Reko International Group Inc.
TSX : REK

Reko International Group Inc.

December 02, 2010 14:39 ET

Reko Announces First Quarter Results for Fiscal 2011 and Approval of Listing on the TSX Venture Exchange

WINDSOR, ONTARIO--(Marketwire - Dec. 2, 2010) - Reko International Group Inc. (TSX:REK) is pleased to announce that its Common Shares have been approved for listing on the TSX Venture Exchange ("TSX-V") and that it intends to apply for voluntary delisting from the TSX. Neither the TSX nor TSX-V has reviewed or accepts responsibility for the adequacy or accuracy of this news release.

Reko also announced results for its first quarter ended October 31, 2010.

Financial Highlights (complete statements follow):
Period Ended October 31, Three Months  
(in $,000 except per share amounts) Unaudited  
  2010   2009  
Sales $ 9,841   $ 9,255  
Net (loss) income   (1,287 )   (1,177 )
EPS (basic)   (0.20 )   (0.18 )
Working capital   (647 )   15,468  
Shareholders' equity   34,872     42,444  
Shareholders' equity per share   5.43     6.61  

Consolidated sales for the quarter ended October 31, 2010, were $9.9 million, compared to $9.3 million in the previous year. This represents an increase of approximately 6.3%. Reko's sales increase is tied to the recovery of the capital equipment market.

The gross profit for the three months ended October 31, 2010, was $0.4 million, or 3.9% of sales, compared to $0.1 million, or 1.5% of sales in the prior year. The increase in gross profit reflects improved sales levels from the prior year.

During the quarter, Reko increased the valuation allowance associated with its SR&ED tax credits by $0.3 million, while also decreasing the valuation allowance associated with its Canadian non-capital loss carryforwards by the same amount. This had the effect of reducing the gross profit by $0.3 million. Absent, this adjustment of valuation allowances, Reko's gross profit for the three months ended October 31, 2010 would have been $0.7 million, or 6.7% of sales.

Selling and administrative expenses for the three months ended October 31, 2010 were $1.5 million, or 15.2% of sales, the same amount as in the prior year, when it represented 15.8% of sales. Although consistent in absolute terms, selling and administrative costs improved as a percentage of sales, as a result of our increased sales levels from the prior year.

The Company's working capital at October 31, 2010 is negative $647,000; however, this calculation of working capital includes $11.1 million related to the final real estate mortgage payment due on our mortgage in the fourth quarter of 2011. Absent this final payment, the working capital calculation at October 31, 2010 would have been $10.5 million. The Company has begun discussions with its existing and prospective lenders to refinance the mortgage.

"While we are pleased to see improved sales levels from the prior year, they still remain lower than necessary to support our return to profitability," said Diane St. John, Chief Executive Officer. "Reko is actively working to identify and secure new business opportunities. As the slow recovery of the capital equipment market strengthens, Reko is well positioned to return to its previous sales levels."

Founded in 1976, Reko International Group (TSX:REK) is a highly integrated, technology driven engineering and manufacturing firm providing engineered solutions for the automotive, aerospace and consumer product markets. In its nine production facilities in Ontario, Reko designs and manufactures precision moulds and other related industrial tooling, factory automation and high tolerance machining of large parts.

REKO INTERNATIONAL GROUP INC.  
  First Quarter Report
 
 
INTERIM CONSOLIDATED BALANCE SHEETS
As at October 31, 2010 with comparative figures for July 31, 2010 (in 000's)
    October 31,   July 31,
    (unaudited)   (audited)
    2010   2010
ASSETS        
Current        
  Cash and cash equivalents $ -- $ 1,303
  Accounts receivable   13,699   10,657
  Other receivables   307   367
  Non-hedging financial derivatives   690   591
  Income taxes receivable   21   22
  Work-in-progress   17,014   19,826
  Prepaid expenses and deposits   667   536
    32,398   33,302
 
Capital assets   31,966   32,825
Future income taxes   2,818   2,814
SR & ED tax credits   4,253   4,460
  $ 71,435 $ 73,401
 
LIABILITIES        
Current        
  Bank indebtedness $ 15,725 $ 14,292
  Accounts payable and accrued liabilities   4,836   6,201
  Current portion of long-term debt   12,484   12,678
    33,045   33,171
 
Long-term debt   1,608   1,925
Future income taxes   1,910   2,149
 
SHAREHOLDERS' EQUITY        
Share capital   18,772   18,772
Contributed surplus   1,751   1,750
Retained earnings   14,349   15,634
    34,872   36,156
  $ 71,435 $ 73,401
 
 
See accompanying notes to the interim consolidated financial statements
 
 
INTERIM CONSOLIDATED STATEMENTS OF LOSS AND COMPREHENSIVE LOSS AND RETAINED EARNINGS
Three months ended October 31, 2010 with comparative figures for October 31, 2009 (in 000's except per share data)
  For the three months
ended October 31,
 
  (unaudited)  
    2010     2009  
Sales $ 9,841   $ 9,255  
Costs and expenses            
  Cost of sales   8,525     8,046  
  Selling and administrative   1,496     1,463  
  Amortization   937     1,066  
    10,958     10,575  
Loss before the following   (1,117 )   (1,320 )
   
   
Interest on long-term debt   226     278  
Interest on other interest bearing obligations, net   217     112  
    443     390  
Loss before income taxes   (1,560 )   (1,710 )
Future income taxes recovered   (275 )   (533 )
    (275 )   (533 )
Net loss and comprehensive loss   (1,287 )   (1,177 )
   
   
Retained earnings, beginning of period   15,634     23,103  
Net loss   (1,287 )   (1,177 )
Retained earnings, end of period $ 14,349   $ 21,926  
   
Loss per common share            
Basic $ (0.20 ) $ (0.18 )
Diluted $ (0.20 ) $ (0.18 )
 
 
See accompanying notes to the interim consolidated financial statements
 
 
INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS
Three months ended October 31, 2010 with comparative figures for October 31, 2009 (in 000's)
    For the three months  
    ended October 31,  
    (unaudited)  
    2010     2009  
OPERATING ACTIVITIES            
Net loss for the period $ (1,287 ) $ (1,177 )
Adjustments for:            
  Amortization   937     1,066  
  Future income taxes   (275 )   (533 )
  SR & ED credits   242     (69 )
  (Gain) loss on sale of capital assets   (7 )   (60 )
  Stock option expense   1     4  
    (389 )   (800 )
Net change in non-cash working capital   (1,764 )   3,251  
Cash provided by operating activities   (2,153 )   2,451  
   
CASH FLOWS FROM FINANCING ACTIVITIES            
Proceeds from (net payments on) bank indebtedness   1,433     (1,946 )
Payments on long-term debt   (511 )   (1,011 )
Cash used in financing activities   922     (2,957 )
   
CASH FLOWS FROM INVESTING ACTIVITIES            
Investment in capital assets   (78 )   (111 )
Proceeds on sale of capital assets   7     586  
Cash provided by investing activities   (72 )   475  
Net change in cash and cash equivalents   (1,303 )   --  
Cash and cash equivalents, beginning of period   1,303     --  
Cash and cash equivalents, end of period $ --   $ --  
 
 
See accompanying notes to the interim consolidated financial statements
 
 
 
Notes to unaudited interim consolidated financial statements for the three months ended October 31, 2010
(in 000's, except for share and per share figures)

1. Significant accounting policies

Management prepared these unaudited interim consolidated financial statements in accordance with Canadian generally accepted accounting principles using the historical cost basis of accounting and approximation and estimates based on professional judgment. These unaudited interim consolidated financial statements contain all adjustments that management believes are necessary for a fair presentation of the Company's financial position, results of operations and cash flows. These statements should be read in conjunction with the Company's most recent annual consolidated financial statements. The accounting policies and estimates used in preparing these unaudited interim consolidated financial statements are consistent with those used in preparing the annual consolidated financial statements, except as noted below.

2. Share capital

The Company had 6,420,920 common shares outstanding at October 31, 2010. During the quarter, no options were granted and no options were exercised.

3. Stock based compensation

The Company has established a stock option plan for directors, officers and key employees. The terms of the plan state that the aggregate number of shares, which may be issued and sold, will not exceed 10% of the issued and outstanding common shares of the Company on a non-diluted basis. The issue price of the shares shall be determined at the time of the grant based on the closing market price of the shares on the specified date of issue. Options shall be granted for a period of five years with a vesting progression of 30% in the year of the grant, 30% in the second year and 40% in the third year with the option expiring after five years. Options given to outside directors vest immediately and can be exercised immediately.

During the quarter, no options were granted. Stock based compensation for the three months ended October 31, 2010 was $1.

4. Financial instruments and risk management

Categories of financial assets and liabilities

Under Canadian generally accepted accounting principles, financial instruments are classified into one of the following five categories: held for trading, held to maturity investments, loans and receivables, available-for-sale financial assets and other financial liabilities. The carrying values of the Company's financial instruments are classified into the following categories:

  October 31, July 31,
  2010 2010
    $   $
Held for trading financial assets        
  Cash and cash equivalents $ -- $ 1,303
  Non-hedging financial derivatives   690   591
  $ 690 $ 1,894
Held for trading financial liabilities        
  Bank indebtedness $ 15,725 $ 14,292
Loans and receivables        
  Accounts receivable $ 15,050 $ 10,657
Other financial liabilities        
  Accounts payable and accrued liabilities $ 4,836 $ 6,201
  Current portion of long-term debt   12,484   12,678
  Long-term debt   1,608   1,925
  $ 18,928 $ 20,804

The Company has determined the estimated fair values of its financial instruments based on appropriate valuation methodologies; however, considerable judgment is required to develop these estimates. The fair values of the Company's financial instruments are not materially different from their carrying value, with the exception of the Company's long-term debt of $14,092. Based on current interest rates for debt with similar terms and maturities, the fair value of the long-term debt is estimated to be $14,398.

Impairment losses recognized on trade receivables

During the quarter, the Company recorded the following transactions with respect to its allowance for doubtful accounts:

       
    October 31, 2010  
Opening allowance for doubtful accounts $ 679  
Less: write-off of allowance and receivables   --  
Plus: bad debt expense   --  
Plus: effect of foreign exchange on U.S. denominated balances   (6 )
Closing allowance for doubtful accounts $ 673  

Risks arising from financial instruments and risk management

The Company's activities expose it to a variety of financial risks: market risk (including foreign exchange and interest rate), credit risk and liquidity risk. The Company's overall risk management program focuses on the unpredictability of financial markets and seeks to minimize potential adverse effects on the Company's financial performance from quarter to quarter. The Company uses derivative financial instruments to achieve this objective. The Company does not purchase any derivative financial instruments for speculative purposes.

Foreign exchange risk

The Company operates in Canada and its functional and reporting currency is Canadian dollars, however a significant portion of its sales are denominated in U.S. dollars. Foreign exchange risk arises because the amount of the receivable or payable for transactions denominated in a foreign currency may vary due to changes in exchange rates ("transaction exposures") and because certain long-term contractual arrangements denominated in a foreign currency may vary due to changes in exchange rates ("translation exposures").

The Company's balance sheet includes U.S. dollar denominated cash, accounts receivable, work-in-progress, capital assets, future income taxes, bank indebtedness and accounts payable and accrued liabilities. The Company is required to revalue these U.S. dollar denominated items to their current Canadian dollar value at each period end.

The objective of the Company's foreign exchange risk management activities is to minimize translation exposures and the resulting volatility of the Company's earnings. The Company manages this risk by entering into foreign exchange option contracts.

Based on the Company's foreign currency exposures, as at October 31, 2010, a change in the U.S. dollar/Canadian dollar foreign exchange rate to reflect a 100 basis point strengthening of the U.S. dollar for the month of October would, assuming all other variables remain constant, have increased net income by $19, with an equal but opposite effect for an assumed 100 basis point weakening of the U.S. dollar. We caution that this sensitivity is based on an assumed net U.S. dollar denominated asset or liability balance at a point in time. Our net U.S. dollar denominated asset or liability position changes on a daily basis, sometimes materially.

Foreign exchange contracts

The Company utilizes financial instruments to manage the risk associated with fluctuations in foreign exchange. At October 31, 2010, the Company had entered into foreign exchange contracts to sell an aggregate amount of $28,400 (USD). These contracts hedge our expected exposure to U.S. dollar denominated net assets and mature at the latest on May 15, 2012, at an average exchange rate of $1.0516 Canadian. The mark-to-market value on these financial instruments as at October 31, 2010 was an unrealized gain of $690; the change in this value from July 31, 2010 has been recorded in net loss for the quarter.

             
             
As at October 31, 2010 Maturity Notional Average Notional Carrying & fair  
    value rate USD value asset  
        equivalent (liability)  
Sell USD / Buy CAD 0 – 6 months $ 10,823   1.0611 $ 10,400 $ 423  
Sell USD / Buy CAD 7 – 12 months   10,202   1.0492   10,000   202  
Sell USD / Buy CAD 12 – 24 months   8,065   1.0417   8,000   65  
   
    $ 29,090   1.0516 $ 28,400 $ 690  
   
             
As at July 31, 2010 Maturity Notional Average Notional Carrying & fair  
    value rate USD value asset  
        equivalent (liability)  
Sell USD / Buy CAD 0 – 6 months $ 11,216 $ 1.0640 $ 10,800 $ 461  
Sell USD / Buy CAD 7 – 12 months   7,199   1.0590   7,000   198  
Sell USD / Buy CAD 13 – 24 months   6,976   1.0340   7,000   (23 )
   
    $ 25,391 $ 1.0538 $ 24,800 $ 591  

Interest rate risk

The Company's interest rate risk primarily arises from its floating rate debt, in particular its bank indebtedness. At October 31, 2010, $15,295 of the Company's total debt portfolio is subject to movements in floating interest rates.

Based on the value of interest-bearing financial instruments, subject to movements in floating interest rates, as at October 31, 2010, an assumed 0.5 percentage point increase in interest rates on the first day of the quarter would, assuming all other variables remain constant, have decreased net income by $19, with an equal but opposite effect for an assumed 0.5 percentage point decrease.

The objective of the Company's interest rate risk management activities is to minimize the volatility of the Company's earnings. Since the Company's exposure to floating interest rates is limited to its bank indebtedness, the Company's ability to effectively manage the volatility of interest rates is limited to locking portions of the Company's bank indebtedness into fixed rates for relatively short periods of time, usually 30 or 90 days.

Credit risk

Credit risk arises from cash and cash equivalents held with banks and financial institutions, derivative financial instruments as well as credit exposure to clients, including outstanding accounts receivable and unbilled contract revenue. The maximum exposure to credit risk is equal to the carrying value of the financial assets.

The objective of managing counterparty credit risk is to prevent losses in financial assets. The Company assesses the credit quality of the counterparties, taking into consideration their financial position, past experience and other factors. Management also monitors the utilization of credit limits regularly. In cases where credit quality of a client does not meet the Company's requirements sales opportunities may be terminated, progress payments may be required or continuing security interests in our products may be required.

In the normal course of business, the Company is exposed to credit risk from its customers, the majority of whom are in the automotive industry. While these accounts receivable are subject to normal industry credit risks, the ultimate source of funds to pay our accounts receivable balances may come from the Detroit 3 original equipment manufacturers, which are currently rated below investment grade by credit rating agencies, two of whom left United States bankruptcy protection in the last year, and in the event that they are unable to satisfy their financial obligations or seek protection from their creditors, the Company may incur additional expenses as a result of such credit exposure. The Company may be able to mitigate a portion of this credit risk through the use of accounts receivable insurance, when and if available to individual customers.

For the three months ended, October 31, 2010, sales to the Company's three largest customers represented 32% of its total sales. These same customers represent approximately 41% of its total accounts receivable, as at October 31, 2010.

Liquidity risk

Liquidity risk arises through an excess of financial obligations over available financial assets due at any point in time. The Company's objective in managing liquidity risk is to maintain sufficient readily available reserves in order to meet its liquidity requirements at any point in time. The Company achieves this by maintaining sufficient cash and cash equivalents and through the availability of funding from credit facilities. As at October 31, 2010, the Company has undrawn lines of credit available to it of approximately $4,275; however, under its current margining provisions with its lender, the maximum it can draw on its available undrawn lines of credit is limited to $3,262.

The Company's mortgage on its land and building are due before the end of the year in two payments, one on June 1, 2011 in the amount of $9,813, and one on July 1, 2011 in the amount of $1,319. The Company has begun discussions with its existing and prospective lenders, and has obtained an updated valuation of its capital assets in support of its efforts to refinance this obligation.

The Company met its financial covenants at the end of the first quarter of 2011. The Company's current financial forecasts suggest that it will earn sufficient levels of EBITDA to meets its minimum monthly EBITDA covenant for the second quarter of 2011, the only period for which the covenant is already set. Despite the Company's current forecasts suggesting the Company will achieve this financial covenant, the Company is exposed to a number of risks that could prevent it from achieving its primary lender defined monthly minimum EBITDA covenant.

5. Management of capital

The Company's objective in managing capital is to ensure sufficient liquidity to pursue its organic growth strategy, while at the same time taking a conservative approach to financial leverage and management of financial risk. The Company's capital is composed of net debt and shareholders' equity. Net debt consists of interest-bearing debt less cash and cash equivalents. The Company's primary uses of capital are to finance increases in non-cash working capital and capital expenditures for capacity expansion. The Company currently funds these requirements out of its internally generated cash flows and when internally generated cash flow is insufficient, its revolving bank credit facility.

The primary measure used by the Company to monitor its financial leverage is its ratio of net debt to shareholders' equity, which it aims to maintain at less than 1.0:1. As at October 31, 2010, the above capital management criteria can be illustrated as follows:

       
  October 31, 2010 July 31, 2010  
  $ $  
Net debt      
  Bank indebtedness 15,725 14,292  
  Current portion of long-term debt 12,484 12,678  
  Long-term debt 1,608 1,925  
  Less: cash and cash equivalents -- (1,303 )
Net debt 29,871 27,997  
Shareholders' equity 34,872 36,156  
Ratio 0.86 0.77  

As part of the Company's existing debt agreements, three financial covenants are monitored and communicated, as required by the terms of credit agreements, on a monthly, quarterly or annual basis depending on the covenant by management to ensure compliance with the agreements. The annual covenant is a debt service ratio – calculated as EBITDA less cash taxes (for the previous 52 weeks) divided by interest coverage plus repayments of long-term debt (based on the upcoming 52 weeks). The quarterly covenants are: i) debt to equity ratio – calculated as total debt, excluding future income taxes divided by shareholders' equity minus minority interest, if any; and (iii) current ratio – calculated as current assets, which for the first quarter of 2011 excludes all amounts related to the mortgage obligation, divided by current liabilities. The monthly covenant is a minimum EBITDA target.

MANAGEMENT'S DISCUSSION AND ANALYSIS

The following is management's discussion and analysis of operations and financial position ("MD&A") and should be read in conjunction with the unaudited interim consolidated financial statements for the three months ended October 31, 2010 and the audited consolidated financial statements and MD&A for the year ended July 31, 2010 included in our 2010 Annual Report to Shareholders. The unaudited interim consolidated financial statements for the three months ended October 31, 2010 have been prepared in accordance with Canadian generally accepted accounting principles ("GAAP"), and the audited consolidated financial statements for the year ended July 31, 2010 have been prepared in accordance with Canadian GAAP. When we use the terms "we", "us", "our", "Reko", or "Company", we are referring to Reko International Group Inc. and its subsidiaries.

This MD&A has been prepared by reference to the MD&A disclosure requirements established under National Instrument 51-102 "Continuous Disclosure Obligations" ("NI 51-102") of the Canadian Securities Administrators. Additional information regarding Reko, including copies of our continuous disclosure materials such as our annual information form, is available on our website at www.rekointl.com or through the SEDAR website at www.sedar.com.

In this MD&A, reference is made to gross profit (loss), which is not a measure of financial performance under Canadian GAAP. The Company calculates gross profit (loss) as sales less cost of sales (including depreciation and amortization). The Company included information concerning this measure because it is used by management as a measure of performance, and management believes it is used by certain investors and analysts as a measure of the Company's financial performance. This measure is not necessarily comparable to similarly titled measures used by other companies.

All amounts in this MD&A are expressed in 000's of Canadian dollars, except per share data and where otherwise indicated.

This MD&A is current to December 1, 2010.

OVERVIEW

Reko designs and manufactures a variety of engineered products and services for original equipment manufacturers ("OEMs") and their Tier 1 suppliers. These products include plastic injection molds, fixtures, gauges, lean cell factory automation, high precision custom machining, and assemblies. Customers are typically OEMs or their Tier 1 suppliers and are predominantly in the automotive market. Divisions of Reko are generally invited to bid upon programmes comprised of a number of custom products used by the customer to produce a complete assembly or product.

For the automotive industry, the Company designs and builds plastic injection molds, hydro-forming dies, two shot molds, and compression molds. Injection molds range in size from less than one cubic foot to approximately four feet wide, ten feet long, and six feet high. They range in weight from approximately 100 pounds to 50 tons. Typically, plastic injection molds are expected to perform up to 1,000,000 production cycles with limited maintenance. Each production cycle lasts between 30 and 120 seconds. Reko has extensive experience and knowledge in mold design and material flow and the impact of pressure on segments of the mold/die. In addition, it designs and builds custom lean factory cell automation for use primarily in the automotive industry and specialty custom machines for other industries. The factory automation systems include asynchronous assembly and test systems, leak and flow test systems, robotic assembly/machines vision work cells and various welding systems. For the transportation and oil and gas industry, the Company machines customer supplied metal castings to customer indicated specifications.

Our design and manufacturing operations are carried on in nine manufacturing plants located at four industrial sites in the suburbs of the City of Windsor in Southwestern Ontario.

INDUSTRY TRENDS AND RISKS

Historically, our success has been primarily dependent upon (i) a favourable U.S. dollar versus the Canadian dollar; (ii) the levels of new model releases of automobiles and light trucks by North American OEMs; and, (iii) our ability to source moulding and automation programmes with them. OEM new model releases can be impacted by many factors, including general economic and political conditions, interest rates, energy and fuel prices, labour relation issues, regulatory requirements, infrastructure, legislative changes, environmental emissions and safety issues.

The economic, industry and risk factors discussed in our Annual Information Form and Annual Report, each in respect of the year ended July 31, 2010, remain substantially unchanged in respect of the three months ended October 31, 2010, however, the most significant of which are repeated below.

Continued support of our lenders could have a material impact on our profitability and continued sustainability

The Company is engaged in a capital-intensive business; has significant financing requirements placed on it by its customers; and its financial resources are inferior to the financial resources of our customer base. There can be no assurance that, if, and when the Company seeks additional equity or debt financing, it will be able to obtain the additional financial resources required to successfully compete in its markets on favourable commercial terms. The Company's continued relationship with its lenders it tied to the Company's ability to meet the financial covenant conditions placed on its lenders. During the past year, our lender has agreed, on multiple occasions to revisit and revise our financial covenants while the Company deals with general economic pressure, industry specific pricing pressure and certain operational issues. There can be no assurance as to the length of time our lender is willing to provide the Company to return its operations to its historically normal financial covenants. Further, additional equity financings may result in dilution to existing shareholders.

Current outsourcing and in-sourcing trends could materially impact our profitability

As global market conditions just begin to improve from the previous two years' financial lows, demand for our customers' products remains weak. During periods of weakened demand, our customers traditionally revisit outsourcing decisions as a method of maintaining their employment levels. As a result of this and other factors, some of our customers are deciding to perform in-house work that in the recent past would have been performed by Reko. Depending upon the depth and breadth of the current economic recovery, Reko may continue to experience significant reductions in securing out-sourced work from customers.

The increasing pressure from our customers to launch new awards without adequate design support could materially impact our profitability

As the automotive industry completes the restructuring of its operations and deals with the production volume volatility that is commonplace today, our OEM and Tier 1 customers continue to operate at substantially reduced design support levels for new vehicle launches. Without an adequate level of support, the quality of information provided to the tool builders to begin their work has dropped significantly. In addition, the tool builders' ability to manipulate the poor quality information is limited as the appropriate resources to approve the manipulations are not available from the OEM or Tier 1. This has introduced significant inefficiencies to the process and decreased the ability of the tool builder to manufacture molds on a profitable basis.

The consequences of deteriorating financial condition of a large number of our customers and their resultant inability to satisfy their financial obligations could materially impact our profitability and cash flow

The financial condition of our traditional customers has deteriorated in recent years due in part to high labour costs (including health care, pension and other post-employment benefit costs), high raw materials, commodities and energy prices, declining sales and other factors. This deterioration ultimately led to General Motors and Chrysler filing for Chapter 11 bankruptcy protection. Additionally, the volatility of gasoline prices has affected and could further threaten sales of certain of their models, such as full-size sport utility vehicles and light trucks. All of these conditions could further threaten the financial condition of some of our customers, putting additional pressure on us to reduce our prices and exposing us to greater credit risk. In the event that our customers are unable to satisfy their financial obligations or seek protection from their creditors, we may incur additional expenses as a result of our credit exposure.

Significant long-term fluctuations in relative currency values of the Euro, U.S. dollar and Canadian dollar could materially impact our profitability

Although we report our financial results in Canadian dollars, a significant portion of our sales are priced in U.S. dollars. Our profitability is affected by movements of the U.S. dollar against the Canadian dollar. However, as a result of economic hedging programmes employed, foreign currency transactions are not fully impacted by the recent movements in exchange rates. Economic hedging programmes are inherently short-term in nature. Despite these measures, significant long-term shifts in relative currency values could have an adverse effect on our profitability and financial condition and any sustained changes in relative currency values could adversely impact our competitiveness in both the short and long-terms.

TSX delisting review could materially impact the level of liquidity in the trading of Reko's shares and/or materially impact the price at which Reko's shares may trade

On September 10, 2010, the TSX advised the Company that it would be conducting a continued listing review. If the Company is found by the TSX to no longer meet the minimum listing requirements of the TSX, the Company's securities may be delisted from the TSX which could have a material adverse affect on the trading price of Reko's shares, particularly if an alternative listing of the securities on the TSX Venture Exchange or on another stock exchange could not be obtained.

UNUSUAL CHANGE IN INCOME TAX VALUATION ALLOWANCES

Currently, Reko maintains three income tax loss carryforward balances: U.S. net operating losses; Canadian non-capital losses; and, Canadian SR&ED tax credits. Each quarter, Reko reviews and considers the expected net realizable value of its loss carryforward balances. As Reko's view of the expected net realizable value of its loss carryforward balances change, it adjusts the valuation allowance associated with each loss carryforward balance.

Consistent with our practices since Third Quarter 2010, we did not record our income tax recovery on our non-capital losses in the current quarter. However, Reko subsequently determined that while its valuation allowance on all of its Canadian loss carryforwards, both the non-capital losses and SR&ED tax credits, was appropriately stated, the allocation of the valuation allowance between the two tax carryforward amounts was inappropriate. Accordingly, Reko increased the valuation allowance associated with its SR&ED tax credits and decreased the valuation allowance associated with its non-capital losses in the amount of $275.

As a result of this change in allocation of valuation allowance, the increase in the valuation associated with its SR&ED tax credits caused an increase in cost of sales in the first quarter of $275 and a corresponding increase in taxes recoverable of $275.

AVERAGE FOREIGN EXCHANGE/FINANCIAL AND OTHER INSTRUMENTS

Reko is exposed to the impacts of changes in the foreign exchange rate between Canadian and United States ("U.S.") dollars. More specifically, approximately 90% of the Company's sales and 20% of its costs are incurred in U.S. dollars. In addition, the Company maintains a significant asset on its balance sheet which represents unutilized non-capital losses available to reduce future taxable income in the U.S. and it operates a sales office in the U.S., maintaining working capital and capital assets.

In order to minimize our exposure to the impacts of changes in the foreign exchange rate, the Company maintains a forward foreign exchange hedging programme ("Programme"). Reko's Programme is based on maintaining our net exposure to the U.S. dollar (total U.S. exposure less forward foreign exchange contracts) between positive and negative $2,000. This Programme is designed to minimize the Company's exposure to foreign exchange risks over the mid-term. As a consequence of this mid-term exposure protection, the Company is subject to short-term paper gains and losses on its net exposure to the U.S. dollar, most particularly during periods when our net exposure to the U.S. is outside of our target exposure. During periods of rapid fluctuation in the foreign exchange rate between the Canadian dollar and the U.S. dollar, regardless of our net exposure to the U.S. dollar, the Company can generate significant gains or losses, which will materially impact financial results. These significant gains or losses are entirely related to mark-to-market accounting rules and represent the product of our net exposure to the U.S. dollar and the change during any given month of the value of the U.S. dollar in relation to the Canadian dollar.

During the each of the last four quarters, the maximum amount of the Company's month-end exposure to the U.S. dollar has been:

Fiscal Period Total U.S. exposure before hedging programme Forward foreign exchange contracts booked Net exposure to the U.S. dollar  
Q1 – 2011 $ 26,516 $ 28,400 $ (1,884 )
Q4 – 2010 $ 26,050 $ 24,800 $ 1,250  
Q3 – 2010 $ 23,488 $ 24,100 $ (612 )
Q2 - 2010 $ 23,798 $ 25,600 $ (1,802 )

As a result of the Company's purchase of forward foreign exchange contracts ("FFECs"), the Company is subject to changes in foreign exchange rates that may not be consistent with changes in the current quoted foreign exchange rates. More specifically, the Company's foreign exchange risk is split such that its net exposure to the U.S. dollar, as detailed above is subject to the change in market foreign exchange rates on a monthly basis and the remainder of its U.S. dollar exposure is subject to foreign exchange risks based on the specific foreign exchange rates contained in its FFECs. The table below presents a comparison between actual foreign exchange rates and Reko's effective rate on its booked FFECs.

     
  For the three months
ended October 31,
For the twelve months
ended July 31,
                 
  2011 2010 2011 2010
    Reko   Reko   Reko   Reko
    effective   effective   effective   effective
  Actual rate Actual rate Actual rate Actual rate
U.S. Dollar equals Canadian Dollar 1.0322 1.0549 1.0750 1.0130 1.0393 1.0655 1.1321 1.1262

The Company's FFECs represent agreements with an intermediary to trade a specified amount of U.S. dollars for Canadian dollars at a specific rate on a specific date. Currently, the date is between one and two years after the date on which the FFEC is booked. The specific rate entered into is not necessarily indicative of what either the intermediary or Reko believes the foreign exchange rate will be on the date the settlement of the trade occurs, rather it is a rate set by the intermediary which Reko can either accept or reject.

During the first quarter, the Company recorded a pre-tax gain of approximately $104 related to the fair value of its U.S. dollar exposures, as compared to a pre-tax gain of $300 in the prior year's first quarter. These foreign exchange gains or losses are reported as part of our sales.

At the end of the first quarter of fiscal 2011, we held FFECs of $28,400 compared to $24,500 at the end of the first quarter of fiscal 2010. During the first quarter of fiscal 2011, on average, we have had $27,400 of FFECs outstanding monthly, compared to $26,600 during the same period as in the prior year.

The following table outlines the level of FFECs presently maintained and the average effective rate of these contracts:

     
Fiscal Period Contract value booked (000's) Effective average rate
Q1 – 2011 $ 28,400 1.0516
Q2 – 2011 $ 22,000 1.0491
Q3 – 2011 $ 16,000 1.0471
Q4 - 2011 $ 11,500 1.0436

The Company notes that at current levels of FFECs and U.S. dollar denominated assets and liabilities, an increase in the value of the U.S. dollar against the Canadian dollar results in the Company recording losses and an increase in the value of the Canadian dollar against the U.S. dollar results in financial gains for the Company.

Foreign currency transactions are recorded at rates in effect at the time of the transaction. FFECs are recorded at month-end at their fair value, with unrealized holding gains and losses recorded in sales.

RESULTS OF OPERATIONS

Sales

Sales for the three months ended October 31, 2010 increases $586, or 6.3%, to $9,841 compared to $9,255 in fiscal 2010.

The increase in sales was largely related to:

  • The slow economic recovery and its improved impacts on the demand for capital equipment;

  • Increases in the awards we are sourced, which we out-source, often in off-shore markets; and,

  • Changes in the fair value of U.S. dollar assets and liabilities, as described above.

These factors were partially offset by:

  • Lower sales dollars earned per hour of work on our automotive work as compared to our original budgets.

Gross profit

The gross profit for the three months ended October 31, 2010 increased $237 to $380 or 3.9% of sales, compared to gross profit of $143, or 0.2% of sales, in the same period in the previous fiscal year.

The increase in gross profit was largely related to:

  • Changes in the fair value of U.S. dollar assets and liabilities; and,

  • Extremely low work volumes that were insufficient to absorb our fixed overhead costs in the prior year.

These factors were partially offset by:

  • The re-allocation of the valuation allowance associated with our SR&ED tax credits, discussed above. Absent this re-allocation of valuation allowances, Reko would have reported gross profit of $655, or 6.7% of sales, in the first quarter ended October 31, 2010.

Selling and administration

Selling and administration expenses ("S,G&A") increased by $32, or 2.2%, to $1,495, or 15.2% of sales for the three months ended October 31, 2010, compared to $1,463, or 15.9% of sales for the same period in the prior year.

The increase in S,G&A was largely related to:

  • Increased sales commissions tied to the increase in sales; and,

  • Increased restructuring charges related to the termination costs associated with employees laid off in the second quarter not returning to work.

Earnings overview

Net loss for the three months ended October 31, 2010 was $1,287, or $0.20 per share, compared to a net loss of $1,177, or $0.18 per share, in the same period of the prior year.

LIQUIDITY AND CAPITAL RESOURCES

Cash flow provided by operations decreased $4,604 from $2,451 for the first quarter last year compared to cash flow used in operations of $2,153 in the current year. The decrease in cash flow from operations is primarily a result of:

  • Increases in our working capital balances, most particularly work-in-progress; compared to decreases in our working capital balances, most particularly accounts receivable, in the prior year.

Financial covenants

The Company was in compliance with all of its financial covenants at the end of the first quarter of 2011. The Company's current forecasts suggest that it will earn sufficient levels of EBITDA to meet its minimum monthly EBITDA covenant. Despite the Company's current forecasts suggesting the Company will achieve its replaced financial covenant, Reko is exposed to a number of risks, as discussed in the section of the MD&A identified as Risks and Uncertainties that could prevent it from achieving its primary lender defined minimum monthly EBITDA covenant.

  Payments due by period
Contractual obligations Total Less than
1 year
1 – 3
years
4 – 5
years
After
5 years
Long-term debt $ 13,606 $ 12,147 $ 1,459 $ -- $ --
Capital lease obligations   486   337   149   --   --
Operating leases   4   3   1   --   --
Purchase obligations   --   --   --   --   --
Other long-term obligations   --   --   --   --   --
Total contractual obligations $ 14,096 $ 12,487 $ 1,609 $ -- $ --

Capital assets and investment spending

For the three months ended October 31, 2010, the Company invested $79 in capital assets. The entire amount of this spending is considered maintenance capital expenditure intended to refurbish or replace assets consumed in the normal course of business.

Cash resources/working capital requirements

As at October 31, 2010, Reko had borrowed $15,725 on its revolving line of credit, compared to $14,292 at July 31, 2010 and $7,469 at October 31, 2010. The revolver borrowings increased by approximately $1,433 in the quarter and increased approximately $8,256 in the past year. We expect borrowings to display a mid-term trend of decreasing over the next four quarters.

Reko has a $20,000 revolver available to it; however, based on our current lender defined margining capabilities, our borrowings are limited to $18,987 of which approximately $3,262 was unused and available at October 31, 2010. Under the terms of our credit facilities, Reko must achieve certain financial covenants including a maximum Total Debt to Tangible Net Worth, a minimum Current Ratio and a minimum monthly EBITDA target.

Except as disclosed elsewhere in this MD&A, there have been no material changes with respect to the contractual obligations of the Company during the year.

Reko does not maintain any off balance sheet financing.

Share capital

The Company had 6,420,920 common shares outstanding at October 31, 2010. During the first quarter, Reko did not grant any options and existing option holders did not exercise any options.

Outstanding share data

Designation of security Number outstanding Maximum number issuable if convertible, exercisable or exchangeable for common shares
Common shares 6,420,920  
Stock options issued 88,000  
Stock options exercisable 66,000  
Total (maximum) number of common shares   6,486,920

CRITICAL ACCOUNTING ESTIMATES

The Company's discussion and analysis of its results of operations and financial position is based upon the consolidated financial statements, which have been prepared in accordance with Canadian GAAP. The preparation of the consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and the related disclosure of contingent assets and liabilities. Management bases its estimates on historical experience and various other assumptions that are believed to be reasonable in the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities. On an ongoing basis, management evaluates these estimates. However, actual results differ from these estimates under different assumptions or conditions.

Management believes the following critical accounting policies affect the more significant judgements and estimates used in the preparation of the consolidated financial statements of the Company. Management has discussed the development and selection of the following critical accounting policies with the Audit Committee of the Board of Directors and the Audit Committee has reviewed its disclosure relating to critical accounting estimates in this MD&A.

Allowances for doubtful accounts receivable

In order for management to establish appropriate allowances for doubtful accounts receivable, estimates are made with regard to economic conditions, potential recoverability through our accounts receivable insurer, and the probability of default by individual customers. The failure to estimate correctly could result in bad debts being either higher or lower than the determined provision as of the date of the balance sheet.

Revenue recognition and tooling and machinery contracts

Revenue from tooling and machinery contracts is recognized on the percentage of completion basis. The percentage of completion basis recognizes revenue and cost of sales on a progressive basis throughout the completion of the tooling or machinery.

Tooling and machinery contracts are generally fixed; however price changes, change orders and program cancellation may affect the ultimate amount of revenue recorded with respect to a contract. Contract costs are estimated at the time of signing the contract and are reviewed at each reporting date. Adjustments to the original estimates of total contract costs are often required as work progresses under the contract. When the current estimates of total contract revenue and total contract costs indicate a loss, a provision for the entire loss on the contract is made. Factors that are considered in arriving at the forecasted profit or loss on a contract include, amongst other items, cost overruns, non-reimbursable costs, change orders and potential price changes.

Impairment of long-lived assets

Management evaluates capital assets for impairment whenever indicators of impairment exist. Indicators of impairment include prolonged operating losses or a decision to dispose of, or otherwise change the use of, an existing capital asset. If the sum of the future cash flows expected to result from the asset, undiscounted and without interest charges, is less than the reported value of the asset, asset impairment must be recognized in the financial statements. The amount of impairment to be recognized is calculated by subtracting the fair value of the asset from the reported value of the asset.

Management believes that accounting estimates related to capital assets are 'critical accounting estimates' because: (i) they are subject to significant measurement uncertainty and are susceptible to change as management is required to make forward-looking assumptions regarding their impact on current operations; and (ii) any resulting impairment loss could have a material impact on the consolidated net income and on the amount of assets reported on the Company's consolidated balance sheet.

Future income taxes and SR&ED tax credits

Future tax assets, in respect of loss carry forwards and scientific research and experimental design credits related primarily to legal entities in Canada and the United States, are recorded in the Company's books. The Company evaluates the realization of its future tax assets by assessing the valuation allowance and by adjusting the amount of such allowance, if necessary. The facts used to assess the likelihood of realization are a forecast of future taxable income and available tax planning strategies that could be implemented to realize the future tax assets. The Company has, and continues to use, tax planning strategies to realize future tax assets in order to avoid the potential loss of benefits.

CONTROLS AND PROCEDURES

Management is responsible for implementing, maintaining and testing the operating effectiveness of adequate systems of disclosure controls and procedures. There are inherent limitations to the effectiveness of any system of disclosure including the possibility of human error and circumvention or overriding of the controls and procedures. Accordingly, even effective controls and procedures can only provide reasonable assurance of achieving their corporate objectives.

Our management used the Committee of Sponsoring Organizations of the Treadway Commission (COSO) framework to evaluate the effectiveness of internal controls over financial reporting. We carried out an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures during fiscal 2010, and concluded that Reko's controls and procedures are operating effectively to ensure that the information required to be disclosed is accumulated and communicated to management including the Chief Executive Officer and the Chief Financial Officer. A similar evaluation will be performed throughout fiscal 2011.

Based on these evaluations, the Chief Executive Officer and the Chief Financial Officer concluded that Reko's disclosure controls and procedures and internal controls over financial reporting do not include any material weaknesses and that they were effective in recording, processing, summarizing and reporting information required to be disclosed within the time period specified in the Canadian Securities Administrators (CSA) rules.

QUARTERLY RESULTS

The following table sets out certain unaudited financial information for each of the eight fiscal quarters up to and including the first quarter of fiscal 2011, ended October 31, 2010. The information has been derived from the Company's unaudited consolidated financial statements, which in management's opinion, have been prepared on a basis consistent with the audited consolidated financial statements contained elsewhere in this MD&A and include all adjustments necessary for a fair presentation of the information presented. Past performance is not a guarantee of future performance and this information is not necessarily indicative of results for any future period.

                 
  Jan/09   Apr/09   July/09   Oct/09  
Sales $ 16,480   $ 14,791   $ 10,128   $ 9,255  
Net income (loss)   875     240     (1,353 )   (1,177 )
Earnings (loss) per share:                        
  Basic   0.12     0.05     (0.20 )   (0.18 )
  Diluted   0.12     0.05     (0.20 )   (0.18 )
  Jan/10   Apr/10   Jul/10   Oct/10  
Sales $ 8,794   $ 9,329   $ 12,733   $ 9,841  
Net income (loss)   (1,867 )   (2,269 )   (2,156 )   (1,287 )
Earnings (loss) per share:                        
  Basic   (0.29 )   (0.36 )   (0.33 )   (0.20 )
  Diluted   (0.29 )   (0.36 )   (0.33 )   (0.20 )

NORMAL COURSE ISSUER BID

The Company does not currently have an open normal course issuer bid.

INTERNATIONAL FINANCIAL REPORTING STANDARDS (IFRS)

For Reko's financial year ended July 31, 2012, Reko will no longer report its financial results using Canadian GAAP, as a result of changes announced by The Canadian Institute of Chartered Accountants in March 2008. Instead it will report its financial results using IFRS. This change affects all entities that are considered publicly accountable entities. Reko is considered a publicly accountable entity due to its listing on the Toronto Stock Exchange.

While not all GAAP and IFRS are different, one of the most significant changes deal with the overriding premise in GAAP that financial reporting is based on historical cost, while IFRS' overriding premise is fair value.

Due to the potential pervasiveness of the changes inherent in moving to IFRS, a significant amount of time is necessary for management to plan its implementation. Possible impacts, besides external financial reporting, include, but are not limited to: banking agreements, business processes, information systems, employee and management incentive programmes, and legal agreements.

During the past two years, management:

  • Engaged internal resources to understand the new rules;

  • Educated its primary accounting staff on the differences between GAAP and IFRS;

  • Concentrated its efforts on those portions of IFRS that are different than GAAP;

  • Identified those business processes that have the potential for amendment to properly transition to IFRS;

  • Finalized its policy selections both on conversion and post conversion; and,

  • Evaluated new financial statement disclosure.

As a result of this analysis, management has determined that the following financial statement line items will be impacted by the conversion to IFRS:

  • Capital assets – on conversion to IFRS, Reko will need to revalue its capital assets. Reko is currently collecting information before deciding whether this revaluation will be based on fair value assessments or reconsideration of prior year amortization. At the present time, insufficient information is available to determine whether or not the revaluation of our capital assets will result in an increase or decrease in their net book value and whether or not the amount will be material;

  • Current portion of deferred income taxes – under IFRS, there is no requirement nor is it allowed, to calculate and present the current portion of deferred income taxes (that portion of deferred income taxes expected to be recognized in the current year) as part of an entity's financial statements. Accordingly, Reko advises that the current portion of its deferred income taxes will be reduced to $Nil on conversion to IFRS. This reduction to $Nil, will impact the amount of the Company's current assets in future periods and any financial ratios or covenants that include the calculation of current assets;

  • Deferred income taxes – on conversion to IFRS, Reko will need to revalue its capital assets. As a result of revaluing its capital assets, Reko will also revalue its deferred income taxes as it relates to its capital assets. At the present time, insufficient information is available to determine whether or not the revaluation of deferred income taxes will be material and whether deferred income taxes will increase or decrease as a result;

  • Contributed surplus – on conversion to IFRS, Reko will need to revalue its contributed surplus as a result of timing differences in the recognition of stock compensation expenses. Until August 1, 2011, Reko is unable to calculate the exact amount of this adjustment. As a result of this adjustment, Reko anticipates its contributed surplus will increase however it does not expect the amount to be material;

  • Retained earnings – as a result of all of the above items, Reko's opening retained earnings on conversion to IFRS will change to reflect the cumulative impact of each of the above items; and,
  • Amortization expense – on conversion to IFRS, Reko will revalue its capital assets. As a result of this revaluation, Reko's expected amortization expense will increase or decrease, in similar proportion and direction with the increase or decrease in the revaluation of its capital assets. As indicated in our discussion on capital assets, insufficient information is available to determine whether amortization expenses in the future will increase or decrease or whether it is by a material amount or not upon conversion to IFRS.

Going forward, management is concentrating on the quantification of the impact of the changes to the financial statements in preparation for our conversion to IFRS on August 1, 2011.

This MD&A contains forward-looking information and forward-looking statements within the meaning of applicable securities laws. We use words such as "anticipate", "plan", "may", "will", "should", expect", "believe", "estimate" and similar expressions to identify forward-looking information and statements. Such forward-looking information and statements are based on assumptions and analyses made by us in light of our experience and our perception of historical trends, current conditions and expected future developments, as well as other factors we believe to be relevant and appropriate in the circumstances. Readers are cautioned not to place undue reliance on forward-looking information and statements, as there can be no assurance that the assumptions, plans, intentions or expectations upon which such statements are based will occur. Forward-looking information and statements are subject to known and unknown risks, uncertainties, assumptions and other factors which may cause actual results, performance or achievements to be materially different from any future results, performance or achievements expressed, implied or anticipated by such information and statements. These risks are described in the Company's MD&A included in our 2010 Annual Information Form, this MD&A and, from time to time, in other reports and filings made by the Company with securities regulators.

While the Company believes that the expectations expressed by such forward-looking information and statements are reasonable, there can be no assurance that such expectations and assumptions will prove to be correct. In evaluating forward-looking information and statements, readers should carefully consider the various factors, which could cause actual results or events to differ materially from those, indicated in the forward- looking information and statements. Readers are cautioned that the foregoing list of important factors is not exhaustive. Furthermore, the Company disclaims any obligations to update publicly or otherwise revise any such factors of any of the forward-looking information or statements contained herein to reflect subsequent information, events or developments, changes in risk factors or otherwise.

REKO INTERNATIONAL GROUP INC.
5390 Brendan Lane
Oldcastle, Ontario
N0R 1L0
www.rekointl.com

SUBSIDIARIES/DIVISIONS:

Canada:

  • Reko Tool & Mould (1987) Inc.
    Divisions – 
    • Reko Automation and Machine Tool
    • Concorde Machine Tool

United States:

  • Reko International Sales Inc.
  • Reko International Holdings Inc.

The TSX or TSX-V has not reviewed nor accepts responsibility for the adequacy or accuracy of this news release.

Contact Information

  • Reko International Group Inc.
    Carl A. Merton
    Chief Financial Officer
    (519) 737-6974
    www.rekointl.com