Xebec Adsorption Inc. Annual Report 2006

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FY2006 Annual Report · Xebec Adsorption Inc.

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SUBJECT:

QuestAir Technologies Inc.
QuestAir Technologies Inc.

DATE:

2006
Annual Report 2006
Annual Report

HI G HLI G H T S F OR 2 0 0 6
HI G HLI G H T S F OR 2 0 0 6

(cid:129)

QuestAir’s joint program

with ExxonMobil Research

and Engineering Company

(cid:129)

Sold ﬁ rst M-3100 methane

(EMRE) passed a critical

puriﬁ cation system in

ExxonMobil review,
authorizing ﬁ nal funding
authorizing ﬁ nal funding

the biogas market. The

system will recover

for the construction of a
for the construction of a

pipeline-grade methane

prototype H-6200 hydrogen
prototype H-6200 hydrogen

from landﬁ ll gas at the

puriﬁ er to be demonstrated
puriﬁ er to be demonstrated

Rumpke Sanitary Landﬁ ll

at an ExxonMobil reﬁ nery
at an ExxonMobil reﬁ nery

in Cincinnati, Ohio.

in 2007.
in 2007.

(cid:129)

Signed licensing

(cid:129)

Agreement signed with

agreement for H-3100

EMRE to jointly market

hydrogen puriﬁ ers with

the H-6200 hydrogen

Hydro-Chem, a leading

puriﬁ er to third-party

hydrogen plant vendor.

customers in the oil

reﬁ ning market.

(cid:129)

Successful equity

offering raising net

Important new
Important new
distribution partner
distribution partner

D e m a n d f o r
D e m a n d f o r
t e c h n o l o g y t o
t e c h n o l o g y t o
g r o w > p g . 6
g r o w > p g . 6

(cid:129)

Revenue growth of 20%

proceeds of approximately

to $7.6 million.

$18.4 million.

68% growth in sales order

(cid:129)

Strengthened patent

backlog to $5.0 million

portfolio to 49 patents

at year end.

and 101 applications

pending, covering 26

Cash used in operations

distinct inventions.

and capital expenditures

of $9.4 million (2005:

$8.7 million).

QUESTAIR’S TECHNOLOGY MAY SEEM COMPLICATED,

BUT ITS IMPACT IS NOT.

Simply put: QuestAir is playing a growing role in energy production

and industrial processes worldwide. We are delivering year-over-

year revenue growth through sales of our proprietary gas

puriﬁ cation systems. We are also developing new products that

will play a vital role in the oil reﬁ ning industry. And, we’re

helping to feed the growing global appetite for more sustainable

alternatives to fossil fuels.

The more you learn about QuestAir, the more you realize we are a
The more you learn about QuestAir, the more you realize we are a

company positioned for great growth today, and tomorrow.
company positioned for great growth today, and tomorrow.

Science ................................................................................... .

cHemiStr y ............................................................................. .

economicS .............................................................................

miLeStoneS ........................................................................... 8.

PreSiDent ÕS meSSAGe ...................................................... 9.

AccoUntinG ......................................................................... 13.

mD&A

AuditorÕs report

consolidated Financial Statements

notes to consolidated Financial Statements

(1)

S ci e n c e:

How PSA works

(a) Under pressure,

adsorbent beds catch
contaminants like
carbon monoxide and
dioxide, producing
purified hydrogen.

(b) When pressure is

reduced, the impurities
are released, refreshing
the bed for another
cycle.

conventional
PSA plant

Pure H

Low pressure

contaminant

(a)

(b)

Feed gas

contaminants
purged

QuestAirÕs rapid-cycle
PSA is less than
1/10 the size of
conventional systems

• QuestAir has sold more than 75 PSA systems to customers in

Europe, North America and Asia. Our customers include industry
leaders like Chevron, The Linde Group and Mitsubishi.

• QuestAir’s PSA systems have logged over 450,000 operating hours

under demanding commercial conditions. Commercial uptime on our
systems has exceeded 99%.

• QuestAir’s proprietary technology is protected by a patent

portfolio of 49 patents and 101 applications pending, covering 26
distinct inventions.

()

1. What is PSA technology?

P S A u s e d i n
i n d u s t r y s i n c e
t h e 1 9 0 s

QuestAir’s technology makes advancements on a proven gas

separation and puriﬁ cation process called pressure swing

adsorption (PSA). PSA is used extensively in the production and

puriﬁ cation of oxygen, nitrogen and hydrogen for industrial

uses. PSA is based on the capacity of certain materials to

adsorb and remove particular gases as pressure is raised

and lowered. PSA can be used to separate a single gas from a

mixture of gases. A typical PSA system involves a number of

connected vessels containing adsorbent material that undergo

several pressurization and depressurization steps to produce

a continuous stream of puriﬁ ed gas.

2. Why does PSA technology matter?

PSA technology is used to purify gases that are critical to a

wide range of industries. PSA is a key part of many industrial

processes that produce the energy, fuels and materials that we

use every day. QuestAir’s primary focus is hydrogen puriﬁ cation
use every day. QuestAir’s primary focus is hydrogen puriﬁ cation

and recovery for use in oil reﬁ ning, and in a range of other
and recovery for use in oil reﬁ ning, and in a range of other

industries, including chemical production, metal reﬁ ning,
industries, including chemical production, metal reﬁ ning,

food processing and electronics manufacturing. QuestAir’s PSA
food processing and electronics manufacturing. QuestAir’s PSA
food processing and electronics manufacturing. QuestAir’s PSA

technology is also being used to recover methane fuel from

renewable sources such as biogas.

3. Why is QuestAir’s PSA technology better?

QuestAir’s patented PSA is superior to traditional technology

because it is simpler, more compact and costs less. It’s simpler

and more reliable because our patented rotary-valves replace the

numerous switching valves used in conventional PSA. It’s more

compact because our proprietary structured adsorbents allow us

to run much faster PSA cycles. Our PSA systems can be up to 1/10

the size of conventional PSA, helping to save space and reduce

capital costs. In addition, our modular, skid-mounted systems

are easier and more cost effective to install. By changing the

type of adsorbent material, we can easily purify a range of

different gases, including hydrogen, methane and helium.

(3)

cHe mi St r y:

Hydrogen used to refine
crude oil

Hydrogen removes
contaminants during
the refining process,
including typical
sulphur-containing
molecules in diesel.

sulphur-free
fuel

+HS

industrial growth

A growing reliance on
heavier crude oil and more
stringent standards for
sulphur levels in diesel
have all combined to fuel
the need for hydrogen.

• Annual global hydrogen production is approximately 50 million tons.

• Approximately 30% of worldwide hydrogen production is used in

the oil refining industry.

• Current hydrogen consumption in oil refining ranges from 300-500

cubic feet per barrel.

()

1. What is hydrogen?

While QuestAir’s PSA technology is being applied to a variety

of gases, our prime area of focus is hydrogen. Hydrogen is

a gas that is lighter than air and exists in its natural

state as H2. A hydrogen atom consists of one proton and one

electron and is the ﬁ rst element on the periodic table. At

room temperature, hydrogen is a gas; when cooled to very low

temperatures it becomes a liquid. Most importantly, hydrogen
temperatures it becomes a liquid. Most importantly, hydrogen
temperatures it becomes a liquid. Most importantly, hydrogen

plays a prevalent role in a variety of industrial and chemical
plays a prevalent role in a variety of industrial and chemical
plays a prevalent role in a variety of industrial and chemical

processes that drive our modern economy.
processes that drive our modern economy.
processes that drive our modern economy.

2. How is hydrogen produced?

Approximately 95% of hydrogen currently consumed worldwide is

generated from natural gas or other hydrocarbon fuels such as

coal. Hydrogen is also recovered from hydrogen-containing gas

streams that are produced as a by-product of the oil reﬁ ning

process. QuestAir technology plays a big role in both supply
process. QuestAir technology plays a big role in both supply

routes. In other industrial processes such as metal reﬁ ning,
routes. In other industrial processes such as metal reﬁ ning,

food processing and electronics manufacturing, hydrogen is

delivered to customers either in compressed or liquid form, or

generated from natural gas at the customer site. QuestAir’s PSA

systems are used in these so-called “on site” hydrogen plants.

3. Where is hydrogen used?

Hydrogen is used to create products that are essential to

our lives, including fertilizer for use in agriculture, and

methanol, an important feedstock in the chemicals industry.

Hydrogen is also used extensively to reﬁ ne crude oil into fuels

such as gasoline and diesel. Hydrogen removes contaminants,

such as sulphur, during the reﬁ ning process to meet strict

environmental and quality standards for today’s transportation

fuels. Hydrogen is also used in the processing of heavy forms

of crude oil such as oil sands, breaking these heavy oils down

into lighter, more useful petroleum products.

P o o r e r q u a l i t y
c r u d e o i l r e q u i r e s
m o r e h y d r o g e n

(5)

e c on o mi c S :

QuestAir recognized revenue

(millions)

market for H equipment in
oil refining industry *

100

Global oil
consumption
(million
barrels
per day)

1990

$10 Bn in
forecasted
H equipment
investments

000

010

* international energy outlook 00; Air Products 005

$10

100%

80%

Supply pressures in the oil refining
sector are spurring investment in
hydrogen. QuestAir is realizing year-
over-year revenue growth and is
strongly positioned for the future as
alternative energy sources are developed.

(percentage
of total
market)

$9.0 - $10.0

$7.

$.3

$3.0

$1.8

003

00 005

007
(target)

emergence of hydrogen as a fuel*

wood

coal

oil

natural
gas

alternative
energy,
including
hydrogen

1850

1900

1950

000

050

100

* Source: marchetti and nakicenovic

• Demand for crude oil is expected to grow from approximately
80 million barrels per day today to over 100 million barrels
per day by 2015.

• Hydrogen demand in oil refining is expected to grow by up to 10%
per annum through to 2010. Hydrogen consumption per barrel of
oil may increase as high as 800-1,000 cubic feet per barrel as
refineries meet ultra-low sulphur diesel regulations and process
heavier crude oil stocks.

• Investment in new hydrogen generation equipment in the oil

refining sector could reach US$10 billion between 2005 and 2015.

()

1. Why is demand for hydrogen escalating in the oil

reﬁ ning industry?

Industrial growth – led by the emerging BRIC economies of

Brazil, Russia, India and China – is increasing world demand

for oil. As demand increases, so too does the need for hydrogen
for oil. As demand increases, so too does the need for hydrogen

used to reﬁ ne this oil into useful products. Higher oil prices
used to reﬁ ne this oil into useful products. Higher oil prices

also mean that heavy crudes and tar sands, once uneconomic

to produce, are now a growing source of new oil supply. These

heavy oils require higher volumes of hydrogen in the reﬁ ning

process. Stricter environmental regulations across the world

are also forcing oil reﬁ neries to use more hydrogen to remove

contaminants from the fuels they produce.

o i l s a n d s
p r o d u c t i o n
f o r e c a s t e d t o
g o f r o m 1 m b / d
t o m b y 0 0

2. How is QuestAir positioned to meet this demand?

Market pressures will drive demand for PSA systems for large

capacity hydrogen plants and for recovering hydrogen in oil

reﬁ neries. QuestAir is strongly positioned in the industry. We

P r o to t yp e
H- 0 0 w ill
b e d e m o n stra te d
a t e xxo n m o b il
r e f in e r y in 0 0 7

are currently developing our next generation PSA system – the
are currently developing our next generation PSA system – the

QuestAir H-6200 – in collaboration with ExxonMobil Research
QuestAir H-6200 – in collaboration with ExxonMobil Research

and Engineering for use in a range of reﬁ nery applications. The
and Engineering for use in a range of reﬁ nery applications. The

H-6200 is a signiﬁ cant advancement in hydrogen recovery for

the oil industry and can signiﬁ cantly improve the economics

of hydrogen supply in reﬁ neries around the world.

3. What are QuestAir’s future markets?

The lasting impact of climate change is now front-page news.

The search for cleaner fuel technology continues, including

the use of hydrogen fuel cells to power vehicles, homes and

buildings. Supplying hydrogen as fuel for fuel cells requires

technology to separate and purify hydrogen from the original

fuel source, which is commonly natural gas. QuestAir has

supplied 14 PSA systems to demonstration hydrogen fuelling

stations in the U.S., Canada and Asia. We are also working

with ExxonMobil Research and Engineering to develop a compact

“on-board” hydrogen generator for use in a range of fuel cell

powered vehicles.

(7)

r e Vi e W o F 0 0 mi L e St on e S :

1. Pass ﬁ nal ExxonMobil program review and receive purchase

orders for prototype large capacity hydrogen PSA.

The ExxonMobil program review was successfully passed in April

2006, authorizing ﬁ nal funding for the prototype construction

and testing. QuestAir received purchase orders totaling

$4.3 million during ﬁ scal 2006 towards the prototype plant

construction.

2. Complete fabrication and shipment of the large capacity

hydrogen PSA to ExxonMobil reﬁ nery.

The ﬁ nal purchase order for the prototype H-6200 was received

in the fourth quarter of ﬁ scal 2006, extending the completion

of the prototype fabrication to around the end of calendar

2006, with shipment to follow shortly thereafter.

3. Sign agreement with EMRE for marketing of large capacity

hydrogen PSA in the oil reﬁ ning industry.

In May 2006, we signed an agreement with EMRE to jointly

market the H-6200 hydrogen puriﬁ er to third-party customers

in the oil reﬁ ning market.

4. Sign agreement to extend large capacity PSA product platform

into new market.

During ﬁ scal 2006, we completed an initial contract with EMRE

to assess the use of the H-6200 technology platform of the

processing of sub-quality or “sour” natural gas. Options for

further funded work in this area, or in other petrochemical

markets are currently being assessed, with a formal agreement

expected to follow in ﬁ scal 2007.

5. Sign an additional distribution agreement for QuestAir’s ﬁ rst

generation gas puriﬁ cation products with a leading hydrogen

plant vendor.

In March 2006, we signed a licensing agreement with Hydro-

Chem, a leading global supplier of industrial hydrogen plants.

QuestAir’s H-3100 hydrogen puriﬁ er will be included as a

standard offer in Hydro-Chem’s product line.

(8)

President’s Message

2006 was a year of very solid progress for
QuestAir. Growth in revenue and in our
backlog of signed customer contracts was
strong for the year, and we made key progress
towards the commercialization of our H-6200
hydrogen puriﬁ er in the oil reﬁ ning market
with ExxonMobil Research and Engineering
(EMRE). We are planning to demonstrate
a commercial-scale H-6200 system at an
ExxonMobil reﬁ nery in Europe starting in
early calendar 2007, and we have begun to
aggressively market the product to oil reﬁ nery
customers under a marketing agreement
signed with EMRE during the year.

million for the year, in line with our cash burn
guidance of $8.5-$9.5 million for the ﬁ scal
year. Our net loss for the year was $10.2 million
($0.24 per share), compared to $9.5 million
($0.31 per share) for ﬁ scal 2005.

Operating Review and
2006 Milestone Update
A number of achievements were made in the
program being undertaken with EMRE to develop
the H-6200 hydrogen puriﬁ er
for reﬁ nery and petrochemical
applications. In April 2006 the
program passed a critical internal
ExxonMobil review, authorizing
ﬁ nal funding to complete the
construction and testing of a
prototype H-6200 hydrogen
puriﬁ er at an ExxonMobil reﬁ nery
located in Europe. During ﬁ scal 2006 we
received purchase orders from ExxonMobil
totaling $4.3 million related to the prototype
construction. The timing of a key purchase order
from ExxonMobil extended the construction of
the prototype plant into the fourth quarter of
calendar 2006. Based on the current project
plan, we expect to ship the prototype early in the
ﬁ rst quarter of calendar 2007, with installation
and startup at the ExxonMobil reﬁ nery being
completed during the ﬁ rst half of calendar 2007.

In the commercial area, we successfully
expanded the vertical markets for our ﬁ rst
generation gas puriﬁ cation products, most
notably with our ﬁ rst sale of a M-3100
methane recovery system in
the growing biogas market. We
also expanded the distribution
channels for our commercial
products through the licensing
and supply agreements signed
with Hydro-Chem and Nuvera
Fuel Cells respectively.

“ Revenues from
the sale of gas
puriﬁ cation systems
and engineering
service contracts
grew by 20%.”

Our ﬁ nancial results for ﬁ scal 2006 were in
line with our expectations, and the ﬁ nancial
guidance that we provided for the year.
Revenues from the sale of gas puriﬁ cation
systems and engineering service contracts
grew by 20% to $7.6 million, in line with our
revenue guidance of $7.5 million for the ﬁ scal
year. Our sales order backlog at year end was
$5.0 million, an increase of 68% from $3.0
million at September 30, 2005. Cash used in
operations and capital requirements was $9.4

(9)

“ During the year,
we made a number
of breakthroughs
in the sale of our
commercial first
generation gas
purification products.”

We also signed a marketing agreement
with EMRE which covers the marketing of
the H-6200 hydrogen purifier to third-party
customers in the oil refining industry. The
agreement outlines the roles that each party
will play in the marketing process, and how
the commercial gains from the sales of the
product will be shared between QuestAir and
EMRE. Following the signing
of this agreement, we began
jointly marketing and promoting
the H-6200 with EMRE, and
currently we are responding
to a number of commercial
enquiries from both ExxonMobil
and third-party refineries.

We completed an initial research
contract with EMRE to assess
the use of the H-6200 platform technology
for the processing of contaminated or “sour”
natural gas. This contract was significant in
demonstrating the potential application of the
product platform to other high-value markets
outside of oil refining. Options for the next
phase of this development work are currently
being assessed.

During the year, we made a number of break-
throughs in the sale of our commercial first
generation gas purification products. During
fiscal 2006, we sold our first M-3100 methane
recovery system, valued at approximately
US$2 million, into the landfill gas process-
ing market. The M-3100 system will upgrade
landfill gas generated at the Rumpke Sanitary
Landfill near Cincinnati, Ohio, generating high
purity methane for injection into the natural

gas distribution network. This initial sale into
the landfill gas market follows a successful
demonstration of a M-3100 system at the
Vancouver Landfill site which was undertaken
during the year. In the industrial hydrogen mar-
ket, we successfully started up two H-3100
hydrogen purifiers installed at the HydroEdge
liquid hydrogen plant in Osaka, Japan. These
are the largest capacity com-
mercial hydrogen purifiers that
we have operated to date, dem-
onstrating the expansion of our
commercial product line into the
intermediate capacity range of
the hydrogen plant market.

We also made significant
progress in expanding the dis-
tribution channels for our first
generation products. We signed a manufac-
turing licensing agreement with Hydro-Chem
LLC, a division of The Linde Group, and a
leading manufacturer of hydrogen plants in
the intermediate capacity range. Under the
terms of the agreement, the H-3100 hydrogen
purifier will be included in Hydro-Chem’s
industrial hydrogen plants, expanding our ac-
cess to the intermediate capacity segment of
the hydrogen plant market.

We maintained our position as the leading
supplier of hydrogen purification systems in
the emerging hydrogen infrastructure market.
During the year, we received orders for five
H-3200 hydrogen purifiers
for hydrogen
fueling stations located in Canada, the United
States and Korea. At year-end, we had sold
14 hydrogen purifiers
into the hydrogen

(10)

infrastructure market. We also signed an
agreement, valued at up to US$700,000 over
2 years, to supply our small capacity H-3300
hydrogen purifiers to Nuvera Fuel Cells. The
H-3300 will be incorporated into Nuvera’s
PowerTap™ hydrogen generators, which
will be marketed as a distributed source of
hydrogen fuel to support fuel cell powered
vehicles such as fork lifts and airport ground
support vehicles.

Early in the fiscal year, we received a $1.4 million
engineering services contract from EMRE
to complete the second phase of a program
to develop a compact on-board hydrogen
generator for use in a range of transportation
applications. Target markets for this product
include potential early term fuel cell markets
such as utility vehicles and auxiliary power units
for heavy duty trucks and military vehicles.

A complete review on our progress towards
our 2006 milestones is presented on page 8
of this report.

2007 Milestones
Each year we set a number of operational
milestones to map our anticipated progress
over the coming year, and to provide our
investors with a means to evaluate our
performance toward creating shareholder
value. Our milestones for 2007 are:

2. Receive the first purchase order for a
commercial H-6200 hydrogen purifier.
EMRE and QuestAir are actively marketing
to both ExxonMobil and
the H-6200
third-party refineries, with the objective
of securing a purchase order for the first
commercial sale during fiscal 2007.

3. Sign an agreement to extend the H-6200
platform technology into a new market.
QuestAir has entered into a number of
to
preliminary engineering contracts
assess the application of the H-6200
platform technology into additional markets
such as natural gas processing and other
separations in the petrochemical industry.
Based on the outcome of these preliminary
studies, we aim to sign an agreement to
undertake the next phase of this product
development.

4. Secure first purchase order for a methane

purification system in the European
biogas market.
There is significant interest in Europe in the
use of renewable sources of methane to
supplement imported natural gas, and as
a carbon neutral source of transportation
fuel for buses and cars. During the year,
we expect to sell our first system in the
European market to recover high purity
methane from biogas.

1. Complete the installation and startup of
the prototype H-6200 hydrogen purifier
at an ExxonMobil refinery.
We expect that the prototype H-6200
installed and
hydrogen purifier will be
started up at the ExxonMobil refinery during
the first half of calendar 2007.

5. Increase recognized revenue to between

$9 and $10 million.
Total recognized revenue is expected to be
between $9 and $10 million in fiscal 2007,
representing an increase of approximately
19% to 32% from $7.6 million in fiscal 2006.
We expect revenue growth from both our

(11)

first generation commercial products and
anticipated engineering service contracts.
Any commercial H-6200 orders received
during fiscal 2007 are not expected to be
recognized as revenue during fiscal 2007
given the expected manufacturing and
installation time of these large units.

6. Manage cash used in operations

and capital expenditures to between
$7 and $8 million.
Cash used in operations and capital
expenditures is expected to be in the
range of $7 to $8 million, reduced from
$9.4 million in fiscal 2006. Expenditures on
both the commercialization of the H-6200
product, as well R&D activities related
to the extension of the H-6200 platform
technology into new markets are expected
to continue through fiscal 2007.

Fiscal 2007 will be a landmark year for
QuestAir with the commercialization of our
H-6200 hydrogen purifier in the oil refining
market. This product provides oil refineries
with a solution to the growing demand for
hydrogen in oil refining, as well as offering a
unique tool to increase refinery productivity
and profitability. As such, we expect the H-
6200 to be the key catalyst to drive QuestAir
to profitability and beyond.

Our major objectives for the coming year
include the installation and startup of the
prototype H-6200 hydrogen purifier at an
ExxonMobil refinery, and the subsequent first
sale of a fully commercial H-6200 system
in the oil refining market. We also expect to
see continued growth in the sale of our first
generation gas purifiers in the industrial
hydrogen and biogas markets.

As always, the progress that we have made
over the year would not have been possible
without the dedication and hard work of our
employees. I would like to thank all of our
employees for their commitment and for the
high quality of work consistently delivered
through the year.

I look forward to reporting to you over
the next year on our accomplishments and
milestones achieved.

Sincerely,

Jonathan Wilkinson
President and CEO

(1)

a c c o u n t i n g

m a n a g e m e n t ’ s d i s c u s s i o n a n d a n a ly s i s ........... 14

a u d i t o r ’ s r e p o r t .. .. .. .. .. ... . ... .. ... . .... .. ... . ... .. ......... 2 8

c o n s o l i d at e d F i n a n c i a l s tat e m e n t s .. .. .. . .......... 2 9

n o t e s t o c o n s o l i d at e d F i n a n c i a l s tat e m e n t s ... 3 2

M a n a g E M E n t ’ S D i S c u S S i o n a n D a n a L y S i S
For year Ended September 30, 2006

the following management discussion and analysis
(“MD&a”), dated December 5th, 2006 (with the exception
of the ‘outstanding Share Data’, which is dated november
30, 2006) should be read in conjunction with the company’s
audited consolidated financial statements and related notes
therein that are prepared in accordance with canadian
generally accepted accounting principles (“canadian
gaaP”). Following a change in the rules governing the aiM
Market of the London Stock Exchange Plc on august 22,
2006, which recognized canadian gaaP as an acceptable
reporting standard, we are no longer required to provide a
reconciliation of our financial results to those that would be
reported under united States generally accepted accounting
principles (“uS gaaP”). consequently, a reconciliation
to uS gaaP is not provided in the notes to the financial
statements for the fiscal year ended September 30, 2006.
all financial information is stated in canadian dollars, unless
otherwise stated. additional information regarding Questair
technologies inc. (“Questair” or “the company”), can be
found on the System for Electronic Document analysis and

Retrieval (SEDaR) at www.sedar.com.

F o r w a r d l o o k i n g s tat e m e n t s
this MD&a contains forward-looking statements, including
statements regarding the future success of our business,
technology, and market opportunities. Forward-looking
statements typically contain words such as “believes”,
“expects”, “anticipates”, “continue”, “could”, “indicates”,
“plans”, “will”, “intends”, “may”, “projects”, “schedule”,
“would” or similar expressions suggesting future outcomes or
events, although not all forward-looking statements contain
these identifying words. Examples of such statements
include, but are not limited to, statements concerning:
(i) management’s belief that its second generation PSa
technology will offer further reductions in size and cost
relative to current commercial products; (ii) the expected
shipment, installation and demonstration timeline of a
commercial-scale prototype of the H-6200 hydrogen purifier;
(iii) the market drivers that will have an important impact
on Questair’s long term prospects and ability to create
shareholder value as described herein; (iv) forecast demand
for hydrogen in the refining of crude oil; (v) forecast growth
of hydrogen consumption per barrel of oil and the expected
drivers of this growth; (vi) the growth opportunities that will
be created for the H-6200 hydrogen purifier as a result of
certain macroeconomic drivers specified herein, and the
related expected growth in revenue; (vii) the expectation
that fiscal 2007 will be a landmark year for Questair with the
commercialization of its H-6200 hydrogen purifier in the oil
refining market; (viii) the expected continued growth in the
sale of Questair’s first generation gas purifiers in the industrial
hydrogen and biogas markets; (ix) Questair’s expected
performance against the operational and financial milestones
for fiscal 2007 as described herein; and (x) Questair’s
intended efforts to mitigate the risk of reduction in demand
for refined petroleum products. these statements are neither
promises nor guarantees, but involve known and unknown

risks and uncertainties that may cause our actual results,
level of activity, performance or achievements to be materially
different from any future results, levels of activity, performance
or achievements expressed in or implied by these forward-
looking statements. these risks include risks related to
revenue growth, operating results, industry and products,
technology, competition and other factors described herein.
although the forward-looking statements contained herein
are based upon what management believes to be current and
reasonable assumptions, the company cannot assure readers
that actual results will be consistent with these forward-looking
statements. the forward-looking statements contained herein
are made as of the date of this Management Discussion and
analysis and are expressly qualified in their entirety by this
cautionary statement. the company undertakes no obligation
to publicly update or revise any such statements to reflect
any change in our expectations or in events, conditions, or
circumstances on which any such statements may be based,
or that may affect the likelihood that actual results will differ
from those set forth in the forward-looking statements.

o u r V i s i o n , s t r at e g y a n d c o r e B u s i n e s s
Vision and Strategy
Questair’s strategic goal is to become a leader in the
development, manufacture and supply of pressure swing
adsorption (“PSa”) gas purification systems for refinery,
industrial, energy and fuel cell markets. our strategy to
achieve this goal has the following key elements:
1. Reach profitability through sales into existing industrial

and refining markets;

2. Leverage key relationships with market leaders such as
ExxonMobil Research and Engineering (“EMRE”), and
Shell Hydrogen;

3. Pursue opportunities that leverage Questair’s

product platforms;

4. Play an active role in the emerging hydrogen economy; and

5. Pursue disciplined cash management.

Core Business
Questair is an emerging developer and supplier of advanced
gas purification systems. our products target a range of
existing energy and industrial markets, including oil refining,
natural gas processing and biogas processing, as well as
emerging markets such as hydrogen fueling stations that
support fuel cell powered vehicles.

our compact, modular gas purification products

incorporate proprietary PSa technology, and offer significant
economic and operational benefits over conventional PSa
technology, including reduced capital, installation and
operating costs. our proprietary technology is protected by
a patent portfolio including 49 patents covering 26 distinct
inventions and 101 patent applications.

Questair has approximately 85 employees located at
our facility and corporate headquarters in Burnaby, British
columbia, canada. We market and support our products on
a global basis from our Burnaby location.

Products, Markets & Customers
Commercial Products: We currently sell a range of
commercial PSa systems for use in small-scale on-site
hydrogen plants for industrial markets, biogas processing
and demonstration hydrogen stations for refueling fuel cell
vehicles. Since 1997 we have sold more than 75 PSa systems
to over 30 customers in north america, asia and Europe.
We market and distribute our products directly to
customers, but we also have non-exclusive distribution
agreements with leading hydrogen plant vendors including
iwatani international, Mitsubishi Kakoki Kaisha and Kti
technip, and an agreement to supply our H-3200 hydrogen
purifiers to HyRadix inc, a leading developer of hydrogen
generators for industrial and hydrogen fueling markets. in
2006 we signed a manufacturing license agreement for our
H-3100 hydrogen purifiers with Hydro-chem, a leading global
supplier of hydrogen plants in the intermediate capacity
range. We also signed an agreement to supply our smaller
capacity H-3300 hydrogen purifiers to nuvera Fuel cells.

Products under development – Oil Refining: We are currently
developing second generation ‘rapid cycle’ PSa technology
which we believe will offer further reductions in size and
cost relative to both our current commercial products and
our competitors’ products. our second generation products
will also be scalable to much higher capacities than our
current products, allowing us to compete in larger, higher
value markets.

the first of these second generation products is the
large capacity H-6200 PSa, which is being developed in
collaboration with EMRE for use in a range of potential
applications in the oil refining, petrochemical and gas
processing industries.

Demand for hydrogen in oil refineries is expected to grow
by up to 10% per year through to 2010, driven by regulations
requiring reduced levels of sulphur in diesel fuel, increased
processing of “heavier” crude feed stocks, and the global
increase in demand for petroleum products. the H-6200
hydrogen purifier will provide refineries with a cost-effective
solution to this growth in hydrogen demand by recovering
hydrogen from hydrogen-containing waste streams within
refineries. Based on the current project timeline, we expect
to install and demonstrate a commercial-scale prototype of
this product (“prototype plant”) at an ExxonMobil refinery in
Europe in the first half of 2007.

in 2006 we signed a marketing agreement with EMRE that
covers the marketing of the H-6200 hydrogen purifier to third-
party customers in the oil refining industry. the agreement
outlines the responsibilities of each party in the marketing
process, and how the commercial gain from the sales of the
product will be shared between Questair and EMRE.
We also are exploring the extension of the H-6200

platform technology into other high value markets including
various petrochemical separations and the processing of
contaminated natural gas.

Products under development – Fuel Cells: We currently
market our commercial PSa products for use in hydrogen
refueling stations that support fuel cell vehicles. to date we
have sold 14 systems into demonstration hydrogen stations
located in the uS, asia and canada. Key customers in this
emerging market include chevron, iwatani international and
Hydrogenics corporation.

We are also collaborating with EMRE on the development
of an on-board hydrogen generator for potential use in a range
of transportation markets including fuel cell powered utility
equipment, auxiliary power units for a wide range of vehicles,
and fuel cell powered buses. the hydrogen generator should
offer a unique, compact, efficient solution to generate hydrogen
directly on board the vehicle itself from a range of readily
available hydrocarbon fuels such as diesel and gasoline.

Key Market Drivers
We believe that there are a number of key market drivers
that will have an important impact on Questair’s long term
prospects and our ability to create shareholder value:
•

increased global demand for refined petroleum products,
combined with increased supplies of heavier ‘sour’ crude
oil, which together have driven the demand for hydrogen in
the oil refining industry.

• government regulations mandating reduced sulphur levels
in transportation fuels, which have also driven the demand
for hydrogen in the oil refining industry to desulphurize
crude oil feedstocks.

• Elevated prices of crude oil and natural gas, which has
focused attention on technologies for increasing the
efficiency of the refining processes, and for the processing
of unexploited reserves of contaminated natural gas.

• Environmental concerns regarding local air pollution

and global warming, which collectively have prompted
the development of renewable energy sources such as
biogas, as well as clean, efficient power generation and
transportation technologies such as fuel cells.

Key Performance Indicators
Management uses a number of key performance indicators
to monitor and assess the implementation of our strategy
and the achievement of our goals. these performance
indicators include both quantitative and qualitative measures
of performance, as follows:
• Sales Bookings and Backlog: Questair recognizes

revenue from the sale of gas purification systems and
engineering service contracts. While revenue from the
sale of engineering service contracts is recognized on
a percentage-of-completion basis over the life of the
contract, revenue from the sale of our commercial gas
purification systems is only recognized once the systems
have been installed, commissioned and accepted by the
customer.1 given the typical lead times of 6-9 months
between receipt of an order for a gas purification system
and installation and commissioning, recognized revenues

1 Refer to the ‘critical accounting Policies and Estimates’ section of the MD&a for an

overview of Questair’s revenue recognition policy.

do not give a current view of our commercial performance.
consequently, we monitor sales bookings and changes
in backlog as more current measures of our commercial
performance. Sales bookings are defined as signed
orders supported by a firm purchase order, while backlog
represents the future revenue from signed orders that
have not yet been recognized as revenue.

• Cash Burn: We believe that careful management of our
cash consumption is critical in order to demonstrate
a path to profitability and limit dilution arising from
potential future equity financings. We monitor ‘cash used
in operations and capital requirements’ as a measure
of our operational cash burn. it should be noted that
this is a non-gaaP measure, and a reconciliation to
gaaP measures is provided in the ‘Liquidity and capital
Resources’ section of the MD&a.

• Progress against key product development timelines and
milestones: the timing and technical progress of our key
development programs, including the refinery program
with EMRE, will have a critical impact on our future
revenue growth and profitability. consequently we closely
monitor progress made in each development program
relative to key program milestones and timelines. Several
key program milestones are included in our corporate
milestones which are set at the beginning of each fiscal
year (see ‘outlook and Milestones for Fiscal 2007’).

• Patents & Intellectual Property: Questair’s competitive

advantage is driven in large part by our technical
leadership and strong intellectual property position. We
monitor the breadth and quality of our patent portfolio
relative to those of our competitors as an important
measure of our technical competitive advantage.

Resources and Capabilities
We have the following resources and capabilities at our
disposal in order to execute our growth strategy:
• Non-Capital Resources: a significant portion of our

sustainable competitive advantage is derived from our
proprietary PSa technology and strong suite of intellectual
property. our technology leadership and the value
proposition of our products are driven directly by the
innovation and technical expertise of our employees, and
consequently, our human resources are our most critical
non-capital resource.

• Financial Resources: at September 30, 2006, Questair had
cash resources and short term investments totaling of $18.4
million, and $3.1 million remaining of a $4 million credit
facility. in addition, we have $1.8 million of remaining funding
available from technology Partnerships canada (“tPc”), a
funding program of the canadian government. at forecast
cash burn rates, we have sufficient financial resources to
fund our operations for at least the next 24 months.

• Systems and Processes: We evaluate our management and
control systems against evolving corporate governance
regulations and guidelines. We follow a rigorous product

management process to manage our key development
programs to ensure that all new products meet customer
specifications, quality requirements and delivery timelines.
in addition, we are iSo 9001:2000 registered and the relevant
components of our commercial PSa products are certified to
the standards of the canadian Standards association (cSa)
and underwriters Laboratory (uL), and conform to the legal
requirements of the European union (cE).

• Partnerships with market leaders: a key element of our

strategy is to leverage the resources, technical expertise
and distribution channels of our development partners
and customers. We have established strong partnerships
and working relationships with market leaders including
EMRE, Shell Hydrogen, chevron as well as our
distribution and licensing partners iwatani, Mitsubishi,
Kti technip, Hydro-chem, HyRadix and nuvera.
We believe that these relationships are a source of
competitive advantage for Questair.

B u s i n e s s o V e r V i e w
We made the following key progress in our commercial
and development activities during fiscal 2006:
• a number of key achievements were made in the

program being undertaken with EMRE to develop the
H-6200 hydrogen purifier for refinery and petrochemical
applications. in april 2006 the program passed a critical
internal ExxonMobil review, authorizing final funding to
complete the construction and testing of a prototype
H-6200 hydrogen purifier at an ExxonMobil refinery
located in Europe. During fiscal 2006 we received
purchase orders from ExxonMobil totaling $4.3 million
related to the prototype construction. a key purchase
order was received in the fourth quarter of fiscal 2006,
which extended the construction of the prototype plant
into the fourth quarter of calendar 2006 (see ‘Subsequent
Events’ section of the MD&a).

• We also signed a marketing agreement with EMRE

which covers the marketing of the H-6200 hydrogen
purifier to third-party customers in the oil refining
industry. the agreement outlines the responsibilities
of each party in the marketing process, and how the
commercial gains from the sales of the product will be
shared between Questair and EMRE. Following the
signing of this agreement, we began jointly marketing
and promoting the H-6200 with EMRE, and currently
we are responding to a number of commercial enquiries
from both ExxonMobil and third-party refineries.

• We completed an initial research contract with EMRE to

assess the use of the H-6200 platform technology for the
processing of contaminated or “sour” natural gas. this
contract was significant in demonstrating the potential
application of the product platform to other high-value
markets outside of oil refining. options for the next phase
of this development work are currently being assessed.

• a number of breakthroughs were made in the sale of our
commercial first generation gas purification products.
During fiscal 2006, we sold our first M-3100 methane
recovery system, valued at approximately uS$2 million,
into the landfill gas processing market. the M-3100 system
will recover pipeline-grade methane from landfill gas
generated at the Rumpke Sanitary Landfill near cincinnati,
ohio. this initial sale into the landfill gas market follows
a successful demonstration of a M-3100 system at the
Vancouver Landfill site which was undertaken during the
year. in the industrial hydrogen market, we successfully
started up two H-3100 hydrogen purifiers installed at the
HydroEdge liquid hydrogen plant in osaka, Japan. these
are the largest capacity commercial hydrogen purifiers that
we have operated to date, demonstrating the expansion of
our commercial product line into the intermediate capacity
range of the hydrogen plant market.

• Significant progress was made in expanding the distribution
channels for our first generation products. We signed a
manufacturing licensing agreement with Hydro-chem LLc,
a division of the Linde group, and a leading manufacturer
of hydrogen plants in the intermediate capacity range.
under the terms of the agreement, the H-3100 hydrogen
purifier will be included in Hydro-chem’s industrial

hydrogen plants, expanding our access to the intermediate
capacity segment of the hydrogen plant market.

• We maintained our position as the leading supplier of

hydrogen purification systems in the emerging hydrogen
infrastructure market. During the year, we received orders for
five H-3200 hydrogen purifiers for hydrogen fueling stations
located in canada, the united States and Korea. at year-
end, we had sold 14 hydrogen purifiers into the hydrogen
infrastructure market. We also signed an agreement, valued
at up to uS$700,000 over 2 years, to supply our small
capacity H-3300 hydrogen purifiers to nuvera Fuel cells.
the H-3300 will be incorporated into nuvera’s Powertap™
hydrogen generators, which will be marketed as a distributed
source of hydrogen fuel to support fuel cell powered vehicles
such as fork lifts and airport ground support vehicles.

• Early in the fiscal year, we received a $1.4 million

engineering services contract from EMRE to complete
the second phase of a program to develop a compact
on-board hydrogen generator for use in a range of
transportation applications. target markets for this
product include potential early term fuel cell markets such
as utility vehicles and auxiliary power units for heavy duty
trucks and military vehicles.

the following progress was made towards the achievement of Questair’s 2006 milestones:

Milestone

Progress

1. Pass final ExxonMobil program review and receive

purchase orders for prototype large capacity hydrogen
PSA.

The ExxonMobil program review was successfully passed in April 2006, authorizing final
funding for the prototype construction and testing. QuestAir received purchase orders
totaling $4.3 million during fiscal 2006 towards the prototype plant construction.

2. Complete fabrication and shipment of the large
capacity hydrogen PSA to ExxonMobil refinery.

The final purchase order for the prototype H-6200 was received in the fourth quarter of
fiscal 2006, extending the completion of the prototype fabrication to around the end of
calendar 2006, with shipment to follow shortly thereafter.

3. Sign agreement with EMRE for marketing of large
capacity hydrogen PSA in the oil refining industry.

In May 2006 we signed an agreement with EMRE to jointly market the H-6200
hydrogen purifier to third-party customers in the oil refining market.

4. Sign agreement to extend large capacity PSA product

platform into new market.

During fiscal 2006 we completed an initial contract with EMRE to assess the use of
the H-6200 technology platform of the processing of sub-quality or “sour” natural gas.
Options for further funded work in this area, or in other petrochemical markets are
currently being assessed, with a formal agreement expected to follow in fiscal 2007.

5. Sign an additional distribution agreement for QuestAir’s
first generation gas purification products with a leading
hydrogen plant vendor.

In March 2006 we signed a licensing agreement with Hydro-Chem, a leading global
supplier of industrial hydrogen plants. QuestAir’s H-3100 hydrogen purifier will be
included as a standard offer in Hydro-Chem’s product line.

F i n a n c i a l o V e r V i e w
the financial highlights for the year ended September 30,
2006 are noted below:
• Revenue was $7,558,093 for the year, increased by
$1,265,784, or 20% compared to fiscal 2005. total
revenues were in line with revenue guidance of at least
$7.5 million for the year.

• Sales order backlog at September 30, 2006 was

$5,043,892, increased by $2,036,344, or 68%, from
September 30, 2005.

• cash used by operations and capital requirements was

$9,430,679 for the year, increased by $736,050 compared
to fiscal 2005. the cash burn was within the cash burn
guidance range of $8.5 million to $9.5 million for the year.

related to Questair’s public listing. the decrease in g&a
expenses in fiscal 2006 includes reductions in stock-based
compensation expenses, as certain options became fully
vested during the period (see ‘Results of operations’).

total assets have increased over the past three years,
and include funds raised from Questair’s initial public offering
(“iPo”) in fiscal 2005 and the subsequent equity offering
in fiscal 2006 as discussed in ‘use of Proceeds from our
Pubic offerings’.

r e s u lt s o F o p e r at i o n s

Revenues
the following table provides a breakdown of our revenues
from the sale of gas purification systems and engineering
service contracts for the reported periods:

($ ‘000)

Gas purification systems
Engineering service contracts
Total revenue

For the years ended September 30,
2005
4,158
2,134
6,292

2006
5,808
1,750
7,558

the total recognized revenue of $7,558,093 for fiscal 2006
was in line with revenue guidance of at least $7,500,000
provided by management in the fiscal 2005 MD&a dated
December 8, 2005. the increase in revenue from gas
purification systems for fiscal 2006 resulted from increased
sales of commercial PSa systems including the H-3100
hydrogen purifier commissioned at the HydroEdge liquid
hydrogen plant in Japan, as well as revenue recognized
towards the construction of the prototype H-6200 hydrogen
purifier to be demonstrated at an ExxonMobil refinery. For
accounting purposes, the sale of the H-6200 prototype
plant is treated as a long-term production-type contract.
consequently, in accordance with gaaP, revenue from the
H-6200 prototype plant is recognized on a percentage-of-
completion basis.

the decrease in revenue from engineering service

contracts for fiscal 2006 resulted from reduced levels of work
completed on the engineering service contracts with EMRE,
as the focus of the refinery program shifted from product
development to the construction of the prototype plant.

Fluctuations in recognized revenue and the receipt of new
sales orders are to be expected in the industrial markets that
we currently serve. in addition, the timing of receipt of new
engineering service contracts can vary from year to year.
as mentioned in the ‘Key Performance indicators’ section,
we believe that both recognized revenue and changes in
our sales order backlog should be monitored together to
determine the strength of our commercial operations.

• net loss was $10,262,918 ($0.24 per share) for the year,
increased $746,060 or 8% from $9,516,858 ($0.31 per
share) in fiscal 2005.

s e l e c t e d F i n a n c i a l i n F o r m at i o n
the following is selected information on Questair’s financial
performance for the past three fiscal years:

($’000 except loss per share data)
Revenue
Net research and development
expenses
General and administrative expenses
Net loss
Loss per share
Total assets
Total long-term liabilities
Deficit
Total shareholders’ equity
Cash used in operations and capital
requirements
Backlog (unaudited)

For the years ended September 30,
2004
3,002

2005
6,292

2006
7,558

5,092
3,311
(10,263)
(0.24)
27,682
533
(95,045)
20,497

5,734
3,427
(9,517)
(0.31)
16,213
434
(84,783)
11,639

4,698
2,479
(9,516)
(1.94)
12,564
121
(73,561)
8,566

9,431
5,044

8,695
3,008

5,670
3,918

Questair’s revenues have increased over the past three
years as a result of growth in the sales of gas purification
systems, which have been driven by sales of our commercial
PSa products, as well as revenue recognized towards the
construction of the prototype H-6200 hydrogen purifier
to be demonstrated at an ExxonMobil refinery. Revenues
from engineering service contracts have also grown over
the past three years, primarily as a result of new contracts
received from EMRE for the development of the H-6200
hydrogen purifier, as well as the onboard hydrogen generator.
the increase in revenue over this time period has been
accompanied by a corresponding increase in sales order
backlog, although there was a reduction in backlog during
fiscal 2005, mainly due to a reduction in engineering service
contracts booked during the year. Backlog increased during
fiscal 2006 as a result of new purchase orders related to the
prototype H-6200 hydrogen purifier and related equipment,
as well as a M-3100 methane recovery system sold into the
landfill gas processing market.

there has been some variability in research and
development (“R&D”) expenditures over the past three
years as a result of changes in the focus and activity level
of our R&D program over this period. the increase in R&D
expenditures in fiscal 2005 was a result of increased activity in
the development program undertaken with EMRE to develop
a large capacity PSa for use in oil refineries. the subsequent
decrease in R&D in fiscal 2006 relates to the transition of
those resources from development activities to construction
of the prototype H-6200 hydrogen purifier being sold to
ExxonMobil as discussed in ‘Results of operations’ below.

general and administrative (“g&a”) expenses have also

fluctuated over the past three years. g&a expenses were
elevated in fiscal 2005 as a result of increased expenses

Questair’s sales order backlog is defined as future revenue from signed contracts that have not yet been recognized as
revenue. the following table provides an analysis of the changes in our sales order backlog for the years ended September 30,
2006 and 2005.

(Unaudited, $ ‘000)

Opening Balance
Bookings
Revenue Recognized
Adjustments2
Ending Balance

For the year ended September 30, 2006
Engineering
Service Contracts
768
1,226
(1,750)
(108)
136

Total
3,008
9,868
(7,558)
(274)
5,044

Gas Purification Systems
2,240
8,642
(5,808)
(166)
4,908

For the year ended September 30, 2005
Gas
Purification Systems
2,812
3,897
(4,158)
(311)
2,240

Engineering
Service Contracts
1,106
1,951
(2,134)
(155)
768

Total
3,918
5,848
(6,292)
(466)
3,008

the total sales order backlog increased by $2,036,344, or
68%, during fiscal 2006. the increase in backlog over the
fiscal year was driven by orders valued at $4,312,553 related
to the prototype H-6200 hydrogen purifier and associated
equipment. in addition, we also received an order valued at
approximately $2,200,000 for an M-3100 methane recovery
system for use in the landfill gas processing market. a
negative adjustment was made to sales order backlog as a
result of foreign exchange fluctuations during the year.

We currently expect that the backlog as of September 30,

2006 will be substantially recognized as revenue by March
31, 2007.

Gross Profit
the following table provides a calculation of our gross profit
for the reported years:

($ ‘000)

Sales
Cost of goods sold
Gross Profit
Gross Margin (%)

For the years ended
September 30,
2005
6,292
3,537
2,755
43.8%

2006
7,558
6,433
1,125
14.9%

the decrease in gross margin for fiscal 2006 compared to
the prior year resulted from a decrease in the proportion
of revenue recognized from engineering service contracts,
which typically contribute high gross margins. in addition,
losses were incurred on the H-3100 hydrogen purifier
installed at the HydroEdge liquid hydrogen plant, and on
the prototype H-6200 hydrogen purifier. Low margins were
expected on the HydroEdge plant since this was the first
sale of the new larger capacity H-3100 design for use in
the intermediate capacity segment of the hydrogen plant
market, and certain non-recurring engineering costs were
incurred to increase the capacity of the H-3100 product
design. ultimately, a loss was recognized on the sale due
to unfavorable exchange rate fluctuations which reduced
recognized revenue, and higher than expected start-up costs.
EMRE and Questair had agreed that the prototype H-6200
would be sold to an ExxonMobil refinery at cost, reflecting the
fact that the prototype H-6200 is intended, in part, for testing
and demonstration purposes. additional functionality and
test instrumentation were subsequently included in the plant

includes adjustments for fluctuations in foreign currency exchange rates as well as
cancelled orders.

design to allow for additional testing under a wider range of
conditions than is required for the European refinery itself. We
agreed to share these specific additional costs with EMRE
to reflect the shared future benefit that will be derived from
the additional test data. the additional costs associated with
enhanced functionality and test instrumentation resulted in an
expected net loss on the overall prototype plant. in accordance
with gaaP, we recorded the total expected loss on the H-6200
prototype as a cost of goods sold in fiscal 2006.

it should be noted that both the HydroEdge and H-6200
prototype systems were the first of their kind manufactured
by Questair, and we made a strategic investment in these
units for market development purposes. as such, the losses
on these two sales do not reflect the expected future margins
for the H-3100 or H-6200 product lines.

Margins are expected to fluctuate from year to year

depending on the mix of revenues recognized from
engineering service contracts and gas purification systems.

Sales and Marketing
Sales and marketing expenses were $1,938,537 for fiscal
2006, an increase of 9% compared to $1,779,703 for the
prior year. the increase in sales and marketing expenses
for fiscal 2006 was attributed to an increased level of sales
activities compared to the prior year.

Research and Development
the gross R&D expenditures, offsetting government funding
and the resulting net R&D expenditures for the relevant
periods, were as follows:

($ ‘000)

Gross R&D Expenditure
Government & Partner Funding
Net R&D Expenditure

For the years ended September 30,
2005
7,667
1,933
5,734

2006
6,907
1,815
5,092

the 10% reduction in gross R&D expenditures for fiscal
2006 compared to the prior year was due to a reduction in
the amount of R&D undertaken as resources were redirected
towards supporting our commercial sales efforts and the
construction of the prototype H-6200 hydrogen purifier.
government funding decreased for the year in proportion to
the reduction in R&D undertaken on the refinery development
program with EMRE, which is eligible for funding from tPc.

General and Administrative
g&a expenses were $3,311,188 for fiscal 2006, a decrease
of 3% from $3,427,315 for the prior year. the decrease in
g&a expenses for the year related to a reduction in stock-
based compensation expenses in the year, partially offset
by increases in accounting and regulatory expenses.

Stock-based compensation expense was $492,302 for
fiscal 2006, a decrease of 35% from $754,759 for the prior
year. Stock-based compensation expenses were higher for the
prior year due to a stock compensation charge related to the
repricing of certain options at the time of our iPo in fiscal 2005.

Amortization
amortization expenses were $1,223,788 for fiscal 2006
compared to $1,531,112 for the prior year. the decrease in
amortization expenses was a result of certain capital assets
becoming fully amortized during the year.

Other Income
other income was $177,630 for fiscal 2006 compared to
$199,877 in the prior year. the reduction in other income
resulted from an increase in foreign exchange losses, offset
partially by increased interest income earned from funds
raised in an equity offering in May 2006 (see Liquidity and
capital Resources).

Net Loss
net loss for fiscal 2006 was $10,262,918 ($0.24 per share)
compared to $9,516,858 ($0.31 per share) for the prior year.
the increase in the net loss for the year was primarily a result
of reduced gross profits compared to the prior year, partially
offset by lower R&D and amortization expenses.

Loss per share is calculated based on the weighted

average number of common shares outstanding through the

year. the reduction in the loss per share for the year was
a result of an increase in the weighted average number of
common shares outstanding compared to the prior year (refer
to ‘outstanding Share Data’).

Capital Expenditures
capital expenditures net of government funding and proceeds
on sale (“net caPEX”), for fiscal 2006 were $1,370,315
compared to $915,424 for the prior year. the increased net
caPEX for the year was driven by leasehold improvements
made to new hydrogen testing facilities that were built during
fiscal 2006, as well as expenditures on a demonstration landfill
gas processing plant installed at the Vancouver Landfill.

it is expected that capital expenditures will fluctuate
from year to year depending on the requirements of specific
product development programs and administrative needs.

Use of Proceeds from our Public Offerings
We disclosed our expectations regarding the use of the net
proceeds of our iPo in our prospectus dated December 14,
2004. in addition, we disclosed our expectations regarding the
use of the net proceeds of our subsequent equity offering in
our prospectus dated May 23, 2006. net cash proceeds from
the iPo were $11,694,571, while net cash proceeds from the
equity offering were $18,410,751. as at September 30, 2006,
we had used $10,430,168 of this amount to fund our operating
activities. the balance of the iPo funds and the entire funds
from the equity offering remain available for the uses described
in the prospectuses, and we intend to use these funds as
described in the prospectuses. circumstances may arise,
however, which may result in a reallocation of funds for sound
business reasons.

the table below compares the estimated use of proceeds

disclosed in our iPo prospectus to the actual results as at
September 30, 2006.

Use of proceeds noted in
Prospectus

Prospectus Comment

Actual Use to
September 30, 2006

Sales and Marketing:
Approximately 20%

To drive sales growth and expand the Company’s market channels

Research and Development:
Approximately 40%

To develop and commercialize products for the Company’s industrial hydrogen and
fuel cell related markets

Capital Expenditures:
Approximately 30%

Working capital, general
corporate purposes and
selective acquisitions or
investments:

Approximately 10%

In conjunction with funds from operations, used for new products, technologies
and businesses that expand, complement or are otherwise related to the
Company’s existing business.

21%

56%

15%

the proportion of spending on R&D was higher than expected as a result of increased research activities related to the refinery
program with ExxonMobil. this increase was offset by lower-than-expected spending on capital assets.

s u m m a r y o F Q u a r t e r ly r e s u lt s

(Unaudited, $ ‘000
except loss per share data)

Total Revenues

Gas Purification Systems
Eng. Service Contracts

% Gross Margin
R&D (net)
General & Administrative
Net Loss
Net Loss per share
Net CAPEX
Cash used in Operations & Net CAPEX
Backlog

Gas Purification Systems
Eng. Service Contracts

2006
Sep 30
2,697
2,530
167
3%
1,330
835
2,724
(0.05)
615
3,508
5,044
4,908
136

Jun 30
1,193
574
619
40%
1,236
776
2,135
(0.05)
354
1,876
4,976
4,570
406

Mar 31
2,796
2,483
313
(7%)
1,253
902
3,336
(0.09)
70
1,724
5,840
4,815
1,025

2005
Dec 31
872
221
651
87%
1,273
798
2,068
(0.06)
331
2,322
5,702
4,359
1,343

Sep 30
1,159
373
786
45%
1,436
917
2,588
(0.06)
19
2,295
3,008
2,240
768

Jun 30
2,644
2,307
337
27%
1,491
941
2,562
(0.07)
575
1,673
3,471
1,848
1,623

Mar 31
1,491
480
1,011
78%
1,533
773
1,843
(0.05)
292
2,732
5,356
3,623
1,733

2004
Dec 31
998
998
0
35%
1,274
796
2,523
(0.29)
30
1,994
5,500
4,102
1,398

our operating results have fluctuated from quarter to
quarter and this trend is expected to continue for the
foreseeable future.

Revenues are comprised of sales of gas purification

systems and engineering services contracts. the mix of these
revenues and amount of revenue has fluctuated quarter by
quarter based on the length of the sales cycle required to
close a customer order, and on contractual terms related
to the timing of delivery and acceptance of products and
services by customers. as a result, percentage gross margins
have fluctuated significantly from quarter to quarter. in
general, gross margins on engineering service contracts are
higher than those on gas purification systems, resulting in
increased gross margins for quarters with a high proportion
of recognized revenue from engineering service contracts.
R&D expenses have generally decreased over the past
four quarters as a result of a shift in the focus of the refinery
program with EMRE from product development to the
construction of the prototype plant and commercialization.
g&a expenses have also varied quarter by quarter,
largely as a result of quarterly variations in stock-based
compensation expenses, legal, regulatory and investor
relations costs.

Review of the Fourth Quarter, Ended September 30, 2006
total revenues for the quarter ended September 30, 2006,
were $2,696,596, increased by 133% from $1,158,898 for the
same period in 2005. the increase in revenues was mostly
related to revenue recognized on a percentage-of-completion
basis towards the construction of the prototype H-6200
hydrogen purifier during the quarter. Sales order backlog
was $5,043,892 at September 30, 2006, increased 1% from
$4,976,342 at June 30, 2006. cash used in operations and
capital expenditures for the quarter ended September 30,
2006 was $3,508,457, increased by 53% from $2,296,158 in
the same period in 2005. cash used in operations increased
by $929,545 from the same period in 2005, driven by
increases in accounts receivable and inventory primarily

related to the prototype H-6200 hydrogen purifier. net caPEX
increased by $282,754 from the same period in 2005, driven
by leasehold improvements for new hydrogen testing facilities
that were completed during the fourth quarter of fiscal 2006.
the net loss for the quarter ended September 30, 2006
was $2,724,580, increased 5% from $2,587,801 in the same
period in 2005.

c a s h F l o w s , l i Q u i d i t y a n d c a p i ta l r e s o u r c e s

Cash Flows
cash and cash equivalents were $11,018,800 at September
30, 2006, increased by $706,977 from $10,311,823 at
September 30, 2005. this increase in cash and cash
equivalents during the year was driven by cash inflows
from financing activities and changes in working capital of
$18,691,614 and $159,695 respectively, partially offset by net
operating losses for the year (excluding changes in working
capital) of $8,537,706 and cash outflows from investing
activities of $9,606,626.

cash used by operations for the year ended September
30, 2006 was $8,378,011, compared to $7,779,205 for the prior
year. the increase in cash used by operations for the year was
driven by an increased loss for the year, as well as an increase
in inventory. this was partially offset by increases in accounts
payable, accrued liabilities and deferred revenue, as well as
decreases in amortization and stock-based compensation.
cash used in investing activities for the year ended

September 30, 2006 was $9,606,626, compared to $1,017,820
for the prior year. the increase in cash used in investing
activities for the year primarily related to a $7,400,000 increase
in short-term investments with maturity dates greater than
ninety days from the date of purchase. no such investments
were made in the prior year. the increase in cash used
in investing activities was also attributed to an increase
in restricted cash set aside to fund remaining equipment
purchases for the H-6200 prototype plant in fiscal 2007.

net cash flow from financing activities was $18,691,614 for
the year ended September 30, 2006, compared to $12,416,925
for the prior year. the cash inflow in the year resulted primarily
from net cash proceeds raised from our common share
offering which closed on May 31, 2006. the cash inflow from
financing activities for the prior year resulted primarily from net
cash proceeds raised from our iPo in December 2004.

as noted in the ‘Key Performance indicators’ section, we
monitor cash used by operations and capital requirements as a
measure of our operational cash burn. cash used by operations
and capital requirements for the year ended September 30,
2006 was $9,430,679, compared to $8,694,629 for the prior
year. cash burn for the year fell within the guidance range
of $8,500,000 to $9,500,000 provided by management on
December 8, 2005. it should be noted that this metric is a non-
gaaP measure of operational cash burn. the calculation of
this measure of cash usage and a reconciliation of this financial
measure to the statement of cash flows is as follows:

($ ‘000)

Cash used in Operating Activities
Add: purchase of property,
plant and equipment (“PP&E”)
Add: government grants and
funding related to PP&E
Add: proceeds from sale of PP&E
Cash used in Operations
and Capital Requirements
Reconciliation to GAAP
Statements of Cash Flow:
Add: Short-term investments
Add: restricted cash
Add: Cash from Financing Activities
Increase in Cash and Cash Equivalents

For the years ended
September 30,
2005
2006
(7,779)
(8,378)

(1,155)

(1,262)

96
6

335
11

(9,431)

(8,695)

(7,400)
(1,154)
18,692
707

-
(102)
12,417
3,620

the increase in cash burn for the year ended September 30,
2006 compared to the prior year resulted from increased
operational losses as well as increased net capital expenditures.

Liquidity and Capital Resources
Since incorporation, we have financed our operations through
cash generated from commercial sales, the issuance of equity
and funding received from government and strategic partners.
at September 30, 2006 cash and short-term investments
were $18,418,800, compared to $10,311,823 at September
30, 2005. not included in cash and short term investments at
September 30, 2006 was $1,256,354 of restricted cash, which
will primarily be used to fund remaining equipment purchases
for the H-6200 prototype plant in fiscal 2007.

on May 31, 2006, we completed an equity offering,
raising gross proceeds of $20,000,250 through the sale of
14,815,000 common shares at a price of $1.35 per share. net
proceeds after share issuance costs were $18,410,751.

We expect to use our current cash resources to complete

the development and commercialization of our products
currently under development, as well as new products

that we may choose to develop in the future. our capital
requirements may vary depending on a number of factors,
including contributions from the sale of our systems and
engineering service contracts, the progress of our current
development programs and any decisions to enter into
additional programs or partnerships. in addition, we review
investment and acquisition opportunities for technologies and
products that would complement our business or assist us
in our commercialization plans. an investment opportunity
would increase our capital requirements. if current funding
and cash generated from operations is insufficient to satisfy
our operating requirements, we may seek to sell additional
equity or to arrange debt or other financing.

Credit Facilities
During fiscal 2005, we signed a credit facilities agreement
with comerica Bank. this agreement was amended and
restated as part of the renewal of these facilities in June 2006.
the amended credit facilities include a uS$1 million accounts
receivable line of credit and a uS$2 million term loan, in
addition to $673,212 outstanding under the original term
loan agreement. Both facilities are subject to annual renewal.
as at September 30, 2006, we had drawn $884,250 against
the term loans net of repayments. We are in compliance with
all of our bank covenants.

Contractual Obligations
the following table lists our contractual obligations at
September 30, 2006. We expect to fund these expenditures
out of our cash reserves:

(Unaudited, $ ‘000)

Bank debt
Capital leases
Operating leases
Purchase
obligations3
Total contractual
obligations

In the
next year
351
-
509

Total
884
-
1258

Payments due by Period
After 5
4-5
2-3
years
years
years
-
-
533
-
-
-
-
144
605

4,532

6,674

5,392

1,138

144

c o n t i n g e n t o F F - B a l a n c e s h e e t F i n a n c i n g
a r r a n g e m e n t s
We have received funding contributions from various
programs of the canadian government to support the
development and commercialization of our gas purification
technology. as at September 30, 2006, funding contributions
remain available under only the first listed program noted
below. if that program were to be terminated early, we would
receive less research funding and our net R&D costs would
be higher than we expect.

Technology Partnerships Canada
on June 6, 2003, we were awarded a $9,600,000
conditionally repayable loan from tPc, a funding program
administered by industry canada. at September 30, 2006,

3 Purchase obligation is defined as an agreement to purchase goods or services that
is enforceable or legally binding on the company that specifies all significant terms,
including: fixed or minimum quantities to be purchased; fixed, minimum or variable price
provisions; and the approximate timing of the transaction.

we had claimed $7,760,083 against this loan. these funds
are repayable under certain conditions. Based on forecasted
R&D expenditures, we expect to draw down on the remaining
$1,839,917 of tPc funding by the end of fiscal 2007, at which
time the contribution phase of this program ends.

We entered into a similar funding arrangement with tPc

on March 31, 1999 and received a total of $4,762,503 in
funding from March 1999 to July 2002. the funding is also
repayable only under certain conditions. the repayment
obligations and total royalty repayments made to date for
these funding programs are listed below:

Funding Award
Date

June 6, 2003

March 31, 1999

Description

Royalties

Term

Royalty Payments to Date

Fast Cycle
Pressure Swing
Adsorption
& Gas
Management
Systems
Program

Pulsar
Pressure Swing
Adsorption
Program

Annual
royalties of
1.165% of
gross business
revenues

Annual
royalties
of 1.8% of
gross project
revenues and
fuel cell related
products

Accrued for future payment:
$146,800

The royalty period began on October 1,
2005 and will end on September 30, 2013
if the cumulative royalties reach a ceiling of
$23.6 million. If the royalties are less than
$23.6 million by September 30, 2013, the
royalty period will continue until the earlier
of September 30, 2021 or until a cumulative
royalty ceiling of $23.6 million is reached.

Royalty period extends to the later of the
date of payment of all amounts due to the
Minister and 2015.
The maximum cumulative repayment is
$8.75 million

Payments:
FY05: $10,698
FY06: $6,960
Total Cumulative payments: $32,952
Accrued for future payment: $13,273

Department of Natural Resources Efficiency and
Alternative Energy Program
on January 4, 2005, we were awarded a grant for $225,000
from the government of canada under the Department
of natural Resources Efficiency and alternative Energy

Program. on January 6, 2004, we received a similar funding
award of $193,944 under the same funding program. Both
funding awards are repayable under certain conditions. the
repayment obligations and total royalty repayments made to
date for these funding programs are listed below:

Funding Award Date

Description

Royalties

Term

Royalty Payments to Date

January 4, 2005

January 6, 2004

Annual royalties
of 0.12% of gross
project revenues

Development
of structured
adsorbent for
the production
of high purity
hydrogen

Development
of a device
that increases
the efficiency
of a High
Temperature fuel
Cell system

Royalty period starts on date of first
gross project revenues and extends
to March 31, 2015, to a maximum
cumulative repayment of $225,000,
whichever occurs first.

Royalty period starts on date of first
gross project revenues and extends
to March 31, 2014, to a maximum
cumulative repayment of $193,944,
whichever occurs first.

Payments: $0
Accrued for future payment: $0

o u t s ta n d i n g s h a r e d ata

During the first quarter of fiscal 2007, we experienced further

Common Shares Outstanding
immediately prior to closing the iPo on December 21,
2004, we completed a reorganization of our share capital
whereby the existing share classes were converted into
a single class of common shares. to complete the share
capital reorganization, certain terms of the preferred shares
relating to automatic conversion rights were amended (refer
to note 9(b) to the audited consolidated financial statements
for fiscal 2006 for further details). on May 31, 2006 we
completed an offering of common shares, issuing 14,815,000
common shares from treasury. as a result of the share capital
reorganization and the issuance of shares upon the iPo and
subsequent equity offering, our authorized share capital
consists of an unlimited number of common shares, of which
52,393,065 common shares were issued and outstanding as
of november 30, 2006. We also have an unlimited number of
preferred shares authorized, none of which are issued.

the following table provides the weighted average number

of common shares outstanding for the relevant years:

Weighted Average Common
Shares Outstanding

For the years ended
September 30,

2006

2005

42,426,280

30,017,856

the average number of common shares outstanding
increased for the year ended September 30, 2006, compared
to the prior year as a result of the issuance of 14,815,000 new
common shares upon the closing of our equity offering on
May 31, 2006.

Stock Options and Warrants Outstanding
as at november 30, 2006 there were 4,910,625 stock options
and 192,308 share purchase warrants outstanding which
collectively could result in the issuance of 5,102,933 common
shares if such options and warrants are exercised by the
holders in accordance with the terms thereof.

r e l at e d pa r t y t r a n s a c t i o n s
Questair had a consulting agreement with Dr. Denis connor,
chairman of the company, for consulting services related to
our government relations activities. under this agreement, Dr.
connor received $18,000 in fees during the quarter ended
December 31, 2005, at which time the contract terminated.

s u B s e Q u e n t e V e n t s
Subsequent to the end of fiscal 2006, there were a number of
developments in our refinery program with EMRE. in october
2006 we renewed our Joint Development agreement (“JDa”)
with EMRE, extending the exclusivity period of our research
collaboration in the refinery and petrochemical market with
EMRE for a further 3 years. the extension of the JDa is intended
to allow us to complete additional product development
work with EMRE to extend the H-6200 product platform into
additional markets in the oil refining and petrochemical markets.

delays in the fabrication of the prototype H-6200 hydrogen
purifier to be demonstrated at the ExxonMobil refinery in
Europe. these delays were principally related to the heavy
construction activity in the oil and gas sector in north america,
which created capacity constraints at one of our key suppliers
that is assembling the prototype plant skid. consequently, we
now expect to complete the fabrication of the prototype plant
around the end of calendar 2006, and to ship the prototype to
Exxon’s refinery early in the first quarter of calendar 2007. the
prototype plant will be installed and started up at the refinery
site during the first half of calendar 2007.

o u t l o o k
Demand for hydrogen in the refining of crude oil is forecast
to grow by between 8-10% per annum through 2010. in
addition, hydrogen consumption per barrel of oil is forecast to
grow from approximately 400 cubic feet per barrel (“cf/bbl”)
to approximately 800 cf/bbl by 2010, driven by increasingly
stringent regulations for sulphur content in transportation fuels,
and increased processing of heavier, sour crude oil stocks.
We believe that these macroeconomic drivers in the oil
refining industry will create a compelling growth opportunity
for our H-6200 hydrogen purifier currently under development.
By focusing on the aggressive penetration of the oil refining
market with the H-6200 product, as well as by extending
this technology platform into additional energy-related
markets such as natural gas processing and petrochemical
separations, we believe that very significant growth in revenue
will be achieved over the next several years.

Fiscal 2007 will be a landmark year for Questair with the
commercialization of our H-6200 hydrogen purifier in the oil
refining market. Key objectives for the coming year include
the installation and start up of the prototype H-6200 hydrogen
purifier at an ExxonMobil refinery, and the subsequent first
sale of a fully commercial H-6200 system in the oil refining
market. We also expect to see continued growth in the sale of
our first generation gas purifiers in the industrial hydrogen and
biogas markets.

Questair’s operational and financial milestones for the

remainder of fiscal 2007 are:
1. Complete the installation and startup of the prototype H-

6200 hydrogen purifier at an ExxonMobil refinery. We expect
that the prototype H-6200 hydrogen purifier will be installed
and started up at the ExxonMobil refinery during the first
half of calendar 2007.

2. Receive the first purchase order for a commercial H-

6200 hydrogen purifier. EMRE and Questair are actively
marketing the H-6200 to both ExxonMobil and third-party
refineries, with the objective of securing a purchase order
for the first commercial sale during fiscal 2007.

3. Sign an agreement to extend the H-6200 platform into
a new market. Questair has entered into a number of
preliminary engineering contracts to assess the application

of the H-6200 platform technology into additional markets
such as natural gas processing and other separations
in the petrochemical industry. Based on the outcome of
these preliminary studies, we aim to sign an agreement to
undertake the next phase of this product development.

4. Secure first purchase order for a methane purification

system in the European biogas market. there is
significant interest in Europe in the use of renewable
sources of methane to supplement imported natural gas,
and as a carbon neutral source of transportation fuel for
busses and cars. During the year, we expect to sell our
first system in the European market to recover high purity
methane from biogas.

5. Increase recognized revenue to between $9 and $10 million.
total recognized revenue is expected to be between $9
and $10 million in fiscal 2007, representing an increase of
approximately 19% to 32% from $7.6 million in fiscal 2006.
We expect revenue growth from both our first generation
commercial products and anticipated engineering service
contracts. any commercial H-6200 orders received during
fiscal 2007 are not expected to be recognized as revenue
during fiscal 2007 given the expected manufacturing and
installation time of these large units.

6. Manage cash used in operations and capital expenditures
to between $7 and $8 million. cash used in operations
and capital expenditures is expected to be in the range of
$7 to $8 million, reduced from $9.4 million in fiscal 2006.
Expenditures on both the commercialization of the H-6200
product, as well R&D activities related to the extension
of the H-6200 platform technology into new markets are
expected to continue through fiscal 2007.

it should be noted that we have made certain assumptions

regarding the receipt of new engineering service contracts
and gas purification sales in determining our revenue and
operational cash burn milestones for fiscal 2007. Failure to
secure certain of these contracts may have a material impact
on our recognized revenue and cash burn for fiscal 2007,
and we will update our financial guidance accordingly if our
financial outlook is impacted in this way.

c r i t i c a l a c c o u n t i n g p o l i c i e s a n d e s t i m at e s
the significant accounting policies that we believe to be
most critical in fully understanding and evaluating our
financial results are revenue recognition, stock-based
compensation, inventory valuation and warranty provisions.
these accounting principles require us to make certain
estimates and assumptions. We believe that the estimates
and assumptions upon which we rely are reasonable based
upon information available at the time that these estimates
and assumptions are made. actual results may differ from
our estimates. our critical accounting estimates affect our
net loss calculation and the balance sheet value of our assets
and liabilities. our accounting policies are described in note 2
to the audited consolidated financial statements.

Revenue Recognition
We earn revenues from the sale of commercial gas
purification systems, long-term production-type contracts,
and from engineering service contracts. Revenue recognized
from long-term production-type contracts and engineering
service contracts are determined under the percentage-of-
completion method, whereby revenues are recognized on
a pro rata basis in relation to contact costs incurred. there
is a risk that estimated costs to complete a contract might
change, which may result in an adjustment to revenues
previously recorded.

During the years ended September 30, 2006 and 2005
there were no material adjustments to long-term production-
type contract and engineering service contract revenue
relating to revenue recognized in a prior period.

Stock-based compensation
We account for stock options using the fair value method
calculated using the Black-Scholes option pricing model.
this requires that certain inputs into the model, including
the expected life of the options and expected volatility of the
stock, be estimated at the time the options are awarded. We
amortize the fair value over the vesting period of the options,
generally a period of four years. Should these estimates
prove to be incorrect, the actual fair value of the options may
differ from the estimated fair value of the options, resulting in
a different stock compensation expense calculation.

Inventory
in establishing whether or not a provision is required for
inventory obsolescence, we estimate the likelihood that
inventory carrying values will be affected by changes in market
demand for our products and by changes in technology, which
could make inventory on hand obsolete. We perform regular
reviews to assess the impact of changes in technology, sales
trends and other changes on the carrying value of inventory.
Where we determine that such changes have occurred and
that they will have a negative impact on the carrying value of
inventory on hand, adequate provisions are made.

the majority of our inventory is purchased directly to
work in process when a customer order is received, and only
a small portion is held in raw materials. this reduces the
exposure to provisions for obsolescence. For the year ended
September 30, 2006, raw materials on hand of $502,472
includes $55,645 of spare parts inventory available for sale to
customers for use on commercial units in the field.

Warranty Provision
a provision for warranty costs is recorded on commercial gas
purification systems at the time of commissioning and customer
acceptance. in estimating the accrued warranty liability, past
and projected experience and the nature of the contracts are
considered. Should these estimates prove to be incorrect,
we may incur costs different from those provided for in our
warranty provision. in each of fiscal 2005 and 2006, actual
warranty costs incurred were less than the provision recorded.

c h a n g e s i n a c c o u n t i n g p o l i c i e s
i n c l u d i n g i n i t i a l a d o p t i o n
the cica released new standards related to financial
instruments in april 2005: Section 3855, Financial Instruments
– Recognition and Measurement; Section 3865, Hedges;
Section 1530, Comprehensive Income; Section 3861,
Financial Instruments – Disclosure and Presentation; and
Section 3251, Equity. these sections specify when a financial
instrument or non-financial derivative is to be recognized
on the balance sheet. these sections will require a financial
instrument or non-financial derivative to be measured at fair
value or using cost-based measures; establish how gains
and losses are to be recognized and presented, including
introducing comprehensive income; specify how hedge
accounting should be applied; and establish new disclosures
about an entity’s accounting for designated hedging
relationships and the methods and assumptions applied in
determining fair values.

under these new standards, derivatives will typically arise

when the currency of our sales orders is different from both
the functional currencies of Questair and our international
customers, and such derivatives will be recognized as either
assets or liabilities on the balance sheet at fair value. all gains
and losses (realized or unrealized) from such derivatives will
be recognized in the income statement in the period in which
they occur.

We intend to use the following methods and assumptions

to estimate the fair value of our financial instruments:
(i) Cash and cash equivalents: the carrying amount reported

on the balance sheet approximates fair value.

(ii) Accounts receivable: the carrying amount reported on the

balance sheet approximates fair value.

(iii) Debt securities: Short-term investments are classified as
held to maturity and their carrying value approximates
fair value being amortized cost using the effective
interest method.

(iv) Debt: the carrying amount of the floating rate debt

approximates fair value.

the mandatory effective date for Sections 1530,
Comprehensive Income; 3855, Financial Instruments
– Recognition and Measurement; 3865, Hedges; 3861,
Financial Instruments – Disclosure and Presentation; 3251,
Equity affect interim and annual financial statements for fiscal
years beginning on or after october 1, 2006. Earlier adoption
was permitted only as of the beginning of a fiscal year ending
on or after December 31, 2004. Questair has elected to
adopt all of these new standards effective october 1, 2006
on a prospective basis. Management is of the opinion that
if any restatement of comparative financial statements was
required, its effect would be minor.

d i s c l o s u r e c o n t r o l s a n d p r o c e d u r e s
the company maintains a set of disclosure controls and
procedures designed to ensure that information required
to be disclosed is recorded, processed, summarized and
reported within the time periods specified in provincial
securities legislation. the company evaluated its disclosure
controls and procedures as defined under Multilateral
instrument 52-109 for the year ended September 30, 2006.
this evaluation was performed by the chief Executive
officer and the chief Financial officer with the assistance
of other company employees to the extent necessary and
appropriate. Based on this evaluation, the chief Executive
officer and chief Financial officer concluded that the design
and operation of these disclosure controls and procedures
were effective.

i n t e r n a l c o n t r o l s a n d p r o c e d u r e s
the company maintains a set of internal controls over financial
reporting which have been designed to provide reasonable
assurance regarding the reliability of financial reporting and
the preparation of financial statements in accordance with
canadian gaaP. the company evaluated the design of its
internal controls and procedures as defined under Multilateral
instrument 52-109 for the year ended September 30, 2006.
this evaluation was performed by the chief Executive officer
and the chief Financial officer with the assistance of other
company employees to the extent necessary and appropriate.
Based on this evaluation, the chief Executive officer and chief
Financial officer concluded that the design of these internal
controls and procedures was effective.

there were no changes in the company’s internal control
over financial reporting that occurred during the fourth fiscal
quarter that have materially affected, or are reasonably
likely to materially affect the company’s internal control over
financial reporting.

r i s k s & u n c e r ta i n t i e s
a detailed explanation of the risk factors which we face is
provided in our annual information Form for the year ended
September 30, 2006 at www.sedar.com. a number of the key
risks, as well as the strategies that management employs to
manage these risks, are discussed briefly below:

Technology and Competitive Risks
the H-6200 hydrogen purifier incorporating Questair’s
second generation PSa technology is in the development
stage. Risks remain related to the successful completion of
the product development program, and our ability to meet
the required cost, reliability and performance standards of a
viable commercial offering. We have undertaken a rigorous
review of the key technical risk areas in collaboration with
ExxonMobil in order to manage these risks. nevertheless,
technical risks and uncertainties will remain until the
prototype plant has been successfully demonstrated at the
ExxonMobil refinery site.

We currently face, and will continue to face competition

from suppliers of conventional PSa systems as well as
alternate gas purification technologies. We will continue
to invest in fundamental R&D to continually improve the
performance and cost position of our products. in addition,
we pursue an active patenting program to protect our
proprietary technology and competitive position.

Market Risks
the market opportunity for our H-6200 hydrogen purifier is
driven in part by the growth in demand for refined petroleum
products. a significant reduction in the demand for these
fuels, as a result of such events as an economic recession
in key markets in the uS and china for example, could
significantly impact our growth prospects. in order to mitigate
this risk, we intend to diversify our market exposure by
extending the H-6200 product platform into markets outside
of oil refining, such as petrochemical separations, natural gas
processing and the production of high purity hydrogen for
industrial uses.

in addition, the rate at which our H-6200 hydrogen purifier

is adopted in the refinery market is also subject to risk and
uncertainty, and could have a material impact on the future
profitability of the company. We seek to mitigate this risk by
diversifying the application of the H-6200 product platform
into a number of large existing markets. our fuel cell related
products provide additional diversification outside of the
traditional energy industry.

in the longer term, there is significant uncertainty

regarding the commercial viability of fuel cell technology and
the adoption of fuel cell powered automobiles and power
products. We seek to manage this risk by focusing on the
sale of our existing commercial products in the nascent fuel
cell market, and pacing our fuel cell related development
programs to the level of engagement of and funding received
from our fuel cell partners.

Regulatory Risk
Demand for our refinery related products is also driven
in part by regulations mandating the reduction of sulphur
levels in transportation fuels such as gasoline and diesel.
in addition the expected demand for fuel cell technologies
in the transportation sector is driven in part by local air
pollution regulations and regulatory pressures to reduce

greenhouse gas emissions. it is clear that a significant roll-
back in any of these regulations could materially impact our
growth prospects. our strategy of diversifying our market
opportunities into multiple markets is intended to minimize
our exposure to regulatory risk in specific markets.

Partner Risk
a key component of our strategy is to partner with market
leaders in the development, marketing and distribution of
new products. We have developed close relationships with
EMRE for its refinery and petrochemical related products, and
also with Shell Hydrogen for the emerging hydrogen fueling
market. our current business and/or future prospects would
be materially impacted if EMRE or Shell Hydrogen were to
terminate their relationships with Questair. We have structured
our key development agreements with these parties such that
we are free to sell to third parties, and we seek to establish
relationships with multiple customers in each of the markets
that we target in order to mitigate this risk.

Financial Risk
We are currently a net consumer of cash, and we may have
to raise additional capital in order to complete our long
term product development and commercialization plans.
it is possible that our future growth prospects could be
significantly impacted if we are unable to raise additional
capital on acceptable terms. in order to mitigate this risk, we
have implemented a disciplined cash management strategy to
limit cash consumption. in addition we are actively pursuing
other forms of financial support such as government and
partner funding in order to reduce our net cash requirements.

Key Personnel Risk
our future growth depends in large part on our ability to
recruit, train and retain key management and technical
personnel. competition for qualified personnel in our industry
is intense, and it is possible that we may not be able to recruit
suitable personnel into key positions in the future. We have
implemented an innovative retention strategy in order to
manage this risk, which includes active career development,
and a recognition and compensation program that rewards
both group and individual contributions and performance.

M a n a g E M E n t ’ S R E S P o n S i B i L i t y F o R F i n a n c i a L R E P o R t i n g

The accompanying financial statements of Questair
technologies inc. and all the information in this annual
Report are the responsibility of management and have been
approved by the Board of Directors.

the financial statements have been prepared by
management in accordance with accounting principles
generally accepted in canada. When alternative accounting
methods exist, management has chosen those it deems
most appropriate in the circumstances. Financial statements
are not precise since they include certain amounts based
on estimates and judgements. Management has determined
such amounts on a reasonable basis in order to ensure that
the financials statements are presented fairly in all material
respects. Management has prepared the financial information
presented elsewhere in the annual Report and has ensured
that it is consistent with that in the financial statements.
Questair technologies inc. endeavours to maintain systems of
internal accounting and administrative controls of high quality,
consistent with reasonable cost. Such systems are necessary
to provide reasonable assurance that the financial information is
relevant, reliable and accurate and that the company’s assets
are appropriately accounted for and adequately safeguarded.

the Board of Directors is responsible for ensuring
that management fulfills its responsibilities for financial
reporting and is ultimately responsible for reviewing and
approving the financial statements. the Board carries out this
responsibility principally through its audit committee. the
audit committee meets periodically with management, as
well as the external auditors, to discuss internal controls over

the financial reporting process, auditing matters and financial
reporting issues, to satisfy itself that each party is properly
discharging its responsibilities, and to review the annual
Report, the financial statements and the external auditors’
report. the committee reports its findings to the Board for
consideration when approving the financial statements for
issuance to the shareholders. the committee also considers,
for review by the Board and approval by the shareholders,
the engagement or re-appointment of external auditors.

the company’s financial statements have been audited

by Pricewaterhousecoopers LLP, the external auditors, in
accordance with generally accepted auditing standards on
behalf of the shareholders. Pricewaterhousecoopers LLP
have full and free access to the audit committee.

Jonathan Wilkinson
President & chief Executive officer

Sherry Tryssenaar
Vice President Finance and administration &
chief Financial officer

a u D i t o R S ’ R E P o R t
To the Shareholders of QuestAir Technologies Inc.

We have audited the consolidated balance sheets of
QuestAir Technologies Inc. as at September 30, 2006
and 2005 and the consolidated statements of operations
and deficit and cash flows for the years then ended. these
financial statements are the responsibility of the company’s
management. our responsibility is to express an opinion on
these financial statements based on our audits.

We conducted our audits in accordance with canadian

generally accepted auditing standards. those standards
require that we plan and perform an audit to obtain
reasonable assurance whether the financial statements are
free of material misstatement. an audit includes examining,
on a test basis, evidence supporting the amounts and
disclosures in the financial statements. an audit also includes
assessing the accounting principles used and significant

estimates made by management, as well as evaluating the
overall financial statement presentation.

in our opinion, these consolidated financial statements
present fairly, in all material respects, the financial position
of the company as at September 30, 2006 and 2005 and
the results of its operations and its cash flows for the years
then ended in accordance with canadian generally accepted
accounting principles.

chartered accountants
Vancouver, British columbia
December 5, 2006

2006
$

2005
$

11,018,800
1,256,354
7,400,000
1,476,024
454,597
3,510,508
337,335
25,453,618
2,103,626
125,000

27,682,244

4,413,717
1,946,781
351,398
-
6,711,896
532,852
7,244,748

10,311,823
102,396
-
1,075,255
493,913
1,945,876
299,757
14,229,020
1,984,014
-

16,213,034

2,210,686
1,602,103
216,839
110,357
4,139,985
433,678
4,573,663

109,020,202
6,462,772
(95,045,478)
20,437,496

27,682,244

89,774,802
6,647,129
(84,782,560)
11,639,371

16,213,034

c o n S o L i D a t E D B a L a n c E S H E E t S
as at September 30, 2006 and 2005

(expressed in canadian dollars)

ASSETS

Current assets
cash and cash equivalents
Restricted cash (note 3)
Short-term investments
accounts receivable
grants and funding receivables
inventories (note 4)
Prepaid expenses

Property, plant and equipment (note 5)
Other long-term assets

LIABILITIES

Current liabilities
accounts payable and accrued liabilities (note 6)
Deferred revenue
current portion of bank debt (note 7)
obligations under capital lease (note 8)

Bank debt (note 7)

ShAREhOLDERS’ EQUITy

Share capital (note 9)
authorized
unlimited common shares, voting, no par value
unlimited preferred shares, issuable in series, no par value
Common shares
Contributed surplus (note 9)
Deficit

Nature of operations and going concern (note 1)
Commitments and contingencies (note 12)

approved by the Board of Directors

Director

See accompanying notes to consolidated financial statements.

c o n S o L i D a t E D S t a t E M E n t S o F o P E R a t i o n S a n D D E F i c i t
For the years ended September 30, 2006 and 2005

(expressed in canadian dollars)

Revenue

Cost of goods sold

Gross profit

Operating expenses
Research and development - net (note 10)
general and administration
Sales and marketing
amortization

Loss before undernoted

Other income (expense)
interest income
other expense

Loss for the year

Deficit - Beginning of year

Preferred share conversion (note 9)

Deficit - End of year

Basic and diluted loss per share (notes 9 and 14)

See accompanying notes to consolidated financial statements.

2006
$

2005
$

7,558,093

6,292,309

6,432,954

3,537,068

1,125,139

2,755,241

5,092,174
3,311,188
1,938,537
1,223,788

5,733,846
3,427,315
1,779,703
1,531,112

11,565,687

12,471,976

(10,440,548)

(9,716,735)

378,872
(201,242)
177,630

226,165
(26,288)
199,877

(10,262,918)

(9,516,858)

(84,782,560)

(73,560,609)

(1,705,093)

(95,045,478)

(84,782,560)

(0.24)

(0.31)

2006
$

2005
$

(10,262,918)

(9,516,858)

1,223,788
8,619
492,302
503

1,531,112
(7,418)
754,759
(9,661)

(8,537,706)

(7,248,066)

(361,454)
(1,546,335)
(162,579)
1,885,385
344,678

159,695

(455,846)
(269,864)
(209,474)
782,382
(378,337)

(531,139)

(8,378,011)

(7,779,205)

(7,400,000)
(1,155,334)
96,791
5,875
(1,153,958)

-
(1,261,919)
335,600
10,895
(102,396)

(9,606,626)

(1,017,820)

20,000,250
(1,589,499)
157,991
(110,860)
(197,749)
431,481
-

15,050,000
(2,835,287)
20,470
(115,568)
-
650,518
(353,208)

18,691,614

12,416,925

706,977

3,619,900

10,311,823

6,691,923

11,018,800

10,311,823

c o n S o L i D a t E D S t a t E M E n t S o F c a S H F L o W S
For the years ended September 30, 2006 and 2005

(expressed in canadian dollars)

Cash flows from operating activities

Loss for the year

items not involving cash
amortization
gain on sale of property, plant and equipment
Stock-based compensation
Foreign currency gain (loss)

changes in non-cash operating working capital
accounts, grants and funding receivables

inventories

Prepaid expenses
accounts payable and accrued liabilities
Deferred revenue

Cash flows from investing activities
increase in short-term investments
Purchase of property, plant and equipment
government grants and funding related to property, plant and equipment
Proceeds on sale of property, plant and equipment
increase in restricted cash

Cash flows from financing activities
issuance of common shares
Share issue costs
issuance of common shares on exercise of stock options
Repayment of obligations under capital lease
Repayment of bank debt
term loan advance
Deferred charges

Increase in cash and cash equivalents

Cash and cash equivalents - Beginning of year

Cash and cash equivalents - End of year

Supplemental cash flow information (note 15)

See accompanying notes to consolidated financial statements.

n o t E S t o c o n S o L i D a t E D F i n a n c i a L S t a t E M E n t S
September 30, 2006 and 2005

1 n at u r e o F o p e r at i o n s a n d g o i n g c o n c e r n

Questair technologies inc. (the “company”), a federally
incorporated canadian company, is an emerging developer,
manufacturer and supplier of advanced pressure swing
adsorption (“PSa”) gas purification systems. PSa systems
are used extensively in the production of hydrogen, oxygen
and nitrogen for a wide variety of industries. the company’s
products, which incorporate patented, proprietary
technology, primarily target hydrogen purification in a
range of existing industrial and energy markets, including
oil refinery and gas processing applications, as well as
emerging markets, such as fuel cell systems for distributed
power generation and retail service stations that will provide
hydrogen fuel for fuel cell powered vehicles.

While the accompanying consolidated financial

statements have been prepared on a going concern basis,
which contemplates the realization of assets and liquidation
of liabilities during the normal course of operations,
certain adverse conditions and events cast doubt upon
the validity of this assumption. the company has not
yet realized profitable operations and has relied on non-
operational sources of financing to fund operations, and,
as at September 30, 2006, has an accumulated deficit of
$95,045,478. the company’s ability to continue as a going
concern will depend on management’s ability to successfully
execute its business plan. the company may seek additional
forms of financing, but cannot provide assurance that it
will be successful in doing so. these consolidated financial
statements do not include adjustments or disclosures that
may result from the company’s inability to continue as
a going concern. if the going concern assumption is not
appropriate for these consolidated financial statements,
then adjustments would be necessary in the carrying value
of assets and liabilities, the reported net losses, and the
balance sheet classifications used.

2 s i g n i F i c a n t a c c o u n t i n g p o l i c i e s

Basis of presentation
these consolidated financial statements have been
prepared in accordance with canadian generally accepted
accounting principles. on november 29, 2004, the
company dissolved its inactive, wholly owned subsidiary,
Questair technologies (uSa) inc.

Use of estimates
the preparation of financial statements in conformity
with canadian generally accepted accounting principles
requires management to make estimates and assumptions
which affect the reported amounts of assets and liabilities
and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts
of revenues and expenses during the period. actual
results could differ from these estimates.

Cash and cash equivalents
cash and cash equivalents consist of cash on deposit and
highly liquid short-term interest bearing securities with
maturities at the date of purchase of three months or less.

Short-term investments
Short-term investments consist of interest bearing
securities with original terms to maturity of less than
one year and are carried at cost, which approximates
fair value. the company has the intention and the ability
to hold these securities to maturity. interest earned and
market value losses are recognized immediately in the
consolidated statement of operations and deficit.

Inventories
inventories are recorded at the lower of cost and
replacement cost for raw materials and supplies and at
the lower of cost and net realizable value for work-in-
progress and finished goods. costs of raw materials are
determined on an average cost basis. Work-in-progress
and finished goods include materials, direct labour and
production overhead. inventories are recorded net of any
obsolescence provision.

Property, plant and equipment
Property, plant and equipment are recorded at cost (net
of third-party funding) less accumulated amortization.
amortization is computed using the straight-line method
over an asset’s estimated useful life at the following rates:

test equipment
computer equipment
Leasehold improvements
Lab and warehouse equipment
Manufacturing equipment
office equipment
Furniture and fixtures

20%
30%
lease term
20%
33%
20%
20%

Impairment of long-lived assets
Long-lived assets are tested for impairment whenever
events or changes in circumstances indicate that the
carrying amount may not be recoverable. the company
tests the recoverability of long-lived assets based on
future undiscounted cash flows expected to result from
the use of the related assets. an impairment loss is
measured as the amount by which the carrying amount of
a long-lived asset exceeds its fair value.

Revenue recognition
the company recognizes revenue on commercial
equipment sales when title has transferred, the customer
has accepted the product, there is persuasive evidence
of an arrangement, collection is probable and the price
is fixed or determinable. Provisions are established for
estimated product returns and warranty costs at the time
revenue is recognized. the company records deferred
revenue when cash is received in advance of all of these
revenue recognition criteria being met.

Revenues from long-term production-type contracts
and engineering service contracts are determined under
the percentage-of-completion method whereby revenues
are recognized on a pro rata basis in relation to contract
costs incurred. costs and estimated profit on contracts in
progress in excess of amounts billed are reflected as work-

in-progress. cash received in advance of revenues being
recognized on contracts is classified as deferred revenue.

the company monitors its contracts with customers on

a regular basis to determine if a loss is likely to occur. if a
loss is anticipated on a contract, the entire estimated loss
is recorded as a cost of sales and a reduction in work-in-
progress in the period in which the loss becomes evident
and reasonably estimable.

Warranty costs
the company provides for future warranty costs on
products sold based on management’s best estimates of
such costs, taking into account past experience and the
nature of the contracts.

Research and development costs
Research costs are expensed as incurred. Development
costs are expensed as incurred unless they meet certain
criteria under canadian generally accepted accounting
principles for deferral and amortization, which relate
primarily to technological feasibility, identified future markets
of the product, and availability of resources to complete
the project. the company has determined that none of its
development costs to date have met these criteria.

Government assistance
government assistance is recorded when receipt is
reasonably assured as either a reduction of the cost of the
applicable assets or a credit to the applicable expenses
in the consolidated statement of operations and deficit as
determined by the terms and conditions of agreements
under which the assistance is provided to the company.
a liability is recorded when repayment of the assistance is
considered probable.

Foreign currency translation
transactions denominated in foreign currencies are
translated to canadian dollars at the rate prevailing at the
time of the transactions. Monetary assets and liabilities
denominated in a foreign currency are translated into
canadian dollars at the current rates in effect at the
balance sheet date. the resulting exchange gains and
losses are recognized in the consolidated statement of
operations and deficit.

Stock-based compensation plans
the company accounts for stock options using the fair
value method calculated using the Black-Scholes option
pricing model. For options granted to directors, officers
and employees, the compensation cost is measured at fair
value at the date of grant and is expensed to operations
over the award’s vesting period. For options granted
to non-employees, the fair value is measured when
performance is complete, a performance commitment is
made or the options are fully vested and non-forfeitable,
whichever is earliest, and the expense is recognized over
the period in which the goods or services from the non-
employees are received. a corresponding increase in

contributed surplus is recorded when stock options are
expensed. When stock options are exercised, capital stock
is credited by the sum of the consideration paid and the
related portion previously recorded in contributed surplus.

Income taxes
the company follows the asset and liability method of
accounting for income taxes. under this method, future
income taxes are recognized for the future income tax
consequences attributable to differences between the
financial statement carrying values and their respective
income tax bases (temporary differences) and for the
benefit of loss carry-forwards. Future tax assets and
liabilities are measured using substantively enacted tax
rates expected to apply to taxable income in the years in
which temporary differences are expected to be recovered
or settled. the effect on future income tax assets and
liabilities of a change in tax rates is included in income in
the period that includes the substantial enactment date.
Future income tax assets are evaluated and if realization
is not considered to be more likely than not, a valuation
allowance is provided.

Financial instruments
a) Fair values

the fair values of cash and cash equivalents, restricted
cash, short-term investments, accounts receivable,
grants and funding receivables, accounts payable and
accrued liabilities, bank debt, and obligations under
capital lease approximate their carrying amounts due
to the short-term nature of these instruments.

b) credit risk

Financial instruments that potentially subject the
company to significant concentrations of credit risk
consist primarily of cash and cash equivalents and
accounts receivable. the company limits its exposure
to credit risk by placing its cash and cash equivalents
and short-term investments with high credit quality
financial institutions and corporations. concentration
of credit risk with respect to accounts receivable is
considered to be limited due to the credit quality of
the customers comprising the company’s customer
base. the maximum amount of credit risk exposure is
limited to the carrying amount of the balances in the
consolidated financial statements.

c) Foreign exchange risk
Predominantly all of the company’s sales are in united
States dollars or Euros. the company does not hold
or issue financial instruments to manage its exposure
to currency rate fluctuations relating to sales. For the
year ended September 30, 2006, the canadian dollar
value of united States dollar denominated sales was
$5,896,343 (2005 - $6,291,859) and Euro denominated
sales was $1,491,613 (2005 - $nil).

d) interest risk

the company is exposed to interest risk on its bank
debt for which the interest rates charged fluctuate
based on the bank prime rate.

Comparative amounts
comparative amounts have been reclassified, where
necessary, to conform to the presentation adopted in the
current year.

as at September 30, 2006, assets under capital lease with
a cost of $353,651 (2005 - $775,725) and accumulated
amortization of $329,756 (2005 - $634,228) are included
in property, plant and equipment. amortization expense
for assets under capital lease recorded in the consolidated
statement of operations and deficit for the year ended
September 30, 2006 was $106,095 (2005 - $100,415).

6 a c c o u n t s paya B l e a n d a c c r u e d l i a B i l i t i e s

3 r e s t r i c t e d c a s h

During 2006, the company was required to deposit cash
with comerica Bank as collateral to secure its obligations
under irrevocable standby and documentary letters of
credit. Restricted cash is released as the letters of credit
are drawn upon or expire. Expiry dates of the letters of
credit vary and extend to March 31, 2007. in addition,
tD Bank requires a restricted deposit to secure corporate
credit card debt. Restricted cash at September 30, 2006
of $1,256,354 (2005 - $102,396) relates to letters of credit
of $1,196,889 (2005 - $43,896) and corporate credit card
security of $59,465 (2005 - $58,500).

i n V e n t o r i e s

Raw materials and supplies
Work-in-progress
Finished goods

2006
$
502,472
2,604,919
403,117
3,510,508

2005
$
350,182
607,759
987,935
1,945,876

5 p r o p e r t y, p l a n t a n d e Q u i p m e n t

Test equipment
Computer equipment
Leasehold improvements
Lab and warehouse
equipment
Manufacturing equipment
Office equipment

Furniture and fixtures

Test equipment
Computer equipment
Leasehold improvements
Lab and warehouse
equipment
Manufacturing equipment
Office equipment
Furniture and fixtures

Cost
$
3,298,337
2,251,760
2,401,764

Accumulated
amortization
$
2,711,364
2,092,415
1,787,215

2006

Net
$
586,973
159,345
614,549

2,803,570

2,122,673

680,897

1,978,529
277,564

203,719
13,215,243

1,929,429
267,137

201,384
11,111,617

49,100
10,427

2,335
2,103,626

Cost
$
3,089,280
2,648,983
2,416,508

Accumulated
amortization
$
2,234,803
2,385,984
2,375,406

2005

Net
$
854,477
262,999
41,102

2,476,721
1,935,635
277,574
201,529
13,046,230

1,732,674
1,872,230
263,869
197,250
11,062,216

744,047
63,405
13,705
4,279
1,984,014

Trade payables
Wages and benefits
Warranty provision
Accounting and legal costs
Taxes payable (GST, PST and VAT)

7 B a n k d e B t

2006
$
3,462,599
467,741
179,130
174,530
129,717
4,413,717

2005
$
1,403,893
325,082
311,182
150,000
20,529
2,210,686

in april 2005, the company signed a credit facilities
agreement with comerica Bank. this agreement was
amended and restated as part of the renewal of these
facilities in June 2006. the amended credit facilities include:
a uS$1 million accounts receivable line of credit; a term loan
of $673,212 (“tranche 1”) equal to the balance outstanding
at June 2006 under the original term loan agreement; and a
new term loan of uS$2 million (“tranche 2”). these facilities
are subject to annual renewal, and are secured by the assets
of the company with certain exceptions. under the terms
of the agreement, the company must comply with financial
covenants and certain other business terms.

the line of credit is limited to 80% of eligible accounts
receivable, subject to certain restrictions. this credit facility
is payable upon demand. the variable interest rate for
the line of credit is prime plus 0.50%. interest is payable
monthly, and the line of credit is renewable annually. as at
September 30, 2006, no balance was drawn on this facility.
the variable interest rate of the term loans is prime plus

0.75%. interest on tranche 1 is initially payable monthly
with 36 equal payments of principal plus interest beginning
october 22, 2005. interest on tranche 2 is initially payable
monthly with 30 equal payments of principal plus interest
beginning January 22, 2007. as at September 30, 2006, the
company had drawn $884,250 (2005 - $650,517) on the
term loans. accrued interest payable as at September 30,
2006 was $3,399 (2005 - $2,776). total interest expense
was $39,794 (2005 - $10,439) for the year ended September
30, 2006. Draws can be made against the tranche 2 term
loan, to a maximum of uS$2 million, prior to June 22, 2007.

8 o B l i g at i o n s u n d e r c a p i ta l l e a s e

the company leases computer equipment under a capital
lease that expires in 2007 and bears interest at a rate of
5.5%. interest paid during 2006 related to obligations
under capital lease was $6,243 (2005 - $11,766), of which
$3,052 was expensed in the current year and $3,191 was
accrued in 2005. at September 30, 2006, future minimum
payments under capital leases are $nil (2005 - $110,357).

9 s h a r e c a p i ta l a n d c o n t r i B u t e d s u r p l u s
a) common shares - issued and outstanding

Balance - September 30, 2004
Conversion of preferred shares
Classes A, B and C as a result of
initial public offering (“IPO”)
Issuance of common shares as a
result of IPO - net of share issuance
costs of $3,355,429
Exercise of share options
Balance - September 30, 2005
Issuance of common shares as a
result of public offering - net of share
issuance costs of $1,589,499
Exercise of share options
Balance - September 30, 2006

Number of
shares
4,922,992

Amount
$
2,795,830

23,738,018

75,229,847

8,600,000
46,611
37,307,621

11,694,571
54,554
89,774,802

14,815,000
270,444

18,410,750
834,650
52,393,065 109,020,202

b) Preferred shares - issued and outstanding

Balance - September 30, 2004
Class A preferred shares
Class B preferred shares
Class C preferred shares
Converted to common shares
as a result of IPO
Balance - September 30, 2005
and 2006

Number of
shares
-
6,493,500
9,034,088
2,832,679

Amount
$
-
12,005,318
52,449,884
10,859,805

(18,360,267)

(75,315,007)

included in the deficit balance at September 30, 2006
of $95,045,478 (2005 - $84,782,560) is non-cash
accretion expense of $13,631,542 (2005 - $13,631,542)
related to the preferred shares prior to conversion to
common shares.

immediately prior to the iPo, the company
reorganized its share capital whereby the existing
classes of shares were converted into a single class
of common shares. to complete this reorganization,
certain terms of the preferred shares relating to
automatic conversion rights were modified as follows:
class a preferred shares were converted into common
shares on a 1:1 basis; class B preferred shares were
converted into common shares on a 1:1.277 basis;
and class c preferred shares were converted into
common shares on a 1:1.856 basis. the modification of
the share rights is accounted for on a fair value basis.
the difference between the fair value of the share
rights prior to the modification and the fair value of the
modified share rights is accounted for as an adjustment
to shareholders’ equity. the modification of the class a
and B preferred shares resulted in an increase in deficit
of $1,705,093 and the conversion of the class c
preferred shares resulted in an increase in contributed
surplus of $1,790,253. the difference of $85,160 was
recorded as reduction to common shares. Both the
charge to deficit and the increase in contributed surplus
were included in the computation of loss per share for
the year ended September 30, 2005.

c) Employee share options
Prior to 2004, the company granted stock options
to certain employees in lieu of cash bonuses and
salary. as cash compensation was foregone by these
employees, options of equivalent value were issued
to them at an exercise price of $0.001 per share. at
September 30, 2006, the company has 282,929 (2005 -
351,969) options in lieu of salary or bonus outstanding.

the company first adopted an incentive stock

option plan (the “Plan”) in 1998 to provide its
employees, officers, directors and consultants with
options to purchase common shares of the company.
immediately prior to the iPo on December 21, 2004,
certain terms of the Plan were amended, and the
company’s stock option pool was increased from
3,785,241 to 5,507,637 stock options (excluding
any options that were issued as compensation for
performance in lieu of salary or bonus). under the
terms of the Plan, stock options are granted with an
exercise price not less than the fair market value of
the company’s common shares on the date of grant.
Stock options generally vest quarterly over four years.
in no event can a stock option be exercisable for more
than 10 years from the date of grant. at September 30,
2006, 437,921 (2005 - 822,254) options are available for
issuance under the company’s Plan.

in 2004, the company’s Board of Directors and major
preferred shareholders approved an award of 1,499,965
stock options under the Plan for key executives upon the
successful completion of the iPo. these stock options
were granted at an exercise price of $1.75, vesting
equally over four years at the end of each calendar
quarter and expiring December 21, 2014. this resulted
in $1,379,968 of stock compensation expense, of which
$308,709 (2005 - $344,955) has been charged to the
consolidated statement of operations and deficit for the
year ended September 30, 2006.

Furthermore, upon the closing of the iPo, the
company exchanged 1,270,398 stock options under
the Plan, with exercise prices between $3.10 and
$5.00, for 635,208 stock options with an exercise price
of $1.75, resulting in $317,461 of stock compensation
expense, of which $19,528 (2005 - $292,206) has been
charged to the consolidated statement of operations
and deficit for the year ended September 30, 2006
related to vested options.

the company calculated the minimum fair value
of each share option grant on the date of grant using
the Black-Scholes option valuation model, with the
following weighted average assumptions:

Dividend yield
Expected volatility
Risk-free interest rate
Expected life of options

2006
$
0%
56%
4.04%
5 years

2005
$
0%
57%
3.61%
5 years

Share option activity since September 30, 2004 is presented below:

Outstanding - September 30, 2004 (2,825,188 shares exercisable)

Granted
Exercised
Forfeited

Outstanding - September 30, 2005 (3,082,400 shares exercisable)

Granted
Exercised
Forfeited

Outstanding - September 30, 2006 (3,413,604 shares exercisable)

Options outstanding - September 30, 2006

Exercise
price range
$
0.001
0.70 - 0.93
1.00 - 1.45
1.62 - 1.75
3.10
5.00

Number of
stock options
outstanding

292,929
1,292,073
1,075,393
2,078,288
135,982
62,394
4,937,059

Weighted
average
remaining
contractual
life (years)
1.29
1.68
3.27
6.16
1.23
1.22
4.69

Weighted
average
exercise
price
$
0.001
0.83
1.09
1.75
3.10
5.00
1.34

Options
3,886,863
1,704,810
(46,611)
(718,202)
4,826,860
735,674
(270,444)
(355,031)
4,937,059

Weighted average
exercise price
$
1.85
1.74
0.44
3.32
1.38
1.09
0.58
1.91
1.34

Options exercisable - September 30, 2006
Weighted
average
exercise
price
$
0.001
0.82
1.03
1.75
3.10
5.00
1.31

Number of
stock options
exercisable
292,929
1,052,876
539,453
1,335,463
130,489
62,394
3,413,604

the company did not issue share options with an
exercise price less than the estimated fair market value
of a common share on the grant date for the year ended
September 30, 2006 (2005 - nil). in 2006, the company
issued 735,674 (2005 - 1,704,810) share options with
an exercise price equal to the fair market value of a
common share on the grant date. these options had
a weighted average exercise price of $1.09 (2005 -
$1.74) and a weighted average fair value of $0.56 (2005
- $0.77). During 2006, $492,302 (2005 - $754,759) of
stock compensation expense has been charged to the
consolidated statement of operations and deficit related
to the vesting of stock option awards and modifications
made during and prior to September 30, 2006.

d) Share purchase warrants
During the year ended September 30, 2006, 430,000

share purchase warrants that had been issued to certain
agents upon closing of the iPo expired unexercised.
as at September 30, 2006, 192,308 transferable share
purchase warrants, issued as part of the agreement
with the canadian Federal Minister of industry under

the technology Partnerships canada (“tPc”) Program,
remain outstanding (note 12(c)). these warrants are
convertible into common shares at an exercise price of
$3.88 and are exercisable until June 6, 2008.

e) contributed surplus
changes in contributed surplus since September 30,

2004 are presented below:

Balance - September 30, 2004
Warrants issued to Agents
Preferred share conversion
Stock-based compensation on share options issued
to employees under the fair value method
Stock-based compensation allocated to common
shares on exercise of share options
Balance - September 30, 2005
Stock-based compensation on share options issued
to employees under the fair value method
Stock-based compensation allocated to common
shares on exercise of share options
Balance - September 30, 2006

Amount
$
4,015,802
120,400
1,790,253

754,759

(34,085)
6,647,129

492,302

(676,659)
6,462,772

10 r e s e a r c h a n d d e V e l o p m e n t

Research and development costs
Government grants and funding from
third parties under development
agreements

2006
$
6,907,360

2005
$
7,666,713

(1,815,186)
5,092,174

(1,932,867)
5,733,846

11 i n c o m e ta x e s

a) Effective tax rate

the income tax expense (recovery) differs from the
amount that would be computed by applying the
combined federal and provincial statutory income tax
rate of 34.12% (2005 - 34.25%) to income before income
taxes. the reasons for the differences are as follows:

Computed tax recovery
Increase (decrease) resulting from

Permanent and other differences
Change in future income tax rates
Expiry of prior year losses
Share issuance costs
Change in valuation allowance

b) Future tax assets and liabilities

Share issuance costs
Non-capital loss carry-forwards
Scientific research
and experimental
development expenses
Non-refundable
provincial tax credits
Reserves
Property, plant and equipment
Total future tax assets before
valuation allowance
Valuation allowance
Net future tax asset

2006
$
(3,502,000)

2005
$
(3,260,000)

329,000
-
739,000
(542,000)
2,976,000
-

268,000
844,000
509,000
(971,000)
2,610,000
-

2006
$
1,103,000
14,003,000

2005
$
875,000
12,523,000

7,149,000

6,371,000

1,075,000
726,000
1,251,000

939,000
653,000
970,000

25,307,000
(25,307,000)
-

22,331,000
(22,331,000)
-

in assessing the realizability of future tax assets,
management considers whether it is more likely than
not that some portion or all of the future tax assets
will be realized. the ultimate realization of future tax
assets depends upon the generation of future taxable
income during the periods in which those temporary
differences become deductible. as management
believes there is sufficient uncertainty regarding
the realization of future tax assets, a full valuation
allowance has been provided.

the company has non-capital losses carried
forward of approximately $41,041,000 available to
reduce taxable income of future years, the benefit of

which has not been recorded in the accounts, which
expire as follows:

2007
2008
2009
2010
2014
2015
2016

$
4,873,000
6,129,000
3,965,000
8,379,000
4,897,000
5,885,000
6,913,000
41,041,000

the company has scientific research and experimental
development expenses of $20,951,000 (2005 -
$18,671,000) which are available to be carried forward
indefinitely and deducted against future taxable income
otherwise calculated.

c) as of September 30, 2006, the company also has
investment tax credits of approximately $7,697,016
(2005 - $6,576,000) available to offset future canadian
federal and provincial income taxes payable. the
investment tax credits expire commencing 2010. the
potential benefit of the investment tax credits has not
been recognized in the consolidated accounts.

12 c o m m i t m e n t s a n d c o n t i n g e n c i e s

a) Leases
at September 30, 2006, the company is committed to
make the following minimum operating lease payments
related to premises and office equipment:

2007
2008
2009
2010 and thereafter

$
508,786
513,331
91,332
144,666
1,258,115

b) Letters of credit
During 2006, the company had banks issue letters of

credit on its behalf to meet its performance obligations
on customer contracts and to secure future payments
to a vendor. at September 30, 2006, $1,158,479 (2005
- $43,896) of these letters of credit is outstanding, with
varying expiry dates extending to March 31, 2007.

c) tPc Programs

Fast Cycle Pressure Swing Adsorption and Gas
Management systems

on June 6, 2003, the company entered into an

agreement with the canadian Federal Minister of
industry under the tPc Program to receive financial
contributions regarding the development and
commercial exploitation of its Fast cycle Pressure
Swing adsorption and gas Management systems.

Pursuant to the agreement, total project costs for
the period from october 1, 2002 to September 30, 2007
will be shared, subject to annual contribution limits,
such that the Minister’s contribution will not exceed the
lesser of 30% of eligible project costs and $9,600,000.

the company has claimed contributions

aggregating $7,760,083 up to September 30, 2006
(2005 - $5,856,857). of this amount, $6,550,322 (2005
- $4,743,887) has been allocated against research and
development expenses, $709,761 (2005 - $612,970)
has been allocated against the cost of property, plant
and equipment, and $500,000 (2005 - $500,000) is
reflected as share purchase warrants. For the year
ended September 30, 2006, $1,806,436 (2005 -
$1,840,623) has been allocated against research and
development expenses and $96,791 (2005 - $195,951)
has been allocated against the cost of property, plant
and equipment. the agreement further states that
the Minister shall provide the company with financial
contributions based on the aforementioned limitations
in exchange for:
i)

the issuance of 192,308 transferable warrants
convertible into common shares at a strike price
of $3.88, exercisable for a term of five years, and

ii) repayable contributions to the Minister during
the royalty period based on 1.165% of gross
business revenues.

the royalty period began on october 1, 2005 and will
end on September 30, 2013 if the cumulative royalties
reach a ceiling of $23,620,000. if the cumulative
royalties are less than $23,620,000 by September 30,
2013, the royalty period will continue until the earlier
of September 30, 2021 or until a cumulative royalty
ceiling of $23,620,000 is reached. any amounts
ultimately determined to be repayable are accrued
as a liability when determinable. as of September 30,
2006, $146,800 (2005 - $35,040) has been accrued as
a liability. under the agreement, royalties are due on
January 31 of each year, beginning in 2007.

Pulsar Pressure Swing Adsorption project
on March 31, 1999, the company entered into an
agreement with the canadian Federal Minister of
industry under the tPc Program to receive financial
contributions regarding the development and
commercial exploitation of its Pulsar Pressure Swing
adsorption project.
Pursuant to the agreement, total project costs for
the period from october 1, 1998 to March 31, 2002 were
to be shared, subject to annual contribution limits, such
that the Minister’s contribution would not exceed the
lesser of 35% of eligible project costs and $4,947,330.
the company received contributions aggregating

$4,762,503. the agreement further provides that
the contributions are repayable solely based on
a royalty of 1.8% of gross project revenues and

revenues from fuel cell related products to a maximum
cumulative repayment of $8.75 million. cumulative
repayments of $32,952 (2005 - $25,992) have been
made to September 30, 2006. any amounts ultimately
determined to be repayable are accrued as a liability
when the project revenues are known and reasonably
estimable. as of September 30, 2006, $13,273 (2005 -
$11,537) has been accrued as a liability. the agreement
terminates on the later of the date of payment of all
amounts due to the Minister and 2015.

d) natural Resources canada agreement

in January 2005, the company received a grant from
the government of canada under the Department of
natural Resources Efficiency and alternative Energy
Program to support the development of structured
adsorbent that will possess enhanced properties to
assist in high purity hydrogen separation. total funding
received by the company of $225,000 was recorded as
a credit of $85,349 to research and development and a
credit of $139,651 to property, plant and equipment in
fiscal 2005. the agreement provides that the Minister
shall provide the company with financial contributions
based on the aforementioned limitations and such
contributions are repayable solely based on 0.12% of
gross project revenues through March 31, 2015, to a
maximum cumulative repayment of $225,000, whichever
occurs first. any amounts ultimately determined to be
repayable are accrued as a liability when the project
revenues are known and reasonably estimable. to date,
no such project revenue has been recorded.

in January 2004, the company received a grant
from the government of canada under the Department
of natural Resources Efficiency and alternative Energy
Program to support the development of a device that
increases the efficiency of a High temperature Fuel cell
system and permits the co-production of hydrogen.
total funding received by the company of $193,944
was recorded as a credit of $142,350 to research and
development and a credit of $51,594 to property, plant
and equipment in fiscal 2004. the agreement provides
that the Minister shall provide the company with
financial contributions based on the aforementioned
limitations and such contributions are repayable solely
based on 0.12% of gross project revenues through
March 31, 2014, to a maximum cumulative repayment
of $193,944, whichever occurs first. any amounts
ultimately determined to be repayable are accrued as
a liability when the project revenues are known and
reasonably estimable. to date, no such project revenue
has been recorded.

e) Exxon Mobil Research and Engineering company
Effective october 2003, the company entered into a
multi-year Joint Development agreement with Exxon
Mobil Research and Engineering company (“EMRE”) to
evaluate specific projects and to develop, commercialize

and market purification products for a range of refinery
and petrochemical applications. under this agreement,
the company is granted certain exclusive rights to
inventions in the field of adsorption based separation or
enrichment and EMRE is granted certain exclusive rights
to inventions in the field of petroleum and petrochemical
processes. the agreement further details how costs for
development projects are shared between the parties,
and provides for revenue sharing between the parties
should resulting products be commercialized for one or
more applications.

in May 2006, the company entered into a multi-
year commercialization agreement (“commercialization
agreement”) with EMRE for the marketing and
commercialization of the H-6200 hydrogen purifier,
the first product developed under the Joint Development
agreement. under the terms of the commercialization
agreement, EMRE will lead the marketing of the H-6200
hydrogen purifier to oil refineries and petrochemical
plants. the company retains sole responsibility for
negotiating and executing agreements with customers,
as well as for manufacturing and order fulfillment.
the company will pay EMRE a portion of the
commercial gain from the sale of H-6200 hydrogen
purifier units and any associated lease of adsorbent
beds based on EMRE’s contribution to the research,
development and commercialization of the H-6200
hydrogen purifier product.

f) Director and officer indemnification

the company’s directors and officers are covered
under a directors’ and officers’ insurance policy.
the aggregate limit of liability applicable to those
insured directors and officers under the policy is
$10 million. under this policy, the company has
reimbursement coverage to the extent that the
company has indemnified a director or officer in
excess of a deductible of $250,000 for each loss
related to securities claims and $100,000 for other
losses. the company’s bylaws also provide for the
indemnification of the directors and officers from and
against liability and costs in respect of any action or
suit against them in connection with the execution of
their duties of office, subject to certain limitations.

13 s e g m e n t e d i n F o r m at i o n

the company’s overall focus is on the development and
commercialization of gas purification systems, being the
company’s only segment.

Summarized product sales and service revenue by
geographic area, as determined by the location of the
customer, is as follows:

Revenue

Europe
United States
Asia
Canada

2006
$

2005
$

3,812,670
2,289,881
1,040,685
414,857
7,558,093

253,216
5,656,316
238,723
144,054
6,292,309

all of the company’s property, plant and equipment are
located in canada.

Major customers, representing 10% or more of total

sales, include:

Customer A
Customer B
Customer C

2006
$
839,743
5,337,481
-

2005
$
-
4,107,165
823,109

14 l o s s p e r s h a r e

Loss per share is calculated using the weighted average
number of common shares outstanding for the year of
42,426,280 (2005 - 30,017,856). outstanding convertible
preferred shares, share options and warrants to purchase
common shares were not included in the computation of
diluted loss per share as their impact is anti-dilutive.

15 s u p p l e m e n ta l c a s h F l o w i n F o r m at i o n

Supplemental cash flow information
Cash paid for interest
Cash received for interest

Non-cash operating, investing
and financing activities
Issuance of common shares on exercise
of stock options
Property, plant and equipment included
in accrued liabilities
Property, plant and equipment
reallocated to inventory

2006
$

2005
$

45,416
255,787

19,436
224,988

676,659

34,085

317,645

18,297

t r a d i n g s y m B o l s a n d e x c h a n g e s

l e g a l c o u n s e l

toronto Stock Exchange: QaR

Farris, Vaughn, Wills & Murphy LLP

aiM (London Stock Exchange Plc.): QaR

700 West georgia Street

Vancouver, Bc V7y 1B3 canada

Tel.

(604) 684 9151

c o r p o r at e a d d r e s s

6961 Russell avenue

Burnaby, Bc V5J 4R8 canada

a u d i t o r s

Pricewaterhousecoopers LLP

250 Howe Street

Vancouver, Bc V6c 3S7 canada

Tel.

(604) 806 7000

Tel.
(604) 454 1134
Fax. (604) 454 1137

i n V e s t o r r e l at i o n s

Andrew Hall
Director, corporate Development

and External communication

(604) 453 6967

Tel.
investors@questairinc.com

Stock Transfer Agent
and Registrar

computershare Limited

Suite 300, 510 Burrard Street

Vancouver, Bc V6c 3B9 canada

Tel.

(604) 661 9400

B O A R D O F D I R E C T O R S
(pictured from left to right)

M A N A G E M E N T T E A M

Jonathan Wilkinson, President and Chief
Executive Ofﬁ cer, QuestAir Technologies Inc.

John Shakeshaft, Chairman
and Chief Executive Ofﬁ cer,
Altis Investment Management

Jonathan Wilkinson, President and Chief
Executive Ofﬁ cer

Andrew Hall, Director, Corporate Development
and External Communication

Stephen Kennedy, Manager, Human Resources

Phillip Baxley, President, Shell Hydrogen LLC

Harold Copping, Management Consultant

Mark Kirby, Vice President,
Business Development

Sherry Tryssenaar, Chief Financial Ofﬁ cer,
QuestAir Technologies Inc.

Dr. Denis Connor, Chairman of the Board,
QuestAir Technologies Inc.; Consultant,
Angstrom Power Inc.

Michael Rosenberg, Director,

Corporate Development and Strategy,

Ballard Power Systems Inc.

Frederic Kosseim, Vice President,
Sales and Marketing

Dr. Edward Rode, Vice President,
Advanced Development

Sherry Tryssenaar, Vice President Finance and
Administration and Chief Financial Ofﬁ cer

Peter Tyszewicz, Vice President,
Manufacturing and Product Development