XS Cargo Income Fund
TSX : XSC.UN

XS Cargo Income Fund

November 10, 2005 08:30 ET

XS Cargo Income Fund Reports Third Quarter Results

EDMONTON, ALBERTA--(CCNMatthews - Nov. 10, 2005) - XS Cargo Income Fund (TSX:XSC.UN) (the "Fund") announced its results for the three months ended September 30, 2005. The Fund reported earnings before non-controlling interest of $2,302,879 or $0.19 per unit outstanding as of September 30, 2005. The business had sales for the third quarter of $20,775,101 compared to sales of $17,058,724 for the third quarter of 2004, an increase of 22%. Gross margin for the third quarter was $7,806,547 compared to gross margin of $5,910,869 for the third quarter of 2004, an increase of 32%.

Michael McKenna, President and Chief Executive Officer of the Fund stated, "During the quarter our sales were adversely affected by a six week shutdown of the ports at Vancouver due to a trucking strike. This shutdown effectively stopped the flow of merchandise imported from China. The overall impact of the strike was to temporarily delay the realization of anticipated earnings growth from our new stores. The disruption had no impact on the Fund's ability to make monthly distributions."

Distributable cash for the three months ended September 30, 2005 was $0.21 per unit and the Fund declared cash distributions of $0.28 per unit.

Jeff Rootman, Vice-President, Finance and Chief Financial Officer of the Fund stated, "The Fund's current monthly cash distributions were determined based on the financial results of the business from the prior year, with no adjustment for the anticipated contribution from new stores. This leaves the Fund in a strong position to withstand disruptions such as the port shutdown. The additional earnings from new stores more than offset the loss of revenues due to the strike. Since our business is seasonal in nature, with approximately 40% of annual distributable cash being generated in the fourth quarter, it is normal for our monthly distributions to exceed our cash generated during the third quarter."

About XS Cargo Income Fund

The Fund is an open-ended trust that holds, indirectly, a 51% interest in XS Cargo Limited Partnership ("XS Cargo LP"). XS Cargo LP is one of the largest broadline closeout retailers in Canada with 25 stores in the provinces of Alberta, British Columbia, Saskatchewan, Manitoba and Ontario. The Fund's trust units are listed on the Toronto Stock Exchange under the symbol "XSC.UN".

Additional information about XS Cargo Income Fund is available at www.sedar.com and the Fund's website at www.xscargo.com.

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This management's discussion and analysis ("MD&A") should be read in conjunction with the unaudited consolidated interim financial statements and accompanying notes (the "Interim Financial Statements") of XS Cargo Income Fund (the "Fund") for the initial period from April 6, 2005 to September 30, 2005, which includes business operations from May 17, 2005 to September 30, 2005. Results are reported in Canadian dollars unless otherwise stated and have been prepared in accordance with Canadian generally accepted accounting principles ("GAAP"). Certain dollar amounts have been rounded to the nearest thousand dollars, while other amounts have been rounded to the nearest hundred thousand dollars. References to notes are to the notes to the Interim Financial Statements of the Fund unless otherwise stated.

This MD&A is dated November 9, 2005.

OVERVIEW OF THE FUND

Issuance of Fund Units and Acquisition

XS Cargo Income Fund is an unincorporated open-ended trust established under the laws of the Province of Alberta pursuant to a Declaration of Trust dated April 6, 2005. The Fund invests in the broadline closeout retail business, through an indirect controlling interest in XS Cargo Limited Partnership ("XS Cargo LP") and its general partner ("GP") (collectively "XS Cargo"), and such other investments as the Trustees may determine.

The Fund commenced business operations on May 17, 2005, when it completed an initial public offering (the "IPO") of 6,106,000 trust units ("Fund Units"), at a price of $10 per unit, for aggregate gross proceeds of $61,060,000. Concurrent with the closing of the IPO, the Fund acquired a 51% indirect interest in XS Cargo LP (note 3) and XS Cargo LP acquired the net assets (the "Acquired Business") of Famous Brands (Edmonton) Inc. (the "Vendor").

The acquisition of the Fund's interest in the Acquired Business has been accounted for using the purchase method.

The purchase price has been allocated to the assets acquired and liabilities assumed, as follows:



Property and equipment 2,373,558
Goodwill 101,788,426
Intangible assets 8,655,000
------------------------------------------------------------------------
112,816,984

Net working capital 16,979,392
------------------------------------------------------------------------
129,796,376
------------------------------------------------------------------------
------------------------------------------------------------------------

Consideration, being cash from IPO and
new credit facilities 71,131,876
XS Cargo LP Exchangeable LP Units 34,719,700
XS Cargo LP Subordinated LP Units 23,944,800
------------------------------------------------------------------------
Total consideration 129,796,376
------------------------------------------------------------------------
------------------------------------------------------------------------


The Fund is in the process of finalizing its estimate of the costs of issuance and the fair value of assets acquired and liabilities assumed. Working capital amounts as at May 17, 2005 have been estimated and, pursuant to the purchase agreement with the Vendor, the purchase price will be adjusted to reflect the actual amount of working capital purchased when it is determined. The Fund expects to complete this process by December 31, 2005.

The Fund Units trade on the Toronto Stock Exchange under the symbol XSC.UN.

Non-GAAP Measures

References to "EBITDA" are to earnings before interest, income taxes, depreciation and amortization and references to "distributable cash" are to cash available for distribution to Unitholders in accordance with the distribution policies of the Fund. Management believes that, in addition to income or loss, EBITDA is a useful supplemental measure of performance and cash available for distribution before debt service, changes in working capital, capital expenditures and income taxes. Specifically, management believes that EBITDA is the appropriate measure from which to make adjustments to determine the distributable cash of the Fund. Distributable cash of the Fund is a measure generally used by open-ended trusts as an indicator of financial performance. As one of the factors that may be considered relevant by prospective investors is the cash distributed by the Fund relative to the price of the Units, management believes that distributable cash of the Fund is a useful supplemental measure that may assist prospective investors in assessing an investment in the Fund.

Earnings from operations for disclosure under "Third Quarter Operating Results" and "Year to Date Operating Results" has been calculated as described below. In the case of the Fund, earnings from operations have been derived by adding interest expense, amortization of property and equipment and intangible assets, unit-based compensation and non-controlling interest to net earnings for the period. In the case of the Vendor, earnings from operations have been derived by adding amortization expense, employee profit sharing plan contributions, interest expense, and income tax expense to net earnings (loss) for the period.

EBITDA, distributable cash and earnings from operations are not earnings measures recognized by GAAP and do not have standardized meanings prescribed by GAAP. Investors are cautioned that EBITDA, distributable cash and earnings from operations should not replace net income or loss (as determined in accordance with GAAP) as an indicator of the Fund's performance, of its cash flows from operating, investing and financing activities or as a measure of its liquidity and cash flows. The Fund's methods of calculating EBITDA, distributable cash and earnings from operations may differ from the methods used by other issuers and may not be comparable to similar measures presented by other issuers.

Basis of Management's Discussion and Analysis

The Fund was established on April 6, 2005 and acquired, indirectly, the Acquired Business on May 17, 2005. Accordingly, the Fund's Interim Financial Statements only include business operations from May 17, 2005 to September 30, 2005.

To provide more meaningful information, the following MD&A refers to the operating results of the Fund for the three months ended September 30, 2005 and the combined nine months (year-to-date) operating results of the Fund from May 17, 2005 to September 30, 2005 and the Vendor from January 1, 2005 to May 16, 2005. These operating results are compared to the Vendor's results of operations for the three months and nine months ended September 30, 2004 (See "Non-GAAP Measures").

It is management's view that employee profit sharing plan contributions incurred by the Vendor are not relevant when compared to the Fund because of differences between the structure and policies of the Fund to those of the Vendor.

The Business of the Fund

XS Cargo LP operates 25 closeout retail stores in Alberta, British Columbia, Manitoba, Saskatchewan and Ontario.

Operating Highlights

Strong business fundamentals and a conservative structure at the time of its initial public offering have allowed the Fund to maintain a strong financial position despite facing significant logistical challenges during the quarter. The most significant disruption was a six-week shutdown of the ports at Vancouver, British Columbia due to a trucking strike, which effectively stopped the flow of our merchandise imported from China. Since merchandise directly imported from China accounts for approximately 20% of XS Cargo's purchases, the strike had a significant, albeit temporary, impact on sales during the quarter as described in "Third Quarter Sales" below. Since the Fund's monthly cash distributions were established based on the Vendor's prior year financial results with no adjustments for the anticipated contribution from new stores, the Fund was in a strong position to withstand unexpected disruptions such as the port strike with no adverse affect on its ability to make monthly distributions. The additional earnings from new stores more that offset the impact of the strike, with earnings from operations for the third quarter of 2005 exceeding earnings from operations for the third quarter of 2004 (see "Third Quarter Operating Results").

Despite the logistical challenges related to Chinese imports, there were several positive developments during the quarter. New stores were opened in Whitby, Ontario and Victoria, British Columbia. Most importantly, gross margin percentages continue to improve, which reflects our continued ability to source brand name, high demand merchandise at significant discounts to regular wholesale prices, and the overall quality of XS Cargo's inventory.

In spite of significant upward pressure on fuel prices, freight expense decreased as a percentage of sales in the quarter. This is the result of opening a new distribution centre in Mississauga, Ontario. The efficiencies gained from two distribution centres more than offset freight price increases. In late September, freight savings began exceeding the additional operating costs of the second distribution centre. A net reduction in total distribution costs is expected in the fourth quarter.

SELECTED FINANCIAL INFORMATION AND RESULTS FROM OPERATIONS

Third Quarter Operating Results

The following table shows the unaudited results of the Fund for the Third Quarter of 2005 compared to the Vendor's Third Quarter of 2004. The sales, cost of sales, and administrative and operating expenses for the period from July 1, 2004 to September 30, 2004 have been derived from the financial statements of the Vendor and are presented for comparative purposes. The results of operations for these periods are not necessarily indicative of the results of operations to be expected in any given period.



Fund Vendor
July 1, July 1, Change
2005 to 2004 to Q3 2005
September 30, September 30, to Q3
2005 2004 2004

Sales 20,775,101 17,058,724 3,716,377
Cost of Sales 12,968,554 11,147,855 1,820,699
---------------------------------------
Gross Margin 7,806,547 5,910,869 1,895,678

Administrative and
Operating Expenses(x) 4,848,017 3,093,100 1,754,917
---------------------------------------
Earnings from Operations,
as defined(x) 2,958,530 2,817,769 140,761



Combined
Fund and
Vendor Vendor
nine nine
Fund Vendor months months Change
May 17 to Jan 1 to ended ended 2005
Sept 30, May 16, September September over
2005 2005 30, 2005 30, 2004 2004

Sales 32,531,053 28,400,077 60,931,130 47,307,885 13,623,245
Cost of Sales 20,296,840 18,380,761 38,677,601 30,936,101 7,741,500
--------------------------------------------------------
Gross Margin 12,234,213 10,019,316 22,253,529 16,371,784 5,881,745

Administrative
and Operating
Expenses(x) 7,396,923 6,234,880 13,631,803 8,950,299 4,681,504
--------------------------------------------------------

Earnings from
Operations, as
defined(x) 4,837,290 3,784,436 8,621,726 7,421,485 1,200,241

(x) Earnings from operations have been calculated as described under
"Non-GAAP Measures" above. For purposes of this table, administrative
and operating expenses exclude the expenses outlined in the calculation
of Earnings from Operations as described under "Non-GAAP Measures".


Third Quarter Sales

Third Quarter sales increased by $3.7 million from $17.1 million in 2004 to $20.8 million in 2005, an increase of 21.6%. The increase in sales was attributable to nine new stores that were open in the Third Quarter of 2005 that were not open in 2004. The new stores contributed a combined $6.0 million in sales, which was offset by a decrease of $2.3 million in same store sales. There were two factors affecting same store sales during the quarter. A trucking strike shut down the ports at Vancouver, British Columbia in July and August, stopping the flow merchandise imported directly from China, which accounts for approximately 20% of the Fund's purchases. Even subsequent to the resolution of the strike, there was a significant backlog of merchandise in both Vancouver and China. Regular flow of merchandise from China had not been restored until after the end of the quarter. In addition to the port strike, four existing stores experienced erosion of sales due to new stores that opened in overlapping trading areas. Those four stores experienced decreases in same store sales of 21%, whereas the stores that were only affected by the port strike experienced decreases in same store sales of 10%. The level of cannibalization from new stores in overlapping trading areas was expected and has not impacted our expansion plan to reach at least 70 XS Cargo stores in Canada.

The following table outlines the percentage of sales by geographical region:



July 1, 2005 to July 1, 2004 to
Region September 30, 2005 September 30, 2004

Ontario 50.1% 49.4%
Alberta 25.4% 22.7%
Saskatchewan and Manitoba 10.8% 14.2%
British Columbia 13.7% 13.7%
----------------------------------------
Total 100.0% 100.0%


Sales by region are relatively consistent with the prior year. Alberta is growing as a percentage of sales with second stores being opened in Calgary and Edmonton as well as a new store in Lethbridge, whereas no new stores have been opened in Saskatchewan or Manitoba causing that region to decrease as a percentage of sales.

Third Quarter Cost of Sales and Gross Margin

Cost of sales increased by $1.8 million from $11.2 million to $13.0 million, an increase of 16.1%, primarily as a result of new store openings.

Gross margin increased by $1.9 million from $5.9 million to $7.8 million, an increase of 32.2%. Of the increase in gross margin, $1.3 million was attributable to nine additional stores in 2005 compared to 2004 and the remaining $0.6 million was the result of a 2.9% increase in gross margin percentage from 34.7% to 37.6%. 1.2% of the gross margin percentage increase was the result of a reduction in freight costs as a percentage of sales from 8.6% of sales in the third quarter of 2004 to 7.4% of sales in the third quarter of 2005. The decrease in freight costs as percentage of sales was due to efficiencies gained from the Mississauga distribution centre that opened in May 2005. The remaining 1.7% increase in gross margin percentage is the result of XS Cargo's continued ability to improve product selection with higher margin items.

Combined Administrative and Operating Expenses

Administrative and operating expenses increased by approximately $1.8 million from $3.1 million to $4.9 million. The increase is primarily the result of increases in rent ($0.5 million increase), wages ($0.5 million increase) and advertising ($0.3 million increase). Most of the increase in these expenses was the result of new store openings. In addition, incremental public company administrative expenses accounted for $0.1 million of the increase. XS Cargo incurred additional administrative and operating costs of $0.3 million in connection with the new distribution centre that opened in May 2005, but the associated freight savings are included in cost of goods sold.

Fund Net Earnings

For the three months ended September 30, 2005, the Fund had net earnings of $1,173,328, or $0.192 per unit on a basic and diluted basis. Since the commencement of business operations (May 17, 2005) the Fund had net earnings of $1,920,624 or $0.315 per unit on a basic and diluted basis.

Financial Position

The following are the significant assets, liabilities and equity of the Fund as at September 30, 2005:



September 30, 2005

Cash 2,918,604

Current assets 21,331,432

Total assets 133,860,566

Current liabilities excluding term loan 5,060,114

Term loan, due May 2006 15,000,000

Non-controlling interest 58,162,266

Unitholders' equity 55,752,809


Distributable Cash and Cash Distributions

The Fund's policy is to distribute annually to unitholders available cash from operations after cash required for capital expenditures, working capital reserve and other reserves considered advisable by the Trustees of the Fund. The policy allows the Fund to make stable monthly distributions to its unitholders based on its estimate of distributable cash for the year. The Fund pays cash distributions on or about the 15th of the month to unitholders of record on the last business day of the previous month.

The following table summarizes the distributions from May 17, 2005 to September 30, 2005:



Fund Units
-----------------------
Record Payment Declared Paid
Date Date $ $

June 30, July 15,
2005 2005 846,902 846,902(x)
July 31, August 15,
2005 2005 572,438 572,438
August 31, September 15,
2005 2005 572,437 572,437
September 30, October 15,
2005 2005 572,438 -
-----------------------
2,564,215 1,991,777
-----------------------
-----------------------



Exchangeable LP Units and
Subordinated LP Units Total
-------------------------- ---------------------
Record Payment Declared Paid Declared Paid
Date Date $ $ $ $

June 30, July 15,
2005 2005 815,304 815,304(x) 1,662,206 1,662,206
July 31, August 15,
2005 2005 326,148 326,148 898,586 898,586
August 31, September 15,
2005 2005 326,148 326,148 898,585 898,585
September 30, October 15,
2005 2005 1,000,943 - 1,573,381 -
-------------------------- ---------------------
2,468,543 1,467,600 5,032,758 3,459,377
-------------------------- ---------------------
-------------------------- ---------------------
(x) The first distribution covered the period from May 17, 2005 to
June 30, 2005. Subsequent distributions are monthly on Fund Units and
Exchangeable LP Units and quarterly on Subordinated LP Units.


Distributions are paid on Fund Units, XS Cargo LP Exchangeable LP Units and XS Cargo LP Subordinated LP Units. As of September 30, 2005 the following number of units were outstanding:



Fund Units (Note 8) 6,106,000
XS Cargo LP Exchangeable LP Units (Note 9) 3,478,914
XS Cargo LP Subordinated LP Units (Note 9) 2,399,269
------------
11,984,183
------------
------------


During the three months ended September 30, 2005, the Fund approved distributions of $0.28125 per Fund Unit to unitholders. Distributions during the period were consistent with the distributions contemplated in the Fund's final prospectus dated May 6, 2005 (available on www.sedar.com.) The Fund currently anticipates making equal monthly distributions of $0.09375 per Fund Unit, or $1.125 per Fund Unit on an annual basis.

It is the Fund's policy to review the monthly distributions on at least a quarterly basis.



Distributable Cash per Unit (Fund Units, XS Cargo LP Exchangeable LP
Units, XS Cargo LP Subordinated LP Units)

Three Months May 17, 2005
Ended September to September
30, 2005 30, 2005

Earnings before non-controlling interest 2,302,879 3,769,603
Add: Amortization of property and equipment 129,470 189,500
Add: Amortization of intangible assets 298,000 447,000
Add: Interest expense 188,181 273,857
------------------------------
EBITDA 2,918,530 4,679,960

Add: Unit based compensation 40,000 157,330
Less: Interest paid (188,181) (273,857)
Less: Purchase of property and equipment (198,396) (223,677)
------------------------------

Distributable cash 2,571,953 4,339,756

Average Units outstanding during the period 11,984,183 11,984,183
Distributable cash per Unit 0.21 0.36

Distributions declared 3,370,552 5,032,758
Distributions declared per Unit 0.28 0.42


For the three months ended September 30, 2005, the Fund had distributable cash per unit of $0.21 (May 17 to September 30, 2005 - $0.36). Basic and diluted earnings per unit for the three months ended September 30, 2005 were $0.19 per unit (May 17 to September 30, 2005 - $0.32).

As disclosed in "Non-GAAP Measures", management views distributable cash as a measure of operating performance of the Fund and therefore begins the reconciliation of distributable cash with net income as opposed to cash flow from operations.

During the three months ended September 30, 2005, cash distributions exceeded distributable cash and the difference was funded with working capital, specifically cash on hand at the beginning of the period. The monthly cash distributions are based on the distributable cash for the 12 months ended January 31, 2005. Since the Fund's business is seasonal in nature, with approximately 40% of the annual distributable cash being generated in the fourth quarter, it is expected that cash distributions based on annual cash flows may exceed distributable cash in some quarters.

Unitholders' Equity and Non-controlling Interest

The following table outlines the Fund Units and non-controlling interest outstanding as of September 30, 2005.



Non-
Issue Unitholders' controlling
Units Costs Equity Interest
# $ $ $
Fund Units 6,106,000 4,928,124 56,131,876 -
Special Voting Units 5,878,183 - - -
Non-controlling
Interest 5,878,183 - - 58,162,266


There were no changes in the number of units issued and outstanding during the period.

LIQUIDITY AND CAPITAL RESOURCES

Distributable Cash and Cash Distributions

The Fund's policy is to make stable monthly distributions to its Unitholders based on its estimate of distributable cash for the year. It has a policy to pay cash distributions on or about the 15th of each month to Unitholders of record on the last business day of the previous month.

During the three months ended September 30, 2005, the Fund declared distributions of $0.28125 per Fund Unit to Unitholders, $1,717,313 in total.

Credit Facilities

In May 2005 the Fund established credit facilities with a Canadian chartered bank. These credit facilities consist of a $7.5 million demand revolving operating loan and a $15 million committed non-revolving term loan. On May 17, 2005 the Fund drew $15 million on the term loan in connection with the acquisition. No amounts have been drawn on the operating loan.

Capital Expenditures

During the quarter the Fund incurred capital expenditures of $198,396 funded by cash generated from operations. $107,387 of the capital expenditures related to new store openings and the remaining $91,009 related to capital expenditures at existing stores and warehouses. As at September 30, 2005, the Fund did not have significant capital expenditure commitments. Subsequent to September 30, 2005, the Fund entered into lease agreements for new stores in Medicine Hat, Albert and Surrey, British Columbia. The new stores will require capital expenditures of approximately $200,000 in fourth quarter and the Fund intends to continue to finance its capital expenditures with cash generated from operations.

Interest Rate Risk and Sensitivity

The Fund is not significantly impacted by interest rate changes. The Fund's long-term debt bears interest with floating rates based on the bank's prime rate, thus exposing the Fund to interest rate fluctuations. A 1.0% increase in interest rates would have an impact of $150,000 annually ($37,500 during the quarter) on distributable cash based on $15 million of debt outstanding.

Contractual Obligations

The table below sets forth the contractual obligations of the Fund as of September 30, 2005, due in the years indicated, which related to various premises operating leases and the $15,000,000 term loan that matures on May 17, 2006, but may be extended with approval of the lender until 2008.



2009 and
Total 2005 2006 2007 2008 thereafter
Operating
leases 15,366,916 900,476 3,112,233 2,521,789 2,261,376 6,571,042
Term
loan 15,000,000 15,000,000 - - - -
----------------------------------------------------------------

Total 30,366,916 15,900,476 3,112,233 2,521,789 2,261,376 6,571,042
----------------------------------------------------------------
----------------------------------------------------------------



Summary of Quarterly Results

July 1 to May 17 to
September June 30,
30, 2005 2005

Sales 20,775,101 11,755,952
Net earnings 1,173,328 747,296
Basic and diluted earnings per unit 0.192 0.122


Due to seasonal shopping trends, the fourth quarter is typically the strongest quarter for XS Cargo and the first quarter is the slowest.

Off-Balance Sheet Arrangements

The Fund has not entered into any off-balance sheet arrangements.

Critical Accounting Estimates

Because of the nature of the Fund's business and assets, management does not believe that there are critical accounting policies that rely on estimates.

Changes in Accounting Policies

Management is not aware of any recent accounting pronouncements or developments that will affect the Fund's financial statements. Management will continue to monitor and assess the impact of accounting pronouncements on the financial statements of the Fund as they become available.

Financial Instruments

Due to the nature of its business, the Fund does not engage in activities or hold assets that would require the Fund to acquire financial instruments for hedging or speculative purposes. The financial instruments that are held by the Fund are held in the normal course of operations and as a result no significant accounting policies need to be adopted or assumptions made in reporting the Fund's financial instruments.

Transactions with Related Parties

Transactions with related parties include XS Cargo LP's purchase of the assets of the business from the Vendor on May 17, 2005. During the three months ended September 30, 2005, the Fund repaid amounts due to the Vendor, and there were no related party transactions during the quarter.

Outlook

Management believes that operating results will continue to improve in the upcoming year due to new store openings, the realization of freight savings from the new distribution centre in Ontario, the consolidation of XS Cargo's existing Edmonton distribution and warehousing operations and the introduction of new revenue streams. XS Cargo has entered into lease agreements for new stores in Medicine Hat, Alberta and Surrey, British Columbia, which are scheduled to open in early December, 2005.

On October 1, 2005, XS Cargo introduced a two-year product replacement extended warranty plan. Management believes that the plan will have a positive impact on net income and cash flow from operations. In connection with the product replacement plan, XS Cargo introduced a variable compensation plan for hourly store employees to be paid from the incremental product replacement plan revenue. This compensation plan is expected to significantly reduce the impact of upward pressure on labour costs that is being driven by increases in minimum wages in certain provinces.

Additional Information

Additional information relating to the Fund is available on SEDAR (www.sedar.com) and on the Fund's website at www.xscargo.com.

RISK FACTORS

The Fund's results of operations, business prospects, financial condition, cash distributions to unitholders and the trading price of the Fund's units are subject to a number of risks. These risk factors include: the ability to maintain profitability and manage growth; the ability to expand through new store openings; the ability to source products in adequate quantities and on acceptable terms; changes in trends and consumer tastes; economic conditions and consumer spending; competition; reliance on centralized distribution centres; freight costs; ability to maintain comparable store sales; seasonality and fluctuations in quarterly results; reliance on management information systems; increase in the cost of, or disruption in the flow of, imported products; successful management of exposure to merchandise returns; foreign exchange fluctuations; costs and availability of insurance coverage; protection of intellectual property; reliance on key personnel; labour matters; absence of history as a public company; dependence on external funding sources; uncertainties arising from world events; income tax legislation; and property taxes. For a discussion of these risks and other risks associated with an investment in Fund Units, see "Risk Factors" detailed in the Fund's final prospectus dated May 6, 2005 available at www.sedar.com.

On September 8, 2005, the Department of Finance launched public consultations on tax issues related to publicly traded income trusts and other "flow-through entities". There is a risk that regulatory authorities could alter the tax treatment of income trusts, the distribution of trust income, or the tax on corporations and dividends, which could adversely affect the income trust structure and their market valuations. As of the date of this MD&A the nature and impact of those changes, if any, are unknown.

FORWARD LOOKING STATEMENTS

This MD&A contains forward-looking statements. All statements other than statements of historical fact contained in this MD&A are forward-looking statements, including, without limitation, statements regarding the future financial position, cash distributions, proposed store openings, budgets, litigation, projected costs and plans and objectives of or involving the Fund or XS Cargo LP. You can identify many of these statements by looking for words such as "believe", "expects", "will", "intends", "projects", "anticipates", "estimates", "continues" or similar words or the negative thereof. These forward-looking statements include statements with respect to the amount and timing of the payment of distributions of the Fund. There can be no assurance that the plans, intentions or expectations upon which these forward-looking statements are based will occur. Forward-looking statements are subject to risks, uncertainties and assumptions, including, but not limited to, those discussed elsewhere in the MD&A. There can be no assurance that such expectations will prove to be correct.

Some of the factors that could affect future results and could cause results to differ materially from those expressed in the forward-looking statements contained herein include, but are not limited to, those discussed under "Risk Factors".

The information contained in this MD&A, including the information set forth under "Risk Factors", identifies additional factors that could affect the operating results and performance of the Fund and XS Cargo LP.

The forward-looking statements contained herein are expressly qualified in their entirety by this cautionary statement. The forward-looking statements included in this MD&A are made as of the date of this MD&A and, except as required by law, the Fund assumes no obligation to update or revise them to reflect new events or circumstances.



XS Cargo Income Fund
Interim Consolidated Financial Statements
Unaudited
September 30, 2005


XS Cargo Income Fund
Consolidated Balance Sheet

September 30, 2005
(Unaudited)

Assets
Current
Cash and cash equivalents 2,918,604
Rebate and other receivables 95,755
Inventory 15,089,260
Deposits on inventory 2,746,328
Prepaid expenses and deposits 481,485
------------------------------------------------------------------------

21,331,432
Property and equipment (Note 4) 2,532,708
Intangible assets (Note 5) 8,208,000
Goodwill (Note 3) 101,788,426
------------------------------------------------------------------------

133,860,566
------------------------------------------------------------------------
------------------------------------------------------------------------

Liabilities
Current
Accounts payable and accrued liabilities 3,486,733
Distributions payable to unitholders (Note 8) 572,438
Distributions payable to non-controlling interest
(Note 9) 1,000,943
------------------------------------------------------------------------

5,060,114
Term loan (Note 6) 15,000,000
------------------------------------------------------------------------

20,060,114
Unamortized lease inducements (Note 7) 149,901
------------------------------------------------------------------------

20,210,015
Non-controlling interest (Note 9) 58,162,266
------------------------------------------------------------------------

78,372,281
------------------------------------------------------------------------

Unitholders' Equity
Fund Units (Note 8) 56,131,876

Cumulative earnings
Cumulative earnings 1,920,624
Distributions declared (2,564,215)
------------------------------------------------------------------------

55,752,809
------------------------------------------------------------------------

133,860,566
------------------------------------------------------------------------
------------------------------------------------------------------------

The accompanying notes are an integral part of these financial
statements


XS Cargo Income Fund
Consolidated Statements of Earnings and Cumulative Earnings
For the period from April 6, 2005, including operations from
May 17, 2005 (date of commencement of business operations) to
September 30, 2005

Three Months Ended May 17 to
September 30, September 30,
2005 2005
(Unaudited) (Unaudited)
------------------------------------------------------------------------


Sales 20,775,101 32,531,053

Cost of sales 12,968,554 20,296,840
------------------------------------------------------------------------

Gross margin 7,806,547 12,234,213
------------------------------------------------------------------------

Expenses
Administrative and operating 4,855,730 7,519,662
Amortization of property and equipment 129,470 189,500
Amortization of intangible assets 298,000 447,000
------------------------------------------------------------------------

5,283,200 8,156,162
------------------------------------------------------------------------

Earnings before the undernoted 2,523,347 4,078,051
------------------------------------------------------------------------

Other expenses
Interest on term loan 188,181 273,857
Foreign exchange loss 32,287 34,591
------------------------------------------------------------------------

220,468 308,448
------------------------------------------------------------------------

Earnings before non-controlling interest 2,302,879 3,769,603

Non-controlling interest 1,129,551 1,848,979
------------------------------------------------------------------------
------------------------------------------------------------------------

Net earnings for the period 1,173,328 1,920,624
------------------------------------------------------------------------
------------------------------------------------------------------------

Cumulative earnings, beginning of period 747,296 -
------------------------------------------------------------------------
------------------------------------------------------------------------

Cumulative earnings, end of period 1,920,624 1,920,624
------------------------------------------------------------------------
------------------------------------------------------------------------

Basic and diluted earnings per unit
(Note 15) 0.192 0.315
------------------------------------------------------------------------
------------------------------------------------------------------------
The accompanying notes are an integral part of these financial
statements

XS Cargo Income Fund
Consolidated Statements of Cash Flows
For the period from April 6, 2005, including operations from
May 17, 2005 (date of commencement of business operations) to
September 30, 2005

Three Months Ended May 17 to
September 30, September 30,
2005 2005
(Unaudited) (Unaudited)
------------------------------------------------------------------------

Cash provided by (used for) the following activities

Operating activities
Net earnings for the period 1,173,328 1,920,624
Items not affecting cash
Non-controlling interest 1,129,551 1,848,979
Amortization of property and equipment 129,470 189,500
Amortization of intangible assets 298,000 447,000
Unit-based compensation (Note 12) 40,000 157,330
Leasehold inducements received 62,900 149,901
------------------------------------------------------------------------

2,833,249 4,713,334

Net change in non-cash working capital (1,486,541) 2,725,623
------------------------------------------------------------------------

1,346,708 7,438,597
------------------------------------------------------------------------

Financing activities
Repayment of amounts due to Vendor (721,214) (901,394)
Net proceeds from the issuance of Units - 56,131,876
Proceeds from term loan - 15,000,000
Distributions paid to unitholders (1,991,777) (1,991,777)
Distributions paid to non-controlling
interest (1,467,600) (1,467,600)
------------------------------------------------------------------------

(4,180,591) 66,771,105
------------------------------------------------------------------------

Investing activities
Purchases of property and equipment (198,396) (223,677)
Business acquisition - net of cash
acquired (Note 3) - (71,067,781)
------------------------------------------------------------------------

(198,396) (71,291,458)
------------------------------------------------------------------------

Increase (decrease) in cash and cash
equivalents (3,032,279) 2,918,604

Cash and cash equivalents, beginning
of period 5,950,883 -
------------------------------------------------------------------------
------------------------------------------------------------------------

Cash and cash equivalents, end of period 2,918,604 2,918,604
------------------------------------------------------------------------
------------------------------------------------------------------------


Supplementary cash flow information:

Interest paid 188,181 273,857
------------------------------------------------------------------------
------------------------------------------------------------------------

The accompanying notes are an integral part of these financial
statements


XS Cargo Income Fund
Notes to the Interim Consolidated Financial Statements
September 30, 2005
Unaudited


1. The Fund

XS Cargo Income Fund (the "Fund") is an unincorporated open-ended trust established under the laws of the Province of Alberta pursuant to the Fund Declaration of Trust dated April 6, 2005. The Fund has been created to invest in the broadline closeout retail business, through an indirect acquisition of the controlling interest of XS Cargo Limited Partnership ("XS Cargo LP") and its general partner ("GP") (collectively "XS Cargo"), and such other investments as the Trustees may determine. Income tax obligations related to the distributions of the Fund are obligations of the Unitholder.

The Fund commenced business operations on May 17, 2005, when it completed an initial public offering (the "IPO") of 6,106,000 trust units ("Fund Units"), at a price of $10 per unit, for aggregate gross proceeds of $61,060,000. Concurrent with the closing of the IPO, the Fund acquired a 51% indirect interest in XS Cargo LP (note 3) and XS Cargo LP acquired the net assets (the "Acquired Business") of Famous Brands (Edmonton) Inc. (the "Vendor"). XS Cargo LP operates 25 closeout retail stores in Alberta, British Columbia, Manitoba, Saskatchewan and Ontario.

2. Accounting policies

These financial statements have been prepared in accordance with Canadian generally accepted accounting principles for interim financial statements and may not include all necessary disclosures required by generally accepted accounting principles for annual financial statements. The financial statements include the following significant accounting policies:

Cash and cash equivalents

Cash and cash equivalents include balances with banks and short-term investments with maturities of three months or less at acquisition.

Inventory

Inventory is valued at the lower of cost, determined using the average cost basis, and net realizable value.

Vendor volume rebate

The Fund receives a volume rebate from a particular vendor, which is accrued based on purchases from that vendor and included in rebate and other receivables. The portion of the rebate related to goods that the Fund has subsequently sold is recorded as a reduction of cost of sales and the portion related to goods that remain in inventory is recorded as a reduction of inventory costs.

Deposits on inventory

On certain purchases the Fund pays either a deposit or the balance in full prior to taking possession of the goods. Such payments are recorded as deposits on inventory until the Fund takes possession of the goods, at which time the balance is transferred to inventory.

Property and equipment

Property and equipment are recorded at cost. Amortization is provided using methods and rates intended to amortize the cost of assets over their estimated useful lives. The Fund will test its property and equipment for impairment when events and circumstances warrant such a review. Amortization rates are set forth below:



Method Rate
------------------------------------------------------------------------
Leasehold improvements straight-line Shorter of lease
term and 5 years
Office, computer and
mobile equipment straight-line 20 %
Signs straight-line 20 %


Goodwill

Goodwill represents the excess of the cost of an acquired business over the estimated fair value of the identifiable net assets acquired. Goodwill is not amortized, but is tested at least annually for impairment. The Fund analyzes its business as one reporting unit because all of the components of the reporting unit have similar economic characteristics. The Fund uses a discounted cash flow model to assess the fair value of the reporting unit annually. If the carrying value of the reporting unit exceeds its fair value, the fair value is allocated to the assets and liabilities of the reporting unit and the resulting difference between the carrying value and fair value of goodwill is recorded as an impairment loss and is reported in income of the current period.

Intangible assets

Intangible assets acquired at the time of the IPO represent management's estimate of the fair value of the XS Cargo brand name and trademark, supplier contract, technology, non-competition agreements and the value attributed to property leases at less than market rates. The intangible assets related to the brand name and trademark, supplier agreement and technology have indefinite lives and are not amortized. The intangible assets related to the non-competition agreements are amortized on a straight-line basis over the 3-year term of the agreements and the amount attributable to property leases is amortized over the remaining term of the lease. The Fund will assess the carrying value of the intangible assets that are not subject to amortization annually, or more frequently if events or changes in circumstances indicate that the asset might be impaired. Intangible assets that are amortized are assessed for impairment when events or changes in circumstances warrant such a review. An impairment loss is recorded when it is determined that the carrying amount of the assets is not recoverable and exceeds the fair value.

Future income taxes

The Fund complies with the Income Tax Act (Canada) to qualify as a mutual fund trust. A mutual fund trust is subject to tax in each taxation year on the amount of its income for the year, including the net realized taxable capital gains, less the portion thereof that it claims in respect of the amounts paid or payable to the unitholders for the year. The Fund intends to allocate all of its income and net realized capital gains, including those amounts derived from XS Cargo LP, so that the Fund will not generally be liable for income tax and as such, corporate income taxes have not been provided for in the Fund.

Revenue recognition

Revenue from retail sales is recognized at the point of sale.

Lease inducements

Lease inducements are received from certain of the Fund's landlords, primarily in the form of rent-free periods. Lease inducements are recorded as a liability when received and are amortized as a reduction of rent expense over the terms of the related leases.

Foreign currency translation

Transaction amounts denominated in foreign currencies are translated into their Canadian dollar equivalents at exchange rates prevailing at the transaction dates. Carrying values of monetary assets and liabilities reflect the exchange rates at the balance sheet date. Translation gains and losses are included in current earnings.

Variable interest entities

The Fund has adopted new guidance issued by the Canadian Institute of Chartered Accountants relating to the consolidation of variable interest entities. Under this guidance, the Fund must identify entities in which it has a variable interest by either contract, ownership or other pecuniary interests. Where the Fund is the primary beneficiary of an entity in which it has a variable interest, that entity is consolidated. As disclosed in note 14, the Fund has a variable interest in one company, but has determined that it is not the primary beneficiary of that entity.

Unit-based compensation

Under the terms of an employment agreement, XS Cargo LP may issue a maximum of 6,944 additional XS Cargo LP Exchangeable LP Units and 4,789 additional XS Cargo LP Subordinated LP Units per annum to the Fund's Chief Financial Officer as performance based compensation, on approval of the Chief Executive Officer and the Fund's Governance and Compensation Committee. Compensation expense, which is included in administrative and operating expenses, is measured at the estimated fair value of the units awarded on the grant date.

Measurement uncertainty

The preparation of financial statements in conformity with Canadian generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of financial statements and the reported amounts of revenues and expenses during the reporting period. For example, amortization is based on the estimated useful lives of property and equipment and inventory is recorded after an evaluation as to the net realizable value and is appropriately reduced if net realizable value is estimated to be below cost. As well, freight costs are allocated to inventory based on a percentage of the freight paid in the year in comparison to the total purchases made in the year. This percentage is then applied to the ending inventory balance.

These estimates are reviewed periodically and, as adjustments become necessary, they are reported in earnings in the periods in which they become known.


3. Issuance of Units and business acquisition

On May 17, 2005, the Fund completed the IPO for aggregate proceeds of $61,060,000. The cost of the issuance of Units was $4,928,124 resulting in net proceeds of $56,131,876. The Fund used the net proceeds from the IPO to acquire an indirect 51% interest in XS Cargo LP, represented by 6,106,000 Ordinary LP Units. XS Cargo LP combined these Funds with proceeds from new credit facilities (note 6) to acquire 100% of the net business assets of the Vendor.

The acquisition of the Fund's interest in the Acquired Business has been accounted for using the purchase method and has been allocated to the assets acquired and liabilities assumed, as follows:



Property and equipment 2,373,558
Goodwill 101,788,426
Intangible assets 8,655,000
------------------------------------------------------------------------

112,816,984

Net working capital 16,979,392
------------------------------------------------------------------------

129,796,376
------------------------------------------------------------------------
------------------------------------------------------------------------

Consideration, being cash from IPO and new credit
facilities 71,131,876
XS Cargo LP Exchangeable LP Units 34,719,700
XS Cargo LP Subordinated LP Units 23,944,800
------------------------------------------------------------------------

Total consideration 129,796,376
------------------------------------------------------------------------
------------------------------------------------------------------------


Included in net working capital is cash acquired of $64,095.

The Fund is in the process of finalizing its estimate of the costs of issuance and the fair value of assets acquired and the liabilities assumed. Working capital amounts as at May 17, 2005 have been estimated and, pursuant to the purchase agreement with the Vendor, the purchase price will be adjusted to reflect the actual amount of working capital purchased when it is determined. The Fund expects to complete this process by December 31, 2005.



4. Property and equipment

September 30,
2005
Accumulated Net book
Cost Amortization value
------------------------------------------------------------------------

Leasehold improvements 353,592 21,260 322,332
Office, computer
and mobile equipment 2,197,058 157,333 2,039,725
Signs 171,558 10,907 160,651
------------------------------------------------------------------------
2,722,208 189,500 2,532,708
------------------------------------------------------------------------
------------------------------------------------------------------------


5. Intangible assets

September 30,
2005
Accumulated Net book
Cost Amortization value
------------------------------------------------------------------------

Indefinite life
Brand name and trademark 690,000 - 690,000
Supplier contract 3,385,000 - 3,385,000
Databases of sales and
purchasing history 430,000 - 430,000
------------------------------------------------------------------------

4,505,000 - 4,505,000
------------------------------------------------------------------------
------------------------------------------------------------------------

Limited life
Operating lease agreements 1,600,000 128,250 1,471,750
Non-competition agreements 2,550,000 318,750 2,231,250
------------------------------------------------------------------------

4,150,000 447,000 3,703,000
------------------------------------------------------------------------
------------------------------------------------------------------------

8,655,000 447,000 8,208,000
------------------------------------------------------------------------
------------------------------------------------------------------------


6. Credit facilities

Term loan

Term loan consists of a committed $15,000,000 non-revolving term loan facility. The term loan is collateralized by a first charge on all present and after acquired personal property and an assignment of inventory. Interest on the term facility is charged at the lender's Canadian prime rate or U.S. base rate plus 0.25% to 0.75% or the bankers' acceptance rate plus 1.75% to 2.25%, depending on the Fund's senior debt to EBITDA ratio. The credit facility includes limits on incurring additional indebtedness or granting encumbrances without the consent of the lender and is subject to the maintenance of senior debt to EBITDA, current assets to current liabilities and fixed charge coverage ratios and minimum equity.

The term loan was drawn in the form of prime rate loans on May 17, 2005 concurrent with the acquisition described in note 3. During the three months ended September 30, 2005, interest was charged at a rate of prime plus 0.25% and totaled $188,181 (May 17, 2005 to September 30, 2005 - $273,857). The term loan matures and the principal amount is due on May 17, 2006 and includes two options to renew for an additional year, with a maximum term to May 17, 2008 based on approval by the lender.

Operating loan

The Fund has available under its credit facilities a $7,500,000 demand revolving loan. Under the terms of the credit facility agreement, the operating loan is collateralized along with the term loan as described above. Interest on the operating loan will vary between the lender's prime rate and the lender's prime rate plus 0.25% depending on the Fund's ratio of senior debt to EBITDA. No amounts have been drawn on the operating loan during the period.



7. Unamortized lease inducements

September 30,
2005
------------------------------------------------------------------------

Cost 187,336
Accumulated amortization (37,435)
------------------------------------------------------------------------

149,901
------------------------------------------------------------------------
------------------------------------------------------------------------


Lease inducements received are non-cash transactions in the form of rent-free periods and, as such, have been added back as a non-cash item in operating activities on the statement of cash flows.

8. Unitholders' Equity

Fund Units

During the period, the following units were issued and are outstanding at the end of the period:



Net
Number of Issue Capital
Units Costs Contributions
Fund Units # $ $
------------------------------------------------------------------------
6,106,000 4,928,124 56,131,876
------------------------------------------------------------------------
6,106,000 4,928,124 56,131,876
------------------------------------------------------------------------
------------------------------------------------------------------------



An unlimited number of Fund Units may be created and issued pursuant to the Declaration of Trust. Each Fund Unit is transferable and represents an equal undivided beneficial interest in any distributions from the Fund, whether of net income, net realized capital gains or other amounts and in the net assets of the Fund in the event of a termination or winding up of the Fund. All Fund Units have equal voting rights or privileges.

Distributions to Unitholders

Distributions to Unitholders are declared monthly and are determined based on the estimated annual earnings before amortization, but reduced by capital expenditures. Distributions totaling $0.28125 per Fund Unit ($1,717,312) were declared by the Fund during the three months ended September 30, 2005 ($0.41995 from May 17, 2005 to September 30, 2005.) The distribution declared for the month of September 2005 in the amount of $0.09375 per Fund unit ($572,438) was included in distributions payable to Unitholders at the balance sheet date and was paid on October 15, 2005.



9. Non-controlling interest


XS Cargo LP XS Cargo LP
Exchangeable LP Subordinated LP
Units Units Total
# # #
------------------------------------------------------------------------

Issued on Closing
of IPO (note 3) 3,471,970 2,394,480 5,866,450
Issued subsequent
to IPO - unit-based
compensation - (note 12) 6,944 4,789 11,733
------------------------------------------------------------------------

3,478,914 2,399,269 5,878,183
------------------------------------------------------------------------
------------------------------------------------------------------------


$ $ $

Issued on Closing of
IPO (note 3) 34,719,700 23,944,800 58,664,500
Issued subsequent
to IPO - unit-based
compensation - (note 12) 69,440 47,890 117,330
------------------------------------------------------------------------

34,789,140 23,992,690 58,781,830

Non-controlling interest
- earnings 1,094,290 754,689 1,848,979

Distributions declared (1,460,970) (1,007,573) (2,468,543)
------------------------------------------------------------------------

34,422,460 23,739,806 58,162,266
------------------------------------------------------------------------
------------------------------------------------------------------------


XS Cargo LP Exchangeable LP Units ("Exchangeable LP Units")

The Exchangeable LP Units issued by XS Cargo LP have economic and voting rights equivalent to the Fund Units (note 8), except in connection with the exchangeability terms as described below. They are exchangeable directly or indirectly, on a one-for-one basis for Fund Units at the option of the holder, under the terms of the Exchange Agreement. The Exchangeable LP Units are not required to be exchanged for Fund Units before transferring to third parties. As a result, they have been treated as non-controlling interest, in accordance with the CICA Emerging Issues Committee Abstract # 151.

Each Exchangeable LP Unit entitles the holder to receive distributions from XS Cargo LP pro rata with distributions made by XS Cargo LP on Fund Units.

XS Cargo LP Subordinated LP Units ("Subordinated LP Units")

The Subordinated LP Units have economic and voting rights equivalent to the Fund Units (note 8), except in connection with the subordination terms as described below. As a result, they have been treated as non-controlling interest, in accordance with the CICA Emerging Issues Committee Abstract #151.

Distributions are to be made monthly on the Fund Units (note 8) and Exchangeable LP Units equal to $0.09375 per Unit to the extent cash is available to make cash distributions. Distributions on the Subordinated LP Units are subordinated and are made quarterly in an amount equal to the amount distributed on Fund Units and Exchangeable LP Units and to the extent cash is available to make such distributions.

The Subordinated LP Units will be automatically exchanged for Exchangeable LP Units on a one-for-one basis and the subordination provisions will apply until the end of any fiscal year ending on or after December 31, 2006 if, for that fiscal year the Fund has earned EBITDA (earnings before interest, taxes, depreciation and amortization) of at least $14.432 million and the Fund has paid distributions of at least $1.125 per Fund Unit for such fiscal year.



Fund Special Voting Units

Number Amount
# $

Issued on Closing of IPO (note 3) 5,866,450 -
Issued subsequent to IPO - unit-
based compensation - (note 12) 11,733 -
------------------------------------------------------------------------
5,878,183 -
------------------------------------------------------------------------
------------------------------------------------------------------------



Fund Special Voting Units are non-participating and are used solely for providing voting rights to persons holding Exchangeable LP Units and Subordinated LP Units. Fund Special Voting Units are not transferable separately from Exchangeable LP Units and Subordinated LP Units to which they relate. The Fund Special Voting Units are not entitled to any beneficial interest in any distribution from the Fund or in the net assets of the Fund in the event of a termination or winding up of the Fund. Each Fund Unit and Fund Special Voting Unit entitles the holder thereof to one vote at all meetings of the Unitholders.

If the Exchangeable LP Units or the Subordinated LP Units are purchased in accordance with the Exchange Agreement, a like number of Fund Special Voting Units will be redeemed by the Fund for a nominal amount. The Fund issued 5,866,450 Fund Special Voting Units relating to the 3,471,970 Exchangeable LP Units and 2,394,480 Subordinated LP units that were issued at the time of the IPO.

Distributions to non-controlling interest

Distributions to non-controlling interest are determined based on estimated annual earnings, before amortization, but reduced by capital expenditures. Distributions totaling $0.28125 per Exchangeable LP Unit ($978,444) and $0.28125 per Subordinated LP Unit ($674,795) were declared by the Fund during the three months ended September 30, 2005 ($0.41995 per Exchangeable LP Unit ($1,460,970) and $0.41995 per Subordinated LP Unit ($1,007,573) from May 17, 2005 to September 30, 2005). Distributions declared on Exchangeable LP Units for the month of September in the amount of $.09375 per unit ($326,148) and Distributions on Subordinated LP Units for the three months ended September 30, 2005 in the amount of $0.28125 per unit ($674,795) were included in distributions payable to non-controlling interest at the balance sheet date and were paid on October 15, 2005.

10. Commitments

The Fund occupies the premises of its stores, warehouses and office under lease agreements requiring basic monthly rents for the periods indicated and in aggregate as follows:



Remaining 3 months ending December 31, 2005 900,476
Years ending December 31,
2006 3,112,233
2007 2,521,789
2008 2,261,376
2009 2,024,744
2010 1,253,982
Thereafter 3,292,316
----------------------------------------------------------------------

Total 15,366,916
----------------------------------------------------------------------
----------------------------------------------------------------------


In addition, as described in note 6, the principal balance on the Fund's committed term loan is due on May 17, 2006, but the Fund has two options to request a one-year extension, with a maximum term to May 17, 2008 based on approval of the lender.

11. Long-term incentive plan

The Fund has adopted a long-term incentive plan (the "Plan") to provide key senior management, officers and directors of the Fund with compensation opportunities that will enhance the ability of the Fund to attract, retain and motivate key personnel and reward these key employees for significant performance and associated per unit cash flow growth. Fund bonuses, in the form of the Units of the Fund, will be provided to eligible employees on an annual basis where the distributable cash of the Fund exceeds certain specified threshold amounts.

If the distributable cash flow per unit exceeds the base distribution, a percentage of the distributable cash (the participation rate) is contributed by the Fund into a long-term incentive pool. The funds in the pool are used to purchase units of the Fund in the open market, to be provided to eligible employees as bonus compensation. Threshold amounts and participation rates are as follows:



Excess percentage Proportion of excess percentage paid to plan Trustee

5% or less Nil
Greater than 5%
and up to 10% 10% of any excess over 5%
Greater than 10%
and up to 20% 10% of any excess over 5%, plus 20% of any
excess over 10%
Greater than 20% 10% of any excess over 5%, plus 20% of any
excess over 10%, plus 25% of any excess over 20%

No amounts have been accrued to the Plan during the period.


12. Unit-based compensation

Under the terms of the Acquisition Agreement between the Vendor and Fund, the Fund assumed certain obligations under an employment agreement with the Chief Financial Offer. Under the terms of that agreement, XS Cargo LP issued 6,944 XS Cargo Exchangeable Units and 4,789 Subordinated LP Units to the Chief Financial Officer following the completion of the initial public offering. The unit-based award was recorded as administrative and operating costs in the amount of $117,330, the estimated fair value of the units on the grant date, and resulted in an increase in non-controlling interest. In addition, under the employment agreement the Fund may issue a maximum of 6,944 of XS Cargo Exchangeable LP Units and 4,789 Subordinated LP Units per year based on performance. For the three months ended September 30, 2005 the Fund has accrued a contingent award of $40,000 which if granted will be issued in May 2006.

13. Financial instruments

Foreign currency risk

The Fund purchases a significant amount of its inventory from suppliers in the United States. Consequently, the Fund's gross margin is exposed to foreign exchange fluctuations. This exposure is limited because the Fund does not enter into significant future purchase commitments, but wires funds in advance upon placing orders with United States suppliers.

Interest rate risk

The Fund's term loan, as described in note 6 bears interest with floating rates over prime or the appropriate bankers' acceptance rate, thus exposing the Fund to interest rate fluctuations.

Fair value of financial instruments

The Fund's financial instruments consist of cash, rebate and other receivables, accounts payable and accrued liabilities, distributions payable and term loan. The carrying amounts of cash, rebate and other receivables, accounts payable and accruals, and distributions payable approximate their fair values due to their relatively short terms to maturity. The carrying value of the term loan approximates fair value since the interest rate fluctuates with the prime rate and approximates market rate.

14. Variable interest entity

Pursuant to the business acquisition described in note 3, the Fund assumed a vendor supply and volume rebate agreement with Samra Imports Ltd., ("Samra"). Samra imports products from China which it sells to the Fund and other customers. Samra is the Fund's largest supplier accounting for approximately 19% of the Fund's purchases since the commencement of the agreement and the Fund is Samra's largest customer. The purpose of the agreement is to outline the supply terms and to provide the Fund with a rebate based on its significant volume of purchases from Samra. The Fund has determined that Samra is a variable interest entity and that the supply and rebate agreement represents a variable interest in Samra. The Fund has determined, however, that it is not the primary beneficiary under the supply and rebate agreement since the Fund is not entitled to receive a majority of Samra's expected residual returns or absorb a majority of its expected losses.

During the three months ended September 30, 2005, the Fund purchased approximately $1,490,000 (May 17, 2005 to September 30, 2005 - $2,010,000) of inventory from Samra, and as at September 30, 2005 the Fund had made deposits of $1,133,911, for inventory that had not yet been delivered. Samra issued the Fund a volume rebate for purchases made from the three months ended September 30, 2005 in the amount of $140,000 (May 17, 2005 to September 30, 2005 - $190,000).

15. Basic and diluted earnings per unit

The following table outlines the adjustments to the numerator and denominator to calculate the basic and diluted earning per unit:



Basic Dilution Diluted
Earnings per Unit Adjustments Earnings per Unit
Three months
ended September
30, 2005

Net earnings 1,173,328 1,129,551 (a) 2,302,879
------------------------------------------------------------------------
Average Units
outstanding 6,106,000 5,878,183 (b) 11,984,183

Earnings per Unit 0.192 0.192

May 17, 2005 to
September 30, 2005
Net earnings 1,920,624 1,848,979 (a) 3,769,603
------------------------------------------------------------------------
Average Units outstanding 6,106,000 5,878,183 (b) 11,984,183

Earnings per Unit 0.315 0.315

(a) Adjustment to add back non-controlling interest if Exchangeable LP
Units and Subordinated LP Units are converted to Fund Units

(b) Adjustment to reflect the conversion of Exchangeable LP Units and
Subordinated LP Units to Fund Units on a one-for-one basis


16. Seasonal nature of the business

The Fund's results for the period are not necessarily indicative of the results that may be expected for the full year due to seasonal variations in sales levels. The business acquired from the Vendor historically experiences a higher level of sales in the fourth calendar quarter due to seasonal shopping patterns. Occupancy-related expenses, certain administrative and operating expenses, amortization, and interest expense remain relatively steady throughout the year.

17. Segmented information

Each store constitutes an operating segment in that its performance is monitored by senior management and discreet financial information is available. Since each store sells the same products to the same types of customers and uses similar distribution and sales processes, they have been aggregated for reporting purposes into one segment.

18. Subsequent events

Subsequent to the balance sheet date, XS Cargo entered into lease agreements to open two new stores in Medicine Hat, Alberta and Surrey, British Columbia.

Contact Information

  • XS Cargo Income Fund
    Michael McKenna
    President and Chief Executive Officer
    (780) 413-4296
    or
    XS Cargo Income Fund
    Jeff Rootman
    Vice-President, Finance and Chief Financial Officer
    (780) 413-4296
    Website: www.xscargo.com