NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS (All tabular amounts in millions of Canadian dollars, except where noted) 1. Accounting Policies These consolidated financial statements of MDS Inc. (MDS or the Company) have been prepared on a basis consistent with the Company's annual financial statements for the year ended October 31, 2005, except as disclosed below, and should be read in conjunction with the accounting policies and other disclosures in those annual financial statements. These financial statements do not include all of the disclosures required by generally accepted accounting principles applicable to annual financial statements. Prior year amounts have been revised to reflect the results of discontinued operations, and a change in the way the Company reports segmented information. (a) Accounting Policy Changes (i) Asset Retirement Obligations The Company adopted CICA Handbook Section 3110 - Asset Retirement Obligations (ARO's), on November 1, 2004. This section describes how to recognize and measure liabilities related to legal obligations of retiring property, plant and equipment. The Company has identified an asset retirement obligation relating to decommissioning costs of a facility located in Kanata, Ontario. A liability will be recognized in the period in which sufficient information exists to estimate the range of potential settlement dates that is required to use a present value technique to estimate fair value. (b) Measurement Uncertainty To determine the assets held for sale related to those operations classified as discontinued operations, we are required to make estimates and assumptions that affect the reported amounts of these assets and liabilities and, therefore, these amounts are subject to measurement uncertainty. 2. Share Capital and Stock Options The following table summarizes information on share capital and stock options and related matters as at October 31, 2006: (number of shares in thousands) Number Amount ------------------------------------------------------------------------- Common shares Balance as at October 31, 2005 142,099 $ 847 Issued during the period 2,220 38 ------------------------------------------------------------------------- Balance as at October 31, 2006 144,319 $ 885 ------------------------------------------------------------------------- ------------------------------------------------------------------------- During the quarter, the Company did not repurchase or cancel any Common shares. Average (number of shares Exercise in thousands) Number Price ------------------------------------------------------------------------- Stock options Balance as at October 31, 2005 7,673 $ 17.76 Activity during the period: Granted 1,019 20.10 Exercised (1,859) 14.76 Cancelled or forfeited (983) 19.94 ------------------------------------------------------------------------- Balance as at October 31, 2006 5,850 $ 18.76 ------------------------------------------------------------------------- ------------------------------------------------------------------------- There were 3,612 stock options exercisable as at October 31, 2006. 3. Discontinued Operations In October 2006, the Company signed an agreement to sell its Canadian laboratory services business, MDS Diagnostic Services in a $1.325 billion transaction. This strategic sale is designed to shift the Company's business focus to the global life sciences market. In 2005, the Company approved a plan to divest of its interests in Source Medical Corporation, Calgary Laboratory Services LP and certain MDS Pharma Services businesses. As a result of these actions, these businesses are classified as discontinued operations. The results of discontinued operations in the quarter and for the year were as follows: Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------- Net revenues $ 92 $ 161 $ 414 $ 675 Cost of revenues (50) (108) (256) (477) Selling, general and administration (17) (32) (61) (113) Depreciation and amortization (2) (3) (10) (14) Goodwill write-down - (15) - (15) Gain on sale of discontinued operations - - 28 - Restructuring charges - (11) (1) (11) Other expenses (3) - (3) - Equity earnings (loss) 1 - 3 2 ------------------------------------------------------------------------- Operating income (loss) 21 (8) 114 47 Interest expense - - - (1) Dividend and interest income 1 1 2 3 Income taxes recovery (expense) 18 (1) 7 (9) Minority interest - net of tax (3) (3) (10) (10) ------------------------------------------------------------------------- Income (loss) from discontinued operations - net of tax $ 37 $ (11) $ 113 $ 30 ------------------------------------------------------------------------- Basic earnings (loss) per share $ 0.25 $ (0.07) $ 0.79 $ 0.22 ------------------------------------------------------------------------- ------------------------------------------------------------------------- During the quarter ending October 31, 2006, a $15 million tax asset was recorded against the income tax expense relating to discontinued operations. This tax asset arises from capital losses that are available and expected to be utilized against the gain arising from the sale of MDS Diagnostic Services. In accordance with Section 3475 of the CICA Handbook, long-lived assets classified as held for sale are measured at the lower of carrying value and fair value less costs to sell. Assets held for sale and liabilities related to assets held for sale comprised: As at As at October 31 October 31 ------------------------------------------------------------------------- 2006 2005 ------------------------------------------------------------------------- Assets held for sale Accounts receivable $ 35 $ 63 Inventories 3 28 Prepaid expenses and other 3 3 Property, plant and equipment 32 64 Future tax asset 70 95 Long-term investments and other 15 15 Goodwill 61 88 Intangibles 1 1 ------------------------------------------------------------------------- Total assets held for sale 220 357 Less: Current assets held for sale(1) (220) (114) ------------------------------------------------------------------------- Long-term assets held for sale $ - $ 243 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Liabilities related to assets held for sale Accounts payable and accrued liabilities $ 37 $ 72 Long-term debt 4 12 Other long-term obligations 7 7 Future tax liabilities 62 81 Minority interest 18 21 ------------------------------------------------------------------------- Total liabilities related to assets held for sale 128 193 Less: Current liabilities related to assets held for sale(1) (128) (50) ------------------------------------------------------------------------- Long-term liabilities related to assets held for sale $ - $ 143 ------------------------------------------------------------------------- ------------------------------------------------------------------------- (1) Assets held for sale and liabilities related to assets held for sale have been classified as current if the Company has signed agreements where such assets are expected to be disposed of within one year. 4. Research and Development Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------- Gross expenditures $ 17 $ 18 $ 60 $ 86 Investment tax credits (1) (2) (9) (8) Recoveries from partners (7) (6) (25) (32) Development costs deferred (2) (3) (7) (15) ------------------------------------------------------------------------- Research and development $ 7 $ 7 $ 19 $ 31 ------------------------------------------------------------------------- ------------------------------------------------------------------------- For the three months ended October 31, 2006, depreciation and amortization includes $2 million (2005 - $1 million) related to equipment used for research and development. 5. Restructuring Charges An analysis of the activity in the provision through October 31, 2006 is as follows: Cumulative drawdowns ------------------------ Provision Balance at Restructuring October 31, Charge Cash Non-cash 2006 ------------------------------------------------------------------------- 2005: Workforce reductions $ 42 $ (36) $ (1) $ 5 Equipment and other asset write-downs - adjustment 8 - (8) - Contract cancellation charges 12 (2) (10) - ------------------------------------------------------------------------- $ 62 $ (38) $ (19) $ 5 ------------------------------------------------------------------------- 2006: Workforce reductions $ 1 $ - $ - $ 1 Contract cancellation charges (9) - 10 1 ------------------------------------------------------------------------- $ (8) $ - $ 10 $ 2 ------------------------------------------------------------------------- $ 7 ------------------------------------------------------------------------- ------------------------------------------------------------------------- The Company has continued to utilize the reserves established in prior years relating to change initiatives affecting support services, senior management reductions, and system implementations. 6. Earnings Per Share a) Dilution Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- (number of shares in millions) 2006 2005 2006 2005 ------------------------------------------------------------------------- Weighted average number of Common shares outstanding - basic 144 142 144 142 Impact of stock options assumed exercised - - - - ------------------------------------------------------------------------- Weighted average number of Common shares outstanding - diluted 144 142 144 142 ------------------------------------------------------------------------- ------------------------------------------------------------------------- b) Pro Forma Impact of Stock-Based Compensation Compensation expense related to the fair value of stock options granted prior to November 1, 2003 is excluded from the determination of net income and is, instead, calculated and disclosed on a pro forma basis in the notes to the consolidated financial statements. Compensation expense for purposes of these pro forma disclosures is determined in accordance with a methodology prescribed in CICA Handbook Section 3870 "Stock-Based Compensation and Other Stock-Based Payments". The Company used the Black- Scholes option valuation model to estimate the fair value of options granted. For purposes of these pro forma disclosures, the Company's net income and basic and diluted earnings per share would have been: Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------- Net income (loss) $ 53 $ (48) $ 145 $ 31 Compensation expense for options granted prior to November 1, 2003 - (1) (2) (5) ------------------------------------------------------------------------- Net income (loss) - pro forma $ 53 $ (49) $ 143 $ 26 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Pro forma basic earnings (loss) per share $ 0.37 $ (0.35) $ 0.99 $ 0.18 Pro forma diluted earnings (loss) per share $ 0.37 $ (0.35) $ 0.99 $ 0.18 ------------------------------------------------------------------------- ------------------------------------------------------------------------- During the quarter, the Company granted 9,000 options (2005 - 26,000) at an average exercise price of $19.77 (2005 - $20.84). These options have a fair value determined using the Black-Scholes model of $4.18 per share (2005 - $7.01) based on the following assumptions: 2006 2005 ------------------------------------------------------------------------- Risk-free interest rate 4.0% 3.9% Expected dividend yield 0.0% 0.7% Expected volatility 0.21 0.32 Expected time to exercise (years) 3.25 5.25 ------------------------------------------------------------------------- ------------------------------------------------------------------------- 7. Other Income (Expense) - Net Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------- Write-off of purchased technology $ - $ - $ - $ (8) Write-down of long-term investments - (6) - (6) Write-down of other long-term assets - - (1) - Unrealized gain (loss) on interest rate swaps 2 (3) - (3) Loss on sale of MAPLE assets - - (10) - Gain on sale of businesses and investments - - 2 - Insurance settlement (1) - 2 - ------------------------------------------------------------------------- Other income (expense) - net $ 1 $ (9) $ (7) $ (17) ------------------------------------------------------------------------- ------------------------------------------------------------------------- 8. Post Employment Obligations The Company sponsors various post-employment benefit plans including defined benefit and contribution pension plans, retirement compensation arrangements, and plans that provide extended health care coverage to retired employees. All defined benefit pension plans sponsored by the Company are funded plans. Other post-employment benefits are unfunded. During 2005, the Company amended the terms of certain post-employment plans such that effective January 1, 2008, and subject to certain transitional conditions, newly retired employees will no longer be entitled to extended health care benefits. The post employment obligation expense for the quarter was $1 million (2005 - $nil). 9. Supplementary Cash Flow Information Non-cash items affecting net income comprise: Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------- Depreciation and amortization $ 19 $ 18 $ 71 $ 61 Write-down of long-term investments - 6 - 6 Stock option compensation (1) 1 4 3 Deferred revenue (1) (7) (7) 12 Future income taxes 37 (1) 22 (14) Equity earnings - net of distribution 7 8 12 8 Write-off of purchased technology - - - 8 Write-down of property, plant and equipment - 7 1 7 Loss on sale of MAPLE assets - - 10 - Gain on sale of businesses and investments - - (2) - Unrealized loss (gain) on interest rate swaps (2) 3 - 3 Other 1 - (1) (5) ------------------------------------------------------------------------- $ 60 $ 35 $ 110 $ 89 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Changes in non-cash working capital balances relating to operations include: Three months to October 31 Year ended October 31 ------------------------------------------------------------------------- 2006 2005 2006 2005 ------------------------------------------------------------------------- Accounts receivable $ (17) $ (19) $ (9) $ (8) Unbilled revenue 51 (8) (22) (26) Inventories 5 5 63 (4) Prepaid expenses and other 17 5 (7) (6) Accounts payable and deferred revenue (1) 70 (66) 63 Income taxes (63) (11) (63) (20) ------------------------------------------------------------------------- $ (8) $ 42 $ (104) $ (1) ------------------------------------------------------------------------- ------------------------------------------------------------------------- 10. Segmented Information Three months to October 31, 2006 ------------------------------------------------------------------------- Pharma- Corporate ceutical and Services Isotopes Instruments Other Total ------------------------------------------------------------------------- Net revenues $ 137 $ 85 $ 69 $ - $ 291 Cost of revenues (101) (44) (44) - (189) Selling, general and administration (43) (16) (3) (7) (69) Research and development - (2) (5) - (7) Depreciation and amortization (9) (4) (6) - (19) Restructuring charges - net 1 2 - 9 12 Other income (expense) - net (1) - - 2 1 Equity earnings (loss) - - - - - ------------------------------------------------------------------------- Operating income (loss) $ (16) $ 21 $ 11 $ 4 $ 20 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Total assets $ 985 $ 697 $ 186 $ 590 $ 2,458 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Capital expenditures $ 11 $ - $ 3 $ 3 $ 17 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Three months to October 31, 2006 ------------------------------------------------------------------------- Pharma- Corporate ceutical and Services Isotopes Instruments Other Total ------------------------------------------------------------------------- Net revenues $ 135 $ 96 $ 73 $ - $ 304 Cost of revenues (95) (44) (45) - (184) Selling, general and administration (31) (20) (5) (12) (68) Research and development - (1) (7) 1 (7) Depreciation and amortization (9) (6) (3) - (18) Restructuring charges - net (20) (4) (3) (29) (56) Other income (expense) - net (6) - - (3) (9) Equity earnings (loss) - - 1 (8) (7) ------------------------------------------------------------------------- Operating income (loss) $ (26) $ 21 $ 11 $ (51) $ (45) ------------------------------------------------------------------------- ------------------------------------------------------------------------- Total assets $ 911 $ 789 $ 222 $ 401 $ 2,323 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Capital expenditures $ 13 $ 26 $ 1 $ 7 $ 47 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Year Ended October 31, 2006 ------------------------------------------------------------------------- Pharma- Corporate ceutical and Services Isotopes Instruments Other Total ------------------------------------------------------------------------- Net revenues $ 522 $ 338 $ 280 $ - $ 1,140 Cost of revenues (399) (172) (172) - (743) Selling, general and administration (137) (58) (18) (35) (248) Research and development - (4) (15) - (19) Depreciation and amortization (34) (16) (21) - (71) Restructuring charges - net - 2 - 6 8 Other income (expense) - net 4 (10) - (1) (7) Equity earnings (loss) (1) - - (5) (6) ------------------------------------------------------------------------- Operating income (loss) $ (45) $ 80 $ 54 $ (35) $ 54 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Capital expenditures $ 41 $ - $ 8 $ 12 $ 61 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Year Ended October 31, 2006 ------------------------------------------------------------------------- Pharma- Corporate ceutical and Services Isotopes Instruments Other Total ------------------------------------------------------------------------- Net revenues $ 543 $ 325 $ 286 $ - $ 1,154 Cost of revenues (380) (163) (166) - (709) Selling, general and administration (147) (57) (19) (22) (245) Research and development (2) (4) (26) 1 (31) Depreciation and amortization (31) (17) (12) (1) (61) Restructuring charges - net (24) (4) (3) (30) (61) Other income (expense) - net (14) - - (3) (17) Equity earnings (loss) - - 1 (7) (6) ------------------------------------------------------------------------- Operating income (loss) $ (55) $ 80 $ 61 $ (62) $ 24 ------------------------------------------------------------------------- ------------------------------------------------------------------------- Capital expenditures $ 30 $ 61 $ 6 $ 28 $ 125 ------------------------------------------------------------------------- ------------------------------------------------------------------------- 11. Financial Instruments The carrying amounts and fair values for all derivative financial instruments are as follows: As at October 31 As at October 31 ------------------------------------------------------------------------- 2006 2005 ------------------------------------------------------------------------- Carrying Fair Carrying Fair Amount Value Amount Value ------------------------------------------------------------------------- Asset (liability) position: Currency forward and option - asset $ 1 $ 1 $ 4 $ 7 Currency forward and option - liabilities $ - $ - $ (1) $ (1) Interest rate swap and option contracts $ (2) $ (2) $ (3) $ (3) ------------------------------------------------------------------------- ------------------------------------------------------------------------- As of October 31, 2006, the Company had outstanding foreign exchange contracts and options in place to sell up to US$64 million, and in certain circumstances up to US$82 million, at a weighted average exchange rate of C$1.1412 maturing over the next five months. The Company also had interest rate swap contracts that economically convert a notional amount of US$80 million of debt from a fixed to a floating interest rate. Foreign exchange options and interest rate swaps not eligible for hedge accounting are included in accounts payable and are marked to market each period. 12. Income Taxes A reconciliation of expected income taxes to reported income tax expense (recovery) is provided below. The effective rate for the quarter was 11% (2005 - 21%).
