UE Waterheater Operating Trust

UE Waterheater Operating Trust

July 27, 2005 16:55 ET

UE Waterheater Operating Trust Announces Strong Financial Results for Second Quarter Ended June 30, 2005

TORONTO, ONTARIO--(CCNMatthews - July 27, 2005) -

NOT FOR DISTRIBUTION IN THE UNITED STATES OR OVER UNITED STATES WIRE SERVICES.

UE Waterheater Operating Trust today released financial results for the second quarter ended June 30, 2005. Highlights for the quarter are as follows:

- Strong revenues for the second quarter of 2005, increasing by 5% over the same period last year

- Operating income increased by 6% to $15.6 million from $14.7 million in 2004

- Announced the proposed acquisition of Protectron Holdings Inc.

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Commenting on the Trust's performance during the quarter, Chief Executive Officer Roger Rossi said, "Management is very pleased with the Trust's performance during the second quarter of 2005, both in terms of improvements in operations and increased customer acquisitions. Current investments in marketing and growth in Comfort Protection Plan sales generate growth in revenues and cash flow, which in turn, provide a solid base for distributions. In addition, we expect the acquisition of Protectron Holdings Inc. to be accretive to cash available for distributions."



Financial Highlights
For the quarter ended June 30, 2005
(Unaudited)
(in thousands, except for unit information)
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Three months ended Six months ended
June 30, June 30,
-----------------------------------------
2005 2004 2005 2004
---------------------------------------------------------------------
Revenue $ 57,210 $ 54,381 $ 113,460 $ 108,643
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Cost of sales, general
and administration 26,791 24,597 53,480 49,640
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Depreciation and
amortization 14,846 15,098 29,647 30,201
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Operating income 15,573 14,686 30,333 28,802
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Mark-to-market valuation
of interest rate contracts 295 (235) 381 5,275
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Finance and interest charges 4,780 4,714 9,496 9,982
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Income before income taxes 10,498 10,207 20,456 13,545
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Taxes 140 304 444 608
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Net income $ 10,358 $ 9,903 $ 20,012 $ 12,937
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Cash from operating
activities 30,757 24,045 43,599 47,699
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Cash used in
financing activities (8,861) (8,344) (17,551) (15,095)
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Cash used in investing
activities (16,909) (13,409) (30,303) (26,277)
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Unitholder distributions
declared 8,861 8,344 17,724 17,876
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Unitholder cash
distributions paid 8,861 8,344 17,551 15,095
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Earnings before finance
and interest charges,
taxes, depreciation and
amortization (EBITDA)(1) 30,419 29,784 59,980 59,003
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Total assets 843,566 837,794 843,566 837,794
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(1) See section, "EBITDA" on page 4.
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About the UE Waterheater Operating Trust

UE Waterheater Operating Trust is an unincorporated, open-ended, limited purpose trust established under the laws of Ontario, created to indirectly acquire and hold, through the water heater rental business of Union Energy Limited Partnership ("Union Energy LP") and its related commercial activities. The Trust is a wholly-owned entity of the UE Waterheater Income Fund (the "Fund"), an unincorporated, open-ended, limited purpose trust established under the laws of the Province of Ontario which holds all the Trust units and Subordinated Trust Notes of the Trust.

Union Energy LP's main business is the rental and service of a portfolio of more than one million residential water heaters in Ontario, under the Union Energy, Ontario Hydro Energy, and Reliance Home Comfort brand names. Union Energy LP owns and services Canada's second largest portfolio of rental water heaters in a program that was initiated in the 1960s. In addition, Union Energy LP has related commercial activities that complement the water heater rental business, being the retail sale, rental, servicing and financing of heating, ventilation and air-conditioning ("HVAC") equipment as well as security monitoring and installation through Protectron Limited Partnership ("Protectron").

The following should be read in conjunction with the Trust's Consolidated Financial Statements for the year ended December 31, 2004. These consolidated financial statements, presented in Canadian dollars, have been prepared in accordance with Canadian generally accepted accounting principles ("GAAP").

Additional information regarding the Trust, including its current Annual Information Form ("AIF"), is available on SEDAR at www.sedar.com.

Certain information included herein is forward looking and based upon assumptions and anticipated results that are subject to uncertainties. Should one or more of these uncertainties materialize or should the underlying assumptions prove incorrect, actual results may vary materially from those expected.

RESULTS OF OPERATIONS

For the quarter ended June 30, 2005, the Trust's net income was $10.4 million on revenues of $57.2 million compared to net income of $9.9 million on revenues of $54.4 million for the three months ended June 30, 2004. Operating income for the quarter ended June 30, 2005 was $15.6 million, an increase of $0.9 million or 6%, over the same period last year.

For the six months ended June 30, 2005, the Trust's net income was $20.0 million on revenues of $113.5 million compared to net income of $12.9 million on revenues of $108.6 million for the six months ended June 30, 2004. Operating income for the six months ended June 30, 2005 was $30.3 million, an increase of $1.5 million or 5%, over the same period last year.

Results for the quarter are in line with management's expectations and reflect current period investments in marketing and customer acquisition costs as the Trust grows its Comfort Protection Plan business, the benefits of which will be realized in future periods. Customer acquisition costs reflect primarily telemarketing expenditures incurred by the Trust as it continues to drive strong growth in its Comfort Protection Plan business. Increased marketing costs reflect expenditures related to researching, developing, and implementing a new brand as the rights to use the Union Energy and the Ontario Hydro Energy brands expire in 2008 and 2007, respectively. The Trust has begun the process of introducing the brand name "Reliance Home Comfort" market by market, as announced at the Fund's recent Annual General and Special Meeting. A staggered implementation approach will allow the Trust to better understand the impact of the move to a new name and will allow the Trust to effectively manage the transition.

Rental revenues increased by 4% and 5%, respectively for the three and six months ended June 30, 2005 when compared to the corresponding periods a year prior, reflecting price increases, rental pool growth, and changes in product mix.

Sales, service and other revenue was $9.2 million and $17.9 million for the three and six months ended June 30, 2005, respectively. Sales, service and other revenue was $8.5 million and $17.7 million, respectively, for the comparable periods in 2004. The Trust continues to leverage cross-selling opportunities to its base of approximately one million customers. Higher revenues from Comfort Protection Plans accounted for most of the revenue growth in the second quarter as compared to the second quarter of 2004. The small increase in year-to-date sales, service and other revenues reflects growth in the Trust's Comfort Protection Plan business, offset by lower revenues in other product lines as compared to the particularly strong sales in 2004, especially in the first quarter.

Finance revenue was $2.6 million and $5.3 million for the three and six months ended June 30, 2005, respectively, compared to $2.4 million and $4.8 million, respectively, for the comparable periods in 2004. Revenues fluctuate primarily with the balance of finance contracts outstanding.

Cost of sales, general and administration expenses for the quarter ended June 30, 2005 increased by $2.2 million or 9% to $26.8 million from $24.6 million for the same period in 2004. For the six months ended June 30, 2005, costs of sales, general and administrative expenses of $53.5 million were $3.8 million higher than the six-month period a year prior. The increases in 2005 over 2004 reflect marketing costs relating to branding initiatives and customer acquisition costs pertaining to growing the Trust's Comfort Protection Plan business.

EBITDA

Earnings before finance and interest charges, taxes and depreciation and amortization ("EBITDA") were $30.4 million for the quarter and $60.0 million for the six months ended June 30, 2005, an increase of $0.6 million, or 2% and $1.0 million, or 2%, respectively, when compared to EBITDA of $29.8 million and $59.0 million for the comparable periods in 2004.

Management believes that in addition to net income or loss, EBITDA is a useful supplemental measure of cash available for distribution prior to debt service, changes in working capital, capital expenditures and income taxes. While EBITDA is commonly regarded as an indirect measure of operating cash flow excluding impacts of non-cash working capital, it is not a recognized measure under GAAP, and therefore has no standardized meaning prescribed by GAAP and may not be comparable to similar terms and measures presented by other similar issuers. EBITDA is intended to provide additional information on the Trust's performance and should not be considered in isolation or as a substitute for measures of performance prepared in accordance with GAAP. In particular, investors should also consider the impact of interest expense on the Trust's long-term debt and its capital expenditure requirements to fully assess the cash flow available to finance cash distributions.



The following table reconciles net income with EBITDA, as calculated
consistently for each period:
(in thousands)

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Three months ended Six months ended
June 30, June 30,
-----------------------------------------
2005 2004 2005 2004

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Net income $ 10,358 $ 9,903 $ 20,012 $ 12,937
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Adjustments:
Depreciation and
amortization 14,846 15,098 29,647 30,201
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Finance and interest
charges(1) 5,075 4,479 9,877 15,257
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Income taxes 140 304 444 608
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Earnings before interest,
taxes, depreciation and
amortization (EBITDA) $ 30,419 $ 29,784 $ 59,980 $ 59,003
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(1) Includes finance and interest charges and mark-to-market
valuation of interest rate contracts
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Depreciation and amortization was $14.8 million for the quarter and $29.6 million for the six months ended June 30, 2005, a decrease of $0.3 million or 2% for the quarter and $0.6 million or 2% for the six months when compared to the same periods in 2004. This decrease reflects rental assets installed at a lower depreciation rate, as well as leasing rather than owning non-rental assets, including vehicles and computer hardware.

Finance and interest charges were $5.1 million and $9.9 million, respectively, for the quarter and six months ended June 30, 2005 compared to $4.5 million for the quarter and $15.3 million for the six months ended June 30, 2004. Finance and interest charges for 2005 represent interest on demand Trust notes and the senior secured notes, net interest payments and mark-to-market valuation of the related interest rate contracts, and other interest expenses, net of interest income. Finance and interest charges for 2004 represent interest on the senior secured notes that were issued on February 10, 2004 and on the bank credit facility prior to issuance of the notes as well as the net interest payments and mark-to-market valuation of the related interest rate contracts.

In November 2003, the Trust entered into interest rate contracts to substantially fix the average effective interest rate on the offering of senior secured notes that were issued on February 10, 2004. Upon issuance of the senior secured fixed interest rate notes, the Trust entered into offsetting interest rate contracts resulting in a total effective fixed cash interest rate of 5.23% per annum for the Trust.

The interest rate contracts are marked-to-market at each balance sheet date. Changes in the market values are recorded in income as they arise, resulting in an expense of $0.3 million and $0.4 million for the three and six months ended June 30, 2005, respectively. For comparable periods, a credit to income of $0.2 million for the three months ended June 30, 2004 and a charge to income of $5.3 million for the six months ended June 30, 2004 resulted.

The liability accrued at June 30, 2005 of $14.4 million will reverse over the terms of the senior secured notes as payments are made under the terms of the interest rate contracts. No cash payments were made in the current quarter; $1.6 million was paid in the first quarter of 2005. No payments were made in the six months ended June 30, 2004.

The amount of earnings realized in the year is well in excess of those determined by management to be adequate to service interest on the outstanding long-term debt of the Trust. Adjusted EBITDA (as defined in the Supplemental Trust Indentures) was 6.4 times Net Interest Expense for the quarter ended June 30, 2005, significantly in excess of the requirement of 3.0 times Net Interest Expense under the Supplemental Trust Indenture pursuant to which the Series 1 and Series 2 Senior Secured Notes were issued.

Summary of quarterly results

The following is a summary of selected consolidated financial information derived from the Trust's unaudited interim consolidated financial statements for each of the eight most recently completed quarters:



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(In thousands of dollars, Second First Fourth Third
except per unit data) Quarter Quarter Quarter Quarter
---------------------------------------------------------------------
2005 2005 2004 2004
---------------------------------------------------------------------
Total revenue $ 57,210 $ 56,250 $ 55,742 $ 56,124
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Net income $ 10,358 $ 9,654 $ 7,332 $ 11,472
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---------------------------------------------------------------------
(In thousands of dollars, Second First Fourth Third
except per unit data) Quarter Quarter Quarter Quarter
---------------------------------------------------------------------
2004 2004 2003 2003
---------------------------------------------------------------------
Total revenue $ 54,381 $ 54,262 $ 51,793 $ 50,736
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Net income $ 9,903 $ 3,034 $ (27,265) $ 7,253
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The second quarter of 2005 reflects increasing rental revenue as previously noted. Total revenue changes for successive quarters are primarily a result of rental portfolio growth, rental price increases, and changes in HVAC business. HVAC revenues change primarily as a result of continuing to leverage cross-selling opportunities to the Trust's rental customers, as well as the seasonal fluctuations inherent in the HVAC business.

Successive increases in net income for the 2005 quarters and as compared to the same quarters in 2004 reflect higher operating income as previously described. Changes in net income from quarter to quarter in 2004 are primarily due to increases in operating income for the first three periods and reduced operating income in the fourth quarter resulting from increased one-year deferred consumer financing contracts related to HVAC sales and increased expenses related to marketing and customer acquisition costs. Changes in net income for 2004 quarters as compared to 2003 result primarily from improved operating performance and changes in income taxes, interest, and mark-to-market valuation of interest rate contracts resulting from the Trust's restructuring.

LIQUIDITY AND CAPITAL RESOURCES

For the quarter ended June 30, 2005, cash generated from operating activities was $30.8 million compared to $24.0 million for the same period a year prior, primarily due to changes in non-cash working capital. The operating cash flow for the current quarter reflects the Trust's strong operating results as well as the net cash inflow of $0.7 million from finance contracts related to Trust sales, and changes in non-cash operating working capital. The change in non-cash working capital during the quarter primarily reflects an interest accrual of $4.4 million related to the senior secured notes not requiring payment until July 31, 2005, and other accruals. The change in non-cash operating working capital for the second quarter of 2004 primarily reflects collection of accounts receivable, net of payment of significant accounts payable. There were no interest payments on the senior secured notes or payments on the related interest rate contracts in the current quarter or the second quarter of 2004.

For the six months ended June 30, 2005, cash generated from operating activities was $43.6 million compared to $47.7 million a year prior. The 2005 period reflects the payment of $8.9 million interest on the senior secured notes and $1.6 million for the related interest rate contracts, net of the interest and incentive accruals since the period of last payment. The 2004 period reflects collection of receivables and payment of significant accounts payable and accrued liabilities. No payments were made on the senior secured notes or the related interest rate contracts in the six months ended June 30, 2004.

Cash used in financing activities for the quarter and six months ended June 30, 2005 was $8.9 million and $17.6 million compared to $8.3 million and $15.1 million for the corresponding periods in 2004, due to the increase in distributions to unitholder. For the quarter ended June 30, 2005, the Trust declared and paid distributions of $8.9 million. During the three and six months ended June 30, 2004, the Trust declared distributions of $8.3 million and $17.9 million and paid $8.3 million and $15.1 million to unitholder, respectively.

On February 10, 2004, the Trust issued $400 million of Series 1 and Series 2 Senior Secured Notes which were given ratings of A from Standard & Poor's and AA (low) from Dominion Bond Rating Service. The proceeds of this issue were used to retire the bank credit facility that was drawn upon when the business was acquired from EPCOR Utilities Inc. ("EPCOR") on December 19, 2003.

There were no debt or unit offerings in the six months ended June 30, 2005 or in the second quarter of 2004.

As at June 30, 2005, the Trust had available a $30.0 million secured revolving loan facility maturing on December 19, 2007, and a $10.0 million secured revolving demand loan facility. Both of these facilities are with Canadian chartered banks and were unused at June 30, 2005. Subsequent to June 30, 2005 the Trust amended the $30.0 million loan facility in conjunction with establishing an acquisition facility of up to $145.0 million to finance the transaction described in the subsequent section of this document, "Unit Issuance and Business Acquisition."

Cash used in investing activities for the three and six months ended June 30, 2005 was $16.9 million and $30.3 million, respectively, compared to $13.4 million and $26.3 million for the three and six months ended June 30, 2004, respectively, of which $16.6 million and $31.7 million was used for the purchase of property, plant and equipment compared to $13.9 million and $28.5 million for the corresponding periods in 2004. Included in capital expenditures during the current quarter and year-to-date total, are $0.4 million and $0.9 million related to compliance with new flammable vapour regulations that became effective in late 2004 and are being phased in over the next two years. Net changes in finance contracts with customers of independent dealers used a total of $1.2 million during the current quarter compared to a neutral cash effect in the second quarter of 2004. There was no significant cash effect from finance contracts with customers of independent dealers during the six months ending June 30, 2005, while $1.2 million was provided in the six months ended June 30, 2004. Proceeds from sale of property, plant and equipment were $0.9 million and $1.4 million for the three and six months ended June 30, 2005, and $0.5 million and $1.0 million for the corresponding periods in 2004.

For the three and six months ended June 30, 2005, the portfolio of rental assets grew by 3,220 and 5,900 net units, respectively, bringing the number of installed units to 1,065,223. In the second quarter of 2005, $9.0 million was spent to replace 16,310 rental units that had reached the end of their useful life and $7.0 million was spent on 9,134 additional rental units. Comparable figures for the second quarter in 2004 were 1,914 net additions, with the addition of 8,348 units at a cost of $5.5 million and 14,868 replacement units at a capital cost of $8.1 million. In the six months ended June 30, 2005, $19.2 million was spent to replace 33,956 water heaters that had reached the end of their useful life and $11.7 million was spent on 17,227 additional units. For the six months ended June 30, 2004, a total of 2,518 net units had been added, with 15,514 new units at a cost of $11.2 million and 31,764 replacement units at a capital cost of $16.5 million.

A breakdown of the changes in the installed units for the three and six months ended June 30, 2005 compared to the corresponding periods in 2004 is as follows:



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(in thousands) Three months ended Six months ended
June 30, June 30,
---------------------------------------------------------------------
2005 2004 2005 2004
---------------------------------------------------------------------

Beginning units 1,062 1,050 1,059 1,049
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Retirements (16) (15) (34) (32)
Replacements 16 15 34 32
Buyouts and terminations (6) (6) (11) (13)
Additions 9 8 17 16
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Net change 3 2 6 3
---------------------------------------------------------------------
Ending units 1,065 1,052 1,065 1,052
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Summary of contractual obligations

The following significant changes in the contractual obligations have occurred from those reported in the Trust's management's discussion and analysis for the year ended December 31, 2004:

The Trust has entered into an agreement to purchase a group of installed water heaters for $1.5 million, with closing expected in August 2005; the Trust has extended the lease for its head-office premises beyond its December 31, 2006 term to 2016; and the acquisition and related financing discussed in "Unit Issuance and Business Acquisition" below.

Refinancing of Senior Secured Notes

The Trust expects to refinance the outstanding Series 1 and Series 2 Senior Secured Notes on the expected final payment date for each Series (being January 30, 2009 and January 31, 2011). A failure to refinance any Series of Senior Secured Notes on its Expected Final Payment Date would give rise to a Cash Sweep Remedy. A Cash Sweep Remedy essentially would preclude the Trust from making distributions and other expenditures (including capital expenditures other than for the replacement of existing water heaters) until the Secured Notes are paid in full. The maturity dates of the Series 1 and Series 2 Senior Secured Notes are January 30, 2016 and January 31, 2018, respectively. Based on current market conditions, the Trust believes that it will be able to arrange such refinancing. However, no assurances can be given with respect to future market conditions.

INTERCOMPANY AND RELATED PARTY TRANSACTIONS

During the three and six months ended June 30, 2005, the Trust paid the Fund $478 million and $957 million, respectively in relation to the demand Trust notes. The same amounts were paid in the three and six months ended June 30, 2004.

DEFERRED UNIT PLAN

Effective June 14, 2005, the Fund unitholders approved a deferred unit compensation plan (the "Deferred Unit Plan"). The Deferred Unit Plan provides for the grant to non-management trustees and directors of deferred Fund units ("Deferred Units").

The Deferred Unit Plan provides that once a Deferred Unitholder ceases to be a trustee or a director, he or she will be entitled to receive a number of Fund units equal to the number of Deferred Units held at the time of retirement.

Additional Deferred Units are granted to holders of Deferred Units based on distributions paid by the Fund on units. The number of Deferred Units granted is calculated by multiplying the aggregate number of Deferred Units held on the record date for a distribution by the amount of such distribution paid by the Fund on one unit and dividing the result by the market price of a unit on the date the distribution is paid.

For the six months ended June 30, 2005, the Fund granted no Deferred Units. No compensation expense relating to Deferred Units was recorded in 2004. The Trust records unit-related compensation expense in the consolidated statement of income using the fair value method.

UNIT ISSUANCE AND BUSINESS ACQUISITION

On July 15, 2005, the Trust acquired 100% of the shares of Protectron, a privately held security monitoring and installation company headquartered in Montreal, Quebec, for approximately $135 million (the "Acquisition"). The transaction was financed through the issuance of Trust units for cash, demand Trust notes and bank credit facilities.

On July 15, 2005, the Fund issued 7,720,000 subscription receipts at a price of $13.60 per subscription receipt, for gross proceeds of approximately $105 million. Holders of the subscription receipts received, for no additional consideration, one unit of the Fund for each subscription receipt held with the closing of the Acquisition. Immediately prior to the closing of the Acquisition, the Fund acquired new Trust units issued from treasury, remaining the Trust's sole unitholder, and demand Trust notes, totaling $99 million in aggregate.

ACCOUNTING POLICIES

INITIAL ADOPTION OF AN ACCOUNTING POLICY

Unit-Based Compensation

On June 14, 2005, the Fund unitholders approved and implemented a deferred unit compensation plan (the "Deferred Unit Plan") providing for the grant to non-management trustees and directors of deferred Fund units ("Deferred Units") as described in the prior section, "Deferred Unit Plan".

The Trust also has established a long-term incentive plan for certain senior executives. Payments under the incentive plan may be made in cash, Fund units, or a combination of cash and Fund units, at the option of the Trust and the Fund. For the three and six months ended June 30, 2005, no Fund units were issued pursuant to the long-term incentive plan.

Under CICA Handbook Section 3870, Stock-based Compensation and Other Stock-Based Payments, Deferred Units and Fund units granted under these plans are accounted for using the fair value-based method. The fair value of Deferred Units granted for annual director fees is recorded as compensation expense in the period granted. The fair value of Deferred Units granted in lieu of cash distributions is recorded as compensation expense in the period the distribution is declared. The fair value of Fund units granted under the long-term incentive plan is recorded as compensation expense over the vesting period.

The implementation of the Deferred Unit Plan had no effect on the interim consolidated financial statements for the second quarter of 2005.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the periods. These estimates are based on our historical experience and various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the reported amounts of revenues, expenses, assets and liabilities that are not readily apparent from other sources. The critical accounting estimates for the Fund are the estimated useful lives of rental assets and the allowance for doubtful accounts.

Estimated useful lives of rental assets

The estimated useful lives of the assets have a direct impact on the amount of the amortization expense. There is measurement uncertainty with respect to the remaining useful life of the installed rental assets, however, the method is supported by amortization studies. Management conducts comprehensive amortization studies on a periodic basis to ensure that the amortization expense is an accurate measurement of the cost of amortization for each asset category and to update the service lives and the resulting amortization rates.

A study completed in June 2003 reported on the leased water heaters and rental appliances acquired prior to November 2001. As a result of the June 2003 report, the effective amortization rates were revised and the change has been accounted for prospectively. No study has been completed on electric water heaters and, accordingly, new electric water heaters are being amortized based on estimates of useful life provided by manufacturers. With respect to the electric water heaters acquired from Hydro One Inc., the Trust is amortizing the cost attributed to these water heaters over the remaining useful lives based on data provided by Hydro One Inc. on the age of the water heaters acquired.

Allowance for doubtful accounts

The allowance for doubtful accounts is evaluated and established based on historical patterns of collections and economic conditions. Adequacy of the provision is assessed on a periodic basis.

FUTURE CHANGES IN ACCOUNTING STANDARDS

The Trust reviews all revisions to the Canadian Institute of Chartered Accountants ("CICA") Handbook when issued.

The following is a discussion of relevant Handbook revisions that were released, revised or became effective since the Trust's financial statements for the year ended December 31, 2004 were issued.

Handbook Section 3840, Related Party Transactions, replaces references to "culmination of the earnings process" with "commercial substance" as a result of issuing new Section 3831, Non-monetary Transactions. A non-monetary transaction has commercial substance when the entity's future cash flows are expected to change significantly as a result of the transaction. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2006.

Handbook Section 1530, Comprehensive Income, requires presenting comprehensive income and its components (defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources) in financial statements as well as net income. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2007.

Handbook Section 3855, Financial Instruments - Recognition and Measurement, establishes standards for recognizing and measuring financial assets, financial liabilities and non-financial derivatives. It provides standards for the classification of financial instruments, related interest, dividends, losses and gains, the circumstances in which financial assets and financial liabilities are offset, and disclosures about financial instruments and non-financial derivatives. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2007.

Handbook Section 3865, Hedges, establishes standards for when and how hedge accounting may be applied, ensuring that counterbalancing gains, losses, revenues and expenses are recognized in net income in the same period or periods. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2007.

Handbook Section 3051, Investments, establishes standards for accounting for investments subject to significant influence and for measuring and disclosing certain other non-financial instrument investments. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2007.

Handbook Section 3251, Equity, replaces Handbook Section 3250, Surplus, and establishes standards for the presentation of equity and changes in equity during the reporting period. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2007.

Handbook Section 3861, Financial Instruments - Disclosure and Presentation, replaces Handbook Section 3860, Financial Instruments - Disclosure and Presentation, and establishes standards for presentation of financial instruments and non-financial derivatives, and identifies information that should be disclosed. Based on our review, we do not expect a material effect on the Trust's financial statements when we adopt the new standard no later than January 1, 2007.

EIC 144, Accounting by a Purchaser for a Vendor Rebate, was amended to address when a customer should recognize and how a customer should measure a rebate. The Abstract is effective for annual and interim periods commencing on or after February 15, 2005 and states that discretionary rebates should be recognized by a customer when paid by the vendor or when the vendor becomes obligated to pay; where there is a binding agreement that requires the vendor to pay a rebate provided the customer completes a specified cumulative level of purchases or remains a customer for a specified period of time, the rebate should be recognized as a reduction of the cost of purchases for the period, provided the rebate is probable and reasonably estimable. The customer should measure the rebate based on the estimated amount of the rebate that is expected to be received for the underlying transactions that have occurred and that result in progress by the customer toward achieving the specified requirement to receive the rebate. There was an insignificant effect on net income from the date of adoption, April 1, 2005.

RISKS AND UNCERTAINTIES

There are certain risk factors that could affect the operations of the Trust and the distributable cash generated by the Trust. Risks relating to the business conducted by the Trust include: (i) changes in the regulatory environment relating to the water heater industry, including amendments to the Consumer Protection Act (Ontario); (ii) lack of written water heater arrangements; (iii) the useful life of water heaters may be less than anticipated; (iv) buy-outs and returns of water heaters; (v) expiration of right to use trademarks and costs of rebranding; (vi) the concentration of suppliers and equipment; (vii) potential product defects and product liability claims; (viii) uninsured or underinsured risks; (ix) the negotiation of collective agreements; (x) changes in consumer practices or changes in water heating technology; (xi) lack of fixture filings; (xii) leverage and restrictive covenants related to the Senior Secured Notes; (xiii) potential tax assessments; (xiv) enforcement of indemnities against EPCOR relating to the acquisition of the portfolio of waterheaters and related commercial activities; and (xv) the lack of geographic diversity in the portfolio of water heaters.

On July 15, 2005, the Fund acquired Protectron. Additional risks related to the security business operated by Protectron include: (i) customer attrition; (ii) competitive market with relatively low barriers to entry; (iii) technological obsolescence; (iv) dependence on key personnel; (v) dependence upon third party contractors and the authorized dealer network to sell, install, service and repair security systems; (vi) potential changes in the regulatory environment; (vii) possible adverse effect of "false alarm" ordinances; (viii) dependence on housing starts; (ix) maintenance of supplier relationships; and (x) potential legal proceedings related to inadequate alarm responses or system failures, and employee acts of omissions.

Risks relating to the structure of the Trust include: (i) reliance on Union Energy LP to fund interest payments on the Senior Secured Notes (ii) reliance on key personnel; (iii) changes in credit ratings (iv) cash flows which may fluctuate (v) the Senior Secured Notes are not qualified investments under the Income Tax Act (Canada) (vi) repayment of the Senior Secured Notes on their expected final payment dates is dependent on the Trust being able to refinance the Senior Secured Notes and a failure to refinance will give rise to certain cash sweep remedies potential (vii) the price of the Senior Secured notes will fluctuate and will be affected by general market conditions; (viii) reliance on the judgment of the trustees of the Trust; and (ix) restrictions on potential growth.

OUTLOOK

The outlook for the Trust and its underlying business is positive and stable for 2005. The Trust has seen strong revenues during the second quarter of 2005 and should continue to deliver strong performance through 2005, which provides a reliable stream of stable cash flow to support cash distributions to its unitholder. Management believes the acquisition of Protectron will be accretive to the Fund's cash available for distribution, will provide an opportunity to leverage its approximately one million customer relationships by cross-selling Protectron's suite of home security services, and is consistent with the Trust's objective of generating sustainable and growing distributable cash per unit.

Management believes that the ongoing cash flow from operations and credit facilities will be sufficient to allow it to meet ongoing requirements for capital expenditures, investments in working capital, interest expense and cash distributions. The Trust's actual cash flow will be dependent upon its future financial performance, which in turn will be subject to financial, tax, business and other factors, including elements beyond the Trust's control.



Attachments:
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statement of Cash Flows


UE WATERHEATER OPERATING TRUST
Consolidated Balance Sheets
(In thousands of dollars)
(Unaudited)
---------------------------------------------------------------------
---------------------------------------------------------------------
June 30, December 31,
2005 2004
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Assets

Current assets:

Cash and cash equivalents $ 18,438 $ 22,693
Accounts receivable 19,157 19,359
Inventories 4,149 4,053
Prepaid expenses 1,326 1,867
Current portion of finance
contracts (Note 4) 15,206 14,840
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58,276 62,812

Property, plant and equipment 411,223 405,354
Finance contracts (Note 4) 55,770 55,372
Intangible assets 198,657 203,296
Goodwill 119,640 119,640
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$ 843,566 $ 846,474
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Liabilities and Equity

Current liabilities:

Accounts payable and accrued
liabilities $ 27,157 $ 31,222
Distribution payable to unitholder 2,954 2,781
Unearned revenue 8,824 8,352
Demand Trust notes 316,942 316,942
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355,877 359,297

Long-term liabilities:

Senior notes payable (Note 5) 400,000 400,000
Interest rate contracts (Note 6) 14,350 15,586
Warranty liability 485 971
Accrued pension liability 1,456 1,524
Employee future benefit liability 1,887 1,873
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418,178 419,954

Equity (Note 7) 69,511 67,223
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$ 843,566 $ 846,474
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See accompanying notes to interim consolidated financial statements.



UE WATERHEATER OPERATING TRUST
Consolidated Statements of Income
(In thousands of dollars)
(Unaudited)
---------------------------------------------------------------------
---------------------------------------------------------------------

Three months Six months
ended June 30, ended June 30,
2005 2004 2005 2004
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Revenue:
Rental $ 45,381 $ 43,502 $ 90,345 $ 86,119
Sales, service and other 9,223 8,485 17,860 17,743
Finance 2,606 2,394 5,255 4,781
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57,210 54,381 113,460 108,643
Expenses:
Cost of sales, general and
administration 26,791 24,597 53,480 49,640
Depreciation of property,
plant and equipment 12,527 12,779 25,008 25,562
Amortization of intangible
assets 2,319 2,319 4,639 4,639
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41,637 39,695 83,127 79,841
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Operating income 15,573 14,686 30,333 28,802

Mark-to-market loss (gain)
on valuation of interest
rate contracts 295 (235) 381 5,275

Interest:
Long-term debt 4,421 4,421 8,794 6,899
Other 359 293 702 3,083
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Income before income taxes 10,498 10,207 20,456 13,545

Income taxes:
Current 140 304 444 608
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Net income $ 10,358 $ 9,903 $ 20,012 $ 12,937
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See accompanying notes to interim consolidated financial statements.


UE WATERHEATER OPERATING TRUST
Consolidated Statements of Cash Flows
(In thousands of dollars)
(Unaudited)
---------------------------------------------------------------------
---------------------------------------------------------------------
Three months Six months
ended June 30, ended June 30,
2005 2004 2005 2004
---------------------------------------------------------------------
Cash provided by (used in):
Operating activities:
Net income $ 10,358 $ 9,903 $ 20,012 $ 12,937
Adjustments and other items
not involving cash:
Depreciation and
amortization 14,846 15,098 29,647 30,201
Gain on disposal of property,
plant and equipment (324) (184) (567) (261)
Difference between pension
and other employee benefits
expense and funding (34) (92) (54) (45)
Mark-to-market valuation of
interest rate contracts 295 (235) 381 5,275
Payments on interest rate
contracts, net - - (1,617) -
Warranty liability (243) (552) (486) (1,039)
Finance contracts related to
Trust sales (Note 4) 678 (942) (771) (800)
Change in non-cash operating
working capital (Note 9(a)) 5,181 1,049 (2,946) 1,431
---------------------------------------------------------------------
30,757 24,045 43,599 47,699
Financing activities:
Distributions to sole
unitholder (8,861) (8,344) (17,551) (15,095)
Repayment of bank loan - - - (400,000)
Proceeds from senior
secured notes - - - 400,000
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(8,861) (8,344) (17,551) (15,095)
Investing activities:
Purchase of property, plant
and equipment (16,640) (13,866) (31,696) (28,496)
Proceeds from sale of
property, plant and
equipment 888 468 1,386 1,042
Finance contracts related
to independent dealers
(Note 4) (1,157) (11) 7 1,177
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(16,909) (13,409) (30,303) (26,277)
---------------------------------------------------------------------
Increase (decrease) in
cash and cash equivalents 4,987 2,292 (4,255) 6,327
Cash and cash equivalents,
beginning of period 13,451 24,456 22,693 20,421
---------------------------------------------------------------------
Cash and cash equivalents,
end of period $ 18,438 $ 26,748 $ 18,438 $ 26,748
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---------------------------------------------------------------------
Supplemental cash flow information (Note 9(b))
See accompanying notes to interim consolidated financial statements.



UE WATERHEATER OPERATING TRUST
Notes to Interim Consolidated Financial Statements
(Unaudited)
June 30, 2005
(In thousands of dollars)
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1. Nature of operations:

The UE Waterheater Operating Trust (the "Trust") is an unincorporated, open-ended trust governed by the laws of the Province of Ontario. It is wholly owned by the UE Waterheater Income Fund (the "Fund").

The principal business of the Trust is integrated and consists of water heater rentals, sales, rental and service of heating, ventilation and air-conditioning ("HVAC") equipment and its related financing to customers within, but not limited to, Ontario.

2. Basis of presentation:

The interim consolidated financial statements have been prepared following the same accounting policies and methods of computation as the consolidated financial statements for the year ended December 31, 2004, with the exception of policies relevant to unit-based compensation as disclosed in Note 3, but do not contain all disclosures required for annual financial statements prepared in accordance with generally accepted accounting principles. Accordingly, the interim consolidated financial statements should be read in conjunction with the consolidated financial statements and the notes thereto in the Fund's annual report for the year ended December 31, 2004.

The consolidated financial statements of the Trust include the accounts of the Trust and its wholly owned subsidiaries: Union Energy Limited Partnership, 4211782 Canada Inc. (formerly Union Energy Inc.), WestCap Trust, 4202201 Canada Inc. and GP Waterheater Trust. Certain comparative figures have been reclassified to conform with the financial presentation adopted in the current period.

3. Significant accounting policies:

Unit-based compensation:

On June 14, 2005, the Fund approved and implemented a deferred unit compensation plan (the "Deferred Unit Plan") providing for the grant to non-management trustees and directors of deferred Fund units ("Deferred Units").

The Fund also has established a long-term incentive plan for certain senior executives. Payments under the incentive plan may be made in cash, units, or a combination of cash and units, at the option of the Fund. For the three and six months ended June 30, 2005, no units were issued pursuant to the long-term incentive plan.

Under CICA Handbook Section 3870, Stock-based Compensation and Other Stock-Based Payments, Deferred Units and units granted under these plans are accounted for using the fair value-based method. The fair value of Deferred Units granted for annual director fees is recorded as compensation expense in the period granted. The fair value of Deferred Units granted in lieu of cash distributions is recorded as compensation expense in the period the distribution is declared. The fair value of Fund units granted under the long-term incentive plan is recorded as compensation expense over the vesting period.

The implementation of the Deferred Unit Plan had no effect on the interim consolidated financial statements for the second quarter of 2005.

4. Finance contracts:



---------------------------------------------------------------------
---------------------------------------------------------------------
June 30, December 31,
2005 2004
---------------------------------------------------------------------
Finance contracts related to Trust sales $ 26,990 $ 26,219
Finance contracts related to independent
dealers 43,986 43,993
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70,976 70,212
Less: current portion 15,206 14,840
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$ 55,770 $ 55,372
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The Trust offers financing on HVAC equipment sold and installed by the Trust and on HVAC equipment sold and installed by independent dealers.

Beginning January 1, 2005, net cash flows from finance contracts related to Trust sales are reflected as operating activities. Net cash flows from finance contracts related to independent dealers are reflected as investing activities. The 2004 comparative figures have been reclassified to conform with the new presentation.

5. Senior notes payable:



---------------------------------------------------------------------
---------------------------------------------------------------------
Senior Secured Annual Expected Final Maturity
Notes Interest Rate Principal Payment Date Date
---------------------------------------------------------------------
Series 1 4.145% $ 200,000 January 30, January 30,
2009 2016
Series 2 4.722% 200,000 January 31, January 31,
2011 2018
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$ 400,000
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---------------------------------------------------------------------


The notes contain certain financial maintenance covenants and interest is paid semi-annually.

The Expected Final Payment Date for each series of notes is the date it is expected that the principal on the notes will be repaid. The Maturity Date is the maturity date for the series but the repayment date is expected to be the earlier date.

6. Interest rate contracts:

The Trust entered into interest rate contracts in November 2003 in order to fix, to the extent possible, the effective borrowing cost to the Fund on an issue of long-term notes made in February 2004.

The Trust does not enter into interest rate contracts or swap agreements for trading or speculative purposes. However, the interest rate contracts entered into by the Trust do not qualify for hedge accounting and, as such, are recorded at their fair value as either an asset or liability, with changes in fair value recognized in income in the period they occur.

The following is a summary of interest rate contracts outstanding at June 30, 2005:



---------------------------------------------------------------------
---------------------------------------------------------------------
Total Net Fair
Settlement Fixed Rate Notional Value Asset Termination
Based On of Interest Value (Liability) Date
---------------------------------------------------------------------

Payment of
fixed rates, 4.74% $ 200,000 $ (11,993) January 2009
receipt of
floating rates 5.13% 200,000 (18,270) January 2011

Receipt of
fixed rates, 3.82% 200,000 5,017 January 2009
payment of
floating rates 4.46% 200,000 10,896 January 2011
---------------------------------------------------------------------
$ (14,350)
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The following is a summary of interest rate contracts outstanding at
December 31, 2004:

---------------------------------------------------------------------
---------------------------------------------------------------------
Total Net Fair
Settlement Fixed Rate Notional Value Asset Termination
Based On of Interest Value (Liability) Date
---------------------------------------------------------------------

Payment of
fixed rates, 4.74% $ 200,000 $ (9,892) January 2009
receipt of
floating rates 5.13% 200,000 (13,237) January 2011

Receipt of
fixed rates, 3.82% 200,000 2,138 January 2009
payment of
floating rates 4.46% 200,000 5,405 January 2011
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$ (15,586)
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7. Equity:

Equity as at June 30, 2005 and December 31, 2004 and 2003 is
comprised of:

-------------------------------------------------
-------------------------------------------------
Number of Units Retained
Outstanding Amount Earnings Equity
-------------------------------------------------
-------------------------------------------------

Equity at the date
of formation of
the Trust $ - $ - $ -

Units issued for cash 2,510,500 25,105 - -
Units issued for
business assets 5,413,000 54,130 - -
Net loss for the
13 days ended
December 31, 2003 - - (9,190) -
-------------------------------------------------

Equity as at
December 31, 2003 7,923,500 $ 79,235 $ (9,190) $ 70,045

Net income for the
year ended
December 31, 2004 - - 31,741 -
Distributions to
unitholder for the
year ended
December 31, 2004 - - (34,563) -
-------------------------------------------------
-------------------------------------------------

Equity as at
December 31, 2004 7,923,500 $ 79,235 $ (12,012) $ 67,223

Net income for the
period ended
June 30, 2005 - - 20,012 -
Distributions to
unitholder for the
period ended
June 30, 2005 - - (17,724) -
-------------------------------------------------

Equity as at
June 30, 2005 7,923,500 $ 79,235 $ (9,724) $ 69,511
-------------------------------------------------
-------------------------------------------------


On December 11, 2003, the Fund subscribed for 2,510,500 units of the Trust for cash consideration of $25,105.

On December 18, 2003, the Trust issued 5,413,000 units as partial consideration for the acquisition of the business.

8. Unit-based compensation:

Effective June 14, 2005, the Trust implemented a deferred unit compensation plan (the "Deferred Unit Plan"). The Deferred Unit Plan provides for the grant to non-management trustees and directors of deferred Fund units ("Deferred Units").

Additional Deferred Units are granted to holders of Deferred Units based on distributions paid by the Fund on Fund units. The number of Deferred Units granted is calculated by multiplying the aggregate number of Deferred Units held on the record date for a distribution by the amount of such distribution paid by the Fund on one unit and dividing the result by the market price of a unit on the date the distribution is paid.

The Deferred Unit Plan provides that once a Deferred Unitholder ceases to be a trustee or a director, he or she will be entitled to receive a number of units equal to the number of Deferred Units held at the time of retirement. The Fund will fulfill any obligation to deliver units under the Deferred Unit Plan by issuing the requisite number of units from treasury.

For the three and six months ended June 30, 2005, no Deferred Units were granted, and consequently no compensation expense was recorded. No compensation expense relating to Deferred Units was recorded in 2004.

The Trust also has established a long-term incentive plan for certain senior executives. Payments under the incentive plan may be made in cash, Fund units, or a combination of cash and Fund units, at the option of the Trust and the Fund. For the three and six months ended June 30, 2005, no Fund units were issued pursuant to the long-term incentive plan.

9. Supplemental cash flow information:

a) The change in non-cash operating working capital consists of the following:



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---------------------------------------------------------------------
Three months ended Six months ended
June 30, June 30,
2005 2004 2005 2004
---------------------------------------------------------------------

Accounts receivable $ (708) $ 1,752 $ 202 $ 5,565
Inventories (29) 155 (96) 1,549
Prepaid expenses 191 439 541 (565)
Accounts payable and
accrued liabilities 5,414 (1,423) (4,065) (5,289)
Unearned revenue 313 126 472 171
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$ 5,181 $ 1,049 $ (2,946) $ 1,431
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b) Cash payment made related to interest and income and capital taxes
during the periods were as follows:

---------------------------------------------------------------------
Three months ended Six months ended
June 30, June 30,
2005 2004 2005 2004
---------------------------------------------------------------------

Interest paid $ 478 $ 502 $ 11,442 $ 3,311
Income and capital
taxes paid 845 1,536 1,294 1,536
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Included in interest is $478 paid to the Fund in each of the periods.

10. Defined benefit pension expense:

The total expense related to the defined benefit pension plan and post-retirement benefit program recognized in operating income was $119 and $244 (2004 - $334 and $674) for the second quarter and year-to-date respectively.

11. Unit issuance and business acquisition:

On July 15, 2005, the Trust acquired 100% of the shares of Protectron Holdings Inc., a privately held security monitoring and installation company headquartered in Montreal, Quebec, for approximately $135 million (the "Acquisition"). The transaction was financed through the issuance of Trust units for cash, demand Trust notes and $38 million advanced on a new acquisition bank credit facility established after June 30, 2005.

On July 15, 2005, the Fund issued 7,720,000 subscription receipts at a price of $13.60 per subscription receipt, for gross proceeds of approximately $105 million. Holders of the subscription receipts received, for no additional consideration, one unit of the Fund for each subscription receipt held with the closing of the Acquisition. Immediately prior to the closing of the Acquisition, the Fund acquired new Trust units issued from treasury, remaining the Trust's sole unitholder, and demand Trust notes, totaling $105 million in the aggregate.

Contact Information