 (7)
              5.36%
              2.36Pierre
      Plamondon
              –
              –
              –
              2,618 (3)
              0.21%
              4.69–
              –
              –
              13,500 (8)
              1.11%
              4.69–
              –
              –
              6,994 (4)
              0.57%
              4.76–
              –
              –
              8,430 (5)
              0.69%
              6.02–
              –
              –
              4,500 (9)
              0.37%
              6.02–
              –
              –
              9,637 (6)
              0.79%
              6.28–
              –
              –
              20,644 (7)
              1.70%
              2.36–
              –
              –
              20,339 (10)
              1.67%
              2.36Pierre-Paul
      Allard
              
              –
              –
              –
              –
              –Pierre
      Marcouiller
              17,109
      (11)
              21.6%
              5.26
              –
              –
              –Guy
      Marier
              17,109
      (11)
              21.6%
              5.26
              –
              –
              –David
      A. Thompson
              19,097
      (11)
              24.1%
              5.26
              –
              –
              –André
      Tremblay
              25,870
      (11)
              32.7%
              5.26
              –
              –
              –Dana
      Yearian
              –
              –
              –
              5,000 (12)
              0.41%
              5.16–
              –
              –
              6,645 (5)
              0.55%
              6.02–
              –
              –
              7,225 (6)
              0.59%
              6.28–
              –
              –
              23,072 (7)
              1.89%
              2.36–
              –
              –
              25,424 (10)
              2.09%
              2.36Jon
      Bradley
              –
              –
              –
              1,333 (13)
              0.11%
              4.51–
              –
              –
              2,500 (14)
              0.21%
              5.59–
              –
              –
              6,122 (6)
              0.50%
              6.28–
              –
              –
              16,826 (7)
              1.38%
              2.36–
              –
              –
              25,416 (10)
              2.09%
              2.36Stephen
      Bull
              –
              –
              –
              1,745 (3)
              0.14%
              4.69–
              –
              –
              13,500 (8)
              1.11%
              4.69–
              –
              –
              4,602 (4)
              0.38%
              4.76–
              –
              –
              5,905 (5)
              0.48%
              6.02–
              –
              –
              10,000 (9)
              0.82%
              6.02–
              –
              –
              7,340 (6)
              0.60%
              6.28–
              –
              –
              17,756 (7)
              1.46%
              2.36–
              –
              –
              13,559 (10)
              1.11%
              2.36
 
  95
 Table of Contents
 
 Name
              DSUs
              RSUsNumber
              Percentage
              Estimated
      Average
                Value
      at the time of
                grant
      US$/DSU (1)
              Number
              Percentage
              Fair
      Value at the
                time
      of grant
                US$/RSU
      (2)Other
      executive officers as a group
              –
              –
              –
              5,899 (3)
              0.48%
              4.69–
              –
              –
              14,175
      (8)
              1.16%
              4.69–
              –
              –
              16,708
      (4)
              1.37%
              4.76–
              –
              –
              3,250 (14)
              0.27%
              5.59–
              –
              –
              25,475
      (5)
              2.09%
              6.02–
              –
              –
              10,500
      (9)
              0.86%
              6.02–
              –
              –
              15,033
      (15)
              1.23%
              6.42–
              –
              –
              1,750 (16)
              0.14%
              6.42–
              –
              –
              25,933
      (6)
              2.13%
              6.28–
              –
              –
              1,750 (17)
              0.14%
              4.16–
              –
              –
              73,133
      (7)
              6.00%
              2.36–
              –
              –
              50,846
      (10)
              4.17%
              2.36All
      of the directors and executive officers as a group
              –
              –
              –
              18,988
      (3)
              1.56%
              4.69–
              –
              –
              41,175
      (8)
              3.38%
              4.69–
              –
              –
              1,333 (13)
              0.11%
              4.51–
              –
              –
              49,781
      (4)
              4.09%
              4.76–
              –
              –
              5,750 (14)
              0.47%
              5.59–
              –
              –
              5,000 (12)
              0.41%
              5.16–
              –
              –
              71,802
      (5)
              5.90%
              6.02–
              –
              –
              25,000
      (9)
              2.05%
              6.02–
              –
              –
              15,033
      (15)
              1.23%
              6.42–
              –
              –
              1,750 (16)
              0.14%
              6.42–
              –
              –
              86,167
      (6)
              7.08%
              6.28–
              –
              –
              1,750 (17)
              0.14%
              4.16–
              –
              –
              216,685 (7)
              17.79%
              2.36–
              –
              –
              135,584 (10)
              11.13%
              2.3679,185
              100%
              5.26
              675,798
              55.49%
              5.62


(1)
            The
      estimated average value at the time of grant of a DSU is the average of
      the estimated value at the time of grant of a DSU which is determined
      based on the highest of the closing prices of the Subordinate Voting
      Shares on the Toronto Stock Exchange and the NASDAQ National Market on the
      last trading day preceding the grant date, using the noon buying rate of
      the Federal Reserve Bank of New York on the grant date to convert the
      NASDAQ National Market closing price to Canadian dollars, as required. The
      value at vesting of a DSU is equivalent to the market value of a
      Subordinate Voting Share when a DSU is converted to such Subordinate
      Voting Share.


(2)
            The
      fair value at the time of grant of a RSU is equal to the market value of
      Subordinate Voting Shares at the time RSUs are
  granted.


(3)
            Those
      RSUs will vest on the fifth anniversary date of the grant in January 2005
      but are subject to early vesting on the third and fourth anniversary date
      of the grant on the attainment of performance objectives as determined by
      the Board of Directors. Accordingly, subject to the attainment of
      performance objectives, the first early vesting is up to 1/3 of the units
      on the third anniversary date of the grant and the second early vesting is
      up to 50% of the remaining units on the fourth anniversary date of the
      grant.


(4)
            Those
      RSUs will vest on the fifth anniversary date of the grant in December 2005
      but are subject to early vesting on the third and fourth anniversary date
      of the grant on the attainment of performance objectives as determined by
      the Board of Directors. Accordingly, subject to the attainment of
      performance objectives, the first early vesting is up to 1/3 of the units
      on the third anniversary date of the grant and the second early vesting is
      up to 50% of the remaining units on the fourth anniversary date of the
      grant.


(5)
            Those
      RSUs will vest on the fifth anniversary date of the grant in October 2006
      but are subject to early vesting on the third and fourth anniversary date
      of the grant on the attainment of performance objectives as determined by
      the Board of Directors. Accordingly, subject to the attainment of
      performance objectives, the first early vesting is up to 1/3 of the units
      on the third anniversary date of the grant and the second early vesting is
      up to 50% of the remaining units on the fourth anniversary date of the
      grant.


(6)
            Those
      RSUs will vest on the fifth anniversary date of the grant in October 2007
      but are subject to early vesting on the third and fourth anniversary date
      of the grant on the attainment of performance objectives as determined by
      the Board of Directors. Accordingly, subject to the attainment of
      performance objectives, the first early vesting is up to 1/3 of the units
      on the third anniversary date of the grant and the second early vesting is
      up to 50% of the remaining units on the fourth anniversary date of the
      grant.


(7)
            Those
      RSUs will vest on the fifth anniversary date of the grant in October 2008
      but are subject to early vesting on the third and fourth anniversary date
      of the grant on the attainment of performance objectives as determined by
      the Board of Directors. Accordingly, subject to the attainment of
      performance objectives, the first early vesting is up to 1/3 of the units
      on the third anniversary date of the grant and the second early vesting is
      up to 50% of the remaining units on the fourth anniversary date of the
      grant.






96
 Table of Contents





(8)
            Those
      RSUs will vest at a rate of 55%, 35% and 10%, on the third, fourth and
      fifth anniversary dates of the grant in
  January 2005.


(9)
            Those
      RSUs will vest at a rate of 1/3 annually commencing on the third
      anniversary date of the grant in
  October 2006.


(10)
            Those
      RSUs will vest on the fifth anniversary date of the grant in October 2008
      but are subject to early vesting on the third anniversary date of the
      grant on the attainment of performance objectives as determined by the
      Board of Directors. Accordingly, subject to the attainment of performance
      objectives, the early vesting is up to 100% of the units on the third
      anniversary date of the grant.


(11)
            Those
      DSUs will vest at the time Director ceases to be a member of the Board of
      the Corporation.


(12)
            Those
      RSUs will vest at a rate of 1/3 annually commencing on the third
      anniversary date of the grant in August
2006.


(13)
            Those
      RSUs will vest at a rate of 1/3 annually commencing on the third
      anniversary date of the grant in February
2005.


(14)
            Those
      RSUs will vest at a rate of 1/2 annually commencing on the third
      anniversary date of the grant in
  February 2006.


(15)
            Those
      RSUs will vest at a rate of 1/3 annually commencing on the third
      anniversary date of the grant in January
2007.


(16)
            Those
      RSUs will vest at a rate of 1/2 annually commencing on the third
      anniversary date of the grant in January
2007.


(17)
            Those
      RSUs will vest at a rate of 1/2 annually commencing on the third
      anniversary date of the grant in January
2008.






Escrowed
      Securities





The following table presents
information regarding the number of securities of each class of the Corporation
held, to our knowledge as of November 3, 2008, in escrow and the percentage
outstanding securities of that class.





Designation
      of Class
            
            Number
      of Securities held in escrow
            
            Percentage
      of ClassSubordinate
      Voting Shares
            
            nil
            
            nilMultiple
      Voting Shares
            
            nil
            
            nil






97
 Table of Contents




Item 7.
              Major
      Shareholder and Related Party
Transaction
  A.  Major
Shareholders


The
following table presents information regarding the beneficial ownership of our
share capital as of November 3, 2008 by persons or groups of affiliated persons
known by us to own more than 5% of our voting shares.





Multiple
      Voting Shares
                Beneficially
      Owned (1)
            Subordinate
      Voting Shares
                Beneficially
      Owned (1)
            Total
      Percentage of
              Voting
      PowerName
            Number
            Percent
            Number
            Percent
            PercentGermain
      Lamonde (2)
            36,643,000
            100%
            173,912
            0.57%
            92.29%Fiducie
      Germain Lamonde (3)
            1,900,000
            5%
            Nil
            Nil
            4.79%G.
      Lamonde Investissements
              Financiers
      inc. (4)
            34,743,000
            95%
            Nil
            Nil
            87.51%Connor,
      Clark & Lunn Investment Mgmt. Ltd.
            Nil
            Nil
            1,693,900
            5.53%
            *





*
            Less
      than 1%


(1)
            Beneficial
      ownership is determined in accordance with the rules of the SEC and
      generally includes voting or investment power with respect to securities.
      Options that are currently exercisable (including options that have an
      exercise price above the market price) are deemed to be outstanding and to
      be beneficially owned by the person holding such options for the purpose
      of computing the percentage ownership of such person, but are not treated
      as outstanding for the purpose of computing the percentage ownership of
      any other person.


(2)
            The
      number of shares held by Germain Lamonde includes 1,900,000 multiple
      voting shares held of record by Fiducie Germain Lamonde and 34,743,000
      multiple voting shares held of record by G. Lamonde Investissements
      Financiers inc.


(3)
            Fiducie
      Germain Lamonde is a family trust for the benefit of Mr. Lamonde and
      members of his family.


(4)
            G.
      Lamonde Investissements Financiers inc. is a company controlled by Mr.
      Lamonde.






Each
multiple voting share is convertible at the option of the holder into one
subordinate voting share. Holders of our subordinate voting shares are entitled
to one vote per share and holders of our multiple voting shares are entitled to
ten votes per share.





As of
November 17, 2008, 30,606,791 subordinate voting shares were outstanding.
Approximately 98.3% (30,077,643) of our subordinate voting shares were held in
bearer form and the remainder (529,148 subordinate voting shares) was held by
161 record holders.  As of November 17, 2008, we believe approximately
60.83% of our outstanding subordinate voting shares were held in the United
States.





B.  Related
Party Transactions


Indebtedness
of Directors, Executive Officers and Employees





Until
February 2007, we have guaranteed the repayment of a loan granted to an employee
by a financial institution for the purchase of our Class “F” shares that were
converted into subordinate voting shares immediately prior to our initial public
offering. As of August 31, 2006, the total principal amount guaranteed by us
was$37,400.





Except as
disclosed in this section, none of our directors, executive officers, associates
or affiliates had any material interest in any transaction with us during the
past three years or in any proposed transaction which has materially affected or
could materially affect us.








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Leases





Until
September 1, 2004, we had a lease agreement with G. Lamonde Investissements
financiers inc., a company controlled by Mr. Germain Lamonde, for
premises located at 465 Godin Avenue in Quebec City, Quebec. Until September 1,
2003, there premises were used for our executive and administrative offices
which were, since then, moved into a building that we own. For fiscal year 2004,
this space was unoccupied. This lease was renewed in December 2001 for five
years, with all terms and conditions remaining the same. However, on September
1, 2004, we were released from our obligations under the lease with a final
payment of $194,000 (CA$250,000). The annual rent for this lease was
CA$144,000.





Location
            Square
      Footage
            Annual
      Rent
            Expiry
      Date465
      Godin
            24,000
            CA$144,000
            November
      30, 2006





Based on
third-party valuation of the property values, we believe this lease agreement
was at prevailing market terms.







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Item 8.
                Financial
      Information
  A.  Consolidated
Statements and Other Financial Information


See Item
18, “Financial Statements” for certain other information required by this
item.





Valuation
and qualifying accounts are as follows (in thousands of
US dollars):





Allowance
for doubtful accounts





Years
      ended August 31,2008
            
            
            2007
            
            
            2006Balance
      – Beginning of year
            
            $
            206
            
            
            $
            451
            
            
            $
            352Addition
      charged to earnings
            
            
            204
            
            
            
            42
            
            
            
            115Write-offs
      of uncollectible accounts
            
            
            (53
            )
            
            
            (271
            )
            
            
            (123
            )Recovery
      of uncollectible accounts
            
            
            (52
            )
            
            
            (16
            )
            
            
            (111
            )Business
      combinations
            
            
            −
            
            
            
            −
            
            
            
            218Balance
      – End of year
            
            $
            305
            
            
            $
            206
            
            
            $
            451





Valuation
allowance on future income tax assets




Years
      ended August 31,2008
              
              
              2007
              
              
              2006Balance
      – Beginning of year
              
              $
              12,492
              
              
              $
              38,543
              
              
              $
              38,406Change
      in valuation allowance
              
              
              (4,927
              )
              
              
              (28,646
              )
              
              
              (1,877
              )Business
      combination
              
              
              8,195
              
              
              
              −
              
              
              
              −Foreign
      currency translation adjustment
              
              
              (231
              )
              
              
              2,595
              
              
              
              2,014Balance
      – End of year
              
              $
              15,529
              
              
              $
              12,492
              
              
              $
              38,543




Export
Sales





Export
and domestic sales in thousands of US dollars and as a percentage of total sales
are as follows:





Years
      ended August 31,2008
            
            2007
            
            2006Export
      Sales
            
            $169,571
            92%
            
            $143,315
            94%
            
            $119,486
            93%Domestic
      Sales
            
            14,219
            8
            
            9,619
            6
            
            8,767
            7$183,790
            100%
            
            $152,934
            100%
            
            $128,253
            100%








100
 Table of Contents





Legal
Proceedings





On
November 27, 2001, a class action suit was filed in the United States District
Court for the Southern District of New York against EXFO, four of the
underwriters of our Initial Public Offering and some of our executive officers
pursuant to the Securities Exchange Act of 1934 and Rule 10b-5 promulgated
thereunder and Sections 11, 12 and 16 of the Securities Act of
1933.  This class action alleges that EXFO’s registration statement
and prospectus filed with the Securities and Exchange Commission on June 29,
2000, contained material misrepresentations and/or omissions resulting from (i)
the underwriters allegedly soliciting and receiving additional, excessive and
undisclosed commissions from certain investors in exchange for which they
allocated material portions of the shares issued in connection with the
company’s Initial Public Offering; and (ii) the underwriters allegedly
entering into agreements with customers whereby shares issued in connection with
the company’s Initial Public Offering would be allocated to those customers in
exchange for which customers agreed to purchase additional amounts of shares in
the after-market at pre-determined prices.





On April
19, 2002, the plaintiffs filed an amended complaint containing master
allegations against all of the underwriters in all of the 310 cases included in
this class action and also filed an amended complaint containing allegations
specific to four of our underwriters, EXFO and two of our executive officers. In
addition to the allegations mentioned above, the amended complaint alleges that
the underwriters (i) used their analysts to manipulate the stock market; and
(ii) implemented schemes that allowed issuer insiders to sell their shares
rapidly after an initial public offering and benefit from high market prices. As
concerns EXFO and two of our executive officers in particular, the amended
complaint alleges that (i) the company’s registration statement was materially
false and misleading because it failed to disclose the additional commissions
and compensation to be received by underwriters; (ii) the two named executive
officers learned of or recklessly disregarded the alleged misconduct of the
underwriters; (iii) the two named executive officers had motive and opportunity
to engage in alleged wrongful conduct due to personal holdings of EXFO’s stock
and the fact that an alleged artificially inflated stock price could be used as
currency for acquisitions; and (iv) the two named executive officers, by virtue
of their positions with EXFO, controlled the company and the contents of the
registration statement and had the ability to prevent its issuance or cause it
to be corrected. The plaintiffs in this suit seek an unspecified amount for
damages suffered.





In July
2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint
and a decision was rendered on February 19, 2003. Only one of the
claims against EXFO was dismissed. On October 8, 2002, the claims
against our officers were dismissed pursuant to the terms of Reservation of
Rights and Tolling Agreements entered into with the plaintiffs.





In June
2004, an agreement of partial settlement was submitted to the court for
preliminary approval.  The proposed partial settlement was between the
plaintiffs, the issuer defendants in the consolidated actions, the issuer
officers and directors named as defendants, and the issuers’ insurance
companies.  The court granted the preliminary approval motion on
February 15, 2005, subject to certain modifications.  On
August 31, 2005, the court issued a preliminary order further approving the
modifications to the settlement and certifying the settlement
classes.  The court also appointed the notice administrator for the
settlement and ordered that notice of the settlement be distributed to all
settlement class members by January 15, 2006. The settlement fairness
hearing occurred on April 24, 2006, and the court reserved decision at that
time.





While the
partial settlement was pending approval, the plaintiffs continued to litigate
against the underwriter defendants.  The district court directed that the
litigation proceed within a number of “focus cases” rather than in all of the
310 cases that have been consolidated.  EXFO's case is not one of
these focus cases.  On October 13, 2004, the district court certified
the focus cases as class actions.  The underwriter defendants appealed
that ruling, and on December 5, 2006, the Court of Appeals for the Second
Circuit reversed the district court’s class certification
decision.








101
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On April
6, 2007, the Second Circuit denied the plaintiffs’ petition for rehearing of
that decision and, on May 18, 2007, the Second Circuit denied the
plaintiffs’ petition for rehearing en banc.  In light
of the Second Circuit’s opinion, liaison counsel for all issuer defendants,
including EXFO, informed the court that this settlement cannot be approved,
because the defined settlement class, like the litigation class, cannot be
certified.  On June 25, 2007, the district court
entered an order terminating the settlement agreement.  On August 14,
2007, the plaintiffs filed their second consolidated amended class action
complaints against the focus cases and, on September 27, 2007, again moved for
class certification. On November 12, 2007, certain of the
defendants in the focus cases moved to dismiss the second consolidated amended
class action complaints. On March 26, 2008, the district court denied the
motions to dismiss, except as to Section 11 claims raised by those plaintiffs
who sold their securities for a price in excess of the initial offering
price and those who purchased outside of the previously certified class period.
Briefing on the class certification motion was completed in May
2008.





Due to
the inherent uncertainties of litigation, it is not possible to predict the
final outcome of the case, nor to determine the amount of any possible
losses. We will continue to defend our position in this litigation that the
claims against EXFO, and our officers, are without merit. Accordingly, no
provision for this case has been made in the consolidated financial
statements as at August 31, 2008.





There are
no other legal or arbitration proceedings pending or threatened of which we are
aware which may have or have had a significant effect on our financial
position.




B.  Dividend
Policy




We do not
currently anticipate paying dividends for at least the three next years. Our
current intention is to reinvest any earnings in our business long-term growth.
Any future determination by us to pay dividends will be at the discretion of our
Board of Directors and in accordance with the terms and conditions of any
outstanding indebtedness and will depend on our financial condition, results of
operations, capital requirements and such other functions as our Board of
Directors considers relevant.






C.  Significant
changes


No
significant changes occurred since the date of our annual consolidated financial
statements included elsewhere in this annual report.








102
 Table of Contents




Item 9.
                Offer
      and Listing





Not Applicable, except for Item 9A (4)
and Item 9C.





NASDAQ
      (US$)
            TSX
      (CA$)High
            Low
            High
            LowSeptember
      1, 2003 to August 31, 2004
            7.09
            2.71
            9.15
            3.75September
      1, 2004 to August 31, 2005
            5.51
            3.92
            6.90
            4.92September
      1, 2005 to August 31, 2006
            8.69
            4.32
            9.60
            5.15September
      1, 2006 to August 31, 2007
            7.57
            4.89
            8.85
            5.55September
      1, 2007 to August 31, 2008
            7.28
            3.92
            7.35
            3.972007
      1st Quarter
            6.13
            4.89
            6.90
            5.552007
      2nd Quarter
            7.48
            5.21
            8.85
            6.052007
      3rd Quarter
            6.94
            5.92
            7.82
            6.702007
      4th Quarter
            7.57
            5.94
            7.95
            6.422008
      1st Quarter
            7.28
            5.10
            7.35
            5.012008
      2nd Quarter
            5.50
            3.92
            5.54
            3.972008
      3rd Quarter
            6.14
            4.06
            6.00
            4.042008
      4th Quarter
            5.47
            3.96
            5.59
            4.152008
      May
            6.14
            5.44
            6.00
            5.332008
      June
            5.47
            4.45
            5.59
            4.522008
      July
            4.45
            4.11
            4.60
            4.152008
      August
            4.49
            3.96
            4.62
            4.152008
      September
            4.57
            3.24
            4.86
            3.382008
      October
            3.19
            2.13
            3.50
            2.502008
      November
            2.96
            2.74
            3.54
            3.25(until
      November 17)





Our
subordinate voting shares have been quoted on the NASDAQ National Market under
the symbol EXFO and listed on The Toronto Stock Exchange under the symbol EXF
since our initial public offering on June 29, 2000. Prior to that time,
there was no public market for our subordinate voting shares. The following
table sets forth, for the periods indicated, the high and low closing sales
prices per subordinate voting share as reported on the NASDAQ National Market
and the Toronto Stock Exchange.





On
November 17, 2008, the last reported sale price for our subordinate voting
shares on the NASDAQ National Market was US$2.74 per share and the last reported
sale price for our subordinate voting shares on the Toronto Stock Exchange was
CA$3.34 per share.







103
 Table of Contents




Item 10.
                Additional
      Information
  A.  Share
Capital


Not
Applicable





B. Memorandum
and Articles of Association





Incorporated
by reference to our registration statement on Form F-1 dated
June 9, 2000 (File No. 333-38956).







C. Material
Contracts





Except as
otherwise disclosed in this annual report and our financial statements and notes
included elsewhere in this annual report, we have no other material
contracts.





D. Exchange
Controls





Subject
to the following paragraph, there is no law or governmental decree or regulation
in Canada that restricts the export or import of capital, or affects the
remittance of dividends, interest or other payments to non-resident holders of
our subordinate voting shares, other than withholding tax
requirements.





There is
no limitation imposed by Canadian law or by our articles of incorporation or our
other charter documents on the right of a non-resident to hold or vote
subordinate voting shares, other than as provided by the Investment Canada Act, the
North American Free Trade
Agreement Implementation Act(Canada) and the World Trade Organization Agreement
Implementation Act. The Investment Canada Actrequires notification and, in certain cases, advance review and approval
by the Government of Canada of an investment to establish a new Canadian
business by a non-Canadian or of the acquisition by a “non-Canadian” of
“control” of a “Canadian business”, all as defined in the Investment Canada Act.
Generally, the threshold for review will be higher in monetary terms for
a member of the World Trade Organization or North American Free Trade
Agreement.







E. Taxation





United
States Taxation





The
information set forth below under the caption “United States Taxation” is a
summary of the material U.S. federal income tax consequences of the ownership
and disposition of subordinate voting shares by a U.S. Holder, as
defined below. These discussions are not a complete analysis or listing of all
of the possible tax consequences of such transactions and do not address all tax
considerations that may be relevant to particular holders in light of their
personal circumstances or to persons that are subject to special tax rules. In
particular, the information set forth under the caption “United States Taxation”
deals only with U.S. Holders that hold subordinate voting shares as capital
assets within the meaning of Section 1221 of the Internal Revenue Code of 1986,
as amended (the “Code”), and who do not at any time own individually, nor
are treated as owning 10% or more of the total combined voting power of all
classes of our stock entitled to vote. In addition, this description of U.S. tax
consequences does not address the tax treatment of special classes of U.S.
Holders, such as financial institutions, regulated investment companies, traders
in securities who elect to mark-to-market their securities, tax-exempt entities,
insurance companies, partnerships, persons holding subordinate voting shares as
part of a hedging, integrated or conversion transaction or as part of a
“straddle,” U.S. expatriates, persons subject to the alternative minimum tax,
persons who acquired their subordinate voting shares through the exercise or
cancellation of employee stock options or otherwise as compensation for
services, dealers or traders in securities or currencies and holders whose
“functional currency” is not the U.S. dollar. This summary does not address U.S.
estate and gift tax consequences or tax consequences under any state and local
tax laws or non-U.S. tax laws.







104
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As used
in this section, the term “U.S. Holder” means a beneficial owner of subordinate
voting shares that is for U.S. federal income tax purposes:





(a)
            an
      individual citizen or resident of the United
  States;





(b)
            a
      corporation created or organized under the laws of the United States or
      any state thereof and the District of
Columbia;





(c)
            an
      estate the income of which is subject to United States federal income
      taxation regardless of its source;





(d)
            a
      trust if (1) a court within the United States is able to exercise primary
      supervision over its administration and one or more U.S. persons as
      described in Section 7701 (a) (30) of the Code have authority to control
      all substantial decisions of the trust or (2) the trust has a
      valid election in effect under applicable U.S. Treasury regulations to be
      treated as a U.S. person; or





(e)
            any
      other person whose worldwide income or gain is otherwise subject to U.S.
      federal income taxation on a net income
basis;





If a
partnership or other flow-through entity holds subordinate voting shares, the
U.S. federal income tax treatment of a partner will generally depend upon the
status of the partner or other owner and upon the activities of the partnership
or other flow-through entity.  If you are a partner of a partnership
holding subordinate voting shares, you should consult your tax
advisor.





Holders
of subordinate voting shares who are not U.S. Holders, sometimes referred to as
“Non-U.S. Holders”, should also consult their own tax advisors, particularly as
to the applicability of any tax treaty.





The
following discussion is based upon:





·
            the Code;


·
            U.S.
      judicial decisions;


·
            administrative
      pronouncements;


·
            existing
      and proposed Treasury regulations;
and


·
            the
      Canada – U.S. Income Tax Treaty.





Any of
the above is subject to change, possibly with retroactive effect, so as to
result in U.S. federal income tax consequences different from those discussed
below. We have not requested, and will not request, a ruling from the U.S.
Internal Revenue Service (the “IRS”) with respect to any of the U.S. federal
income tax consequences described below, and as a result, there can be no
assurance that the IRS will not disagree with or challenge any of the
conclusions we have reached and describe here.





The
following discussion is for general information only and is not intended to be,
nor should it be construed to be, legal or tax advice to any holder of
subordinate voting shares and no opinion or representation with respect to the
U.S. federal income tax consequences to any holder is made.  Holders
of subordinate voting shares are urged to consult their tax advisors as to the
particular consequences to them under U.S. federal, state, local and applicable
non-U.S. tax laws of the acquisition, ownership and disposition of subordinate
voting shares.







105
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Dividends





Subject
to the discussion of passive foreign investment companies below, the gross
amount of any distribution paid by us to a U.S. Holder will generally be subject
to U.S. federal income tax as foreign source dividend income to the extent
paid out of our current or accumulated earnings and profits, as determined under
U.S. federal income tax principles. Such income will be includable in the
gross income of a U.S. Holder on the day received by the U.S.
Holder.  The amount of any distribution of property other than cash
will be the fair market value of such property on the date of the distribution.
In the case of a taxable corporate U.S. Holder, such dividends will be taxable
as ordinary income and will not be eligible for the corporate dividends received
deduction, which is generally allowed to U.S. corporate shareholders on
dividends received from a domestic corporation. In the case of a non-corporate
U.S. Holder, including individuals, such dividends should generally be eligible
for a maximum tax rate of 15% for dividends received before January 1,
2011, provided such holder holds the subordinate voting shares for at least 60
days and certain other conditions are satisfied, including, as we believe to be
the case, that we are not a “passive foreign investment company”. To the extent
that an amount received by a U.S. Holder exceeds such holder’s allocable
share of our current and accumulated earnings and profits, such excess will be
applied first to reduce such U.S. Holder’s tax basis in his subordinate voting
shares, thereby increasing the amount of gain or decreasing the amount of loss
recognized on a subsequent disposition of the subordinate voting shares. Then,
to the extent such distribution exceeds such U.S. Holder’s tax basis, it will be
treated as capital gain. We do not currently maintain calculations of our
earnings and profits for U.S. federal income tax purposes.





The gross
amount of distributions paid in Canadian dollars, or any successor or other
foreign currency, will be included in the income of such U.S. Holder in a U.S.
dollar amount calculated by reference to the spot exchange rate in effect on the
day the distributions are paid regardless of whether the payment is in fact
converted into U.S. dollars.  If the Canadian dollars, or any
successor or other foreign currency, are converted into U.S. dollars on the date
of the payment, the U.S. Holder should not be required to recognize any foreign
currency gain or loss with respect to the receipt of Canadian dollars as
distributions. The U.S. Holder will have a basis in any Canadian dollars or
other foreign currency distributed equal to their U.S. dollar value on the
payment date.  If, instead, the Canadian dollars are converted at a
later date, any currency gains or losses resulting from the conversion of the
Canadian dollars will be treated as U.S. source ordinary income or loss.
U.S. Holders are urged to consult their own tax advisors concerning the U.S. tax
consequences of acquiring, holding and disposing of Canadian
dollars.





A U.S.
Holder may be entitled to deduct, or claim a foreign tax credit for, Canadian
taxes that are withheld on dividends received by the U.S. Holder, subject to
applicable limitations in the Code. The limitation on foreign taxes eligible for
credit is calculated separately with respect to specific classes of income. For
this purpose, for taxable years beginning before January 1, 2007, dividends
distributed generally will constitute foreign source “passive income”, or, in
the case of certain U.S. Holders, “financial services income”, and, for taxable
years beginning after December 31, 2006, such dividends should generally
constitute foreign source “passive category income”, or, in the case of certain
U.S. Holders, “general category income”. The rules governing the foreign tax
credit are complex, and additional limitations on the credit apply to
individuals receiving dividends from non-U.S. corporations if the dividends are
eligible for the 15% maximum tax rate on dividends described
above.  U.S. Holders are urged to consult their tax advisors
regarding the availability of the foreign tax credit under their particular
circumstances.





A
Non-U.S. Holder of subordinate voting shares generally will not be subject to
U.S. federal income or withholding tax on dividends received on subordinate
voting shares unless such income is effectively connected with the conduct by
such Non-U.S. Holder of a trade or business in the United
States.







106
 Table of Contents





Sale
or Exchange





A U.S.
Holder’s initial tax basis in the subordinate voting shares will generally be
cost to the holder. A U.S. Holder’s adjusted tax basis in the
subordinate voting shares will generally be the same as cost, but may differ for
various reasons including the receipt by such holder of a distribution that was
not made up wholly of earnings and profits as described above under the heading
“Dividends.” Subject to the discussion of passive foreign investment companies
below, gain or loss realized by a U.S. Holder on the sale or other disposition
of subordinate voting shares will be subject to U.S. federal income taxation as
capital gain or loss in an amount equal to the difference (if any) between the
U.S. Holder’s adjusted tax basis (determined in U.S. dollars) in the subordinate
voting shares and the U.S. dollar value of the amount realized on the
disposition of such subordinate voting shares. Capital gains of non-corporate
U.S. Holders, including individuals, derived with respect to a sale, exchange or
other disposition prior to January 1, 2011 of subordinate voting shares held for
more than one year are subject to a maximum federal income tax rate of 15%.
The deductibility of capital losses is subject to limitations. In the case of a
non-corporate U.S. Holder, the federal tax rate applicable to capital gains will
depend upon:





·
            the
      holder’s holding period for the subordinate voting shares, with a
      preferential rate available for subordinate voting shares held for more
      than one year; and


·
            the
      holder’s marginal tax rate for ordinary
income.





Any gain
realized will generally be treated as U.S. source gain and loss realized by
a U.S. Holder generally also will be treated as from sources within the
United States.





The
ability of a U.S. Holder to utilize foreign taxes as a credit to offset U.S.
taxes is subject to complex limitations and conditions. The consequences of
the separate limitation calculation will depend upon the nature and sources of
each U.S. Holder’s income and the deductions allocable thereto. Alternatively, a
U.S. Holder may elect to claim all foreign taxes paid as an itemized deduction
in lieu of claiming a foreign tax credit. A deduction does not reduce U.S. tax
on a dollar-for-dollar basis like a tax credit, but the availability of the
deduction is not subject to the same conditions and limitations applicable to
foreign tax credits.





If a U.S.
Holder receives any foreign currency on the sale of subordinate voting shares,
such U.S. Holder may recognize ordinary income or loss as a result of currency
fluctuations between the date of the sale of subordinate voting shares and the
date the sale proceeds are converted into U.S. dollars.





A
Non-U.S. Holder of subordinate voting shares generally will not be subject to
U.S. federal income or withholding tax on any gain realized on the sale or
exchange of such subordinate voting shares unless:





·
            such
      gain is effectively connected with the conduct by such Non-U.S. Holder of
      a trade or business in the United States;
  or


·
            in
      the case of any gain realized by an individual Non-U.S. Holder, such
      Non-U.S. Holder is present in the United States for 183 days or
      more in the taxable year of such sale and certain other conditions are
      met.





Passive
Foreign Investment Company





We
believe that our subordinate voting shares should not currently be treated as
stock of a passive foreign investment company for United States federal income
tax purposes, but this conclusion is a factual determination made annually and
thus may be subject to change based on future operations as well as the
composition and valuation of our assets. In particular, a significant portion of
our gross assets are comprised of cash and short-term investments, which the
PFIC rules treat as passive without regard to the purpose for which we hold
those assets. If the proportion of these passive assets were to increase
relative to the fair market value of our other assets, we may be treated as a
passive foreign investment company. In general, we will be a passive foreign
investment company with respect to a U.S. Holder if, for any taxable year in
which the U.S. Holder holds our subordinate voting shares, either:








107
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·
            at
      least 75% of our gross income for the taxable year is passive income;
      or


·
            at
      least 50% of the average value of our assets is attributable to assets
      that produce or are held for the production of passive
    income.





For this
purpose, passive income includes, among other things, income such
as:





·
            dividends;


·
            interest;


·
            rents
      or royalties, other than certain rents or royalties derived from the
      active conduct of trade or
business;


·
            annuities;
      and


·
            gains
      from assets that produce passive
income.





If a
non-U.S. corporation owns at least 25% by value of the stock of another
corporation, the non-U.S. corporation is treated for purposes of the passive
foreign investment company tests as owning its proportionate share of the assets
of the other corporation and as receiving directly its proportionate share of
the other corporation’s income.





If we are
treated as a passive foreign investment company, a U.S. Holder that did not make
a qualified electing fund election, if available, or a mark-to-market election,
as described below, would be subject to special rules with respect
to:





·
            any
      gain realized on the sale or other disposition of subordinate voting
      shares; and


·
            any
      “excess distribution” by us to the U.S.
Holder.





Generally,
“excess distributions” are any distributions to the U.S. Holder in respect of
the subordinate voting shares during a single taxable year that are greater than
125% of the average annual distributions received by the U.S. Holder in respect
of the subordinate voting shares during the three preceding taxable years or, if
shorter, the U.S. Holder’s holding period for the subordinate voting
shares.





Under the
passive foreign investment company rules,





·
            the
      gain or excess distribution would be allocated ratably over the U.S.
      Holder’s holding period for the subordinate voting
  shares;


·
            the
      amount allocated to the taxable year in which the gain or excess
      distribution was realized and to taxable years prior to the first year in
      which we were classified as a PFIC would be taxable as ordinary income;
      and


·
            the
      amount allocated to each other prior year would be subject to tax as
      ordinary income at the highest tax rate in effect for that year, and the
      interest charge generally applicable to underpayments of tax would be
      imposed in respect of the tax attributable to each such
    year.





A U.S.
Holder owning actually or constructively “marketable stock” of a passive foreign
investment company may be able to avoid the imposition of the passive foreign
investment company tax rules described above by making a mark-to-market
election. Generally, pursuant to this election, a U.S. Holder would include in
ordinary income or, subject to the following sentence, loss, for each taxable
year during which such stock is held, an amount equal to the difference as of
the close of the taxable year between the fair market value of its stock and its
adjusted tax basis in such stock.  Any mark-to-market loss is treated
as an ordinary deduction, but only to the extent of the ordinary income that the
U.S. Holder has included pursuant to the election in prior taxable
years.  The electing U.S. Holder’s basis in its stock would be
adjusted to reflect any of these income or loss amounts.  Holders
desiring to make the mark-to-market election should consult their tax advisors
with respect to the application and effect of making such election.








108
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In the
case of a U.S. Holder who does not make a mark-to-market election, the special
passive foreign investment company tax rules described above will not apply to
such U.S. Holder if the U.S. Holder makes an election to have us treated as
a qualified electing fund and we provide certain required information to
holders. For a U.S. Holder to make a qualified electing fund election, we
would have to satisfy certain reporting requirements. We have not determined
whether we will undertake the necessary measures to be able to satisfy such
requirements in the event that we were treated as a passive foreign investment
company.





A U.S.
Holder that makes a qualified electing fund election will be currently taxable
on its pro rata share of our ordinary earnings and net capital gain, at ordinary
income and capital gains rates, respectively, for each of our taxable years,
regardless of whether or not distributions were received. The U.S. Holder’s
basis in the subordinate voting shares will be increased to reflect taxed but
undistributed income. Distributions of income that had previously been taxed
will result in a corresponding reduction of basis in the subordinate voting
shares and will not be taxed again as a distribution to the U.S. Holder. U.S.
Holders desiring to make a qualified electing fund election should consult their
tax advisors with respect to the advisability of making such
election.





United
States Backup Withholding and Information Reporting





A U.S.
Holder will generally be subject to information reporting with respect to
dividends paid on, or proceeds of the sale or other disposition of, our
subordinate voting shares that are paid within the United States or through some
U.S. related financial intermediaries to U.S. Holders, unless the U.S. Holder is
a corporation or comes within certain other categories of exempt recipients.
A U.S. Holder that is not an exempt recipient will generally be subject to
backup withholding with respect to the proceeds from the sale or the disposition
of, or with respect to dividends on, subordinate voting shares unless the U.S.
Holder timely provides a taxpayer identification number and complies with the
other applicable requirements of the backup withholding rules. A U.S Holder who
fails to provide a correct taxpayer identification number may be subject to
penalties imposed by the United States Internal Revenue Service.





Non-U.S.
Holders will generally be subject to information reporting and possible backup
withholding with respect to the proceeds of the sale or other disposition of
subordinate voting shares effected within the United States, unless the holder
certifies to its foreign status or otherwise establishes an exemption and the
broker does not have actual knowledge or reason to know that the holder is a
U.S. Holder.  Payments of dividends on or proceeds from the sale of
subordinate voting shares within the United States by a payor within the United
States to a non-exempt U.S. or Non-U.S. Holder will be subject to backup
withholding if such holder fails to provide appropriate certification. In the
case of such payments by a payor within the United States to a foreign
partnership other than a foreign partnership that qualifies as a
“withholding foreign partnership” within the meaning of such Treasury
regulations, the partners of such partnership will be required to provide the
certification discussed above in order to establish an exemption from backup
withholding tax and information reporting requirements.





Backup
withholding is not an additional tax.  Any amounts withheld under the
backup withholding rules will be allowed as a refund or credit against a
holder’s U.S. federal income tax liability, provided that the required
information is furnished to the IRS.





Canadian
Federal Income Tax Considerations





The
following is a summary of the material Canadian federal income tax
considerations generally applicable to a U.S. person who holds subordinate
voting shares and who, for the purposes of the Income Tax Act(Canada) (the
“ITA”), and the Canada-United
States Income Tax Convention(1980) (the “Convention”), as applicable and
at all relevant times:





·
            is
      resident in the United States and not resident in
  Canada,


·
            holds
      the subordinate voting shares as capital
  property,


·
            does
      not have a “permanent establishment” or “fixed base” in Canada, as defined
      in the Convention; and


·
            deals
      at arm’s length with us. Special rules, which are not discussed below, may
      apply to “financial institutions”, as defined in the ITA, and to
      non-resident insurers carrying on an insurance business in Canada and
      elsewhere.






109
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This
discussion is based on the current provisions of the ITA and the Convention and
on the regulations promulgated under the ITA, all specific proposals to amend
the ITA or the regulations promulgated under the ITA announced by or on behalf
of the Canadian Minister of Finance prior to the date of this annual report and
the current published administrative practices of the Canada Customs and Revenue
Agency. It does not otherwise take into account or anticipate any changes in law
or administrative practice nor any income tax laws or considerations of any
province or territory of Canada or any jurisdiction other than Canada, which may
differ from the Canadian federal income tax consequences described in this
document.





Under the
ITA and the Convention, dividends paid or credited, or deemed to be paid or
credited, on the subordinate voting shares to a U.S. person who owns less than
10% of the voting shares will be subject to Canadian withholding tax at the rate
of 15% of the gross amount of those dividends or deemed dividends. If a U.S.
person is a corporation and owns 10% or more of the voting shares, the rate is
reduced from 15% to 5%. Subject to specified limitations, a U.S. person may be
entitled to credit against U.S. federal income tax liability for the amount of
tax withheld by Canada.





Under the
Convention, dividends paid to specified religious, scientific, charitable and
similar tax exempt organizations and specified organizations that are resident
and exempt from tax in the United States and that have complied with specified
administrative procedures are exempt from this Canadian withholding
tax.





A capital
gain realized by a U.S. person on a disposition or deemed disposition of the
subordinate voting shares will not be subject to tax under the ITA unless the
subordinate voting shares constitute taxable Canadian property within the
meaning of the ITA at the time of the disposition or deemed disposition. In
general, the subordinate voting shares will not be “taxable Canadian property”
to a U.S. person if they are listed on a prescribed stock exchange, which
includes The Toronto Stock Exchange, unless, at any time within the five-year
period immediately preceding the disposition, the U.S. person, persons with whom
the U.S. person did not deal at arm’s length, or the U.S. person together with
those persons, owned or had an interest in or a right to acquire more than 25%
of any class or series of our shares.





If the
subordinate voting shares are taxable Canadian property to a U.S. person, any
capital gain realized on a disposition or deemed disposition of those
subordinate voting shares will generally be exempt from tax by virtue of the
Convention if the value of the subordinate voting shares at the time of the
disposition or deemed disposition is not derived principally from real property,
as defined by the Convention, situated in Canada. The determination as to
whether Canadian tax would be applicable on a disposition or deemed disposition
of the subordinate voting shares must be made at the time of the disposition or
deemed disposition.





Holders
of subordinate voting shares are urged to consult their own tax advisors to
determine the particular tax consequences to them, including the application and
effect of any state, local or foreign income and other tax laws, of the
acquisition, ownership and disposition of subordinate voting
shares.








F. Dividends
and Paying Agents





Not
Applicable.








G. Statement
by Experts





Not
Applicable.








H. Documents
on Display





Any
statement in this annual report about any of our contracts or other documents is
not necessarily complete. If the contract or document is filed as an exhibit to
the registration statement, the contract or document is deemed to modify the
description contained in this annual report. You must review the exhibits
themselves for a complete description of the contract or
document.








110
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You may
review a copy of our filings with the SEC, including exhibits and schedules
filed with it, at the SEC’s public reference facilities at 100 F Street, N.E.,
Washington, D.C. 20549 and at the regional offices of the SEC located at 233
Broadway, New York, New York 10279 and at the Northwestern Atrium Center, 500
West Madison Street, Suite 1400, Chicago, Illinois 60661. You may also obtain
copies of such materials from the Public Reference Section of the SEC, Room
1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, at
prescribed rates. You may call the SEC at 1-800-SEC-0330 for further information
on the public reference rooms. The SEC maintains a Web site (http://www.sec.gov)that
contains reports, proxy and information statements and other information
regarding registrants that file electronically with the SEC. Although we make
many of our filings with the SEC electronically as a foreign private issuer, we
are not obligated to do so.





You may
read and copy any reports, statements or other information that we file with the
SEC at the addresses indicated above and you may also access them electronically
at the Web site set forth above. These SEC filings are also available to the
public from commercial document retrieval services.





We are
required to file reports and other information with the SEC under the Securities
Exchange Act of 1934. Reports and other information filed by us with the SEC may
be inspected and copied at the SEC’s public reference facilities described
above. As a foreign private issuer, we are exempt from the rules under the
Exchange Act prescribing the furnishing and content of proxy statements and our
officers, Directors and principal shareholders are exempt from the reporting and
short-swing profit recovery provisions contained in Section 16 of the Exchange
Act. Under the Exchange Act, as a foreign private issuer, we are not required to
publish financial statements as frequently or as promptly as United States
companies.








I. Subsidiary
Information





See Item
4.C. of this annual report.







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 Table of Contents




Item 11.
                Qualitative
      and Quantitative Disclosures about Market
Risk


Market
Risk





Currency
Risk





Our
measurement currency is the Canadian dollar. We are exposed to currency risks
due to the export of our Canadian-manufactured products, the large majority
of which are denominated in US dollars. These risks are partially hedged by
operating expenses denominated in US dollars, the purchase of raw materials
in US dollars and forward exchange contracts. The increased strength of the
Canadian dollar, compared to the US dollar, over the last couple of years caused
our operating expenses to increase as some of these expenses are denominated in
Canadian dollars. Any further increase in the value of the Canadian dollar in
the upcoming months will negatively affect our results of
operations.





We enter
into forward exchange contracts to manage the risk of exchange rate fluctuations
between the Canadian and US dollar on cash flows related to anticipated future
revenue streams denominated in US dollars. We do not enter into forward
exchange contracts for hedging purposes.





The
following table summarizes the forward exchange contracts in effect as at
August 31, 2008, classified by expected transaction dates, none of which
exceed three fiscal  years, as well as the notional amounts of such
contracts (in thousands of US dollars) along with the weighted average
contractual forward rates under such contracts. The notional amounts of such
contracts are used to calculate the contractual payments to be made under these
contracts.





Years
      ending August 31,2009
            
            
            2010
            
            
            2011Forward
      exchange contracts to sell US dollars in exchange for Canadian
      dollars
              Contractual
      amounts
            
            $
            36,600
            
            
            $
            17,400
            
            
            $
            2,400Weighted
      average contractual forward rates
            
            
            1.0686
            
            
            
            1.0535
            
            
            
            1.0619





Fair
Value





The fair
value of forward exchange contracts, which represents the amount we would
receive or pay to settle the contracts based on the exchange rate at year end,
amounted to net gains of $62,000 as at August 31, 2008 ($3.4 million as at
August 31, 2007).





Interest
rate and liquidity risks





We are
exposed to the impact of interest rate changes and changes in the market values
of our short-term investments. We do not use derivative financial instruments
for our short-term investments. As at August 31, 2008, our short-term
investments consist of commercial paper issued by ten (seven as of August 31,
2007) high-credit quality corporations and trusts; therefore, we consider the
risk of non-performance of these financial instruments to be limited. None of
these debts instruments are expected to be affected by a liquidity risk and none
of them represent asset-backed commercial paper. For the purposes of managing
our cash position, we have established a cash management policy, which we follow
and monitor on a regular basis. These short-term investments will be used for
working capital and other general corporate purposes, including other potential
acquisitions.








112
 Table of Contents





Credit
risk





Financial
instruments that potentially subject us to credit risk consist primarily of our
cash, our short-term investments, our accounts receivable and our forward
exchange contracts. As mentioned in the interest rate risk section, our
short-term investments consist of debt instruments issued by high credit
quality, corporations and trusts. Our cash and forward exchange contracts are
held with or issued by high credit quality, financial institutions; therefore,
we consider the risk of non-performance on these instruments to be
limited.





Generally,
we do not require collateral or other security from customers for trade accounts
receivable; however, credit is extended to customers following an evaluation of
creditworthiness. In addition, we perform ongoing credit reviews of all our
customers and establish an allowance for doubtful accounts receivable when
accounts are determined to be uncollectible. Allowance for doubtful accounts
amounted to $206,000 and $305,000 as at August 31, 2007 and 2008,
respectively.







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 Table of Contents


Item 12.
                  Description
      of Securities Other than Equity
Securities




Not
Applicable.











PART
II.


Item 13.
                    Defaults,
      Dividends Arrearages and
Delinquencies


Not
Applicable.


Item 14.
                    Material
      Modifications to the Rights of Security Holders and Use of
      Proceeds






Not
Applicable.


Item 15.
                    Controls
      and Procedures






(a)
Evaluation of Disclosure Controls and Procedures





Under the
supervision and with the participation of our management, including the Chief
Executive Officer and Chief Financial Officer, we have evaluated the
effectiveness of our disclosure controls and procedures as at the end of the
period covered by this annual report. Based on that evaluation, the Chief
Executive Officer and Chief Financial Office have concluded that these
disclosure controls and procedures are effective as at August 31,
2008.





(b)
Management’s Annual Report on Internal Control over Financial
Reporting





EXFO
management is responsible for establishing and maintaining adequate internal
control over financial reporting. EXFO’s internal control over financial
reporting is a process designed to provide reasonable assurance regarding the
reliability of financial reporting and the preparation of financial statements
for external purposes in accordance with generally accepted accounting
principles in Canada.1





EXFO’s
internal control over financial reporting includes those policies and procedures
that (i) pertain to the maintenance of records that, in reasonable detail,
accurately and fairly reflect the transactions and dispositions of the assets of
EXFO; (ii) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles in Canada, and that receipts and
expenditures of the company are being made only in accordance with
authorizations of management and directors of EXFO; and (iii) provide reasonable
assurance regarding prevention or timely detection of unauthorized
acquisition, use, or disposition of EXFO’s assets that could have a material
effect on the financial statements.





Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.





1
              Our consolidated financial
      statements are prepared in accordance with generally accepted accounting
      principles in Canada (“Canadian GAAP”) and significant differences in
      measurement and disclosure from generally accepted accounting principles
      in United States (“U.S. GAAP”) are set out in note 19 to our
      consolidated financial statements included elsewhere in this annual
      report.





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The
recent acquisitions of Navtel Communications Inc. and Brix Networks Inc. have
been excluded from management’s assessment of internal controls as at August 31,
2008, because these companies were acquired by EXFO in March and April 2008,
respectively; therefore, it was not possible for management to assess their
internal control over financial reporting in the period between the consummation
dates and the date of management’s assessment. Navtel is
a wholly-owned subsidiary of the company whose total assets and total revenues
represent 0.3% and 0.7%, respectively, of the related consolidated financial
statements as at and for the year ended August 31, 2008.  Brix is a
wholly-owned subsidiary of the company whose total assets and total revenues
represent 1.0% and 2.2%, respectively, of the related consolidated financial
statements as at and for the year ended August 31, 2008.




Management
conducted an evaluation of the effectiveness of EXFO’s internal control over
financial reporting based on the criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO). Based on this evaluation, management concluded that
EXFO’s internal control over financial reporting was effective as at
August 31, 2008.





Our
independent registered public accounting firm, PricewaterhouseCoopers LLP,
independently assessed the effectiveness of EXFO’s internal control over
financial reporting. They have issued an attestation report, which is included
on page F-1 of this Annual Report on Form 20-F.





(c)
Changes in Internal Control over Financial Reporting





There
were no changes in our internal control over financial reporting during the
period covered by this annual report that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.







115
 Table of Contents





Item 16.
            [Reserved]




Item 16A.
            Audit
      Committee Financial
Expert


Our Board
of Directors has determined that Mr. André Tremblay, CA, chairman of our audit
committee is an audit committee financial expert. Mr. Tremblay is
independent of management. For a description of Mr. Tremblay’s
education and experience, please refer to Item 6A. The other members of the
Audit Committee are Mr. Pierre Marcouiller, Mr. Guy Marier and Mr. Michael Unger
until June 2008, and Mr. David A. Thompson joined in April 2008, all of whom are
independent. For a description of their respective education and
experience, please also refer to Item 6A.








Item 16B.
            Code
      of Ethics




In 2003,
we adopted a code of ethics that applies to our chief executive officer, our
chief financial officer and our manager of financial reporting and accounting. A
copy of this code of ethics has been filed as exhibit 11.1 to our fiscal
year 2005 annual report. In March 2005, the Board updated and adopted the
following policies:





·
            Board
      of Directors Corporate Governance
Guidelines;


·
            Code
      of Ethics for our Principal Executive Officer and Senior Financial
      Officers;


·
            Ethics
      and Business Conduct Policy;


·
            Statement
      of Reporting Ethical Violations (Whistle
  Blower).





A copy of
those policies has been filed respectively as exhibits 11.2 through 11.5
inclusively to our fiscal year 2005 annual report. All these policies are also
readily available on our website at www.EXFO.com. Accordingly, we believe that
our corporate governance practices are in alignment to current regulatory
requirements. We will provide without charge to each person, on the written or
oral request of such person, a copy of our code of ethics. Requests for
such copies should be directed to us at the following address: 400 Godin Avenue,
Quebec, Quebec, G1M 2K2, Canada, Attention: Corporate Secretary, telephone
number (418) 683-0211.





As
reported at item 7B of this annual report, previous to the coming into force of
the requirement for a code of ethics, we had entered into a lease agreement with
G. Lamonde Investissements financiers inc., a company controlled by our chief
executive officer, for premises located at 465 Godin Avenue in Quebec City,
Quebec and on September 1, 2004, we were released from our obligations under
this lease with a final payment of $194,000. In addition, in September
2002, we acquired from G. Lamonde Investissements financiers inc. the building
located at 436 Nolin Street. The purchase price paid was based on an independent
third party valuation and the transaction was approved by our audit committee
and Board of Directors with Mr. Lamonde abstaining.








Item 16C.
            Principal Accountant Fees and
      Services


Audit
Fees





During
the financial years ended August 31, 2007 and August 31, 2008, our principal
accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $190,000
and $239,000 respectively for the audit of our annual consolidated
financial statements and services in connection with statutory and regulatory
filings.





Audit-Related
Fees





During
the financial years ended August 31, 2007 and August 31, 2008, our principal
accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $313,000
and $128,000, respectively for services mainly related to Sarbanes-Oxley
Act.








116
 Table of Contents





Tax
Fees





During
the financial years ended August 31, 2007 and August 31, 2008, our principal
accountant, PricewaterhouseCoopers LLP, billed us aggregate amounts of $135,000
and $142,000, respectively for services related to tax compliance, tax advice
and tax planning.





All
Other Fees





Not
applicable.





Audit
Committee Pre-Approval Policies and Procedures





On
September 25, 2002, our audit committee adopted a policy requiring prior
approval by the audit committee of the annual audit plan and fees which has been
integrated in the Audit Committee Charter (refer to Item 6C for further details
on the Audit Committee Charter). In the event any adjustments to audit fees may
be required during the course of a financial year, such adjustments shall be
approved by the chairman of the audit committee, acting alone, and shall be
reported to the full audit committee at its next meeting.





In the
case of non-audit fees (excluding tax matters), the policy provides that
proposals shall be submitted to the chairman of the audit committee and our
chief financial officer at the same time and the chairman of the audit committee
will be responsible for approval of such proposal, subject to any modifications
that he may require. The chairman will make a report to the full audit
committee at its next meeting.





As
concerns tax services to be provided by our principal accountant, our policy
provides that the principal accountant will present to the audit committee for
pre-approval, on or before the beginning of each financial year,
an engagement for tax matters that are foreseeable for the upcoming year
and the audit committee shall be responsible for pre-approval thereof,
subject to any modifications it may make to such proposals. In the event tax
services are required that were not pre-approved by the audit committee, the
procedure set forth in the previous paragraph will apply.





During
the financial year ended on August 31, 2008, 100% of tax fees were approved by
the audit committee pursuant to this policy. During the financial year ended on
August 31, 2008, only full-time permanent employees of our principal accountant,
PricewaterhouseCoopers LLP, performed work to audit our financial
statements.




Item 16D.
            Exemptions from the Listing
      Standards for Audit
Committees


Not
Applicable.







Item 16E.
            Purchases of Equity Securities
      by the Issuer and Affiliated
Purchasers


Not
Applicable.









PART
III.






Item 17.
            Financial
      Statements




Not
Applicable.





Item 18.
            Financial
      Statements




See pages
F-3 to F-43.







117
 Table of Contents





Item 19.
            Exhibits


Number
            Exhibit1.1
            Amended
      Articles of Incorporation of EXFO (incorporated by reference to Exhibit
      3.1 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
      File No. 333-38956).1.2
            Amended
      By-laws of EXFO (incorporated by reference to Exhibit 1.2 of EXFO’s annual
      report on Form-20F dated January 15, 2003, File No.
      000-30895).1.3
            Amended
      and Restated Articles of Incorporation of EXFO (incorporated by reference
      to Exhibit 1.3 of EXFO’s annual report on Form 20-F dated January 18,
      2001, File No. 000-30895).2.1
            Form
      of Subordinate Voting Share Certificate (incorporated by reference to
      Exhibit 4.1 of EXFO’s Registration Statement on Form F-1 filed on June 9,
      2000, File No. 333-38956).2.2
            Form
      of Registration Rights Agreement between EXFO and Germain Lamonde dated
      July 6, 2000 )  (incorporated by reference to Exhibit 10.13 of
      EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No.
      333-38956).3.1
            Form
      of Trust Agreement among EXFO, Germain Lamonde, GEXFO Investissements
      Technologiques inc., Fiducie Germain Lamonde and G. Lamonde
      Investissements Financiers inc. (incorporated by reference to Exhibit
      4.2  of EXFO’s Registration Statement on Form F-1 filed on June
      9, 2000, File No. 333-38956).4.1
            Agreement
      of Merger and Plan of Reorganization, dated as of November 4, 2000, by and
      among EXFO, EXFO Sub, Inc., EXFO Burleigh Instruments, Inc., Robert G.
      Klimasewski, William G. May, Jr., David J. Farrell and William S. Gornall
      (incorporated by reference to Exhibit 4.1 of EXFO’s annual report on Form
      20-F dated January 18, 2001, File No. 000-30895).4.2
            Amendment
      No. 1 to Agreement of Merger and Plan of Agreement, dated as of December
      20, 2000, by and among EXFO, EXFO Sub, Inc., EXFO Burleigh Instruments,
      Inc., Robert G. Klimasewski, William G. May, Jr., David J. Farrell and
      William S. Gornall (incorporated by reference to Exhibit 4.2 of EXFO’s
      annual report on Form 20-F dated January 18, 2001, File No.
      000-30895).4.3
            Agreement
      of Merger, dated as of August 20, 2001, by and among EXFO, Buyer Sub, and
      Avantas Networks Corporation and Shareholders of Avantas Networks
      corporation (incorporated by reference to Exhibit 4.3 of EXFO’s annual
      report on Form 20-F dated January 18, 2002, File No.
      000-30895).4.4
            Amendment
      No. 1 dated as of November 1, 2002 to Agreement of Merger, dated as of
      August 20, 2001, by and among EXFO, 3905268 Canada Inc., Avantas Networks
      Corporation and Shareholders of Avantas Networks (incorporated by
      reference to Exhibit 4.4 of EXFO’s annual report on Form 20-F dated
      January 18, 2002, File No. 000-30895).4.5
            Offer
      to purchase shares of Nortech Fibronic Inc., dated February 6, 2000 among
      EXFO, Claude Adrien Noel, 9086-9314 Québec inc., Michel Bédard, Christine
      Bergeron and Société en Commandite Capidem Québec Enr. and Certificate of
      Closing, dated February 7, 2000 among the same parties (including summary
      in English) (incorporated by reference to Exhibit 10.2 of EXFO’s
      Registration Statement on Form F-1 filed on June 9, 2000, File No.
      333-38956).4.6
            Share
      Purchase Agreement, dated as of March 5, 2001, among EXFO Electro-Optical
      Engineering, Inc., John Kennedy, Glenn Harvey and EFOS Corporation
      (incorporated by reference to Exhibit 4.1 of EXFO’s Registration Statement
      on Form F-3 filed on July 13, 2001, File No. 333-65122).4.7
            Amendment
      Number One, dated as of March 15, 2001, to Share Purchase Agreement, dated
      as of March 5, 2001, among EXFO Electro-Optical Engineering, Inc., John
      Kennedy, Glenn Harvey and EFOS Corporation. (incorporated by reference to
      Exhibit 4.2 of EXFO’s Registration Statement on Form F-3 filed on July 13,
      2001, File No. 333-65122).4.8
            Share
      Purchase Agreement, dated as of November 2, 2001 between JDS Uniphase Inc.
      and 3905268 Canada Inc. (incorporated by reference to Exhibit 4.8 of
      EXFO’s annual report on Form 20-F dated January 18, 2002, File No.
      000-30895).4.9
            Intellectual
      Property Assignment and Sale Agreement between EFOS Inc., EXFO
      Electro-Optical Engineering, Inc., John Kennedy, Glenn Harvey and EFOS
      Corporation. (incorporated by reference to Exhibit 4.3 of EXFO’s
      Registration Statement on Form F-3 filed on July 13, 2001, File No.
      333-65122).4.10
            Offer
      to acquire a building, dated February 23, 2000, between EXFO and Groupe
      Mirabau inc. and as accepted by Groupe Mirabau inc. on February 24, 2000
      (including summary in English) (incorporated by reference to Exhibit 10.3
      of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File
      No. 333-38956).








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4.11
            Lease
      Agreement, dated December 1, 1996, between EXFO and GEXFO Investissements
      Technologiques inc., as assigned to 9080-9823 Québec inc. on September 1,
      1999 (including summary in English) (incorporated by reference to Exhibit
      10.4 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
      File No. 333-38956).4.12
            Lease
      Agreement, dated March 1, 1996, between EXFO and GEXFO Investissements
      Technologiques inc., as assigned to 9080-9823 Québec inc. on September 1,
      1999 (including summary in English) (incorporated by reference to Exhibit
      10.5 of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000,
      File No. 333-38956).4.13
            Lease
      renewal of the existing leases between 9080-9823 Québec inc. and EXFO,
      dated November 30, 2001(incorporated by reference to Exhibit 4.13 of
      EXFO’s annual report on Form 20-F dated January 18, 2002, File No.
      000-30895).4.14
            Loan
      Agreement between EXFO and GEXFO Investissements Technologiques inc.,
      dated May 11, 1993, as assigned to 9080-9823 Québec inc. on September
      1, 1999 (including summary in English)  (incorporated by
      reference to Exhibit 10.9 of EXFO’s Registration Statement on Form F-1
      filed on June 9, 2000, File No. 333-38956).4.15
            Resolution
      of the Board of Directors of EXFO, dated September 1, 1999, authorizing
      EXFO to acquire GEXFO Distribution Internationale inc. from GEXFO
      Investissements Technologiques inc. (including summary in English)
      (incorporated by reference to Exhibit 10.10 of EXFO’s Registration
      Statement on Form F-1 filed on June 9, 2000, File No.
      333-38956).4.16
            Form
      of Promissory Note of EXFO issued to GEXFO Investissements Technologiques
      inc. dated June 27, 2000 )  (incorporated by reference to
      Exhibit 10.12 of EXFO’s Registration Statement on Form F-1 filed on June
      9, 2000, File No. 333-38956).4.17
            Term
      Loan Offer, dated March 28, 2000, among EXFO and National Bank of Canada
      as accepted by EXFO on April 3, 2000 (including summary in English)
      (incorporated by reference to Exhibit 10.11 of EXFO’s Registration
      Statement on Form F-1 filed on June 9, 2000, File No.
      333-38956).4.18
            Employment
      Agreement of Germain Lamonde dated May 29, 2000 (incorporated by reference
      to Exhibit 10.15 of EXFO’s Registration Statement on Form F-1 filed on
      June 9, 2000, File No. 333-38956).4.19
            Employment
      Agreement of Bruce Bonini dated as of September 1, 2000 (incorporated by
      reference to Exhibit 4.24 of EXFO’s annual report on Form 20-F dated
      January 18, 2002, File No. 000-30895).4.20
            Employment
      Agreement of Juan-Felipe Gonzalez dated as of September 1, 2000
      (incorporated by reference to Exhibit 4.25 of EXFO’s annual report on Form
      20-F dated January 18, 2002, File No. 000-30895).4.21
            Employment
      Agreement of David J. Farrell dated as of December 20, 2000 (incorporated
      by reference to Exhibit 4.26 of EXFO’s annual report on Form 20-F dated
      January 18, 2002, File No. 000-30895).4.22
            Deferred
      Profit Sharing Plan, dated September 1, 1998 (incorporated by reference to
      Exhibit 10.6 of EXFO’s Registration Statement on Form F-1 filed on June 9,
      2000, File No. 333-38956).4.23
            Stock
      Option Plan, dated May 25, 2000 (incorporated by Reference to Exhibit 10.7
      of EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File
      No. 333-38956).4.24
            Share
      Plan, dated April 3, 2000 (incorporated by reference to Exhibit 10.8 of
      EXFO’s Registration Statement on Form F-1 filed on June 9, 2000, File No.
      333-38956).4.25
            Directors’
      Compensation Plan (incorporated by reference to Exhibit 10.17 of EXFO’s
      Registration Statement on Form F-1 filed on June 9, 2000, File No.
      333-38956).4.26
            Restricted
      Stock Award Plan, dated December 20, 2000 (incorporated by reference to
      Exhibit 4.21 of EXFO’s annual report on Form 20-F dated January 18, 2001,
      File No. 000-30895).4.27
            Asset
      Purchase Agreementby and Among EXFO
      Electro-Optical Engineering Inc., EXFO Gnubi Products Group Inc., gnubi
      communications, L.P., gnubi communications General Partner, LLC, gnubi
      communications Limited Partner, LLC, gnubi communications, Inc., Voting
      Trust created by The Irrevocable Voting Trust Agreement Among Carol
      Abraham Bolton, Paul Abraham and James Ray Stevens, James Ray Stevens and
      Daniel J. Ernst dated September 5, 2002 (incorporated by reference to
      Exhibit 4.30 of EXFO’s annual report on Form 20-F dated January 15, 2003,
      File No. 000-30895).4.28
            EXFO
      Protocol Inc. Executive Employment Agreement with Sami Yazdi signed
      November 2, 2001 (incorporated by reference to Exhibit 4.28 of EXFO’s
      annual report on Form 20-F dated January 15, 2003, File No.
      000-30895).4.29
            Second
      Amending Agreement to the Employment Agreement of Bruce Bonini dated as of
      September 1, 2002, (incorporated by reference to Exhibit 4.29 of EXFO’s
      annual report on Form 20-F dated January 15, 2004, File No.
      000-30895).








119
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4.30
            Severance
      and General Release Agreement with Bruce Bonini dated August 8, 2003,
      (incorporated by reference to Exhibit 4.30 of EXFO’s annual report on Form
      20-F dated January 15, 2004, File No. 000-30895).4.31
            Separation
      Agreement and General Release with Sami Yazdi dated April 1, 2003,
      (incorporated by reference to Exhibit 4.31 of EXFO’s annual report on Form
      20-F dated January 15, 2004, File No. 000-30895).4.32
            Executive
      Employment Agreement of James Stevens dated as of October 4, 2003,
      (incorporated by reference to Exhibit 4.32 of EXFO’s annual report on Form
      20-F dated January 15, 2004, File No. 000-30895).4.33
            Termination
      Terms for John Holloran Jr. dated May 28, 2003, (incorporated by reference
      to Exhibit 4.33 of EXFO’s annual report on Form 20-F dated January 15,
      2004, File No. 000-30895).4.34
            Employment
      Agreement of Pierre Plamondon dated as of September 1, 2002, (incorporated
      by reference to Exhibit 4.34 of EXFO’s annual report on Form 20-F dated
      January 15, 2004, File No. 000-30895).4.35
            Long-Term
      Incentive Plan, dated May 25, 2000, amended in October 2004 and effective
      January 12, 2005 (incorporated by reference to Exhibit 4.35 of EXFO’s
      annual report on Form 20-F dated November 29, 2005, File No.
      000-30895).4.36
            Deferred
      Share Unit Plan, effective January 12, 2005 (incorporated by reference to
      Exhibit 4.36 of EXFO’s annual report on Form 20-F dated November 29, 2005,
      File No. 000-30895).4.37
            Asset
      Purchase Agreement by and Among EXFO Electro-Optical Engineering Inc.,
      Consultronics Limited., Andre Rekai, Consultronics Europe Limited,
      Consultronics Development Kft. and Consultronics Inc. dated January 5,
      2006 (incorporated by reference to Exhibit 4.37 of EXFO’s annual report on
      Form 20-F dated November 23, 2006, File No. 000-30895).4.38
            Share
      Purchase Agreement by and Among EXFO Electro-Optical Engineering Inc.,
      Navtel Communications Inc. and Vengrowth Investment Fund, BDC Capital Inc.
      and others, dated March 26, 2008 (incorporated by reference to Exhibit
      4.38 of EXFO’s annual report on Form 20-F dated November 26, 2008, File
      No. 000-30895).4.39
            Agreement
      and Plan of Merger by and among Gexfo Distribution Internationale Inc.,
      EXFO Service Assurance Inc. and Brix Networks, Inc. and Charles River
      Ventures, LLC dated April 2, 2008 (incorporated by reference to EXFO’s
      Material Change Report on Form 6-K dated May 2, 2008, File No.
      000-30895).4.40
            Issuer
      Tender Offer, Letter of Transmittal and Notice of Guaranteed Delivery
      dated November 10, 2008 (incorporated by reference as Exhibits (a) (1)
      (i), (a) (1) (ii) and (a) (1) (iii) to EXFO’s Schedule TO dated November
      10, 2008, File No. 000-30895).8.1
            Subsidiaries
      of EXFO (list included in Item 4C of this annual report).11.1
            Code
      of Ethics for senior financial officers, (incorporated by reference to
      Exhibit 11.1 of EXFO’s annual report on Form 20-F dated January 15, 2004,
      File No. 000-30895).11.2
            Board
      of Directors Corporate Governance Guidelines (incorporated by reference to
      Exhibit 11.2 of EXFO’s annual report on Form 20-F dated November 29, 2005,
      File No. 000-30895).11.3
            Code
      of Ethics for our Principal Executive Officer and Senior Financial
      Officers (incorporated by reference to Exhibit 11.3 of EXFO’s annual
      report on Form 20-F dated November 29, 2005, File No.
      000-30895).11.4
            Ethics
      and Business Conduct Policy (incorporated by reference to Exhibit 11.4 of
      EXFO’s annual report on Form 20-F dated November 29, 2005, File No.
      000-30895).11.5
            Statement
      of Reporting Ethical Violations (Whistle Blower) (incorporated by
      reference to Exhibit 11.5 of EXFO’s annual report on Form 20-F dated
      November 29, 2005, File No. 000-30895).11.6
            Audit
      Committee Charter (incorporated by reference to Exhibit 11.6 of EXFO’s
      annual report on Form 20-F dated November 29, 2005, File No.
      000-30895).11.7
            Human
      Resources Committee Charter (incorporated by reference to Exhibit 11.7 of
      EXFO’s annual report on Form 20-F dated November 29, 2005, File No.
      000-30895).12.1
            Certification
      of the Chief Executive Officer Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.12.2
            Certification
      of the Chief Executive Officer Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.13.1
            Certification
      of the Chief Financial Officer Pursuant to Section 302 of the
      Sarbanes-Oxley Act of 2002.13.2
            Certification
      of the Chief Financial Officer Pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002.






120
 Table of Contents





SIGNATURES







The
registrant hereby certifies that it meets all of the requirements for filing on
Form 20 -F and that it has duly caused and authorized the
undersigned to sign this annual report on its behalf.








EXFO
ELECTRO-OPTICAL ENGINEERING INC.








By:     
/s/Germain
Lamonde
 Name: Germain
Lamonde
 Title:  
Chairman of the Board, President
 and Chief Executive Officer





Date:  November 26,
2008.







121
 Table of Contents





Exhibit
12.1


Certification
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002





I,
Germain Lamonde, certify that:




1.
            I
      have reviewed this annual report on Form 20-F of EXFO Electro-Optical
      Engineering Inc. ("EXFO");




2.
            Based
      on my knowledge, this report does not contain any untrue statement of a
      material fact or omit to state a material fact necessary to make the
      statements made, in light of the circumstances under which such statements
      were made, not misleading with respect to the period covered by this
      report;




3.
            Based
      on my knowledge, the financial statements, and other financial information
      included in this report, fairly present in all material respects the
      financial condition, results of operations and cash flows of EXFO as at,
      and for, the periods presented in this
report;




4.
            EXFO's
      other certifying officer and I are responsible for establishing and
      maintaining disclosure controls and procedures (as defined in Exchange Act
      Rules 13a-15(e) and 15d-15(e)) and internal control over financial
      reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))
      for EXFO and have:




a.
            Designed
      such disclosure controls and procedures or caused such disclosure controls
      and procedures to be designed under our supervision, to ensure that
      material information relating to EXFO, including its consolidated
      subsidiaries, is made known to us by others within those entities,
      particularly during the period in which this report is being
      prepared;




b.
            Designed
      such internal control over financial reporting, or caused such internal
      control over financial reporting to be designed under our supervision, to
      provide reasonable assurance regarding the reliability of financial
      reporting and the preparation of financial statements for external
      purposes in accordance with generally accepted accounting
      principles;




c.
            Evaluated
      the effectiveness of EXFO's disclosure controls and procedures and
      presented in this report our conclusions about the effectiveness of the
      disclosure controls and procedures, as at the end of the period covered by
      this report based on such evaluation;
and




d.
            Disclosed
      in this report any change in EXFO's internal control over financial
      reporting that occurred during the period covered by the annual report
      that has materially affected, or is reasonably likely to materially
      affect, EXFO's internal control over financial
  reporting.




5.
            EXFO's
      other certifying officer and I have disclosed, based on our most recent
      evaluation of internal control over financial reporting, to EXFO's
      auditors and the audit committee of EXFO's board of
    directors:




a.
            All
      significant deficiencies and material weaknesses in the design or
      operation of internal control over financial reporting which are
      reasonably likely to adversely affect EXFO's ability to record, process,
      summarize and report financial information;
and




b.
            Any
      fraud, whether or not material, that involves management or other
      employees who have a significant role in EXFO’s internal control over
      financial reporting.







Date:
November 26, 2008








/s/Germain
Lamonde


Germain
Lamonde


Chairman
of the Board,


President
and Chief Executive Officer


(Principal
Executive Officer)







122
 Table of Contents





Exhibit
12.2


Certification
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002





Pursuant
to section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of
section 1350, chapter 63 of title 18, United States Code), the undersigned
officer of EXFO, hereby certifies, that:





1.
            The
      annual report of Form 20-F for the year ended August 31, 2008 of EXFO
      fully complies with the requirements of section 13(a) or 15(d) of the
      Securities Exchange Act of 1934;
and





2.
            The
      information contained in this annual report fairly presents, in all
      material respects, the financial condition and results of operations of
      EXFO.








Date:   
November 26, 2008.











/s/Germain
Lamonde


Germain
Lamonde


Chairman
of the Board,


President
and Chief Executive Officer


(Principal
Executive Officer)





The
foregoing certification is being furnished solely pursuant to section 906 of the
Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350,
chapter 63 of title 18, United States Code) and is not being filed as part
of the Report or as separate disclosure document.








123
 Table of Contents





Exhibit
13.1


Certification
pursuant to Section 302 of the Sarbanes-Oxley Act of 2002





I, Pierre
Plamondon, certify that:




1.
            I
      have reviewed this annual report on Form 20-F of EXFO Electro-Optical
      Engineering Inc. ("EXFO");




2.
            Based
      on my knowledge, this report does not contain any untrue statement of a
      material fact or omit to state a material fact necessary to make the
      statements made, in light of the circumstances under which such statements
      were made, not misleading with respect to the period covered by this
      report;




3.
            Based
      on my knowledge, the financial statements, and other financial information
      included in this report, fairly present in all material respects the
      financial condition, results of operations and cash flows of EXFO as at,
      and for, the periods presented in this
report;




4.
            EXFO's
      other certifying officer and I are responsible for establishing and
      maintaining disclosure controls and procedures (as defined in Exchange Act
      Rules 13a-15(e) and 15d-15(e)) and internal control over financial
      reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f))
      for EXFO and have:




a.
            Designed
      such disclosure controls and procedures or caused such disclosure controls
      and procedures to be designed under our supervision, to ensure that
      material information relating to EXFO, including its consolidated
      subsidiaries, is made known to us by others within those entities,
      particularly during the period in which this report is being
      prepared;




b.
            Designed
      such internal control over financial reporting, or caused such internal
      control over financial reporting to be designed under our supervision, to
      provide reasonable assurance regarding the reliability of financial
      reporting and the preparation of financial statements for external
      purposes in accordance with generally accepted accounting
      principles;




c.
            Evaluated
      the effectiveness of EXFO's disclosure controls and procedures and
      presented in this report our conclusions about the effectiveness of the
      disclosure controls and procedures, as at the end of the period covered by
      this report based on such evaluation;
and




d.
            Disclosed
      in this report any change in EXFO's internal control over financial
      reporting that occurred during the period covered by the annual report
      that has materially affected, or is reasonably likely to materially
      affect, EXFO's internal control over financial
  reporting.




5.
            EXFO's
      other certifying officer and I have disclosed, based on our most recent
      evaluation of internal control over financial reporting, to EXFO's
      auditors and the audit committee of EXFO's board of
    directors:




a.
            All
      significant deficiencies and material weaknesses in the design or
      operation of internal control over financial reporting which are
      reasonably likely to adversely affect EXFO's ability to record, process,
      summarize and report financial information;
and




b.
            Any
      fraud, whether or not material, that involves management or other
      employees who have a significant role in EXFO's internal control over
      financial reporting.







Date:
November 26, 2008








/s/Pierre
Plamondon


Pierre
Plamondon, CA


Vice-President
Finance


and Chief
Financial Officer


(Principal
Financial Officer)







124
 Table of Contents





Exhibit
13.2


Certification
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002





Pursuant
to section 906 of the Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of
section 1350, chapter 63 of title 18, United States Code), the undersigned
officer of EXFO, hereby certifies, that:





1.
            The
      annual report of Form 20-F for the year ended August 31, 2008 of EXFO
      fully complies with the requirements of section 13(a) or 15(d) of the
      Securities Exchange Act of 1934;
and





2.
            The
      information contained in this annual report fairly presents, in all
      material respects, the financial condition and results of operations of
      EXFO.








Date:   
November 26, 2008.











/s/Pierre
Plamondon


Pierre
Plamondon, CA


Vice-President
Finance


and Chief
Financial Officer


(Principal
Financial Officer)





The
foregoing certification is being furnished solely pursuant to section 906 of the
Sarbanes-Oxley Act of 2002 (subsections (a) and (b) of section 1350,
chapter 63 of title 18, United States Code) and is not being filed as part
of the Report or as separate disclosure document.







125
 Table of Contents


Report
of the Independent Registered Public Accounting Firm
  
  To
the Shareholders of
 EXFO
Electro-Optical Engineering Inc.
   We have
completed integrated audits of the consolidated financial statements and
internal control over financial reporting of EXFO Electro-Optical Engineering
Inc. as at August 31, 2008 and 2007 and an audit of its 2006
consolidated financial statements. Our opinions, based on our audits, are
presented below.
  Consolidated
financial statements
  We have
audited the accompanying consolidated balance sheets of EXFO Electro-Optical
Engineering Inc.as
at August 31, 2008 and 2007, and the related consolidatedstatements of earnings,
comprehensive income and accumulated other comprehensive income, retained
earnings (deficit) and contributed surplus and cash flowsfor each of the years in
the three-year period ended August 31, 2008. We have also audited the
financial statement schedule, Valuation and Qualifying Accounts, in Item 8.A. of
this Annual Report on Form 20-F. These consolidated financial statements and
financial statement schedule are the responsibility of the Company's management.
Our responsibility is to express an opinion on these consolidated financial
statements and financial statement schedule based on our audits.
  We
conducted our audits of the Company's financial statements in accordance with
Canadian generally accepted auditing standards and the standards of the Public
Company Accounting Oversight Board (United States). Those standards require that
we plan and perform an audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit of financial
statements includes examining, on a test basis, evidence supporting the amounts
and disclosures in the financial statements. A financial statement audit also
includes assessing the accounting principles used and significant estimates made
by management, and evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
  In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as at August 31,
2008 and 2007 and the results of its operations and its cash flows for each of
the years in the three-year period ended August 31, 2008in accordance with
Canadian generally accepted accounting principles. Furthermore, in our opinion,
the financial statement schedule, Valuation and Qualifying Accounts, in Item
8.A. of this Annual Report on Form 20-F presents fairly, in all material
respects, the information set forth therein when read in conjunction with the
related consolidated financial statements.
  As
discussed in Note 2 to the consolidated financial statements, the Company
changed its accounting policies related to financial instruments.
  Internal
control over financial reporting
  We have
also audited EXFO Electro-Optical Engineering Inc.'s internal control over
financial reporting as at August 31, 2008, based on criteria established in
InternalControl —Integrated Frameworkissued by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO). The
Company's management is responsible for maintaining effective internal control
over financial reporting and for its assessment of the effectiveness of internal
control over financial reporting. Our responsibility is to express an opinion on
the effectiveness of the Company's internal control over financial reporting
based on our audit.




F-1
 Table of Contents


We
conducted our audit of internal control over financial reporting in accordance
with the standards of the Public Company Accounting Oversight Board (United
States). Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether effective internal control over financial
reporting was maintained in all material respects. An audit of internal control
over financial reporting includes obtaining an understanding of internal control
over financial reporting, assessing the risk that a material weakness exists,
testing and evaluating the design and operating effectiveness of internal
control based on the assessed risk, and performing such other procedures as we
consider necessary in the circumstances. We believe that our audit provides a
reasonable basis for our opinion.
  A
company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain
to the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company;
(ii) provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and expenditures of
the company are being made only in accordance with authorizations of management
and directors of the company; and (iii) provide reasonable assurance
regarding prevention or timely detection of unauthorized acquisition, use, or
disposition of the company’s assets that could have a material effect on the
financial statements.
  Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
  As
described in the Management's Report on Internal Control Over Financial
Reporting, management has excluded Navtel Communications Inc. (“Navtel”) and
Brix Networks Inc. (“Brix”) from its assessment of internal control over
financial reporting as of August 31, 2008 because these companies were acquired
by EXFO in March 2008 and April 2008, respectively; therefore, it was not
possible for management to assess their internal control over financial
reporting in the period between the consummation dates and the date of
management's assessment. We have also excluded Navtel and Brix from our audit of
internal control over financial reporting. Navtel is a wholly-owned subsidiary
of the Company whose total assets and total revenues represent 0.3% and 0.7%,
respectively, of the related consolidated financial statements as at and for the
year ended August 31, 2008.  Brix is a wholly-owned subsidiary of the
Company whose total assets and total revenues represent 1.0% and 2.2%,
respectively, of the related consolidated financial statements as at and for the
year ended August 31, 2008.
  In our
opinion, the Company maintained, in all material respects, effective internal
control over financial reporting as at August 31, 2008based on criteria
established in Internal Control — Integrated
Framework issued by the COSO.
  
  /s/
PricewaterhouseCoopers LLP
 Chartered
Accountants
  Quebec,
Quebec, Canada
 October
15, 2008, except as to Note 20 which is as of November 10, 2008




F-2
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Consolidated
Balance Sheets










As
      at August 31,2008
            
            
            2007AssetsCurrent
      assetsCash
            
            $
            5,914
            
            
            $
            5,541Short-term
      investments (notes 8, 11 and 17)
            
            
            81,626
            
            
            
            124,217Accounts
      receivable (notes 8 and 17)Trade
            
            
            31,473
            
            
            
            26,699Other
      (note 17)
            
            
            4,753
            
            
            
            2,479Income
      taxes and tax credits recoverable (notes 3 and 14)
            
            
            4,836
            
            
            
            6,310Inventories
      (notes 5 and 8)
            
            
            34,880
            
            
            
            31,513Prepaid
      expenses
            
            
            1,774
            
            
            
            1,391Future
      income taxes (note 15)
            
            
            9,140
            
            
            
            7,609174,396
            
            
            
            205,759Tax credits recoverable(notes 3 and 14)
            
            
            20,657
            
            
            
            −Property, plant and equipment(notes 6 and 8)
            
            
            19,875
            
            
            
            18,117Intangible assets(notes
      7 and 8)
            
            
            19,945
            
            
            
            9,628Goodwill(note
      7)
            
            
            42,653
            
            
            
            28,437Future income taxes(note 15)
            
            
            15,540
            
            
            
            17,197$
            293,066
            
            
            $
            279,138LiabilitiesCurrent
      liabilitiesAccounts
      payable and accrued liabilities (note 9)
            
            $
            24,713
            
            
            $
            22,721Deferred
      revenue
            
            
            5,079
            
            
            
            2,59829,792
            
            
            
            25,319Deferred
      revenue
            
            
            3,759
            
            
            
            3,414Future income taxes(note 15)
            
            
            –
            
            
            
            24033,551
            
            
            
            28,973Commitments (note
      10)Contingencies (note
      11)Shareholders’
      equityShare
      capital (note 12)
            
            
            142,786
            
            
            
            150,019Contributed
      surplus
            
            
            5,226
            
            
            
            4,453Retained
      earnings (note 12)
            
            
            60,494
            
            
            
            42,275Accumulated
      other comprehensive income (note 2)
            
            
            51,009
            
            
            
            53,418259,515
            
            
            
            250,165$
            293,066
            
            
            $
            279,138




The
accompanying notes are an integral part of these consolidated financial
statements.









/s/
      Germain Lamonde
              GERMAIN
      LAMONDE
              Chairman,
      President and CEO
            /s/
      André Tremblay
              ANDRÉ
      TREMBLAY
              Chairman,
      Audit Committee





F-3
 Table of Contents




EXFO
Electro-Optical Engineering Inc. Consolidated
Statements of Earnings






Years
      ended August 31,2008
            
            
            2007
            
            
            2006Sales (note
      18)
            
            $
            183,790
            
            
            $
            152,934
            
            
            $
            128,253Cost of sales(1,2)
            
            
            75,624
            
            
            
            65,136
            
            
            
            57,275Gross
      margin
            
            
            108,166
            
            
            
            87,798
            
            
            
            70,978Operating
      expensesSelling
      and administrative (1)
            
            
            61,153
            
            
            
            49,580
            
            
            
            40,298Net
      research and development (1)(notes 14 and 15)
            
            
            26,867
            
            
            
            16,668
            
            
            
            15,404Amortization
      of property, plant and equipment
            
            
            4,292
            
            
            
            2,983
            
            
            
            3,523Amortization
      of intangible assets
            
            
            3,871
            
            
            
            2,864
            
            
            
            4,394Impairment
      of long-lived assets (note 4)
            
            
            –
            
            
            
            –
            
            
            
            604Government
      grants (note 14)
            
            
            –
            
            
            
            (1,079
            )
            
            
            (1,307
            )Total
      operating expenses
            
            
            96,183
            
            
            
            71,016
            
            
            
            62,916Earnings
      from operations
            
            
            11,983
            
            
            
            16,782
            
            
            
            8,062Interest
      income
            
            
            4,639
            
            
            
            4,717
            
            
            
            3,253Foreign
      exchange gain (loss)
            
            
            442
            
            
            
            (49
            )
            
            
            (595
            )Earnings before income taxes
      and extraordinary gain(note 15)
            
            
            17,064
            
            
            
            21,450
            
            
            
            10,720Income taxes(note
      15)Current
            
            
            (7,094
            )
            
            
            3,741
            
            
            
            2,585Future
            
            
            14,094
            
            
            
            –
            
            
            
            –Recognition
      of previously unrecognized future income tax assets
            
            
            (5,324
            )
            
            
            (24,566
            )
            
            
            –1,676
            
            
            
            (20,825
            )
            
            
            2,585Earnings
      before extraordinary gain
            
            
            15,388
            
            
            
            42,275
            
            
            
            8,135Extraordinary gain(note
      3)
            
            
            3,036
            
            
            
            –
            
            
            
            –Net
      earnings for the year
            
            $
            18,424
            
            
            $
            42,275
            
            
            $
            8,135Basic
      and diluted earnings before extraordinary gain per share
            
            $
            0.22
            
            
            $
            0.61
            
            
            $
            0.12Basic
      and diluted net earnings per share
            
            $
            0.27
            
            
            $
            0.61
            
            
            $
            0.12Basic
      weighted average number of shares outstanding (000’s)
            
            
            68,767
            
            
            
            68,875
            
            
            
            68,643Diluted weighted average number
      of shares outstanding (000’s)(note 16)
            
            
            69,318
            
            
            
            69,555
            
            
            
            69,275(1)  
      Stock-based compensation
      costs included in:Cost
      of sales
            
            $
            148
            
            
            $
            118
            
            
            $
            127Selling
      and administrative
            
            
            830
            
            
            
            633
            
            
            
            701Net
      research and development
            
            
            294
            
            
            
            230
            
            
            
            204$
            1,272
            
            
            $
            981
            
            
            $
            1,032(2)  
      The cost of sales is exclusive of amortization, shown
      separately.










F-4
 Table of Contents




EXFO
Electro-Optical Engineering Inc. Consolidated
Statements of Comprehensive Income and Accumulated
 Other Comprehensive
Income


Comprehensive
      incomeYears
      ended August 31,2008
            
            
            2007
            
            
            2006Net
      earnings for the year
            
            $
            18,424
            
            
            $
            42,275
            
            
            $
            8,135Foreign
      currency translation adjustment
            
            
            (2,289
            )
            
            
            9,881
            
            
            
            13,115Changes
      in unrealized gains (losses) on short-term investments
            
            
            31
            
            
            
            –
            
            
            
            –Unrealized
      gains on forward exchange contracts
            
            
            962
            
            
            
            –
            
            
            
            –Reclassification
      of realized gains on forward exchange contracts in net
      earnings
            
            
            (3,915
            )
            
            
            –
            
            
            
            –Future
      income tax effect of the above items
            
            
            909
            
            
            
            –
            
            
            
            –Comprehensive
      income
            
            $
            14,122
            
            
            $
            52,156
            
            
            $
            21,250











Accumulated
      other comprehensive incomeYears
      ended August 31,2008
            
            
            2007Foreign
      currency translation adjustmentCumulative
      effect of prior years
            
            $
            53,418
            
            
            $
            43,537Current
      year
            
            
            (2,289
            )
            
            
            9,88151,129
            
            
            
            53,418Unrealized
      gains (losses) on forward exchange contractsAdjustment
      related to the implementation of new accounting standards (note
      2)
            
            
            1,948
            
            
            
            –Current
      year, net of realized gains and future income taxes
            
            
            (2,044
            )
            
            
            –(96
            )
            
            
            –Unrealized
      gains (losses) on short-term investmentsAdjustment
      related to the implementation of new accounting standards (note
      2)
            
            
            (55
            )
            
            
            –Current
      year, net of future income taxes
            
            
            31
            
            
            
            –(24
            )
            
            
            –Accumulated
      other comprehensive income
            
            $
            51,009
            
            
            $
            53,418





Total
retained earnings and accumulated other comprehensive income amounted to $95,693
and $111,503 as at August 31, 2007 and 2008, respectively.









F-5
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Consolidated
Statements of Retained Earnings (Deficit) and Contributed Surplus
   
 Retained
      earnings (deficit)Years
      ended August 31,2008
                
                
                2007
                
                
                2006Balance
      – Beginning of year
                
                $
                42,275
                
                
                $
                –
                
                
                $
                (381,846
                )Add
      (deduct)Adjustment
      related to the implementation of new accounting standards (note
      2)
                
                
                55
                
                
                
                –
                
                
                
                –Net
      earnings for the year
                
                
                18,424
                
                
                
                42,275
                
                
                
                8,135Premium
      on redemption of share capital (note 12)
                
                
                (260
                )
                
                
                –
                
                
                
                –Elimination
      of deficit by reduction of share capital (note 12)
                
                
                –
                
                
                
                –
                
                
                
                373,711Balance
      – End of year
                
                $
                60,494
                
                
                $
                42,275
                
                
                $
                –










Contributed
      surplusYears
      ended August 31,2008
            
            
            2007
            
            
            2006Balance
      – Beginning of year
            
            $
            4,453
            
            
            $
            3,776
            
            
            $
            2,949Add
      (deduct)Stock-based
      compensation costs
            
            
            1,287
            
            
            
            973
            
            
            
            1,027Reclassification
      of stock-based compensation costs to share capital upon exercise of stock
      awards (note 12)
            
            
            (514
            )
            
            
            (296
            )
            
            
            (200
            )Balance
      – End of year
            
            $
            5,226
            
            
            $
            4,453
            
            
            $
            3,776









F-6
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Consolidated
Statements of Cash Flows






Years
      ended August 31,2008
              
              
              2007
              
              
              2006Cash
      flows from operating activitiesNet
      earnings for the year
              
              $
              18,424
              
              
              $
              42,275
              
              
              $
              8,135Add
      (deduct) items not affecting cashChange
      in discount on short-term investments
              
              
              1,035
              
              
              
              (404
              )
              
              
              (229
              )Stock-based
      compensation costs
              
              
              1,272
              
              
              
              981
              
              
              
              1,032Amortization
              
              
              8,163
              
              
              
              5,847
              
              
              
              7,917Impairment
      of long-lived assets
              
              
              –
              
              
              
              –
              
              
              
              604Gain
      on disposal of capital assets
              
              
              –
              
              
              
              (117
              )
              
              
              –Deferred
      revenue
              
              
              47
              
              
              
              1,299
              
              
              
              786Government
      grants
              
              
              –
              
              
              
              (752
              )
              
              
              (1,307
              )Future
      income taxes
              
              
              8,770
              
              
              
              (24,566
              )
              
              
              –Extraordinary
      gain
              
              
              (3,036
              )
              
              
              –
              
              
              
              –34,675
              
              
              
              24,563
              
              
              
              16,938Change
      in non-cash operating itemsAccounts
      receivable
              
              
              (4,338
              )
              
              
              (5,468
              )
              
              
              (2,637
              )Income
      taxes and tax credits
              
              
              (12,833
              )
              
              
              (3,403
              )
              
              
              329Inventories
              
              
              (2,166
              )
              
              
              (5,456
              )
              
              
              (2,287
              )Prepaid
      expenses
              
              
              (127
              )
              
              
              85
              
              
              
              79Accounts
      payable and accrued liabilities
              
              
              (1,416
              )
              
              
              4,105
              
              
              
              (144
              )13,795
              
              
              
              14,426
              
              
              
              12,278Cash
      flows from investing activitiesAdditions
      to short-term investments
              
              
              (717,020
              )
              
              
              (807,056
              )
              
              
              (673,289
              )Proceeds
      from disposal and maturity of short-term investments
              
              
              760,310
              
              
              
              793,435
              
              
              
              681,500Additions
      to capital assets
              
              
              (6,508
              )
              
              
              (5,547
              )
              
              
              (3,378
              )Net
      proceeds from disposal of capital assets
              
              
              –
              
              
              
              3,092
              
              
              
              –Business
      combinations, net of cash acquired (note 3)
              
              
              (41,016
              )
              
              
              –
              
              
              
              (18,054
              )(4,234
              )
              
              
              (16,076
              )
              
              
              (13,221
              )Cash
      flows from financing activitiesRepayment
      of long-term debt
              
              
              –
              
              
              
              (472
              )
              
              
              (415
              )Redemption
      of share capital (note 12)
              
              
              (8,068
              )
              
              
              –
              
              
              
              –Exercise
      of stock options
              
              
              61
              
              
              
              802
              
              
              
              557(8,007
              )
              
              
              330
              
              
              
              142Effect
      of foreign exchange rate changes on cash
              
              
              (1,181
              )
              
              
              8
              
              
              
              535Change
      in cash
              
              
              373
              
              
              
              (1,312
              )
              
              
              (266
              )Cash
      – Beginning of year
              
              
              5,541
              
              
              
              6,853
              
              
              
              7,119Cash
      – End of year
              
              $
              5,914
              
              
              $
              5,541
              
              
              $
              6,853Supplementary
      informationInterest
      paid
              
              $
              55
              
              
              $
              57
              
              
              $
              65Income
      taxes paid
              
              $
              759
              
              
              $
              3,527
              
              
              $
              2,541


F-7
 Table of Contents




EXFO
Electro-Optical Engineering Inc. Notes
to Consolidated Financial Statements


1  Nature
of Activities





EXFO
Electro-Optical Engineering Inc. (“EXFO”) designs, manufactures and markets a
line of test and monitoring solutions for network service providers and
equipment manufacturers in the global telecommunications industry.
The Telecom Division, which represents the company’s main business
activity, offers integrated solutions extending across the full technology
lifecycle from design to technology deployment and onto service assurance and
covering all layers of a network infrastructure to enable triple-play
services and next-generation, converged IP networking. The Life Sciences and
Industrial Division offers solutions for medical-device and opto-electronics
assembly, fluorescence microscopy and other life sciences sectors. EXFO’s
products are sold in approximately 95 countries around the
world.








2  Summary
of Significant Accounting Policies





Basis
of presentation





These
consolidated financial statements have been prepared in accordance with
generally accepted accounting principles (“GAAP”) in Canada, and significant
differences in measurement and disclosure from U.S. GAAP are set out in note 19.
These consolidated financial statements include the accounts of the company and
its domestic and international subsidiaries. All significant intercompany
accounts and transactions have been eliminated.





Accounting
estimates





The
preparation of financial statements in accordance with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and the disclosures
of contingent assets and liabilities at the date of the financial
statements, as well as the reported amounts of revenues and expenses during the
reporting years. Significant estimates include the fair value of financial
instruments, the allowance for doubtful accounts receivable, the amount of tax
credits recoverable, the provision for excess and obsolete inventories, the
useful lives of capital assets, the valuation of long-lived assets, the
valuation allowance for future income taxes, the amount of certain accrued
liabilities and deferred revenue as well as stock-based compensation costs.
Actual results could differ from those estimates.





Reporting
currency





The
measurement currency of the company is the Canadian dollar. The company has
adopted the US dollar as its reporting currency. The financial statements
are translated into the reporting currency using the current rate method. Under
this method, the financial statements are translated into the reporting currency
as follows: assets and liabilities are translated at the exchange rate in
effect on the date of the balance sheet, while revenues and expenses are
translated at the monthly average exchange rate. The cumulative foreign currency
translation adjustment arising from such translation is included
in accumulated other comprehensive income in
shareholders’ equity.





In the
event that management decides to declare dividends, such dividends would be
declared in Canadian dollars.





Foreign
currency translation





Foreign
currency transactions





Transactions
denominated in currencies other than the measurement currency are translated
into the relevant measurement currency as follows: monetary assets and
liabilities are translated at the exchange rate in effect on the date of the
balance sheet, and revenues and expenses are translated at the exchange rate in
effect on the date of the transaction. Non-monetary assets and liabilities are
translated at historical rates. Foreign exchange gains and losses arising from
such translation are reflected in the statements of earnings.







F-8
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements


Integrated
foreign operations





The
financial statements of integrated foreign operations are remeasured into the
relevant measurement currency using the temporal method. Under this method,
monetary assets and liabilities are remeasured at the exchange rate in effect on
the date of the balance sheet. Non-monetary assets and liabilities are
remeasured at historical rates, unless such assets and liabilities are carried
at market value, in which case, they are remeasured at the exchange rate in
effect on the date of the balance sheet. Revenues and expenses are remeasured at
the monthly average exchange rate. Foreign exchange gains and losses arising
from such remeasurement are reflected in the statements of
earnings.





Forward
exchange contracts





Forward
exchange contracts are utilized by the company to manage its foreign currency
exposure. Forward exchange contracts, which qualify for hedge accounting, are
entered into by the company to hedge anticipated US-dollar-denominated sales and
the related accounts receivable. The company’s policy is not to utilize those
derivative financial instruments for trading or speculative
purposes.





In
accordance with the new requirements of the Canadian Institute of Chartered
Accountants (CICA) Handbook Section 3855, “Financial Instruments – Recognition
and Measurement”, adopted by the company on September 1, 2007, the company’s
forward exchange contracts are recorded at fair value in the balance sheet, and
changes in their fair value are reported in comprehensive income. Upon the
recognition of related hedged sales, accumulated changes in fair value are
reclassified in the statements of earnings.





Prior to
the adoption of Section 3855 on September 1, 2007, the company’s forward
exchange contracts qualified for hedge accounting; therefore, foreign exchange
translation gains and losses on these contracts were recognized as an adjustment
of the revenues when the corresponding hedged sales were
recorded.





Short-term
investments





All
investments with original terms to maturity of three months or less and that are
not required for the purposes of meeting short-term cash requirements are
classified as short-term investments.





In
accordance with the new requirements of the CICA Handbook Section 3855,
“Financial Instruments – Recognition and Measurement”, adopted by the company on
September 1, 2007, short-term investments are classified as available-for-sale
securities; therefore, they are carried at fair value in the balance sheet, and
any changes in their fair value are reflected in comprehensive income. Upon
the disposal of these assets, accumulated changes in their fair value are
reclassified in the statements of earnings.





Interest
income on short-term investments is recorded in interest income in the
statements of earnings and in cash flows from operating activities in the
statements of cash flows.





Prior to
the adoption of Section 3855 on September 1, 2007, short-term investments were
valued at the lower of cost and market value. Cost consisted of acquisition cost
plus amortization of discount or less amortization of premium.





Inventories





Inventories
are valued on an average cost basis, at the lower of cost and replacement cost
for raw materials and at the lower of cost and net realizable value for work in
progress and finished goods.








F-9
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements


Property,
plant and equipment and amortization





Property,
plant and equipment are recorded at cost, less related government grants and
research and development tax credits. Amortization is provided on a
straight-line basis over the estimated useful lives as follows:





TermLand
      improvements
            
            5
      yearsBuildings
            
            25
      yearsEquipment
            
            2
      to 10 yearsLeasehold
      improvements
            
            The
      lesser of useful life and remaining lease
term





Intangible
assets, goodwill and amortization





Intangible
assets primarily include the cost of core technology and software, net of
accumulated amortization. Core technology represents existing technology that
was acquired in business combinations and that has reached technological
feasibility. Amortization is provided on a straight-line basis over the
estimated useful lives of five years for core technology and four and 10 years
for software.





Goodwill
represents the excess of the purchase price of acquired businesses over the
estimated fair value of net identifiable assets acquired. Goodwill is not
amortized but must be tested for impairment on an annual basis or more
frequently if events or circumstances indicate that it might be impaired.
Recoverability of goodwill is determined at the reporting unit level, using a
two-step approach. First, the carrying value of a reporting unit is compared to
its fair value, which is usually determined based on a combination of discounted
future cash flows and a market approach. If the carrying value
of a reporting unit exceeds its fair value, the second step is
performed. In this step, the amount of impairment loss, if any, represents the
excess of the carrying value of goodwill over its fair value, and the loss is
charged to earnings in the period in which it is incurred. For the purposes
of this impairment test, the fair value of goodwill is estimated in the same way
as goodwill is determined in business combinations; that is, the excess of
the fair value of a reporting unit over the estimated fair value of its net
identifiable assets.





The
company performs its annual impairment test in the third quarter of each fiscal
year for all its existing reporting units.





Impairment
of long-lived assets





Long-lived
assets are reviewed for impairment when events or circumstances indicate that
cost may not be recoverable. Impairment exists when the carrying amount/value of
an asset or group of assets is greater than the undiscounted future cash flows
expected to be provided by the asset or group of assets. The amount of
impairment loss, if any, is the excess of the carrying value over the fair
value. The company assesses fair value of long-lived assets based on discounted
future cash flows.





Warranty





The
company offers its customers warranties of one to three years, depending on the
specific products and terms of the purchase agreement. The company’s typical
warranties require it to repair or replace defective products during the
warranty period at no cost to the customer. Costs related to original warranties
are accrued at the time of shipment, based upon estimates of expected rework and
warranty costs to be incurred. Costs associated with separately priced extended
warranties are expensed as incurred.





Revenue
recognition





For
products in which software is incidental, the company recognizes revenue when
persuasive evidence of an arrangement exists, the product has been delivered,
the price is fixed or determinable, and collection of the resulting receivable
is reasonably assured. Provisions are made for estimated returns,
warranties and support obligations.







F-10
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements


For
products in which software is not incidental, revenues are separated into two
categories: product and post-contract customer support (PCS) revenues, based
upon vendor-specific objective evidence of fair value. Product revenues for
these sales are recognized as described above. PCS revenues are deferred and
recognized ratably over the years of the support arrangement. PCS revenues are
recognized at the time the product is delivered when provided substantially
within one year of delivery, the costs of providing this support are
insignificant (and accrued at the time of delivery), and no (or infrequent)
software upgrades or enhancements are provided.





Maintenance
contracts generally include the right to unspecified upgrades and enhancements
on a when-and-if available basis and ongoing customer support. Revenue from
these contracts is recognized ratably over the terms of the maintenance
contracts on a straight-line basis.





Revenue
for extended warranties is recognized on a straight-line basis over the warranty
period.





For all
sales, the company uses a binding purchase order as evidence that a sales
arrangement exists.





Delivery
generally occurs when the product is handed over to a transporter for
shipment.





At the
time of the transaction, the company assesses whether the price associated with
its revenue transaction is fixed or determinable and whether or not
collection is reasonably assured. The company assesses whether the price is
fixed or determinable based on the payment terms associated with the
transaction. The company assesses collection based on a number of
factors, including past transaction history and the creditworthiness of the
customer. Generally, collateral or other security is not requested from
customers.





Most
sales arrangements do not generally include acceptance clauses. However, when a
sales arrangement does include an acceptance provision, acceptance occurs
upon the earliest of receipt of a written customer acceptance or expiration of
the acceptance period. For these sales arrangements, the sale is recognized when
acceptance occurs.





Advertising
costs





Advertising
costs are expensed as incurred.





Government
grants





Grants
related to operating expenses are included in earnings when the related expenses
are incurred. Grants related to capital expenditures are deducted from the
related assets. Grants are included in earnings or deducted from the related
assets, provided there is reasonable assurance that the company has complied and
will comply with all the conditions related to the grant.





Research
and development expenses





All
expenses related to research, as well as development activities that do not meet
generally accepted criteria for deferral are expensed as incurred, net of
related tax credits and government grants. Development expenses that meet
generally accepted criteria for deferral, in accordance with the CICA Handbook
Section 3450, “Research and Development”, are capitalized, net of related tax
credits and government grants, and are amortized against earnings over the
estimated benefit period. Research and development expenses are mainly comprised
of salaries and related expenses, material costs as well as fees paid to
third-party consultants.





As at
August 31, 2008, the company had not deferred any development
costs.








F-11
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements


Income
taxes





The
company provides for income taxes using the liability method of tax allocation.
Under this method, future income tax assets and liabilities are determined based
on deductible or taxable temporary differences between financial statement
values and tax values of assets and liabilities as well as the carry forward of
unused tax losses and reductions, using substantively enacted income tax rates
expected to be in effect for the years in which the assets are expected
to be realized or the liabilities to be settled.





The
company establishes a valuation allowance against future income tax assets if,
based on available information, it is more likely than not that some
or all of the future income tax assets will not be realized.





Earnings
per share





Basic
earnings per share are determined using the weighted average number of common
shares outstanding during the year.





Diluted
earnings per share are determined using the weighted average number of common
shares outstanding during the year, plus the effect of dilutive potential common
shares outstanding during the year. This method requires that diluted earnings
per share be calculated (using the treasury stock method) as if all dilutive
potential common shares had been exercised at the latest at the beginning of the
year or on the date of issuance, as the case may be, and that the funds obtained
thereby (plus an amount equivalent to the unamortized portion of related
stock-based compensation costs) be used to purchase common shares of the
company at the average market price of the common shares during the
year.





Stock-based
compensation costs





The
company accounts for stock-based compensation on stock options, restricted share
units and deferred share units, using the fair value-based method. The company
accounts for stock-based compensation on stock appreciation rights, using the
intrinsic value method. Stock-based compensation costs are amortized to expense
over the vesting periods.





New
accounting standards and pronouncements





Adopted
in fiscal 2008





On
September 1, 2007, the company adopted the CICA Handbook Section 1530,
“Comprehensive Income”, Section 3251, “Equity”, Section 3855, “Financial
Instruments – Recognition and Measurement”, and Section 3865, “Hedges”. Sections
3251 and 3865 have been adopted prospectively, while Section 3855 has been
applied retroactively, without restatement of prior years’ financial
statements, and Section 1530 has been applied retroactively with restatement of
prior years’ financial statements.





Following
the adoption of Section 3855, the company classified its financial instruments
as follows:





Cash





Cash is
classified as a financial asset held for trading and is carried at fair value in
the balance sheet, and any changes in its fair value are reflected in the
statements of earnings.





Short-term
investments





The
company has elected to classify its short-term investments as available-for-sale
securities; therefore they are carried at fair value in the balance sheet, and
any changes in their fair value are reflected in comprehensive income. Upon the
disposal of these assets, accumulated changes in their fair value are
reclassified in the statements of earnings. Also, upon the adoption of this new
standard, unrealized losses on short-term investments as at August 31, 2007, in
the amount of $55,000 (previously recorded in the statements of earnings),
have been reclassified from the opening balance of retained earnings to the
opening balance of accumulated other comprehensive income for the year ended
August 31, 2008.







F-12
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements


Accounts
receivable





Accounts
receivable are classified as loans and receivables. After their initial
measurement at fair value, they are carried at amortized cost, which
generally corresponds to nominal amount due to their short-term
maturity.





Accounts
payable and accrued liabilities





Accounts
payable and accrued liabilities are classified as other financial liabilities.
They are initially measured at their fair value. Subsequent measurements are at
amortized cost, using the effective interest rate method. For the company, that
value corresponds to nominal amount as a result of their short-term
maturity.





Forward
exchange contracts





Forward
exchange contracts, which qualify for hedge accounting, are entered into by the
company to hedge anticipated US-dollar-denominated sales and the related
accounts receivable. They are recorded at fair value in the balance sheet, and
changes in their fair value are reported in comprehensive income. Upon the
recognition of related hedged sales, accumulated changes in fair value are
reclassified in the statements of earnings. Unrecognized gains on forward
exchange contracts as at August 31, 2007, in the amount of $1,948,000,
net of future income taxes of $916,000, have been reflected as an adjustment to
the opening balance of accumulated other comprehensive income for the year ended
August 31, 2008.





Cumulative
foreign currency translation adjustment





The
cumulative foreign currency translation adjustment, which is solely the result
of the translation of the company’s consolidated financial statements in US
dollars (the reporting currency), has been reclassified to be presented
as a component of accumulated other comprehensive income for all years
presented.





Transition





The
company has elected to use September 1, 2002, as the transition date for
embedded derivatives.





Other
than the adjustments described above for the short-term investments and the
forward exchange contracts, the recognition, derecognition and measurement
methods used to prepare the consolidated financial statements have not changed
from the methods of years prior to the effective date of these new standards.
Consequently, there were no further adjustments to record on
transition.





Section
1506, “Accounting Changes”





On
September 1, 2007, the company adopted Section 1506, “Accounting Changes”. This
section establishes criteria for changes in accounting policies and accounting
treatment and disclosures regarding changes in accounting policies, estimates
and corrections of errors. In particular, this section allows for voluntary
changes in accounting policy only when they result in the financial statements
providing reliable and more relevant information. Furthermore, this section
requires disclosure when an entity has not applied a new source of GAAP that has
been issued but is not yet effective. Such disclosure is provided below.
The adoption of this section had no effect on the company’s consolidated
financial statements for the year ended August 31, 2008.





To
be adopted after fiscal 2008





In
December 2006, the CICA issued three new sections, which provide a complete set
of disclosure and presentation requirements for financial instruments: Section
3862, “Financial Instruments − Disclosures”; Section 3863, “Financial
Instruments − Presentation”; and Section 1535, “Capital
Disclosures”.






F-13
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements


Section
3862 replaces the disclosure portion of Section 3861, “Financial
Instruments − Disclosure and Presentation”. The new standard
places increased emphasis on disclosures regarding risks associated with both
recognized and unrecognized financial instruments and how these risks are
managed. It is also intended to remove any duplicate disclosures and simplify
the disclosures about concentrations of risk, credit risk, liquidity risk and
price risk currently found in Section 3861.





Section
3863 carries forward the presentation requirements from Section 3861,
unchanged.





Section
1535 applies to all entities, regardless of whether they have financial
instruments and are subject to external capital requirements. The new section
requires disclosure of information about an entity’s objectives, policies and
processes for managing capital, as well as quantitative data about capital and
whether the entity has complied with any capital requirements.





Sections
1535, 3862 and 3863 apply to fiscal years beginning on or after October 1, 2007.
The company will adopt these new standards on September 1, 2008, and is
currently assessing the disclosure effects these new standards will have on its
consolidated financial statements.





In June
2007, the CICA issued Section 3031, “Inventories”. This standard requires the
measurement of inventories at the lower of cost and net realizable value and
includes guidance on the determination of cost, including allocation of
overheads and other costs to inventory. The standard also requires the
consistent use of either first-in, first-out (FIFO) or weighted average cost
formula to measure the cost of inventories and requires the reversal of previous
write-downs to net realizable value when there is a subsequent increase in the
value of inventories. The new standard applies to fiscal years beginning
on or after January 1, 2008. The company will adopt this new standard on
September 1, 2008, and its adoption will have no significant effect on its
consolidated financial statements.





In June
2007, the CICA amended Section 1400, “General Standards of Financial Statement
Presentation” to include new requirements regarding an entity’s ability to
continue as a going concern. These amendments apply to fiscal years beginning on
or after January 1, 2008. The company will adopt these amendments on
September 1, 2008, and their adoption will have no effect on its consolidated
financial statements.





In
February 2008, the CICA issued Section 3064, “Goodwill and intangible assets”,
which supersedes Section 3062, “Goodwill and other intangible assets” and
Section 3450, “Research and development costs”. Various changes have been made
to other sections of the CICA Handbook for consistency purposes. Section 3064
establishes standards for the recognition, measurement, presentation and
disclosure of goodwill subsequent to its initial recognition and of intangible
assets by profit-oriented enterprises. Standards concerning goodwill remain
unchanged from the standards included in the previous Section 3062. This new
section applies to fiscal years beginning on or after October 1, 2008. The
company will adopt this new standard on September 1, 2009, and has not yet
determined the effects its adoption will have on its consolidated financial
statements.








3  Business
Combinations





Fiscal
2008





Navtel
Communications Inc.





On March
26, 2008, the company acquired all issued and outstanding shares of Navtel
Communications Inc. Based in Toronto, Canada, Navtel Communications Inc.
was a privately held company specializing in tests for next-generation Internet
Protocol networks. On March 26, 2008, Navtel Communications Inc. was
liquidated into the parent company.





This
acquisition was settled for a total cash consideration of $11,477,000, or
$11,332,000 net of $145,000 of cash acquired. The total consideration included
acquisition-related costs of $172,000.







F-14
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











This
acquisition was accounted for using the purchase method and, consequently, the
results of operations of the acquired business have been included in the
consolidated financial statements of the company since March 26, 2008, being the
date of acquisition.





The
purchase price, including acquisition-related costs, was allocated based on the
estimated fair value of acquired net assets at the date of acquisition as
follows:





Assets
      acquired, net of cash acquiredAccounts
      receivable
            
            $
            776Inventories
            
            
            447Other
      current assets
            
            
            320Tax
      credits
            
            
            7,074Core
      technology
            
            
            2,919Future
      income tax assets
            
            
            8,586Current
      liabilities assumedAccounts
      payable and accrued liabilities
            
            
            (431
            )Deferred
      revenue
            
            
            (523
            )Future
      income tax liabilities
            
            
            (2,737
            )Net
      identifiable assets acquired
            
            
            16,431Purchase
      price, net of cash acquired
            
            
            11,332Excess
      of the fair value of net identifiable assets acquired over the purchase
      price
            
            $
            (5,099
            )





The
excess of the fair value of the net identifiable assets acquired over the
purchase price in the amount of $5,099,000 has been eliminated in part by fully
reducing the value assigned to acquired core technology and related future
income tax liabilities. The remaining excess in the amount of $3,036,000 has
been presented as an extraordinary gain in the statement of earnings for the
year ended August 31, 2008. The basic and diluted extraordinary gain per share
amounted to $0.04 for the year ended August 31, 2008.





This
business reports to the Telecom Division.





Brix
Networks Inc. (renamed EXFO Service Assurance Inc.)





On April
22, 2008, the company acquired all issued and outstanding shares of Brix
Networks Inc. (renamed EXFO Service Assurance Inc.). Based in the Boston (MA)
area, Brix Networks Inc. was a privately held company offering VoIP and IPTV
test solutions across the three areas that most affect the success of a
real-time service: signaling quality (signaling path performance), delivery
quality (media transport performance) and content quality (overall quality of
experience).





This
acquisition was settled for a cash consideration of $29,696,000, or $29,684,000
net of $12,000 of cash acquired, plus a contingent cash consideration of up
to a maximum of $7,537,000, based upon the achievement of a bookings volume
exceeding $16,000,000 up to $40,000,000 in the 12 months following the
acquisition. The purchase price allocation took into account severance expenses
of $497,000 (note 4) for the termination of employees of the acquired business.
Severance expenses payable as at August 31, 2008, in the amount of $292,000
(note 9), will be paid in the first quarter of fiscal 2009. Any amount payable
for the contingent cash consideration will increase goodwill.





This
acquisition was accounted for using the purchase method and, consequently, the
results of operations of the acquired business have been included in the
consolidated financial statements of the company since April 22, 2008, being the
date of acquisition.







F-15
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











The
purchase price, including acquisition-related costs, was allocated based on the
estimated fair value of acquired net assets at the date of acquisition as
follows:





Assets
      acquired, net of cash acquiredAccounts
      receivable
            
            $
            1,106Inventories
            
            
            1,229Other
      current assets
            
            
            488Capital
      assets
            
            
            1,097Core
      technology
            
            
            13,765Future
      income tax assets
            
            
            1,641Current
      liabilities assumedAccounts
      payable and accrued liabilities
            
            
            (2,565
            )Deferred
      revenue
            
            
            (2,445
            )Net
      identifiable assets acquired
            
            
            14,316Goodwill
            
            
            15,368Purchase
      price, net of cash acquired
            
            $
            29,684





Intangible
assets are amortized on a straight-line basis over their estimated useful life
of five years.





Upon
completion of the final purchase price allocation in the fourth quarter of
fiscal 2008, the company revised the estimated fair value assigned to deferred
revenue and reduced the fair value from $4,120,000 to $2,445,000, thus reducing
goodwill as well.





Future
income tax assets at the acquisition date amounted to $13,701,000 and were
mainly comprised of net operating losses and research and development expenses
carried forward. A valuation allowance of $8,195,000 was recorded against these
assets. In the event that the company would reverse a portion or all of the
valuation allowance, the amount of such reversal would reduce the amount of
goodwill recognized at the date of acquisition.





This
business, including acquired goodwill, reports to the Telecom Division. Acquired
goodwill is not deductible for tax purposes.





Fiscal
2006





Consultronics
Limited





On
January 26, 2006, the company acquired substantially all the assets of
Consultronics Limited. Based in Toronto, Canada, and with operations in the
United Kingdom and Hungary, Consultronics was a privately held company
specializing in x-Digital Subscriber Line (xDSL), IP TV and VoIP test solutions
for broadband access networks.





This
acquisition was settled for a total cash consideration of $19,093,000 or
$18,838,000 net of $255,000 of cash acquired. The purchase price allocation took
into account severance expenses of $660,000 (note 4) for the termination
of employees of the acquired business, as well as other acquisition-related
costs of $822,000.





This
acquisition was accounted for using the purchase method and, consequently, the
results of operations of the acquired business have been included in the
consolidated statements of earnings of the company since January 26, 2006, being
the date of acquisition.








F-16
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements












The
purchase price, including acquisition-related costs, was allocated based on the
estimated fair value of acquired net assets at the date of acquisition as
follows:





Assets
      acquired, net of cash acquiredAccounts
      receivable
            
            $
            2,298Inventories
            
            
            2,452Other
      current assets
            
            
            385Property,
      plant and equipment
            
            
            3,115Core
      technology
            
            
            8,709Current
      liabilities assumed
            
            
            (2,826
            )Loans
      assumed
            
            
            (402
            )Net
      identifiable assets acquired
            
            
            13,731Goodwill
            
            
            5,107Purchase
      price, net of cash acquired
            
            $
            18,838





Acquired
core technology is amortized on a straight-line basis over its estimated useful
life of five years.





This
business, including acquired goodwill, reports to the Telecom Division. Acquired
goodwill is deductible for tax purposes.








4  Special
Charges





Impairment
of long-lived assets





Fiscal
2006





In June
2006, the company entered into an agreement to sell one of its buildings
(located in Rochester, NY) along with some equipment, and it recorded an
impairment charge of $604,000 in fiscal 2006. The impairment charge represented
the excess of the carrying value of these assets over the expected net selling
price. These assets were finally sold during the fourth quarter of fiscal 2006
for the expected net selling price. These assets were related to the Life
Sciences and Industrial Division.





Restructuring
charges





Year
ended August 31, 2008




Balance
      as at
              August 31, 2007
            
            
            Additions
            
            
            Payments
            
            
            Balance
      as at
              August 31, 2008Fiscal 2008 plan (notes 3 and 9)Severance expenses
            
            $
            −
            
            
            $
            497
            
            
            $
            (205
            )
            
            $
            292








F-17
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Year
ended August 31, 2007





Balance
      as at
              August 31,2006
            
            
            Additions
            
            
            Payments
            
            
            Balance
      as at
              August 31,2007Fiscal 2006 planSeverance expenses
            
            $
            631
            
            
            $
            −
            
            
            $
            (631
            )
            
            $
            −Fiscal 2003 planExited leased facilities
            
            
            60
            
            
            
            −
            
            
            
            (60
            )
            
            
            −Total for all plans (note
      9)
            
            $
            691
            
            
            $
            −
            
            
            $
            (691
            )
            
            $
            −




Year
ended August 31, 2006





Balance
      as at
              August 31,2005
            
            
            Additions
            
            
            Payments
            
            
            Balance
      as at
              August 31,2006Fiscal 2006 planSeverance expenses (note 3)
            
            $
            –
            
            
            $
            660
            
            
            $
            (29
            )
            
            $
            631Fiscal 2003 planExited leased facilities
            
            
            150
            
            
            
            –
            
            
            
            (90
            )
            
            
            60Total for all plans
            
            $
            150
            
            
            $
            660
            
            
            $
            (119
            )
            
            $
            691








5  Inventories





As
      at August 31,2008
            
            
            2007Raw
      materials
            
            $
            17,651
            
            
            $
            16,898Work
      in progress
            
            
            1,961
            
            
            
            1,387Finished
      goods
            
            
            15,268
            
            
            
            13,228$
            34,880
            
            
            $
            31,513








F-18
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











6  Property,
Plant and Equipment





As
      at August 31,2008
            
            
            2007Cost
            
            
            Accumulated
              amortization
            
            
            Cost
            
            
            Accumulated
              amortizationLand
      and land improvements
            
            $
            2,295
            
            
            $
            1,184
            
            
            $
            2,265
            
            
            $
            1,177Buildings
            
            
            12,319
            
            
            
            3,985
            
            
            
            12,300
            
            
            
            3,516Equipment
            
            
            36,423
            
            
            
            27,083
            
            
            
            33,184
            
            
            
            25,710Leasehold
      improvements
            
            
            3,698
            
            
            
            2,608
            
            
            
            3,236
            
            
            
            2,46554,735
            
            
            $
            34,860
            
            
            
            50,985
            
            
            $
            32,868Less:Accumulated
      amortization
            
            
            34,860
            
            
            
            
            
            
            
            32,868$
            19,875
            
            
            
            
            
            
            $
            18,117





As at
August 31, 2006, 2007 and 2008, unpaid purchases of property, plant and
equipment amounted to $176,000, $464,000 and $414,000,
respectively.








7  Intangible
Assets and Goodwill





As
      at August 31,2008
            
            
            2007Cost
            
            
            Accumulated
              amortization
            
            
            Cost
            
            
            Accumulated
              amortizationCore
      technology
            
            $
            62,933
            
            
            $
            45,981
            
            
            $
            50,014
            
            
            $
            43,298Software
            
            
            8,631
            
            
            
            5,638
            
            
            
            8,083
            
            
            
            5,17171,564
            
            
            $
            51,619
            
            
            
            58,097
            
            
            $
            48,469Less:Accumulated
      amortization
            
            
            51,619
            
            
            
            
            
            
            
            48,469$
            19,945
            
            
            
            
            
            
            $
            9,628





Estimated
amortization expense for intangible assets in each of the next five fiscal years
amounts to $5,387,000 in 2009, $5,336,000 in 2010, $4,127,000 in 2011,
$2,909,000 in 2012 and $1,752,000 in 2013.





Additions
to intangible assets for the years ended August 31, 2006, 2007 and 2008 amounted
to $9,190,000, $1,156,000 and $14,828,000, respectively.







F-19
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Changes
in the carrying value of goodwill are as follows:




Years
      ended August 31,2008
              
              
              2007Telecom
      Division
              
              
              Life
      Sciences and Industrial Division
              
              
              Total
              
              
              Telecom
      Division
              
              
              Life
      Sciences and Industrial Division
              
              
              TotalBalance
      - Beginning of year
              
              $
              23,622
              
              
              $
              4,815
              
              
              $
              28,437
              
              
              $
              22,545
              
              
              $
              4,597
              
              
              $
              27,142Addition
      from business combinations (note 3)
              
              
              15,368
              
              
              
              −
              
              
              
              15,368
              
              
              
              −
              
              
              
              −
              
              
              
              −Foreign
      currency translation adjustment
              
              
              (1,124
              )
              
              
              (28
              )
              
              
              (1,152
              )
              
              
              1,077
              
              
              
              218
              
              
              
              1,295Balance
      – End of year (note 18)
              
              $
              37,866
              
              
              $
              4,787
              
              
              $
              42,653
              
              
              $
              23,622
              
              
              $
              4,815
              
              
              $
              28,437







8  Credit
Facilities





The
company has a line of credit that provides for advances of up to CA$10,000,000
(US$9,411,000). This line of credit bears interest at prime rate. As at August
31, 2008, an amount of CA$1,542,000 (US$1,451,000) was reserved from this line
of credit for letters of guarantee (note 11).





The
company also has a second line of credit, which provides for advances of up to
CNY10,000,000 (US$1,500,000) and up to US$2,500,000. This line of credit bears
interest at the Chinese prime rate for advances made in CNY and at LIBOR plus
3.5% for advances made in US dollars. As at August 31, 2008, this line of credit
was unused.





Finally,
the company has other lines of credit of $20,000,000 for the foreign currency
risk exposure related to its forward exchange contracts (note 17). As at August
31, 2008, an amount of $1,473,000 was reserved from these lines of
credit.





These
lines of credit are renewable annually. Short-term investments, accounts
receivable, inventories and all tangible and intangible assets of the company
are pledged as collateral against these lines of credit.








9  Accounts
Payable and Accrued Liabilities





As
      at August 31,2008
            
            
            2007Trade
            
            $
            10,303
            
            
            $
            11,749Salaries
      and social benefits
            
            
            8,888
            
            
            
            7,929Warranty
            
            
            974
            
            
            
            800Commissions
            
            
            761
            
            
            
            824Tax
      on capital
            
            
            923
            
            
            
            524Restructuring
      charges (note 4)
            
            
            292
            
            
            
            −Forward
      exchange contracts (note 17)
            
            
            714
            
            
            
            −Other
            
            
            1,858
            
            
            
            895$
            24,713
            
            
            $
            22,721








F-20
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Changes
in the warranty provision are as follows:





As
      at August 31,2008
            
            
            2007Balance
      – Beginning of year
            
            $
            800
            
            
            $
            1,006Provision
            
            
            655
            
            
            
            801Addition
      from business combinations
            
            
            175
            
            
            
            −Settlements
            
            
            (656
            )
            
            
            (1,007
            )Balance
      – End of year
            
            $
            974
            
            
            $
            800






10  Commitments





The
company entered into operating leases for certain of its premises and equipment,
which expire at various dates through August 2013. As at August 31, 2008,
minimum rentals payable under these operating leases in each of the next five
years will amount to $3,596,000 in 2009, $3,051,000 in 2010, $1,528,000 in 2011,
$629,000 in 2012 and $57,000 in 2013. Total commitments for these operating
leases amount to $8,861,000.





For the
years ended August 31, 2006, 2007 and 2008, rental expenses amounted to
$1,523,000, $1,847,000 and $2,427,000, respectively.







11  Contingencies





Class
action





On
November 27, 2001, a class-action suit was filed in the United States District
Court for the Southern District of New York against the company, four
of the underwriters of its Initial Public Offering and some of its executive
officers pursuant to the Securities Exchange Act of 1934 and Rule 10b-5
promulgated thereunder and Sections 11, 12 and 16 of the Securities Act of 1933.
This class action alleges that the company’s registration statement and
prospectus filed with the Securities and Exchange Commission on June 29, 2000,
contained material misrepresentations and/or omissions resulting from (i) the
underwriters allegedly soliciting and receiving additional, excessive and
undisclosed commissions from certain investors in exchange for which they
allocated material portions of the shares issued in connection with the
company’s Initial Public Offering; and (ii) the underwriters allegedly
entering into agreements with customers whereby shares issued in connection with
the company’s Initial Public Offering would be allocated to those customers in
exchange for which customers agreed to purchase additional amounts of shares in
the after-market at predetermined prices.





On April
19, 2002, the plaintiffs filed an amended complaint containing master
allegations against all of the underwriters in all of the 310 cases
included in this class action and also filed an amended complaint containing
allegations specific to four of the company’s underwriters, the company and
two of its executive officers. In addition to the allegations mentioned above,
the amended complaint alleges that the underwriters (i) used their analysts to
manipulate the stock market; and (ii) implemented schemes that allowed
issuer insiders to sell their shares rapidly after an initial public offering
and benefit from high market prices. As concerns the company and its two
executive officers in particular, the amended complaint alleges that (i) the
company’s registration statement was materially false and misleading because it
failed to disclose the additional commissions and compensation to be
received by underwriters; (ii) the two named executive officers learned of or
recklessly disregarded the alleged misconduct of the underwriters; (iii) the two
named executive officers had motive and opportunity to engage in alleged
wrongful conduct due to personal holdings of the company’s stock and the fact
that an alleged artificially inflated stock price could be used as currency for
acquisitions; and (iv) the two named executive officers, by virtue of their
positions with the company, controlled the company and the contents of the
registration statement and had the ability to prevent its issuance or cause it
to be corrected. The plaintiffs in this suit seek an unspecified amount for
damages suffered.







F-21
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











In July
2002, the issuers filed a motion to dismiss the plaintiffs’ amended complaint
and a decision was rendered on February 19, 2003. Only one of the claims
against the company was dismissed. On October 8, 2002, the claims against
its officers were dismissed pursuant to the terms of Reservation of Rights and
Tolling Agreements entered into with the plaintiffs.





In June
2004, an agreement of partial settlement was submitted to the court for
preliminary approval. The proposed partial settlement was between the
plaintiffs, the issuer defendants in the consolidated actions, the issuer
officers and directors named as defendants, and the issuers’ insurance
companies. The court granted the preliminary approval motion
on February 15, 2005, subject to certain modifications. On
August 31, 2005, the court issued a preliminary order further approving the
modifications to the settlement and certifying the settlement classes. The court
also appointed the notice administrator for the settlement and ordered that
notice of the settlement be distributed to all settlement class members by
January 15, 2006.  The settlement fairness hearing occurred on
April 24, 2006, and the court reserved decision at that time.





While the
partial settlement was pending approval, the plaintiffs continued to litigate
against the underwriter defendants.  The district court directed that the
litigation proceed within a number of “focus cases” rather than in all of the
310 cases that have been consolidated. The company's case is not one
of these focus cases.  On October 13, 2004, the district court
certified the focus cases as class actions. The underwriter defendants
appealed that ruling, and on December 5, 2006, the Court of Appeals for the
Second Circuit reversed the district court’s class certification
decision.





On April
6, 2007, the Second Circuit denied the plaintiffs’ petition for rehearing of
that decision and, on May 18, 2007, the Second Circuit denied the plaintiffs’
petition for rehearing en
banc. In light of the Second Circuit’s opinion, liaison counsel for all
issuer defendants, including the company, informed the court that this
settlement cannot be approved, because the defined settlement class, like the
litigation class, cannot be certified. On June 25, 2007, the district court
entered an order terminating the settlement agreement. On August 14, 2007, the
plaintiffs filed their second consolidated amended class-action complaints
against the focus cases and, on September 27, 2007, again moved for
class certification. On November 12, 2007, certain of the
defendants in the focus cases moved to dismiss the second consolidated amended
class-action complaints. On March 26, 2008, the district court denied the
motions to dismiss, except as to Section 11 claims raised by those plaintiffs
who sold their securities for a price in excess of the initial offering price
and those who purchased outside of the previously certified class period.
Briefing on the class certification motion was completed in May
2008.





Due to
the inherent uncertainties of litigation, it is not possible to predict the
final outcome of the case, nor to determine the amount of any possible losses.
The company will continue to defend its position in this litigation that the
claims against it, and its officers, are without merit. Accordingly, no
provision for this case has been made in the consolidated financial statements
as at August 31, 2008.





Letters
of guarantee





As at
August 31, 2008, in the normal course of its operations, the company had
outstanding letters of guarantee in the amount of CA$6,018,000 (US$5,663,000),
which expire at various dates through fiscal 2010. From this amount, the company
had CA$1,542,000 (US$1,451,000) worth of letters of guarantee for its own
selling and purchase requirements, which were reserved from one of the lines of
credit (note 8). The remainder in the amount of CA$4,476,000 (US$4,212,000) was
used by the company to secure its line of credit in CNY. This line of credit was
unused as at August 31, 2008 (note 8). These letters of guarantee
were secured by short-term investments.








12 Share
Capital





Authorized –
unlimited as to number, without par value


Subordinate
      voting and participating, bearing a non-cumulative dividend to be
      determined by the Board of Directors, ranking pari passu with
      multiple voting shares


Multiple
      voting and participating, entitling to ten votes each, bearing a
      non-cumulative dividend to be determined by the Board of Directors,
      convertible at the holder’s option into subordinate voting shares on a
      one-for-one basis, ranking pari passu with
      subordinate voting shares






F-22
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











The
following table summarizes the share capital activity since August 31,
2005:




Multiple
      voting shares
              
              
              Subordinate
      voting sharesNumber
              
              
              Amount
              
              
              Number
              
              
              Amount
              
              
              Total amountBalance
      as at August 31, 2005
              
              
              37,900,000
              
              
              $
              1
              
              
              
              30,665,774
              
              
              $
              521,874
              
              
              $
              521,875Exercise
      of stock options (note 13)
              
              
              –
              
              
              
              –
              
              
              
              182,425
              
              
              
              557
              
              
              
              557Redemption
      of restricted share units (note 13)
              
              
              –
              
              
              
              –
              
              
              
              4,770
              
              
              
              –
              
              
              
              –Conversion
      of multiple voting shares into subordinate voting shares
              
              
              (757,000
              )
              
              
              –
              
              
              
              757,000
              
              
              
              –
              
              
              
              –Reclassification
      of stock-based compensation costs to share capital upon exercise of stock
      awards
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              200
              
              
              
              200Elimination
      of deficit by reduction of share capital (1)
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              (373,711
              )
              
              
              (373,711
              )Balance
      as at August 31, 2006
              
              
              37,143,000
              
              
              
              1
              
              
              
              31,609,969
              
              
              
              148,920
              
              
              
              148,921Exercise
      of stock options (note 13)
              
              
              –
              
              
              
              –
              
              
              
              250,528
              
              
              
              802
              
              
              
              802Redemption
      of  restricted share units (note 13)
              
              
              –
              
              
              
              –
              
              
              
              1,064
              
              
              
              –
              
              
              
              –Conversion
      of multiple voting shares into subordinate voting shares
              
              
              (500,000
              )
              
              
              –
              
              
              
              500,000
              
              
              
              –
              
              
              
              –Reclassification
      of stock-based compensation costs to share capital upon exercise of stock
      awards
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              296
              
              
              
              296Balance
      as at August 31, 2007
              
              
              36,643,000
              
              
              
              1
              
              
              
              32,361,561
              
              
              
              150,018
              
              
              
              150,019Exercise
      of stock options (note 13)
              
              
              –
              
              
              
              –
              
              
              
              18,500
              
              
              
              61
              
              
              
              61Redemption
      of restricted share units (note 13)
              
              
              –
              
              
              
              –
              
              
              
              65,870
              
              
              
              –
              
              
              
              –Redemption
      of deferred share units (note 13)
              
              
              –
              
              
              
              –
              
              
              
              20,695
              
              
              
              –
              
              
              
              –Reclassification
      of stock-based compensation costs to share capital upon exercise of stock
      awards
              
              
              –
              
              
              
              –
              
              
              
              –
              
              
              
              514
              
              
              
              514Redemption
      of share capital (2)
              
              
              –
              
              
              
              –
              
              
              
              (1,682,921
              )
              
              
              (7,808
              )
              
              
              (7,808
              )Balance
      as at August 31, 2008
              
              
              36,643,000
              
              
              $
              1
              
              
              
              30,783,705
              
              
              $
              142,785
              
              
              $
              142,786




(1)
            On
      August 31, 2006, upon the approval of the Board of Directors, the company
      eliminated its deficit against its share
  capital.


(2)
            On
      November 5, 2007, the Board of Directors of the company approved a share
      repurchase program, by way of a normal course issuer bid on the
      open market, of up to 9.9% of the company’s public float (as defined by
      the Toronto Stock Exchange), or 2,869,585 subordinate voting shares, at
      the prevailing market price. The company uses cash, short-term investments
      or future cash flows from operations to fund the repurchase of shares. The
      period of the normal course issuer bid commenced on November 8, 2007, and
      ended on November 7, 2008. All shares repurchased by the company under the
      bid are cancelled (note 20).








F-23
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











13 Stock-Based
Compensation Plans





The
maximum number of additional subordinate voting shares issuable under the
Long-Term Incentive Plan and the Deferred Share Unit Plan cannot exceed
6,306,153 shares. The maximum number of subordinate voting shares that may
be granted to any individual on an annual basis cannot exceed 5% of the
number of outstanding subordinate voting shares. The company settles stock
options and redeems restricted share units and deferred share units through the
issuance of common shares from treasury.





Long-term
incentive plan





In May
2000, the company established a Stock Option Plan for directors, executive
officers and employees and those of the company’s subsidiaries, as determined by
the Board of Directors. In January 2005, the company made certain amendments to
the existing Stock Option Plan, including the renaming of the plan to Long-Term
Incentive Plan, which includes stock options and restricted share units. This
plan was approved by the shareholders of the company.





Stock
Options





The
exercise price of stock options granted under the Long-Term Incentive Plan is
the market price of the common shares on the date of grant. Stock options
granted under the plan generally expire ten years from the date of grant and
vest over a four-year period, being the required period of service from
employees, generally with 25% vesting on an annual basis commencing on the first
anniversary of the date of grant. The Board of Directors may accelerate the
vesting of any or all outstanding stock options upon the occurrence of a change
of control.





The
following table summarizes stock option activity since August 31,
2005:


Years
      ended August 31,2008
              
              
              2007
              
              
              2006Number
              
              
              Weighted
      average exercise price
              
              
              Number
              
              
              Weighted
      average exercise price
              
              
              Number
              
              
              Weighted
      average exercise price(CA$)
              
              
              
              
              
              (CA$)
              
              
              
              
              
              (CA$)Outstanding
      – Beginning of year
              
              
              1,929,388
              
              
              $
              21
              
              
              
              2,439,375
              
              
              $
              20
              
              
              
              2,763,759
              
              
              $
              19Granted
              
              
              −
              
              
              
              −
              
              
              
              −
              
              
              
              −
              
              
              
              31,992
              
              
              
              6Exercised
              
              
              (18,500
              )
              
              
              3
              
              
              
              (250,528
              )
              
              
              4
              
              
              
              (182,425
              )
              
              
              4Forfeited
              
              
              (8,750
              )
              
              
              6
              
              
              
              (37,869
              )
              
              
              5
              
              
              
              (68,489
              )
              
              
              6Expired
              
              
              (80,657
              )
              
              
              29
              
              
              
              (221,590
              )
              
              
              37
              
              
              
              (105,462
              )
              
              
              27Outstanding
      – End of year
              
              
              1,821,481
              
              
              $
              21
              
              
              
              1,929,388
              
              
              $
              21
              
              
              
              2,439,375
              
              
              $
              20Exercisable
      – End of year
              
              
              1,762,969
              
              
              $
              21
              
              
              
              1,746,699
              
              
              $
              22
              
              
              
              1,852,870
              
              
              $
              25




The
intrinsic value of stock options exercised during fiscal 2006, 2007 and 2008 was
$481,000, $743,000 and $43,000, respectively.





The
weighted average grant-date fair value of stock options granted during fiscal
2006 amounted to $4.76.





Expected
forfeitures are immaterial to the company and are not reflected in the table
above.








F-24
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements





The fair
value of stock options granted in fiscal 2006 was estimated using the
Black-Scholes options valuation model with the following weighted average
assumptions:





Risk-free
      interest rate
            
            3.9%Expected
      volatility
            
            87%Dividend
      yield
            
            NilExpected
      life
            
            66
      months





The
factors considered in developing assumptions used in the Black-Scholes option
valuation model are the following:





The
risk-free interest rate is based on the interest rate on Government of Canada
bonds for maturities consistent with the expected life of the stock options. The
historical volatility of the company’s common share price is used to establish
the expected share price volatility. Finally, the company estimates the expected
life of the stock options based on historical data related to employees’
exercise of stock options.





The
following table summarizes information about stock options as at August 31,
2008:


Stock
      options outstanding
              
              Stock
      options exercisableExercise
      price
              
              
              Number
              
              
              Weighted
                average
                exercise
                price
              
              
              Intrinsic
                value
              
              Weighted
                average
                remaining
                contractual
                life
              
              Number
              
              
              Weighted
                average
                exercise
                price
              
              
              Intrinsic
                value
              
              Weighted
                average
                remaining
                contractual
                life(CA$)
              
              
              
              
              
              (CA$)
              
              
              (CA$)
              
              
              
              
              
              
              (CA$)
              
              
              (CA$)$2.50
      to $3.36
              
              
              
              259,625
              
              
              $
              2.51
              
              
              $
              509
              
              4.1
      years
              
              
              259,625
              
              
              $
              2.51
              
              
              $
              509
              
              4.1
      years$3.96
      to $5.60
              
              
              
              409,404
              
              
              
              5.10
              
              
              
              2
              
              5.7
      years
              
              
              356,170
              
              
              
              5.03
              
              
              
              2
              
              5.5
      years$6.22
      to $9.02
              
              
              
              149,641
              
              
              
              6.56
              
              
              
              –
              
              5.4
      years
              
              
              144,363
              
              
              
              6.58
              
              
              
              –
              
              5.4
      years$14.27 to $20.00
              
              
              
              396,846
              
              
              
              15.55
              
              
              
              –
              
              3.1
      years
              
              
              396,846
              
              
              
              15.55
              
              
              
              –
              
              3.1
      years$29.70 to $43.00
              
              
              
              437,474
              
              
              
              36.39
              
              
              
              –
              
              2.2
      years
              
              
              437,474
              
              
              
              36.39
              
              
              
              –
              
              2.2
      years$51.25 to $68.17
              
              
              
              132,561
              
              
              
              66.45
              
              
              
              –
              
              2.0
      years
              
              
              132,561
              
              
              
              66.45
              
              
              
              –
              
              2.0
      years$83.66
              
              
              
              35,930
              
              
              
              83.66
              
              
              
              –
              
              2.0
      years
              
              
              35,930
              
              
              
              83.66
              
              
              
              –
              
              2.0
      years1,821,481
              
              
              $
              20.66
              
              
              $
              511
              
              3.7
      years
              
              
              1,762,969
              
              
              $
              21.16
              
              
              $
              511
              
              3.6
      years




Restricted
Share Units (RSUs)





RSUs are
“phantom” shares that rise and fall in value based on the market price of the
company’s subordinate voting shares and are redeemable for actual subordinate
voting shares or cash at the discretion of the Board of Directors as determined
on the date of grant. Vesting dates are also established by the Board of
Directors on the date of grant. The vesting dates are subject to a minimum term
of three years and a maximum term of ten years from the award date, being the
required period of service from employees. RSUs granted under the plan
expire at the latest ten years from the date of grant. Fair value of RSUs
equals the market price of the common shares on the date of grant. This plan was
approved by the shareholders ofthe company.








F-25
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











The
following table summarizes RSU activity since August 31, 2005:




Years
      ended August 31,2008
              
              
              2007
              
              
              2006Outstanding
      – Beginning of year
              
              
              488,015
              
              
              
              327,877
              
              
              
              176,185Granted
              
              
              469,847
              
              
              
              219,002
              
              
              
              173,803Redeemed
              
              
              (65,870
              )
              
              
              (1,064
              )
              
              
              (4,770
              )Forfeited
              
              
              (44,201
              )
              
              
              (57,800
              )
              
              
              (17,341
              )Outstanding
      – End of year
              
              
              847,791
              
              
              
              488,015
              
              
              
              327,877




None of
the RSUs outstanding, as at August 31, 2006, 2007 and 2008, were redeemable. As
at August 31, 2008, the weighted average remaining contractual life of
the outstanding RSUs was 8.6 years. The weighted average grant-date fair
value of RSUs granted during fiscal 2006, 2007 and 2008 amounted to $5.39, $6.48
and $5.46, respectively.





As at
August 31, 2008, the intrinsic value of RSUs outstanding was
$3,566,000.





Expected
forfeitures are immaterial to the company and are not reflected in the table
above.





As at
August 31, 2008, unrecognized stock-based compensation costs of unvested RSUs
amounted to $3,390,000. The weighted average period over which they are
expected to be recognized is 3.1 years.





Deferred
share unit plan





In
January 2005, the company established a Deferred Share Unit (DSU) Plan for the
members of the Board of Directors as part of their annual retainer fees.
Each DSU entitles the Board members to receive one subordinate voting share.
DSUs are acquired on the date of grant and will be redeemed in subordinate
voting shares when the Board member ceases to be Director of the company.
This plan was approved by the shareholders of the company.





The
following table summarizes DSU activity since August 31, 2005:




Years
      ended August 31,2008
              
              
              2007
              
              
              2006Outstanding
      – Beginning of year
              
              
              64,718
              
              
              
              43,290
              
              
              
              23,734Granted
              
              
              35,162
              
              
              
              21,428
              
              
              
              19,556Redeemed
              
              
              (20,695
              )
              
              
              –
              
              
              
              –Outstanding
      – End of year
              
              
              79,185
              
              
              
              64,718
              
              
              
              43,290




None of
the DSUs outstanding as at August 31, 2006, 2007 and 2008 were redeemable. The
weighted average grant-date fair value of DSUs granted during fiscal 2006, 2007
and 2008 amounted to $5.81, $6.29 and $5.14.





As at
August 31, 2008, the intrinsic value of DSUs outstanding was
$335,100.








F-26
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Stock
appreciation rights plan





In August
2001, the company established the Stock Appreciation Rights Plan for certain
employees. Under that plan, eligible employees are entitled to receive a cash
amount equivalent to the difference between the market price of the common
shares on the date of exercise and the exercise price determined on the date of
grant. Stock appreciation rights granted under the plan generally expire ten
years from the date of grant and vest over a four-year period, being the
required period of service from employees, with 25% vesting on an annual basis
commencing on the first anniversary of the date ofgrant. This plan was
approved by the shareholders of the company.





The
following table summarizes stock appreciation rights activity since August 31,
2005:




Years
      ended August 31,2008
              
              
              2007
              
              
              2006Number
              
              
              Weighted
      average
                exercise
                price
              
              
              Number
              
              
              Weighted
      average
                exercise
                price
              
              
              Number
              
              
              Weighted
      average
                exercise
                priceOutstanding
      – Beginning of year
              
              
              27,700
              
              
              $
              11
              
              
              
              24,500
              
              
              $
              11
              
              
              
              19,000
              
              
              $
              12Granted
              
              
              3,000
              
              
              
              6
              
              
              
              5,200
              
              
              
              6
              
              
              
              5,500
              
              
              
              6Forfeited
              
              
              –
              
              
              
              –
              
              
              
              (2,000
              )
              
              
              2
              
              
              
              –
              
              
              
              –Outstanding
      – End of year
              
              
              30,700
              
              
              $
              10
              
              
              
              27,700
              
              
              $
              11
              
              
              
              24,500
              
              
              $
              11Exercisable
      – End of year
              
              
              19,550
              
              
              $
              12
              
              
              
              13,875
              
              
              $
              15
              
              
              
              11,000
              
              
              $
              18




The
following table summarizes information about stock appreciation rights as at
August 31, 2008:




Stock
      appreciation
                rights
      outstanding
              
              Stock
      appreciation
                rights
      exercisableExercise
      price
              
              Number
              
              Weighted
      average remaining contractual life
              
              Number$4.51
      to $6.50
              
              25,700
              
              7.2
      years
              
              14,550$22.25
              
              2,500
              
              2.4
      years
              
              2,500$45.94
              
              2,500
              
              2.0
      years
              
              2,50030,700
              
              6.4
      years
              
              19,550





F-27
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











14 Other
Disclosures





Net
research and development expenses





Net
research and development expenses comprise the following:




Years
      ended August 31,2008
              
              
              2007
              
              
              2006Gross
      research and development expenses
              
              $
              32,454
              
              
              $
              25,201
              
              
              $
              19,488Research
      and development tax credits and grants
              
              
              (5,587
              )
              
              
              (5,371
              )
              
              
              (4,084
              )Recognition
      of previously unrecognized research and development tax
      credits (note 15)
              
              
              –
              
              
              
              (3,162
              )
              
              
              –$
              26,867
              
              
              $
              16,668
              
              
              $
              15,404




Government
grants





During
1998, the company entered into an agreement with the Quebec Minister of
Industry, Commerce, Science and Technology (“The Minister”). Pursuant to this
agreement, the Minister agreed to contribute, in the form of grants,
up to CA$2,220,000 over the period from January 1, 1998, through
December 31, 2002, payable based on the number of full-time jobs created
during that period.





The above
grants were subject to the condition that jobs created pursuant to the agreement
be maintained for a period of at least five years from the date of
creation. Since the beginning of the program, the company had deferred in the
balance sheet CA$1,450,000 (US$1,307,000) from the amounts received until it
received the final approval by the sponsor of the program related to jobs
created. In fiscal 2006, the sponsor of the program granted the company its
final approval, and the company recorded CA$1,450,000 (US$1,307,000) in the
earnings from operations in the statement of earnings
of fiscal 2006.





Furthermore,
until December 31, 2006, companies operating in the Quebec City area were
eligible for a refundable credit granted by the Quebec provincial government.
This credit was earned based on the increase of eligible production and
marketing salaries incurred in the Quebec City area at a rate of 40%. From the
total amount claimed by the company under this program, a sum of CA$1,142,000
(US$1,079,000) was deferred in the balance sheet until the company received the
final approval of eligible salaries by the sponsor of the program. In fiscal
2007, the sponsor of the program granted the company its final approval, and the
company recorded CA$1,142,000 (US$1,079,000) in the earnings from operations
in the statement of earnings of fiscal 2007.





Defined
contribution plans





The
company maintains separate defined contribution plans for certain eligible
employees. These plans, which are accounted for on an accrual basis, are
summarized as follows:





·
            Deferred
      profit-sharing plan





The
company maintains a plan for certain eligible Canadian resident employees, under
which the company may elect to contribute an amount equal to 2% of an
employee’s gross salary, provided that the employee has contributed at least 2%
of his gross salary to a tax-deferred registered retirement savings plan. Cash
contributions to this plan and expenses for the years ended August 31, 2006,
2007 and 2008, amounted to $316,000, $419,000 and $531,000,
respectively.








F-28
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











·
            401K
      plan





The
company maintains a 401K plan for eligible U.S. resident employees. Under this
plan, the company must contribute an amount equal to 3% of an employee’s current
compensation. During the years ended August 31, 2006, 2007 and 2008, the company
recorded cash contributions and expenses totaling $126,000, $166,000 and
$216,000, respectively.








15 Income
Taxes





Fiscal
2006





Since
fiscal 2003, the company has maintained a full valuation allowance against its
consolidated future income tax assets. In fiscal 2006, the company recorded
an income tax expense of $2,585,000. Most of this expense represented income
taxes payable at the Canadian federal level, which were reduced by research and
development tax credits that were recorded against gross research and
development expenses in the statement of earnings of that year.





Fiscal
2007





During
fiscal 2007, after reviewing both available positive and negative evidence, and
because the company was in a cumulative profit position in the parent
company (Canadian federal and provinces level) and in one of its subsidiaries,
located in the United States, and also because the company expected to generate
sufficient taxable income in future years, management concluded that it was more
likely than not that future income tax assets and deferred non-refundable
research and development tax credits of the parent company and a portion of the
company’s future income tax assets in the United States would be realizable.
Consequently, it reversed a portion of its valuation allowance against future
income tax assets in the amount of $24,566,000 and recognized previously
unrecognized non-refundable research and development tax credits in the amount
of $3,162,000 (note 14). Future income tax assets recognized in 2007 were
recorded in the income tax provision, while research and development tax credits
were recorded against gross research and development expenses in the
statement of earnings for that year.





However,
in the United States (federal level), based on available positive and negative
evidence as at August 31, 2007, as well as the level and the nature of
cumulative and expected profits, the company maintained a valuation allowance
of $7,568,000 on a portion of its future income tax assets in
this tax jurisdiction because it was more likely than not that these assets
would not be recovered. These future income tax assets consisted of operating
losses carried forward.





In other
tax jurisdictions where the company has future income tax assets, the company
was still in a cumulative loss position as at August 31, 2007, and available
negative evidence outweighed positive evidence. Consequently, for these tax
jurisdictions, the company maintained a full valuation allowance against its
future income tax assets. As at August 31, 2007, the
valuation allowance recorded by the company for these tax jurisdictions amounted
to $4,924,000 and mainly related to deferred operating losses.





Fiscal
2008





During
fiscal 2008, reductions to the Canadian federal statutory tax rate were
substantively enacted. Therefore, Canadian federal future income tax assets
decreased by $1,524,000, and generated a future income tax expense in the
same amount during the year.








F-29
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











In
addition, during fiscal 2008, taking into consideration these new Canadian
federal substantively enacted tax rates, the company reviewed its tax strategy
for the future use of its Canadian federal operating losses, research and
development expenses, certain timing differences and research and development
tax credits to minimize income taxes payable on future years’ taxable income.
Consequently, it amended its prior year’s income tax returns to generate a net
operating loss to be carried back to prior years, which reinstated
previously used research and development tax credits. This resulted
in an increase of its tax-related assets of $2,715,000 and an income
tax recovery of the same amount in the statement of earnings for the year ended
August 31, 2008.





Finally,
during fiscal 2008, considering the expected positive impacts the acquisitions
of Navtel Communications Inc. and Brix Networks Inc. will have on future years’
taxable income at the United States (federal) level and because actual taxable
income in the United States is greater than initially expected, management
concluded that it was more likely than not that all future income tax assets of
its existing consolidated U.S. group would be recovered. Consequently, it
reversed its valuation allowance against future income tax assets in the amount
of $7,617,000. The portion of the valuation allowance that was reversed, and
that was attributable to the effects of the Navtel Communications Inc. and Brix
Networks Inc. acquisitions, inthe amount of $652,000 and
$1,641,000, respectively, were included in the purchase price allocation of the
related acquired businesses. The remainder of the reversal, in the amount of
$5,324,000, has been recorded in income taxes in the statement of earnings
for the year ended August 31, 2008.








F-30
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











The
reconciliation of the income tax provision calculated using the combined
Canadian federal and provincial statutory income tax rate with the income tax
provision in the financial statements is as follows:





Years
      ended August 31,2008
            
            
            2007
            
            
            2006Income
      tax provision at combined Canadian federal and provincial statutory tax
      rate (31% in 2008 and 32% in 2007 and 2006)
            
            $
            5,290
            
            
            $
            6,864
            
            
            $
            3,430Increase
      (decrease) due to:Foreign
      income taxed at different rates
            
            
            147
            
            
            
            (12
            )
            
            
            (85
            )Non-taxable
      income
            
            
            (448
            )
            
            
            (109
            )
            
            
            (207
            )Non-deductible
      expenses
            
            
            998
            
            
            
            692
            
            
            
            527Change
      in tax rates
            
            
            1,522
            
            
            
            105
            
            
            
            497Change
      in tax strategy
            
            
            (2,715
            )
            
            
            –
            
            
            
            –Foreign
      exchange effect of translation of foreign integrated
      subsidiaries
            
            
            32
            
            
            
            45
            
            
            
            61Other
            
            
            378
            
            
            
            236
            
            
            
            239Recognition
      of previously unrecognized future income tax assets
            
            
            (5,324
            )
            
            
            (24,566
            )
            
            
            –Utilization
      of previously unrecognized  future income tax
    assets
            
            
            (1,872
            )
            
            
            (4,715
            )
            
            
            (3,336
            )Unrecognized  future
      income tax assets on temporary deductible differences and unused tax
      losses and deductions
            
            
            3,668
            
            
            
            635
            
            
            
            1,459$
            1,676
            
            
            $
            (20,825
            )
            
            $
            2,585The
      income tax provision consists of the following:CurrentCanada
            
            $
            (7,474
            )
            
            $
            3,568
            
            
            $
            2,573Other
            
            
            380
            
            
            
            173
            
            
            
            12(7,094
            )
            
            
            3,741
            
            
            
            2,585FutureCanada
            
            
            12,111
            
            
            
            3,726
            
            
            
            2,687United
      States
            
            
            376
            
            
            
            428
            
            
            
            (601
            )Other
            
            
            (189
            )
            
            
            (74
            )
            
            
            (209
            )12,298
            
            
            
            4,080
            
            
            
            1,877Valuation
      allowanceCanada
            
            
            812
            
            
            
            (23,092
            )
            
            
            (2,687
            )United
      States
            
            
            (4,545
            )
            
            
            (5,628
            )
            
            
            601Other
            
            
            205
            
            
            
            74
            
            
            
            209(3,528
            )
            
            
            (28,646
            )
            
            
            (1,877
            )8,770
            
            
            
            (24,566
            )
            
            
            –$
            1,676
            
            
            $
            (20,825
            )
            
            $
            2,585Details
      of the company’s income taxes:Earnings
      (loss) before income taxes and extraordinary gainCanada
            
            $
            18,347
            
            
            $
            19,634
            
            
            $
            13,202United
      States
            
            
            (748
            )
            
            
            1,059
            
            
            
            (2,103
            )Other
            
            
            (535
            )
            
            
            757
            
            
            
            (379
            )$
            17,064
            
            
            $
            21,450
            
            
            $
            10,720






F-31
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Significant
components of the company’s future income tax assets and liabilities are as
follows:




As
      at August 31,2008
              
              
              2007Future
      income tax assetsLong-lived
      assets
              
              $
              3,696
              
              
              $
              4,304Provisions
      and accruals
              
              
              3,475
              
              
              
              6,257Deferred
      revenue
              
              
              1,466
              
              
              
              1,005Share
      issue expenses
              
              
              –
              
              
              
              106Research
      and development expenses
              
              
              12,424
              
              
              
              10,422Losses
      carried forward
              
              
              29,890
              
              
              
              17,23050,951
              
              
              
              39,324Valuation
      allowance
              
              
              (15,529
              )
              
              
              (12,492
              )35,422
              
              
              
              26,832Future
      income tax liabilitiesResearch
      and development tax credits
              
              
              (5,607
              )
              
              
              (2,026
              )Long-lived
      assets
              
              
              (5,135
              )
              
              
              –Other
              
              
              –
              
              
              
              (240
              )(10,742
              )
              
              
              (2,266
              )Future
      income tax assets, net
              
              $
              24,680
              
              
              $
              24,566





As at
August 31, 2008, the company had available operating and capital losses in
several tax jurisdictions, against which a valuation allowance of
$12,046,000 was recorded. The valuation allowance includes $6,291,000 for which
subsequently recognized benefits will be allocated to reduce goodwill (note
3).





The
following table summarizes the year of expiry of these losses by tax
jurisdiction:





Canada
            
            
            United
      StatesYear
      of expiry
            
            Federal
            
            
            Provincial
            
            
            and
      Other2013
            
            $
            787
            
            
            $
            712
            
            
            $
            –2014
            
            
            2,186
            
            
            
            2,184
            
            
            
            –2015
            
            
            1,174
            
            
            
            1,174
            
            
            
            –2016
            
            
            –
            
            
            
            22
            
            
            
            –2017
            
            
            –
            
            
            
            33
            
            
            
            –2019
            
            
            –
            
            
            
            –
            
            
            
            8262020
            
            
            –
            
            
            
            –
            
            
            
            3,4702021
            
            
            –
            
            
            
            –
            
            
            
            10,2022022
            
            
            –
            
            
            
            –
            
            
            
            9,6152023
            
            
            –
            
            
            
            –
            
            
            
            12,0872024
            
            
            –
            
            
            
            –
            
            
            
            7,0762025
            
            
            –
            
            
            
            –
            
            
            
            4,3502026
            
            
            1,019
            
            
            
            1,019
            
            
            
            1,9712027
            
            
            4,087
            
            
            
            4,087
            
            
            
            –2028
            
            
            395
            
            
            
            395
            
            
            
            769Indefinite
            
            
            14,154
            
            
            
            14,494
            
            
            
            19,634$
            23,802
            
            
            $
            24,120
            
            
            $
            70,000








F-32
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











As at
August 31, 2008, in addition to operating and capital losses, the company had
available research and development expenses in Canada amounting to $41,795,000
at the federal level and $29,264,000 at the provincial level; in the United
States, research and development expenses amounted to $4,680,000. A valuation
allowance of $2,850,000 was recorded against these assets. The valuation
allowance includes $1,872,000 for which subsequently recognized benefits will
be allocated toreduce goodwill (note 3).
In Canada, these expenses can be carried forward indefinitely against future
years’ taxable income in their respective tax jurisdiction, and in the United
States, these expenses can be carried forward against taxable income of fiscal
years 2013 to 2016.





Finally,
as at August 31, 2008, the company had non-refundable research and development
tax credits at the Canadian federal level in the amount of $21,300,000 that can
be carried forward against future years’ income taxes payable over the next
20 years. As at August 31, 2008, from this amount, $660,000 was
not recorded in the financial statements.


16  Earnings
per Share


The
following table summarizes the reconciliation of the basic weighted average
number of shares outstanding and the diluted weighted average number of shares
outstanding:




Years
      ended August 31,2008
              
              
              2007
              
              
              2006Basic
      weighted average number of sharesoutstanding
      (000’s)
              
              
              68,767
              
              
              
              68,875
              
              
              
              68,643Plus
      dilutive effect of:Stock
      options (000’s)
              
              
              291
              
              
              
              448
              
              
              
              502Restricted
      share units (000’s)
              
              
              181
              
              
              
              179
              
              
              
              99Deferred
      share units (000’s)
              
              
              79
              
              
              
              53
              
              
              
              31Diluted
      weighted average number of shares outstanding (000’s)
              
              
              69,318
              
              
              
              69,555
              
              
              
              69,275Stock
      awards excluded from the calculation of the diluted weighted average
      number of shares outstanding because their exercise price was greater
      than the average market price of the common shares (000’s)
              
              
              1,404
              
              
              
              1,207
              
              
              
              1,628







17 Financial
Instruments





Short-term
investments





Short-term
investments consist of the following:





As
      at August 31,2008
            
            2007Commercial
      paper denominated in Canadian dollars, bearing interest at annual rates of
      2.80% to 3.32% in 2008 and 3.98% to 4.67% in 2007, maturing on different
      dates between September 2008 and February 2009 in fiscal 2008, and
      September 2007 and January 2008 in fiscal 2007
            
            $ 81,626
            
            $124,217








F-33
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Fair
value





Cash and
short-term investments are carried at fair value. Accounts receivable and
accounts payable and accrued liabilities are financial instruments whose
carrying values approximate their fair values.





The fair
value of short-term investments based on market value, amounted to $124,217,000
and $81,626,000 as at August 31, 2007 and 2008,
respectively.





The fair
value of forward exchange contracts, which represents the amount that the
company would receive or pay to settle the contracts based on the forward
exchange rate at year end, amounted to net gains of $3,422,000 and $62,000
as at August 31, 2007 and 2008, respectively. As at August 31,
2008, forward exchange contracts, in the amount of $614,000, are presented
in the other receivables in the balance sheet, and forward exchange contracts,
in the amount of $714,000, are presented in accounts payable and accrued
liabilities in the balance sheet (note 9). As at August 31, 2007, the carrying
value of forward exchange contracts amounted to $555,000.





Based on
the portfolio of forward exchange contracts as at August 31, 2008, the company
estimates that the portion of the net unrealized losses on these contracts as of
that date, which will be realized and reclassified from accumulated other
comprehensive income to net earnings over the next 12 months, amounts to
$100,000.





Credit
risk





Financial
instruments that potentially subject the company to credit risk consist
primarily of cash, short-term investments, accounts receivable and forward
exchange contracts. The company’s short-term investments consist of debt
instruments issued by ten (seven in 2007) high-credit quality corporations and
trusts. None of these debt instruments are expected to be affected by
a liquidity risk, and none of them represent asset-backed commercial paper. The
company’s cash and forward exchange contracts are held with or issued by
high-credit quality financial institutions; therefore, the company considers the
risk of non-performance on these instruments to be remote.





Generally,
the company does not require collateral or other security from customers for
trade accounts receivable; however, credit is extended to customers following an
evaluation of creditworthiness. In addition, the company performs ongoing credit
reviews of all its customers and establishes an allowance for doubtful accounts
receivable when accounts are determined to be uncollectible. Allowance for
doubtful accounts amounted to $206,000 and $305,000 as at
August 31, 2007 and 2008, respectively.





Interest
rate risk





As at
August 31, 2008, the company’s exposure to interest rate risk is summarized
as follows:





Cash
            
            Non-interest
      bearingShort-term
      investments
            
            As
      described aboveAccounts
      receivable
            
            Non-interest
      bearingAccounts
      payable and accrued liabilities
            
            Non-interest
      bearing








F-34
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Forward
exchange contracts





The
company is exposed to currency risks as a result of its export sales of products
manufactured in Canada, the majority of which are denominated in US
dollars. These risks are partially hedged by forward exchange contracts and
certain operating expenses. As at August 31, 2007 and 2008, the company
held contracts to sell US dollars at various forward rates, which are summarized
as follows (note 8):




Contractual
                amounts
              
              
              Weighted
      average contractual
                forward
      ratesAs
      at August 31, 2007September
      2007 to August 2008
              
              $
              36,900
              
              
              
              1.1295September
      2008 to August 2009
              
              
              14,200
              
              
              
              1.1180September
      2009 to December 2009
              
              
              1,200
              
              
              
              1.1425As
      at August 31, 2008September
      2008 to August 2009
              
              $
              36,600
              
              
              
              1.0686September
      2009 to August 2010
              
              
              17,400
              
              
              
              1.0535September
      2010 to August 2011
              
              
              2,400
              
              
              
              1.0619







18 Segment
Information





The
company is organized under two reportable segments: the Telecom Division and the
Life Sciences and Industrial Division. The Telecom Division offers integrated
test solutions and network monitoring systems to network service providers,
cable TV operators, system vendors and component manufacturers throughout the
global telecommunications industry. The Life Sciences and Industrial Division
offers solutions in medical-device and opto-electronics assembly, fluorescence
microscopy and other life sciences sectors.





The
reporting structure reflects how the company manages its business and how it
classifies its operations for planning and measuring performance.





The
following tables present information by segment:





Year
      ended August 31, 2008Telecom
      Division
            
            
            Life
      Sciences and Industrial Division
            
            
            TotalSales
            
            $
            160,981
            
            
            $
            22,809
            
            
            $
            183,790Earnings
      from operations
            
            $
            9,524
            
            
            $
            2,459
            
            
            $
            11,983Unallocated
      items:Interest
      income
            
            
            
            
            
            
            
            
            
            
            4,639Foreign
      exchange gain
            
            
            
            
            
            
            
            
            
            
            442Earnings
      before income taxes and extraordinary gain
            
            
            
            
            
            
            
            
            
            
            17,064Income
      taxes
            
            
            
            
            
            
            
            
            
            
            1,676Earnings
      before extraordinary gain
            
            
            
            
            
            
            
            
            
            
            15,388Extraordinary
      gain
            
            
            
            
            
            
            
            
            
            
            3,036Net
      earnings for the year
            
            
            
            
            
            
            
            
            
            $
            18,424Amortization
      of capital assets
            
            $
            4,128
            
            
            $
            164
            
            
            $
            4,292Stock-based
      compensation costs
            
            $
            1,171
            
            
            $
            101
            
            
            $
            1,272Capital
      expenditures
            
            $
            6,327
            
            
            $
            181
            
            
            $
            6,508








F-35
 Table of Contents




EXFO Electro-Optical
Engineering Inc. Notes
to Consolidated Financial Statements





Year
      ended August 31, 2007Telecom
      Division
            
            
            Life
      Sciences and Industrial Division
            
            
            TotalSales
            
            $
            129,839
            
            
            $
            23,095
            
            
            $
            152,934Earnings
      from operations
            
            $
            13,132
            
            
            $
            3,650
            
            
            $
            16,782Unallocated
      items:Interest
      income
            
            
            
            
            
            
            
            
            
            
            4,717Foreign
      exchange loss
            
            
            
            
            
            
            
            
            
            
            (49
            )Earnings
      before income taxes
            
            
            
            
            
            
            
            
            
            
            21,450Income
      taxes
            
            
            
            
            
            
            
            
            
            
            (20,825
            )Net
      earnings for the year
            
            
            
            
            
            
            
            
            
            $
            42,275Recognition
      of previously unrecognized research and development tax credits (note
      14)
            
            $
            (3,162
            )
            
            $
            −
            
            
            $
            (3,162
            )Government
      grants (note 14)
            
            $
            (1,079
            )
            
            $
            −
            
            
            $
            (1,079
            )Amortization
      of capital assets
            
            $
            5,557
            
            
            $
            290
            
            
            $
            5,847Stock-based
      compensation costs
            
            $
            886
            
            
            $
            95
            
            
            $
            981Capital
      expenditures
            
            $
            5,424
            
            
            $
            123
            
            
            $
            5,547








Year
      ended August 31, 2006Telecom
      Division
            
            
            Life
      Sciences and Industrial Division
            
            
            TotalSales
            
            $
            107,376
            
            
            $
            20,877
            
            
            $
            128,253Earnings
      from operations
            
            $
            6,679
            
            
            $
            1,383
            
            
            $
            8,062Unallocated
      items:Interest
      income
            
            
            
            
            
            
            
            
            
            
            3,253Foreign
      exchange loss
            
            
            
            
            
            
            
            
            
            
            (595
            )Earnings
      before income taxes
            
            
            
            
            
            
            
            
            
            
            10,720Income
      taxes
            
            
            
            
            
            
            
            
            
            
            2,585Net
      earnings for the year
            
            
            
            
            
            
            
            
            
            $
            8,135Government
      grants (note 14)
            
            $
            (1,307
            )
            
            $
            −
            
            
            $
            (1,307
            )Amortization
      of capital assets
            
            $
            6,689
            
            
            $
            1,228
            
            
            $
            7,917Stock-based
      compensation costs
            
            $
            962
            
            
            $
            70
            
            
            $
            1,032Impairment
      of long-lived assets (note 4)
            
            $
            −
            
            
            $
            604
            
            
            $
            604Capital
      expenditures
            
            $
            3,049
            
            
            $
            329
            
            
            $
            3,378








F-36
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Total
assets by reportable segment are detailed as follows:




As
      at August 31,2008
              
              
              2007Telecom
      Division
              
              $
              145,168
              
              
              $
              109,065Life
      Sciences and Industrial Division
              
              
              9,571
              
              
              
              9,199Unallocated
      assets
              
              
              138,327
              
              
              
              160,874$
              293,066
              
              
              $
              279,138




Unallocated
assets are comprised of cash, short-term investments, other receivables on
forward exchange contracts, income taxes and tax credits recoverable as well as
future income taxes.





Sales to
external customers by geographic region are detailed as follows:




Years
      ended August 31,2008
            
            
            2007
            
            
            2006United
      States
            
            $
            79,471
            
            
            $
            73,679
            
            
            $
            59,457Canada
            
            
            14,219
            
            
            
            9,619
            
            
            
            8,767Latin
      America
            
            
            8,858
            
            
            
            7,592
            
            
            
            8,380Americas
            
            
            102,548
            
            
            
            90,890
            
            
            
            76,604China
            
            
            13,960
            
            
            
            9,329
            
            
            
            9,084Other
            
            
            15,148
            
            
            
            11,445
            
            
            
            10,186Asia-Pacific
            
            
            29,108
            
            
            
            20,774
            
            
            
            19,270Europe,
      Middle-East and Africa
            
            
            52,134
            
            
            
            41,270
            
            
            
            32,379$
            183,790
            
            
            $
            152,934
            
            
            $
            128,253




Sales
were allocated to geographic regions based on the country of residence of the
related customers. In fiscal 2006 and 2007, one customer represented more than
10% of sales with 13.8% of sales ($17,706,000) in 2006 and 14.7% of sales
($22,480,000) in 2007. In fiscal 2008, no customer represented more than 10% of
sales. For fiscal 2006 and 2007, this customer purchased from the Telecom
Division.








F-37
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Long-lived
assets by geographic region are detailed as follows:




As
      at August 31,2008
              
              
              2007Property,
      plant and equipment
              
              
              Intangible
      assets
              
              
              Goodwill
              
              
              Property,
      plant and equipment
              
              
              Intangible
      assets
              
              
              GoodwillCanada
              
              $
              15,916
              
              
              $
              7,479
              
              
              $
              23,007
              
              
              $
              15,939
              
              
              $
              9,563
              
              
              $
              24,801United
      States
              
              
              918
              
              
              
              12,397
              
              
              
              19,646
              
              
              
              13
              
              
              
              21
              
              
              
              3,636China
              
              
              1,965
              
              
              
              16
              
              
              
              −
              
              
              
              1,520
              
              
              
              22
              
              
              
              −Other
              
              
              1,076
              
              
              
              53
              
              
              
              −
              
              
              
              645
              
              
              
              22
              
              
              
              −$
              19,875
              
              
              $
              19,945
              
              
              $
              42,653
              
              
              $
              18,117
              
              
              $
              9,628
              
              
              $
              28,437






19 United
States Generally Accepted Accounting Principles





As a
registrant with the Securities and Exchange Commission in the United States
(SEC), the company is required to reconcile its financial statements for
significant differences in measurement and disclosure between generally accepted
accounting principles as applied in Canada (Canadian GAAP) and those applied in
the United States (U.S. GAAP). Furthermore, additional significant disclosures
required under U.S. GAAP and Regulation S-X of the SEC are also provided in the
accompanying financial statements and notes. The following summarizes the
significant quantitative differences between Canadian and U.S. GAAP, as
well as other significant disclosures required under U.S. GAAP and
Regulation S-X of the SEC not already provided in the accompanying financial
statements.





Reconciliation
of net earnings to conform to U.S. GAAP





The
following summary sets out the significant differences between the company’s
reported net earnings and net earnings per share under Canadian GAAP as compared
to U.S. GAAP. Refer to corresponding explanatory notes in the
Reconciliation Items section.




Years
      ended August 31,2008
            
            
            2007
            
            
            2006Net
      earnings for the year in accordance with Canadian GAAP
            
            
            
            
            $
            18,424
            
            
            $
            42,275
            
            
            $
            8,135Unrealized
      losses on available-for-sale securities
            
            
            a
            )
            
            
            −
            
            
            
            55
            
            
            
            –Stock-based
      compensation costs related to stock appreciation rights
            
            
            b
            )
            
            
            –
            
            
            
            (73
            )
            
            
            –Net
      earnings for the year in accordance with U.S. GAAP
            
            
            
            
            
            $
            18,424
            
            
            $
            42,257
            
            
            $
            8,135Out
      of which:Earnings
      before extraordinary gain
            
            
            
            
            
            $
            15,388
            
            
            $
            42,257
            
            
            $
            8,135Extraordinary
      gain
            
            
            
            
            
            $
            3,036
            
            
            $
            –
            
            
            $
            –Basic
      and diluted earnings before extraordinary gain per share in accordance
      with U.S. GAAP
            
            
            
            
            
            $
            0.22
            
            
            $
            0.61
            
            
            $
            0.12Basic
      and diluted net earnings per share in accordance with
      U.S. GAAP
            
            
            
            
            
            $
            0.27
            
            
            $
            0.61
            
            
            $
            0.12Basic
      weighted average number of shares outstanding (000’s)
            
            
            
            
            
            
            68,767
            
            
            
            68,875
            
            
            
            68,643Diluted
      weighted average number of shares outstanding (000’s)
            
            
            
            
            
            
            69,318
            
            
            
            69,555
            
            
            
            69,275






F-38
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Reconciliation
of shareholders’ equity to conform to U.S. GAAP





The
following summary sets out the significant differences between the company’s
reported shareholders’ equity under Canadian GAAP as compared to U.S. GAAP.
Refer to the corresponding explanatory note in the Reconciliation Items
section.




As
      at August 31,2008
              
              
              2007Shareholders’
      equity in accordance with Canadian GAAP
              
              
              
              
              $
              259,515
              
              
              $
              250,165Forward
      exchange contracts (note 2)
              
              
              c
              )
              
              
              –
              
              
              
              2,864Goodwill
              
              
              d
              )
              
              
              (12,640
              )
              
              
              (12,697
              )Future
      income tax assets (note 2)
              
              
              
              
              
              
              –
              
              
              
              (916
              )Stock
      appreciation rights
              
              
              b
              )
              
              
              (73
              )
              
              
              (73
              )Shareholders’
      equity in accordance with U.S. GAAP
              
              
              
              
              
              $
              246,802
              
              
              $
              239,343




Statements
of cash flows





For the
years ended August 31, 2006, 2007 and 2008, there were no significant
differences between the statements of cash flows under Canadian GAAP as compared
to U.S. GAAP, except for the subtotal before change in non-cash operating items,
whose presentation is not permitted under U.S. GAAP.





Reconciliation
items





a)
            Short-term
      investments





Upon the
adoption by the company of the CICA Handbook Section 3855 on September 1, 2007,
existing GAAP differences between Canadian GAAP and U.S. GAAP with respect to
accounting for short-term investments were eliminated (note 2). Under Canadian
GAAP, prior to the adoption of Section 3855 on September 1, 2007, short-term
investments were carried at the lower of cost and market value and any
unrealized loss was reflected in the statements of earnings. Under U.S. GAAP,
short-term investments are classified as “available-for-sale securities” and
carried at their fair value and any changes in their fair value are
reflected in comprehensive income consistent with the accounting treatment
required by Section 3855.





b)
            Stock-based
      compensation costs related to stock appreciation
  rights





Under
U.S. GAAP, stock-based compensation costs related to stock appreciation rights
must be measured using the fair value-based method at the end of each period.
The company uses the Black-Scholes options valuation model to measure the
fair value of its stock appreciation rights, based on the same assumptions than
those used for stock options. Changes in the fair value of these awards must be
charged to earnings. Under Canadian GAAP, stock appreciation rights are measured
using the intrinsic value method, based on the market price of the common shares
at the end of each period, and changes in the intrinsic value of these
awards are charged to earnings.








F-39
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











c)
            Forward
      exchange contracts





Upon the
adoption by the company of the CICA Handbook Section 3855 on September 1, 2007,
the existing GAAP differences between Canadian GAAP and U.S. GAAP with respect
to accounting for forward exchange contracts were eliminated (note 2).
Under Canadian GAAP, prior to the adoption of Section 3855 on September 1, 2007,
forward exchange contracts qualifying for hedge accounting were not recognized
on the balance sheet and foreign exchange translation gains and losses on these
contracts were only recognized as an adjustment of the revenue when the
corresponding hedged sales were recorded. Under U.S. GAAP, the forward exchange
contracts qualifying for hedge accounting are recorded at fair value in the
balance sheet, and changes in their fair value are reported in comprehensive
income. Upon the recognition of the hedged sales, accumulated changes in fair
value are reclassified in the statements of earnings consistent with the
accounting treatment required by Section 3855.





d)
            Goodwill





Under
U.S. GAAP, until the adoption of SFAS 142, “Goodwill and Other Intangible
Assets”, when assets being tested for recoverability were acquired in business
combinations accounted for by the purchase method, the goodwill that arose in
that transaction had to be included as part of the asset grouping in determining
recoverability. The intangible assets tested for recoverability prior to the
adoption of SFAS 142 were acquired in business combinations that were accounted
for using the purchase method and, consequently, the company allocated goodwill
to those assets on a pro rata basis, using the relative fair values of the
long-lived assets and identifiable intangible assets acquired as determined at
the date of acquisition. The carrying value of goodwill identified with the
impaired intangible assets was written down before any reduction was made to the
intangible assets.





Under
Canadian GAAP, no allocation of goodwill was required and each asset was tested
for recoverability separately based on its pre-tax undiscounted future cash
flows over its expected period of use.





This
created a permanent difference in the carrying value of goodwill under Canadian
GAAP and U.S. GAAP.





e)
            Research
      and development tax credits





Under
Canadian GAAP, all research and development tax credits are recorded as a
reduction of gross research and development expenses in the statements or
earnings. Under U.S. GAAP, tax credits that are refundable against income taxes
otherwise payable are recorded in the income taxes. These tax credits amounted
to $2,546,000, $6,639,000 and $3,692,000 for fiscal 2006, 2007 and 2008,
respectively. This difference has no impact on the net earnings and the net
earnings per share figures for the reporting years.





f)
            Elimination
      of deficit by reduction of share
capital





As at
August 31, 2006, under Canadian GAAP, the company proceeded to eliminate its
deficit against its share capital (note 12). However, under U.S. GAAP, such
elimination is not permitted, which creates a permanent difference
of $373,711,000 in the deficit and the share capital between the Canadian
GAAP and U.S. GAAP figures. This difference has no impact on the total amount of
the shareholders’ equity.





g)
            New
      accounting standards and
pronouncements





Adopted
in fiscal 2006





In
December 2004, the FASB issued SFAS 123(R), “Share-Based Payments”. This
statement supersedes ABP 25, “Accounting for Stock Issued to Employees” and
related implementation guidance, and revises SFAS 123 in a number of areas.
Under SFAS 123(R), all forms of share-based payment to employees result in
compensation cost recognized in financial statements. This statement is
effective for fiscal years beginning after June 15, 2005. The company adopted
this statement on September 1, 2005, using the modified prospective application
method of transition and its adoption had no significant impact on its financial
statements.





F-40
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











Adopted
in fiscal 2007





In May
2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections – a
replacement of APB Opinion No. 20 and FASB Statement No. 3”. This statement
replaces APB 20, “Accounting Changes”, and SFAS 3, “Reporting
Accounting Changes in Interim Financial Statements”, and changes the
requirements for the accounting for and reporting of a change in accounting
principle. This statement applies to all voluntary changes in accounting
principle. It also applies to changes required by an accounting pronouncement in
the unusual instance that the pronouncement does not include specific transition
provisions. In general, this statement requires a company to account for the
adoption of a new accounting policy by applying the new principle to prior
accounting periods as if that principle had always been adopted. The company
adopted this new statement on September 1, 2006, and its adoption had
no effect on its consolidated financial statements.





Adopted
in fiscal 2008





In June
2006, the FASB issued FASB Interpretation No. 48 (FIN 48), “Accounting for
Uncertainty in Income Taxes – an Interpretation of FASB Statement No. 109”,
which clarifies the accounting for uncertainties in income taxes recognized in
accordance with SFAS 109, “Accounting for Income Taxes”. The interpretation is
effective for fiscal years beginning after December 15, 2006. The company
adopted this interpretation on September 1, 2007, and its adoption had no impact
on its consolidated financial statements. Upon the adoption of FIN 48, the
company elected to classify interest and penalties in interest
expense.





To
be adopted after fiscal 2008





In
September 2006, the FASB issued SFAS 157, “Fair Value Measurements”, which
establishes a framework for measuring fair value in GAAP and is applicable to
other accounting pronouncements, in which fair value is considered to be the
relevant measurement attribute. SFAS 157 also expands disclosures about fair
value measurement. In February 2008, the FASB amended SFAS 157 to exclude
leasing transactions and to delay the effective date by one year for
non-financial assets and liabilities that are recognized or disclosed at fair
value in the financial statements on a non-recurring basis. This
statement is effective for fiscal years beginning after November 15, 2007. The
company will adopt this statement on September 1, 2008, and is
currently evaluating the impact its adoption will have on its consolidated
financial statements.





In
February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial
Assets and Financial Liabilities – Including an amendment of FASB Statement No.
115”, which permits entities to choose to measure many financial instruments and
certain other items at fair value. Most of the provisions of this statement
apply only to entities that elect the fair value option. However, the amendment
to SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities”,
applies to all entities with available-for-sale and trading securities. This
statement is effective for fiscal years beginning after November 15, 2007. The
company will adopt this statement on September 1, 2008, and it will
not elect to use the fair value option as of the date of adoption.





In
December 2007, the FASB issued SFAS 141(R), “Business Combinations”,
and SFAS 160, “Non-controlling Interests in Consolidated Financial
Statements, an amendment of ARB No. 51”. These new standards will
significantly change the accounting and reporting for business combination
transactions and non-controlling (minority) interests in consolidated
financial statements. SFAS 141(R) and SFAS160 are required to be adopted
simultaneously and are effective for the first annual reporting period beginning
on or after December 15, 2008. Earlier adoption is prohibited. The company
will adopt this statement on September 1, 2009, and is currently evaluating the
impact the adoption of SFAS 141(R) and SFAS 160 will have on its
consolidated financial statements.








F-41
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











In March
2008, the FASB issued SFAS 161, “Disclosure about Derivative Instruments and
Hedging Activities – an Amendment of FASB Statement no. 133”, which will
require entities to provide enhanced disclosures about (a) how and why an entity
uses derivative instruments, (b) how derivative instruments and related hedged
items are accounted for under SFAS 133 and its related interpretations, and (c)
how derivative instruments and related hedged items affect an entity’s financial
position, financial performance and cash flow. SFAS 161 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008, with early application encouraged. The company will
adopt this statement on September 1, 2009, and is currently evaluating the
impact its adoption will have on its note disclosures related to derivative
instruments and hedging activities.





In April
2008, the FASB issued the FASB staff position (FSP) FAS 142-3, “Determination of
the Useful Lives of Intangible Assets”.  This
FSP amends the factors that should be considered in developing renewalor
extension assumptions used to determine the useful life of a recognized
intangible asset underSFAS
142, “Goodwill and Other
Intangible Assets”. The intent of
this FSP is toimprove
the consistency between the useful life of a recognized intangible asset under
SFAS 142and
the period of expected cash flows used to measure the fair value of the asset
under SFAS141 (revised 2007), “Business
Combinations”, and other U.S.
generally acceptedaccounting
principles (GAAP).This
FSP shall be effective for financial statements issued for fiscal years
beginning after December15,
2008, and interim periods within those fiscal years. Early adoption is
prohibited. The guidancefor
determining the useful life of a recognized intangible asset in paragraphs 7–11
of this FSP shallbe
applied prospectively to intangible assets acquired after the effective date.
The disclosurerequirements
in paragraphs 13–15 shall be applied prospectively to all intangible assets
recognized as of, and subsequent to, the effective date. The company will adopt
this FSP on September 1, 2009, andis currently evaluating
the impact its adoption will have on its consolidated financialstatements.





In May
2008, the FASB issued SFAS 162,“The Hierarchy of
Generally Accepted Accounting Principles”. The new standard isintended to improve
financial reporting by identifying a consistent framework, or hierarchy,
forselecting
accounting principles to be used in preparing financial statements that are
presented inconformity with U.S. GAAP
for non-governmentalentities. For
non-governmental entities, the guidance in SFAS 162 replaces that prescribed
inStatement on
Auditing Standards (SAS) No. 69, “The Meaning of Present Fairly in Conformity
withGenerally
Accepted Accounting Principles” and will become effective 60 days following the
SEC'sapproval of the
Public Company Accounting Oversight Board’s amendments to AU Section411, “The Meaning of
Present Fairly in Conformity with Generally Accepted Accounting
Principles”.The
company is currently evaluating the impact the adoption of SFAS 162 will have on
its consolidated financialstatements.








20 Subsequent
Events





On
November 6, 2008, the Board of Directors of the company approved a renewal of
its share repurchase program, by way of a normal course issuer bid on the open
market, of up to 10% of its public float (as defined by the Toronto Stock
Exchange), or 2,738,518 subordinate voting shares, at the prevailing market
price. The company expects to use cash, short-term investments or future cash
flows from operations to fund the repurchase of shares. The period of the normal
course issuer bid commences on November 10, 2008, and will end on
November 9, 2009, or on an earlier date if the company repurchases the
maximum number of shares permitted under the bid. The program does not require
the company to repurchase any specific number of shares, and it may be modified,
suspended or terminated at any time and without prior notice. All shares
repurchased under the bid will be cancelled.








F-42
 Table of Contents




EXFO Electro-Optical
Engineering Inc.


Notes
to Consolidated Financial Statements











On
November 10, 2008, the Board of Directors of the company approved a substantial
issuer bid (the “Offer”) to purchase for cancellation up to 8,823,529
subordinate voting shares for an aggregate purchase price not to exceed
CA$30,000,000. The Offer is being made by way of a “modified Dutch Auction”
pursuant to which shareholders may tender all or a portion of their shares (i)
at a price not less than CA$3.40 per share and not more than CA$3.90 per share,
in increments of CA$0.05 per share, or (ii) without specifying a purchase price,
in which case their shares will be purchased at the purchase price determined in
accordance with the Offer. The Offer will expire on December 16, 2008, unless
withdrawn, extended or varied by the company. The company expects to use cash,
short-term investments or future cash flows from operations to fund the
repurchase of shares. The Offer is not conditional upon any minimum number of
shares being tendered, but it is subject to certain other
conditions.





Upon the
approval of the Offer, the company suspended the normal course issuer bid
referred to above, until 20 business days following the expiration of the
Offer.






F-43