UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Form 10-Q

 

 

 

Commission file number 001-32868

 

DELEK US HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

 

(615) 771-6701

(Registrant’s telephone number, including area code)

 

 

Not Applicable

(Former name, former address and former fiscal year, if changed since last report)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  Yes o     No þ

 

At October 31, 2008, there were 53,680,570 shares of common stock, $0.01 par value, outstanding.

 

TABLE OF CONTENTS

 

 

 

Delek US Holdings, Inc.

 

Condensed Consolidated Balance Sheets (Unaudited)

 

 

See accompanying notes to the condensed consolidated financial statements

Delek US Holdings, Inc.

 

Condensed Consolidated Statements of Operations (Unaudited)

 

 

See accompanying notes to the condensed consolidated financial statements

Delek US Holdings, Inc.

 

Condensed Consolidated Statements of Cash Flows (Unaudited)

 

 

See accompanying notes to the consolidated financial statements

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited)

 

 

Delek US Holdings, Inc. (Delek, we, our or us) is the sole shareholder of MAPCO Express, Inc. (Express), MAPCO Fleet, Inc. (Fleet), Delek Refining, Inc. (Refining), Delek Finance, Inc. (Finance) and Delek Marketing & Supply, Inc. (Marketing) (collectively, the Subsidiaries).

 

We are a Delaware corporation formed in connection with our acquisition in May 2001 of 198 retail fuel and convenience stores from a subsidiary of the Williams Companies. Since then, we have completed several other acquisitions of retail fuel and convenience stores. In April 2005, we expanded our scope of operations to include complementary petroleum refining and wholesale and distribution businesses by acquiring a refinery in Tyler, Texas. We initiated operations of our marketing segment in August 2006 with the purchase of assets from Pride Companies LP and affiliates (Pride Acquisition). Delek and Express were incorporated during April 2001 in the State of Delaware. Fleet, Refining, Finance, and Marketing were incorporated in the State of Delaware during January 2004, February 2005, April 2005 and June 2006, respectively.

 

We are a controlled company under the rules and regulations of the New York Stock Exchange where our shares are traded under the symbol “DK.” As of September 30, 2008, approximately 73.4% of our outstanding shares are beneficially owned by Delek Group Ltd. (Delek Group), a conglomerate that is domiciled and publicly traded in Israel, has significant interests in fuel supply businesses and is controlled indirectly by Mr. Itshak Sharon (Tshuva).

 

Delek is a diversified energy business focused on petroleum refining, wholesale sales of refined products and retail marketing. Management views operating results primarily in three segments: refining, marketing and retail. The refining segment operates a high conversion, independent refinery in Tyler, Texas. The marketing segment sells refined products on a wholesale basis in West Texas through company-owned and third-party operated terminals. The retail segment markets gasoline, diesel and other refined petroleum products and convenience merchandise through a network of 495 company-operated retail fuel and convenience stores. Segment reporting is more fully discussed in Note 8. In addition, we own a minority equity interest in Lion Oil Company, a privately-held Arkansas corporation, which operates a 75,000 barrel per day high-conversion crude oil refinery and other pipeline and product terminals, which is more fully discussed in Note 5.

 

 

Basis of Presentation

 

The condensed consolidated financial statements include the accounts of Delek and its wholly-owned subsidiaries. We hold a 34.6% minority interest in Lion Oil Company, which we account for as an equity method investment. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with U.S. generally accepted accounting principles have been condensed or omitted, although management believes that the disclosures are adequate to make the financial information presented not misleading. Our unaudited condensed consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States applied on a consistent basis with those of the annual audited financial statements included in our Annual Report on Form 10-K and in accordance with the rules and regulations of the Securities and Exchange Commission (SEC). These unaudited, condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto for the year ended December 31, 2007 included in our Annual Report on Form 10-K filed with the SEC on March 3, 2008.

 

In the opinion of management, all adjustments necessary for a fair presentation of the financial position and the results of operations for the interim periods have been included. All significant intercompany transactions and account balances have been eliminated in consolidation. All adjustments are of a normal, recurring nature. Operating results for the interim period should not be viewed as representative of results that may be expected for any future interim period or for the full year.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Reclassifications

 

Certain December 31, 2007 balance sheet amounts, primarily associated with various receivables and payables, have been reclassified using a gross presentation method. Sales of intermediate feedstocks, which had previously been presented on a net basis in cost of goods sold, have been reclassified to net sales. This change in presentation resulted in an increase in both net sales and cost of goods sold of $5.3 million and $5.4 million for the three and nine months ended September 30, 2007, respectively.

 

Certain pipeline expenses previously presented in cost of goods sold have been reclassified to operating expense, general and administrative expenses, and depreciation and amortization. This change in presentation, which was made as of December 31, 2007, resulted in a decrease in cost of goods sold totaling $1.2 million and $3.0 million for the three and nine months ended September 30, 2007, respectively. These other expenses were increased, in total, by the same amounts.

 

These reclassifications were made in order to conform to the current year reporting and had no effect on net income or shareholders’ equity, as previously reported.

 

Cash and Cash Equivalents

 

Delek maintains cash and cash equivalents in accounts with large, national financial institutions and retains nominal amounts of cash at the convenience store locations as petty cash. All highly liquid investments purchased with an original maturity of three months or less are considered to be cash equivalents. As of December 31, 2007, these cash equivalents consisted primarily of time deposits, money market investments and high-quality commercial paper. As of September 30, 2008, these cash equivalents consisted primarily of overnight investments in U.S. Government obligations and bank repurchase obligations collateralized by U.S. Government obligations.

 

Short-Term Investments

 

Short-term investments as of December 31, 2007 primarily consisted of investment grade market auction rate debt securities and municipal rate bonds, which were classified as “available for sale” under the provisions of Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. These short-term investments were carried at cost, which approximated fair market value. As of September 30, 2008, we held no short-term investments.

 

Our auction rate investment, totaling $5.6 million, held three auctions, in February, May and August 2008 which were not fully subscribed. During 2008, we have reclassified this investment from short-term investments to other non-current assets. The underlying security for this investment is Merrill Lynch non-cumulative preferred stock. The auction rate investment is rated at investment grade levels of BBB+/Baa1 as of September 30, 2008. Based on our ability to access cash and cash equivalents, our expected operating cash flows and availability under our existing borrowing facilities, we currently do not anticipate the lack of liquidity on this auction rate security to materially impact our overall liquidity.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Accounts Receivable

 

Accounts receivable primarily represent receivables related to credit card sales, receivables from vendor promotions and trade receivables generated in the ordinary course of business. Delek had an allowance for doubtful accounts related to trade receivables of less than $0.1 million as of both September 30, 2008 and December 31, 2007. All other accounts receivable amounts are considered to be fully collectible.

 

Inventory

 

Refinery inventory consists of crude oil, refined products and blendstocks which are stated at the lower of cost or market. Cost is determined under the last-in, first-out (LIFO) valuation method. Cost of crude oil, refined product and blendstock inventories in excess of market value are charged to cost of goods sold. Such changes are subject to reversal in subsequent periods, not to exceed LIFO cost, if prices recover.

 

Marketing inventory consists of refined products which are stated at the lower of cost or market on a first-in, first-out (FIFO) basis.

 

Retail merchandise inventory consists of gasoline, diesel fuel, other petroleum products, cigarettes, beer, convenience merchandise and food service merchandise. Fuel inventories are stated at the lower of cost or market on a FIFO basis. Non-fuel inventories are stated at estimated cost as determined by the retail inventory method.

 

Property, Plant and Equipment

 

Assets acquired by Delek in conjunction with acquisitions are recorded at estimated fair market value in accordance with the purchase method of accounting as prescribed in SFAS No. 141, Business Combinations. Other acquisitions of property and equipment are carried at cost. Betterments, renewals and extraordinary repairs that extend the life of the asset are capitalized. Maintenance and repairs are charged to expense as incurred. Delek owns certain fixed assets on leased locations and depreciates these assets and asset improvements over the lesser of management’s estimated useful lives of the assets or the remaining lease term.

 

Depreciation is computed using the straight-line method over management’s estimated useful lives of the related assets, which are as follows:

 

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Property, plant and equipment and accumulated depreciation by reporting segment as of and for the three and nine months ended September 30, 2008 are as follows (in millions):

 

 

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, Delek evaluates the realizability of property, plant and equipment as events occur that might indicate potential impairment. We do not believe any property, plant and equipment impairment exists as of September 30, 2008.

 

Capitalized Interest

 

Delek had several capital construction projects in the refining segment and construction related to the new “prototype” stores being built in the retail segment. The refining segment capitalized interest of $0.5 million and $2.7 million, respectively, for the three and nine months ended September 30, 2008 and $0.5 million and $1.0 million, respectively, for the three and nine months ended September 30, 2007. The retail segment capitalized a nominal amount of interest during the three months ended September 30, 2008 and $0.2 million of interest for the nine months ended September 30, 2008. For both the three and nine months ended September 30, 2007, the retail segment capitalized $0.1 million. The marketing segment did not capitalize interest for the three or nine months ended September 30, 2008 or 2007.

 

Refinery Turnaround Costs

 

Refinery turnaround costs are incurred in connection with planned shutdowns and inspections of the refinery’s major units to perform necessary repairs and replacements. Refinery turnaround costs are deferred when incurred, classified as property, plant and equipment and amortized on a straight-line basis over that period of time estimated to lapse until the next planned turnaround occurs. Refinery turnaround costs include, among other things, the cost to repair, restore, refurbish or replace refinery equipment such as vessels, tanks, reactors, piping, rotating equipment, instrumentation, electrical equipment, heat exchangers and fired heaters. During December 2005, we successfully completed a major turnaround covering the fluid catalytic cracking unit, sulfuric acid alkylation unit, sulfur recovery unit, amine unit and kerosene and gasoline treating units. Turnaround activities for other units are currently expected to occur during late 2009.

 

Goodwill

 

Goodwill is accounted for under the provisions of SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142). This statement addresses how intangible assets and goodwill should be accounted for upon and after their acquisition. Specifically, goodwill and intangible assets with indefinite useful lives are not amortized, but are subject to annual impairment tests based on their estimated fair value. In accordance with the provisions of SFAS 142, we perform an annual review of impairment of goodwill in the fourth quarter by comparing the carrying value of the applicable reporting unit to its estimated fair value. Additionally, goodwill is tested for impairment between annual reviews if an event occurs such that it would be more likely than not that a reduction in carrying amount has occurred. If the reporting unit’s carrying amount exceeds its fair value,

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

the impairment test must be completed by comparing the implied fair value of the reporting unit’s goodwill to its carrying amount. If the implied fair value is less than the carrying amount, a goodwill impairment charge is recorded. We do not believe any goodwill impairment existed as of September 30, 2008.

 

Derivatives

 

Delek records all derivative financial instruments, including interest rate swap agreements, interest rate cap agreements, fuel-related derivatives, OTC future swaps and forward contracts at estimated fair value regardless of their intended use in accordance with the provisions of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities (SFAS 133), as amended and interpreted. Changes in the fair value of the derivative instruments are recognized periodically in operations unless we elect to apply the hedge accounting treatment permitted under the provisions of SFAS 133 which allows such changes to be classified as other comprehensive income. We validate the fair value of all derivative financial instruments on a monthly basis, utilizing valuations from third party financial and brokerage institutions.

 

The company’s policy under the guidance of FASB Staff Position No. FIN 39-1, Amendment of FASB Interpretation No. 39 (FSP 39-1), is to offset the fair value amounts recognized for our derivative postions with a counterparty against the cash collateral arising from these derivative positions.

 

Fair Value of Financial Instruments

 

Effective January 1, 2008, Delek adopted the provisions of SFAS No. 157, Fair Value Measurements (SFAS 157), which pertain to certain balance sheet items measured at fair value on a recurring basis. SFAS 157 defines fair value, establishes a framework for measuring fair value and expands disclosures about such measurements that are permitted or required under other accounting pronouncements. While SFAS 157 may change the method of calculating fair value, it does not require any new fair value measurements. See Note 9 for further discussion.

 

Effective January 1, 2008, Delek adopted the provisions of SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — an amendment of FASB Statement No. 115 (SFAS 159). This statement permits the election to carry financial instruments and certain other items similar to financial instruments at fair value on the balance sheet, with all changes in fair value reported in earnings. By electing the fair value option in conjunction with a derivative, an entity can achieve an accounting result similar to a fair value hedge without having to comply with complex hedge accounting rules. At January 1, 2008, we did not make the fair value election for any financial instruments not already carried at fair value in accordance with other accounting standards, so the adoption of SFAS 159 did not impact our condensed consolidated financial statements.

 

Self-Insurance Reserves

 

Delek is primarily self-insured for employee medical, workers’ compensation and general liability costs, with varying limits of per claim and aggregate stop loss insurance coverage in amounts determined reasonable by management. We maintain an accrual for these costs based on claims filed and an estimate of claims incurred but not reported. Differences between actual settlements and recorded accruals are recorded in the period identified.

 

Vendor Discounts and Deferred Revenue

 

Delek receives cash discounts or cash payments from certain vendors related to product promotions based upon factors such as quantities purchased, quantities sold, merchandise exclusivity, store space and various other factors. In accordance with Emerging Issues Task Force (EITF) 02-16, Accounting by a Reseller for Consideration Received from a Vendor, we recognize these amounts as a reduction of inventory until the

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

products are sold, at which time the amounts are reflected as a reduction in cost of goods sold. Certain of these amounts are received from vendors related to agreements covering several periods. These amounts are initially recorded as deferred revenue, are reclassified as a reduction in inventory upon receipt of the products, and are subsequently recognized as a reduction of cost of goods sold as the products are sold.

 

Delek also receives advance payments from certain vendors relating to non-inventory agreements. These amounts are recorded as deferred revenue and are subsequently recognized as a reduction of cost of goods sold as earned.

 

Environmental Expenditures

 

It is Delek’s policy to accrue environmental and clean-up related costs of a non-capital nature when it is both probable that a liability has been incurred and the amount can be reasonably estimated. Environmental liabilities represent the current estimated costs to investigate and remediate contamination at our properties. This estimate is based on internal and third-party assessments of the extent of the contamination, the selected remediation technology and review of applicable environmental regulations, typically considering estimated activities and costs for the next 15 years, unless a specific longer range estimate is practicable. Accruals for estimated costs from environmental remediation obligations generally are recognized no later than completion of the remedial feasibility study and include, but are not limited to, costs to perform remedial actions and costs of machinery and equipment that is dedicated to the remedial actions and that does not have an alternative use. Such accruals are adjusted as further information develops or circumstances change. Expenditures for equipment necessary for environmental issues relating to ongoing operations are capitalized.

 

Asset Retirement Obligations

 

Delek recognizes liabilities which represent the fair value of a legal obligation to perform asset retirement activities, including those that are conditioned on a future event when the amount can be reasonably estimated. In the retail segment these obligations relate to the net present value of estimated costs to remove underground storage tanks at owned retail sites and at those leased retail sites for which tank removal is legally required under the applicable leases. The asset retirement obligation for storage tank removal on retail sites is being accreted over the expected life of the owned retail site or the average retail site lease term. In the refining segment, these obligations relate to the required disposal of waste in certain storage tanks, asbestos abatement at an identified location and other estimated costs that would be legally required upon final closure of the refinery. In the marketing segment, these obligations relate to the required cleanout of the pipeline and terminal tanks, and removal of certain above-grade portions of the pipeline situated on right-of-way property.

 

The reconciliation of the beginning and ending carrying amounts of asset retirement obligations as of September 30, 2008 and December 31, 2007 is as follows (in millions):

 

 

 

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

 

In order to determine fair value, management must make certain estimates and assumptions including, among other things, projected cash flows, a credit-adjusted risk-free rate and an assessment of market conditions that could significantly impact the estimated fair value of the asset retirement obligation.

 

Revenue Recognition

 

Revenues for products sold are recorded at the point of sale upon delivery of product, which is the point at which title to the product is transferred, and when payment has either been received or collection is reasonably assured.

 

Delek derives service revenue from the sale of lottery tickets, money orders, car washes and other ancillary product and service offerings. Service revenue and related costs are recorded at gross amounts and net amounts, as appropriate, in accordance with the provisions of EITF 99-19, Reporting Revenue Gross as a Principal Versus Net as an Agent. We record service revenue and related costs at gross amounts when Delek is the primary obligor, is subject to inventory risk, has latitude in establishing prices and selecting suppliers, influences product or service specifications, or has several but not all of these indicators. When Delek is not the primary obligor and does not possess other indicators of gross reporting as discussed previously, we record net service revenue.

 

Cost of Goods Sold and Operating Expenses

 

For the retail segment, cost of goods sold comprises the costs of specific products sold. Operating expenses include costs such as wages of employees at the stores, lease and utilities expense for the stores, credit card interchange transaction charges and other costs of operating the stores. For the refining segment, cost of goods sold includes all the costs of crude oil, feedstocks and external costs. Operating expenses include the costs associated with the actual operations of the refinery. For the marketing segment, cost of goods sold includes all costs of refined products, additives and related transportation. Operating expenses include the costs associated with the actual operation of owned and leased terminals, terminaling expense at third-party locations and pipeline maintenance costs.

 

Sales, Use and Excise Taxes

 

Delek’s policy is to exclude sales, use and excise taxes from revenue when we are an agent of the taxing authority, in accordance with EITF 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (that is, Gross versus Net Presentation).

 

Deferred Financing Costs

 

Deferred financing costs represent expenses related to issuing our long-term debt and obtaining our lines of credit. These amounts are amortized over the remaining term of the respective financing and are included in interest expense. See Note 6 for further information.

 

Advertising Costs

 

Delek expenses advertising costs as the advertising space is utilized. Advertising expense for the three and nine months ended September 30, 2008 was $0.5 million and $1.7 million, respectively, and $0.5 million and $1.5 million, respectively, for the three and nine months ended September 30, 2007.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Operating Leases

 

Delek leases land and buildings under various operating lease arrangements, most of which provide the option, after the initial lease term, to renew the leases. Some of these lease arrangements include fixed rental rate increases, while others include rental rate increases based upon such factors as changes, if any, in defined inflationary indices.

 

In accordance with SFAS No. 13, Accounting for Leases, for all leases that include fixed rental rate increases, Delek calculates the total rent expense for the entire lease period, considering renewals for all periods for which failure to renew the lease imposes economic penalty, and records rental expense on a straight-line basis in the accompanying condensed consolidated statements of operations.

 

Income Taxes

 

Income taxes are accounted for under the provisions of SFAS No. 109, Accounting for Income Taxes. This statement generally requires Delek to record deferred income taxes for the differences between the book and tax bases of its assets and liabilities, which are measured using enacted tax rates and laws that will be in effect when the differences are expected to reverse. Deferred income tax expense or benefit represents the net change during the year in our deferred income tax assets and liabilities.

 

In July 2006, the FASB issued FIN 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109, Accounting for Income Taxes (FIN 48). FIN 48, which is the most significant change to accounting for income taxes since the adoption of the liability approach, prescribes a comprehensive model for how companies should recognize, measure, present and disclose in their financial statements uncertain tax positions taken or expected to be taken on a tax return. The interpretation clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. In addition, FIN 48 clearly scopes out income taxes from SFAS No. 5, Accounting for Contingencies. The interpretation also revises disclosure requirements to include an annual tabular rollforward of unrecognized tax benefits.

 

Delek adopted the provisions of FIN 48 effective January 1, 2007. The adoption of the interpretation to all of Delek’s tax positions resulted in an increase in the liability for unrecognized tax benefits and a cumulative effect adjustment of $0.1 million recognized as an adjustment to retained earnings. At January 1, 2007, Delek had unrecognized tax benefits of $0.2 million which, if recognized, would affect our effective tax rate. There was an increase of $4.2 million to the liability for unrecognized tax benefits related to timing differences during the three and nine months ended September 30, 2008, which also resulted in the reduction of a corresponding deferred tax liability. This increase in the unrecognized tax benefits resulted from a tax law change enacted at the end of 2007 but which was retroactive for two prior year filings. There were no significant changes in the liability during the three or nine months ended September 30, 2007. Delek anticipates remittance to the IRS of $4.2 million as a result of previously unrecognized tax liabilities associated with the 2006 and 2007 filed returns, which will be amended in the next 12 months.

 

Delek files a consolidated U.S. federal income tax return, as well as income tax returns in various state jurisdictions. Delek is no longer subject to U.S. federal income tax examinations by tax authorities for years before 2005 or state and local income tax examinations by tax authorities for the years before 2003. The Internal Revenue Service has examined Delek’s income tax returns through 2004 and during the second quarter of 2008, began the process of examining the returns for 2005 and 2006.

 

Delek recognizes accrued interest and penalties related to unrecognized tax benefits as an adjustment to the current provision for income taxes. Interest of $0.2 million was recognized related to unrecognized tax benefits during both the three and nine months ended September 30, 2008. A nominal amount of interest was recognized related to unrecognized tax benefits during the three and nine months ended September 30, 2007.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Delek benefits from federal tax incentives related to its refinery operations. Specifically, Delek is entitled to the benefit of the domestic manufacturer’s production deduction for federal tax purposes. Additionally, in 2007 Delek was entitled to federal tax credits related to the production of ultra low sulfur diesel fuel. The combination of these two items reduces Delek’s federal effective tax rate to an amount that, for the three and nine months ended September 30, 2007, is less than the statutory rate of 35%.

 

Earnings Per Share

 

Basic and diluted earnings per share (EPS) are computed by dividing net income by the weighted average common shares outstanding. The common shares used to compute Delek’s basic and diluted earnings per share are as follows:

 

 

Outstanding stock options totaling 1,807,859 and 1,866,059 common shares were excluded from the diluted earnings per share calculation for the three and nine months ended September 30, 2008, respectively. Outstanding stock options totaling 816,438 and 1,563,388 common shares were excluded from the diluted earnings per share calculation for the three and nine months ended September 30, 2007, respectively. These share equivalents did not have a dilutive effect under the treasury stock method.

 

Shareholders’ Equity

 

On August 6, 2008, Delek announced that its Board of Directors voted to declare a quarterly cash dividend of $0.0375 per common share, payable to shareholders of record on August 27, 2008. This dividend was paid on September 17, 2008.

 

Stock-Based Compensation

 

SFAS No. 123R, Share Based Payment (SFAS 123R) requires the use of a valuation model to calculate the fair value of stock-based awards. Delek uses the Black-Scholes-Merton option-pricing model to determine the fair value of stock-based awards as of the date of grant.

 

Restricted stock units (RSUs) are measured based on the fair market value of the underlying stock on the date of grant. Vested RSUs are not issued until the minimum statutory withholding requirements have been remitted to us for payment to the taxing authority. As a result, the actual number of shares accounted for as issued may be less than the number of RSUs vested, due to any withholding amounts which have not been remitted.

 

We generally recognize compensation expense related to stock-based awards with graded or cliff vesting on a straight-line basis over the vesting period.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Comprehensive Income

 

For the three and nine months ended September 30, 2008, comprehensive income includes net income and changes in the fair value of derivative instruments designated as cash flow hedges. Comprehensive income for the three and nine months ended September 30, 2007 was equivalent to net income (in millions).

 

 

New Accounting Pronouncements

 

In December 2007, the FASB issued SFAS No. 141 (Revised), Business Combinations (SFAS 141(R)). This statement will apply to all transactions in which an entity obtains control of one or more other businesses. In general, SFAS 141(R) requires the acquiring entity in a business combination to recognize the fair value of all the assets acquired and liabilities assumed in the transaction; establishes the acquisition-date as the fair value measurement point; and modifies the disclosure requirements. This statement applies prospectively to business combinations for which the acquisition date is on or after January 1, 2009. However, accounting for changes in valuation allowances for acquired deferred tax assets and the resolution of uncertain tax positions for prior business combinations will impact tax expense instead of impacting the prior business combination accounting starting January 1, 2009. We are currently evaluating the changes provided in this statement.

 

Also in December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements — an amendment of ARB No. 51 (SFAS 160), which changes the classification of non-controlling interests, sometimes called a minority interest, in the consolidated financial statements. Additionally, this statement establishes a single method of accounting for changes in a parent company’s ownership interest that do not result in deconsolidation and requires a parent company to recognize a gain or loss when a subsidiary is deconsolidated. This statement is effective January 1, 2009, and will be applied prospectively with the exception of the presentation and disclosure requirements which must be applied retrospectively. Delek has no minority interest reporting in its consolidated reporting, therefore adoption of SFAS 160 is not expected to have an impact on its financial position or results of operations.

 

In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities, an amendment of FASB Statement No. 133 (SFAS 161). SFAS 161 applies to all derivative instruments and nonderivative instruments that are designated and qualify as hedging instruments pursuant to paragraphs 37 and 42 of SFAS 133 and related hedged items accounted for under SFAS 133. The standard requires entities to provide greater transparency through additional disclosures about how and why an entity uses derivative instruments, how derivative instruments and related hedged items are accounted for under SFAS 133 and its related interpretations, and how derivative instruments and related hedged items affect an entity’s financial position, results of operations, and cash flows. SFAS 161 is effective for financial statements issued for fiscal years beginning after November 15, 2008. Delek will adopt SFAS 161 effective January 1, 2009. We are currently evaluating the potential effect of this statement on our financial position or results of operations.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

 

Carrying value of inventories consisted of the following (in millions):

 

 

At September 30, 2008 and December 31, 2007, the excess of replacement cost (FIFO) over the carrying value (LIFO) of refinery inventories was $35.7 million and $47.6 million, respectively.

 

Delek estimates LIFO valuations on a quarterly basis, assuming these valuations reflect expected year-end inventory results. However, actual LIFO valuations are made on an annual basis using year-end quantities and market values.

 

Temporary Liquidations

 

During the three months ended September 30, 2008, we carried a temporary LIFO liquidation gain in our refinery inventory of $8.1 million, which we expect to be restored by the end of the year. The temporary LIFO liquidation gain has been deferred as a component of accrued expenses and other current liabilities in the accompanying September 30, 2008 condensed consolidated balance sheet.

 

During the three months ended September 30, 2007, we carried a temporary LIFO liquidation gain in our refinery inventory of $0.1 million, which was restored by the end of the year. The temporary LIFO liquidation gain was deferred as a component of accrued expenses and other current liabilities.

 

Permanent Liquidations

 

During the first half of 2008, we incurred a permanent reduction in the LIFO layer resulting in a liquidation in our refinery work in process and finished goods inventories in the amount of $14.9 million and during the three months ended September 30, 2008, we incurred a change in the value of this reduction in the LIFO layer resulting in a liquidation loss of $7.9 million. The total liquidation gain incurred for the nine months ended September 30, 2008 was $7.0 million. This liquidation, which represents a reduction of approximately 177,000 barrels, was recognized as a reduction of cost of goods sold in the nine months ended September 30, 2008.

 

During the three months ended September 30, 2007, we incurred a permanent reduction in the LIFO layer resulting in a liquidation gain in our refinery finished goods inventory in the amount of $1.3 million, in addition to the permanent reduction incurred during the first half of 2007 in the amount of $2.0 million. The total liquidation gain incurred in the nine months ended September 30, 2007 was $3.3 million. This liquidation gain represents a reduction of approximately 162,000 barrels and was recognized as a reduction of cost of goods sold in the nine months ended September 30, 2007.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

 

Calfee Acquisition

 

In the first quarter of 2007, Delek, through its Express subsidiary, agreed to purchase 107 retail fuel and convenience stores located in northern Georgia and eastern Tennessee, and related assets, from the Calfee Company of Dalton, Inc. and its affiliates (the Calfee acquisition). We completed the purchase of 103 stores and assumed the management of all 107 stores in the second quarter of 2007. The purchase of the remaining four locations closed on July 27, 2007. Of the 107 stores, Delek owns 70 of the properties and assumed leases for the remaining 37 properties. Delek purchased the assets for approximately $71.8 million, including $0.1 million of cash. In addition to the consideration paid as acquisition cost for the Calfee acquisition, Delek incurred and capitalized $2.9 million in acquisition transaction costs. We recognized goodwill in connection with this acquisition and believe it is related to the synergy that is created in combining these retail stores with others in our chain to establish MAPCO as a market leader in the Chattanooga and northern Georgia corridor. The allocation of the aggregate purchase price of the Calfee acquisition is summarized as follows (in millions):

 

 

The Calfee acquisition was accounted for using the purchase method of accounting, as prescribed in SFAS 141, and the results of operations associated with the Calfee stores have been included in the accompanying condensed consolidated statements of operations from the date of acquisition. The purchase price was allocated to the underlying assets and liabilities based on their estimated fair values. Delek has finalized the valuation work associated with certain intangibles. During the nine months ended September 30, 2008, the final allocation of the Calfee acquisition purchase price resulted in a net increase to goodwill of $2.6 million.

 

 

Investment in Lion Oil Company

 

On August 22, 2007, Delek completed the acquisition of approximately 28.4% of the issued and outstanding shares of common stock of Lion Oil Company (Lion Oil). On September 25, 2007, Delek completed the acquisition of an additional approximately 6.2% of the issued and outstanding shares of Lion Oil, bringing its total ownership interest to approximately 34.6%. Total cash consideration paid to the sellers by Delek in both transactions totaled approximately $88.2 million. Delek also incurred and capitalized $0.9 million in acquisition transaction costs. In addition to cash consideration, Delek issued to one of the sellers 1,916,667 unregistered shares of Delek common stock, par value $0.01 per share, valued at $51.2 million using the closing price of our stock on the date of the acquisition. As of September 30, 2008, our total investment in Lion Oil was $131.6 million.

 

Lion Oil, a privately held Arkansas corporation, owns and operates a 75,000 barrel per day, crude oil refinery in El Dorado, Arkansas, three crude oil pipelines, a crude oil gathering system and two refined petroleum product terminals in Memphis and Nashville, Tennessee. The two terminals supply products to some of Delek’s 180 convenience stores in the Memphis and Nashville markets. These product purchases are made

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

at market value and totaled $2.0 million and $10.4 million during the three and nine months ended September 30, 2008, respectively.

 

Delek includes its proportionate share of the operating results of Lion Oil in its consolidated statements of operations two months in arrears. We do not believe this lag has a material adverse effect on our financial statements. These results are reported in earnings or loss from equity method investment. Summarized unaudited financial information of Delek’s proportionate share of Lion Oil is as follows (in millions):

 

 

 

In addition to the net loss above, Delek recognized $0.1 and $0.8 million in amortization of the equity investment for the three and nine months ended September 30, 2008, respectively. The difference between the cost of Delek’s investment in Lion Oil and its share of underlying equity in the net assets of Lion Oil is attributable to the difference between the fair value at the date of acquisition and Lion Oil’s historical cost. The portion of the difference attributable to the refinery is being amortized over the estimated remaining useful life at the date of acquisition, which is 25 years. The remaining difference is attributable to base levels of inventory which will be recognized when the base level of inventory is liquidated.

 

 

Outstanding borrowings under Delek’s existing debt instruments and capital lease obligations are as follows (in millions):

 

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Senior Secured Credit Facility

 

The senior secured credit facility consists of a $120.0 million revolving credit facility and $165.0 million term loan facility which as of September 30, 2008, had $17.0 million outstanding under the revolver and $131.2 million outstanding under the term loan. As of September 30, 2008, Lehman Commercial Paper Inc. (LCPI) was the administrative agent and a lender under the facility. As of the same date, Express had been informed by LCPI that it would not be funding its pro rata lender participation of future borrowings under the revolving credit facility. Since the communication of its intention through the date of this filing, LCPI has not participated in any borrowings by Express under the revolving credit facility. LCPI’s commitment amount under the revolving credit facility is $12 million. However, the unavailability of LCPI’s pro rata lender participation in the revolving credit facility is not expected to have a material impact on Express’s liquidity or its operations. Borrowings under the senior secured credit facility are secured by substantially all the assets of MAPCO Express, Inc. and its subsidiaries. Letters of credit outstanding under the facility totaled $20.4 million as of September 30, 2008. The senior secured credit facility term loan requires quarterly principal payments of approximately 0.25% of the principal balance through March 31, 2011 and a balloon payment of approximately 94.25% of the principal balance due upon maturity on April 28, 2011. We are also required to make certain prepayments of this facility depending on excess cash flow as defined in the credit agreement. In accordance with this excess cash flow calculation, we prepaid $9.5 million in March 2008. In June 2008, Express sold real property operated by a third party for $3.9 million. In September 2008, Express sold its leasehold interest in a location it operated for $4.5 million. The proceeds of the June sale, net of expenses, were used to pay down the term loan, while the net proceeds of the September sale were retained, pursuant to the terms of the facility, for asset reinvestment purposes. The senior secured credit facility revolver is payable in full upon maturity on April 28, 2010. The senior secured credit facility term and senior secured credit facility revolver loans bear interest based on predetermined pricing grids which allow us to choose between a “Base Rate” or “Eurodollar” rate. Interest is payable quarterly for Base Rate loans and for the applicable interest period on Eurodollar loans. At September 30, 2008, the weighted average borrowing rate was approximately 4.9% for the senior secured credit facility term loan and 5.6% for the senior secured credit facility revolver. Additionally, the senior secured credit facility requires us to pay a quarterly fee of 0.5% per year on the average available revolving commitment under the senior secured credit facility revolver. Amounts available under the senior secured revolver as of September 30, 2008 were approximately $70.6 million excluding the commitment of LCPI as a lender under this facility.

 

We are required to comply with certain financial and non-financial covenants under the senior secured credit facility. We were in compliance with all covenant requirements as of September 30, 2008.

 

SunTrust ABL Revolver

 

On October 16, 2006, we amended and restated our existing asset-based revolving credit facility. The amended and restated agreement, among other things, increased the size of the facility from $250 to $300 million, including a $300 million sub-limit for letters of credit, and extended the maturity of the facility by one year to April 28, 2010. The revolving credit agreement bears interest based on predetermined pricing grids that allow us to choose between a “Base Rate” or “Eurodollar” rate. Interest is payable quarterly for Base Rate loans and for the applicable interest period on Eurodollar loans. Availability under the SunTrust ABL revolver is determined by a borrowing base defined in the SunTrust ABL revolver, supported primarily by cash, certain accounts receivable and inventory.

 

In addition, the SunTrust ABL revolver supports our issuances of letters of credit used primarily in connection with the purchases of crude oil for use in our refinery that at no time may exceed the aggregate borrowing capacity available under the SunTrust ABL revolver. As of September 30, 2008, we had no outstanding borrowings under the agreement but had letters of credit outstanding totaling approximately

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

$137.4 million. Excess collateral capacity under the SunTrust ABL revolver as of September 30, 2008 was $85.7 million, measured above the block reserve requirement under the facility of $15 million.

 

The SunTrust ABL revolver contains a negative covenant that prohibits us from creating, incurring or assuming any liens, mortgages, pledges, security interests or other similar arrangements against the property, plant and equipment of the refinery, subject to customary exceptions for certain permitted liens.

 

Under the SunTrust ABL revolver, we are also subject to certain non-financial covenants and, in the event that our availability under the borrowing base is less than $45.0 million on any given measurement date we are also subject to certain reporting obligations. If our borrowing base is less than $30.0 million on any given measurement date, we will further be subject to certain financial covenants. We were in compliance with all covenant requirements as of September 30, 2008.

 

Fifth Third Revolver

 

In conjunction with the Pride Acquisition discussed in Note 1, on July 27, 2006, Delek executed a short-term revolver with Fifth Third Bank, as administrative agent, in the amount of $50.0 million. The proceeds of this revolver were used to fund the working capital needs of our then new subsidiary, Delek Marketing & Supply, LP. The Fifth Third revolver initially matured on July 30, 2007, but on July 27, 2007 the maturity was extended until January 31, 2008. On December 19, 2007, we amended and restated our existing revolving credit facility. The amended and restated agreement, among other things, increased the size of the facility from $50.0 to $75.0 million, including a $25.0 million sub-limit for letters of credit, and extended the maturity of the facility to December 19, 2012. The revolver bears interest at our election at either (x) a spread of 1.5% to 2.5%, as determined by a leverage-based pricing matrix, over the LIBOR for the applicable interest period or (y) a spread of 0.0% to 1.0%, as determined by the same matrix, over Fifth Third’s base rate. Borrowings under the Fifth Third revolver are secured by substantially all of the assets of Delek Marketing & Supply, LP. As of September 30, 2008, the weighted average borrowing rate for amounts borrowed was 4.0%. We had letters of credit outstanding of $23.0 million as of September 30, 2008. Amounts available under the Fifth Third revolver as of September 30, 2008 were approximately $50.0 million. We are required to comply with certain financial and non-financial covenants under this revolver. We were in compliance with all covenant requirements as of September 30, 2008.

 

Lehman Credit Agreement

 

On March 30, 2007, Delek entered into a credit agreement with LCPI, as administrative agent, Lehman Brothers Inc., as arranger and joint book runner, and JPMorgan Chase Bank, N.A., as documentation agent, arranger and joint book runner. The credit agreement provides for unsecured loans of $65.0 million, the proceeds of which were used to pay a portion of the acquisition costs for the assets of Calfee Company of Dalton, Inc. and affiliates, and to pay related costs and expenses in April 2007. The current amount outstanding under this agreement is $45.0 million. The loans become due on March 30, 2009 and bear interest, at Delek’s election in accordance with the terms of the credit agreement, at either a Base Rate or Eurodollar rate, plus in each case, an applicable margin of initially 1.0% in respect of Base Rate loans, and 2.0% in respect of Eurodollar loans, which applicable margin is subject to increase depending on the number of days the loan remains outstanding. Interest is payable quarterly for Base Rate loans and for the applicable interest period for Eurodollar loans. As of September 30, 2008, the weighted average borrowing rate was 6.0%. This agreement was amended in June 2008 to redefine certain financial covenants required under the agreement. We are required to comply with certain financial and non-financial covenants under this credit agreement. We were in compliance with all covenant requirements as of September 30, 2008.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Promissory Notes

 

On May 23, 2006, Delek executed a $30.0 million promissory note in favor of Israel Discount Bank of New York (IDB Note). The proceeds of this note were used to repay the existing promissory notes in favor of Israel Discount Bank and Bank Leumi US. The IDB Note matures on May 30, 2009, and bears interest, payable semi-annually, at a spread of 2.0% over the LIBOR, for interest periods of 30, 60, 90 or 180 days as selected by us. As of September 30, 2008 the weighted average borrowing rate for amounts borrowed under the IDB Note was 5.2%. We are not required to comply with any financial or non-financial covenants under this note.

 

On July 27, 2006, we executed a $30.0 million promissory note in favor of Bank Leumi USA. The proceeds of this note were used to fund a portion of the Pride Acquisition and its working capital needs. This note matures on July 27, 2009, and bears interest, payable for the applicable interest period, at a spread of 2.0% per year over the LIBOR rate (Reserve Adjusted) for interest periods of 30, 90 or 180 days. As of September 30, 2008, the weighted average borrowing rate for amounts borrowed under the Bank Leumi Note was 5.8%. We are not required to comply with any financial or non-financial covenants under this note.

 

On May 12, 2008, we executed a second promissory note in favor of Bank Leumi USA for $20.0 million. The proceeds of this note were used to reduce short term debt and for working capital needs. This note matures on May 11, 2011, and bears interest, payable for the applicable interest period, at a spread of 2.825% per year over the LIBOR rate (Reserve Adjusted) for interest periods of 30 or 90 days. As of September 30, 2008, the weighted average borrowing rate for amounts borrowed under the Bank Leumi Note was 5.3%. We are required to comply with certain financial and non-financial covenants under this credit agreement. We were in compliance with all covenant requirements as of September 30, 2008.

 

Reliant Bank Revolver

 

On March 28, 2008, we entered into a revolving credit agreement with Reliant Bank, a Tennessee bank, headquartered in Brentwood, Tennessee. The credit agreement provides for unsecured loans of up to $12.0 million and we had no borrowings under this facility as of September 30, 2008. Any borrowings become due on March 28, 2011 and bear interest, payable for the applicable interest period, at a spread of 2.5% per year over the 30 day LIBOR rate. This agreement was amended in September 2008 to conform certain portions of the financial covenant definition with those contained in some of our other credit agreements. We are required to comply with certain financial and non-financial covenants under this revolver. We were in compliance with all covenant requirements as of September 30, 2008.

 

Letters of Credit

 

As of September 30, 2008, Delek had in place letters of credit totaling approximately $184.0 million with various financial institutions securing obligations with respect to its workers’ compensation and general liability self-insurance programs, as well as purchases of crude oil for the refinery, purchases of refined product for our marketing segment and fuel for our retail fuel and convenience stores. No amounts were outstanding under these facilities at September 30, 2008.

 

Interest-Rate Derivative Instruments

 

Delek had interest rate cap agreements in place totaling $75.0 million and $98.8 million of notional principal amounts at September 30, 2008 and December 31, 2007, respectively. These agreements are intended to economically hedge floating rate debt related to our current borrowings under the senior secured credit facility. However, as we have elected to not apply the permitted hedge accounting treatment, including formal hedge designation and documentation, in accordance with the provisions of SFAS 133, as amended, the fair value of the derivatives is recorded in other non-current assets in the accompanying consolidated balance

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

sheets with the offset recognized in earnings. The derivative instruments mature on various dates ranging from March 2009 through July 2010. The estimated fair value of interest rate swap and interest rate cap agreements at September 30, 2008 and December 31, 2007 totaled $0.2 million and $1.0 million, respectively.

 

In accordance with SFAS 133, as amended, we recorded non-cash expense (income) representing the change in estimated fair value of the interest rate cap agreements of $0.1 million and $0.8 million for the three and nine months ended September 30, 2008, respectively, and $(0.4) million and $0.2 million for the three and nine months ended September 30, 2007, respectively.

 

While Delek has not elected to apply permitted hedge accounting treatment in accordance with the provisions of SFAS No. 133 in the past, we may choose to elect that treatment in future transactions.

 

 

In April 2006, Delek’s Board of Directors adopted the Delek US Holdings, Inc. 2006 Long-Term Incentive Plan (the Plan) pursuant to which Delek may grant stock options, stock appreciation rights, restricted stock, restricted stock units and other stock-based awards of up to 3,053,392 shares of Delek’s common stock to certain directors, officers, employees, consultants and other individuals who perform services for Delek or its affiliates. The options granted under the Plan are granted at market price or higher. In approximately 75% of the grants, vesting occurs ratably over a period from three to five years. In approximately 25% of the grants, vesting occurs at the end of the fourth year. All of the options granted require continued service in order to vest in the option.

 

Compensation Expense Related to Equity-based Awards

 

Compensation expense for the equity-based awards amounted to $0.8 million ($0.5 million, net of taxes) and $2.5 million ($1.7 million, net of taxes) for the three and nine months ended September 30, 2008, respectively, and $0.9 million ($0.6 million, net of taxes) and $2.4 million ($1.7 million, net of taxes) for the three and nine months ended September 30, 2007, respectively. These amounts are included in general and administrative expenses in the accompanying consolidated statements of operations.

 

As of September 30, 2008, there was $5.1 million of total unrecognized compensation cost related to non-vested share-based compensation arrangements, which is expected to be recognized over a weighted-average period of 1.3 years.

 

 

We report our operating results in three reportable segments: refining, marketing and retail. Decisions concerning the allocation of resources and assessment of operating performance are made based on this segmentation. Management measures the operating performance of each of its reportable segments based on the segment contribution margin.

 

Segment contribution margin is defined as net sales less cost of sales and operating expenses, excluding depreciation and amortization. Operations which are not specifically included in the reportable segments are included in the corporate and other category, which primarily consists of operating expenses, depreciation and amortization expense and interest income and expense associated with corporate headquarters.

 

The refining segment processes crude oil that is transported through our crude oil pipeline and an unrelated third-party pipeline. The refinery processes the crude and other purchased feedstocks for the manufacture of transportation motor fuels including various grades of gasoline, diesel fuel, aviation fuel and other petroleum-based products that are distributed through its product terminal located at the refinery.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Our marketing segment sells refined products on a wholesale basis in West Texas through company-owned and third-party operated terminals. This segment also provides marketing services to the Tyler refinery.

 

Our retail segment markets gasoline, diesel, other refined petroleum products and convenience merchandise through a network of company-operated retail fuel and convenience stores throughout the southeastern United States. As of September 30, 2008, we had 495 stores in total consisting of 263 located in Tennessee, 94 in Alabama, 81 in Georgia, 36 in Virginia and 14 in Arkansas. The remaining 7 stores are in Kentucky, Louisiana and Mississippi. The retail fuel and convenience stores operate under Delek’s brand names MAPCO Express^® , MAPCO Mart^® , East Coast^® , Discount Food Mart^tm, Fast Food and Fuel^tm and Favorite Markets^® brands. In the retail segment, management reviews operating results on a divisional basis, where a division represents a specific geographic market. Management reporting also provides tracking of product sales across the system, activity associated with specific acquisitions and activity by brand. These divisional operating segments exhibit similar economic characteristics, provide the same products and services, and operate in such a manner such that aggregation of these operations is appropriate for segment presentation.

 

Our refining business has a services agreement with our marketing segment, which among other things, requires the refining segment to pay service fees to the marketing segment based on the number of gallons sold at the Tyler refinery and a sharing of a portion of the marketing margin achieved in return for providing marketing, sales and customer services. This intercompany transaction fee was $4.8 million and $10.8 million in the three and nine months ended September 30, 2008, respectively, and $4.2 million and $11.7 million in the three and nine months ended September 30, 2007, respectively. All inter-segment transactions have been eliminated in consolidation.

 

The following is a summary of business segment operating performance as measured by contribution margin for the period indicated (in millions):

 

 

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

 

 

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

 

 

 

 

Fair Value Measurements

 

Effective January 1, 2008, Delek adopted SFAS No. 157, Fair Value Measurements (SFAS 157), which defines fair value, establishes a framework for its measurement and expands disclosures about fair value measurements. We elected to implement this statement with the one-year deferral permitted by FASB Staff Position (FSP) 157-2 for nonfinancial assets and nonfinancial liabilities measured at fair value, except those that are recognized or disclosed on a recurring basis (at least annually.) The deferral applies to nonfinancial assets and liabilities measured at fair value in a business combination; impaired properties, plant and equipment; intangible assets and goodwill; and initial recognition of asset retirement obligations and restructuring costs for which we use fair value. We are still evaluating the potential impact to our consolidated financial statements from implementation of the standard for these assets and liabilities.

 

Due to our election under FSP 157-2, for 2008, SFAS 157 applies to interest rate and commodity derivatives that are measured at fair value on a recurring basis in periods subsequent to initial recognition. The implementation of SFAS 157 did not cause a change in the method of calculating fair value of our assets and liabilities with the exception of assessing the impact of nonperformance risk on derivatives, which is not considered material at this time. The primary impact from adoption was additional disclosure.

 

SFAS 157 requires disclosures that categorize assets and liabilities measured at fair value into one of three different levels depending on the observability of the inputs employed in the measurement. Level 1 inputs are quoted prices in active markets for identical assets or liabilities. Level 2 inputs are observable inputs other than quoted prices included within Level 1 for the asset or liability, either directly or indirectly through

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

market-corroborated inputs. Level 3 inputs are unobservable inputs for the asset or liability reflecting our assumptions about pricing by market participants.

 

We value our exchange-cleared derivatives using unadjusted closing prices provided by the exchange as of the balance sheet date, and these are classified as Level 1 in the fair value hierarchy. Over the Counter (OTC) commodity swaps and physical commodity purchase and sale contracts are generally valued using quotations provided by brokers based on exchange pricing and/or price index developers such as PLATTS and ARGUS. These are classified as Level 2. We currently do not carry any longer-term contracts or less liquid contracts, as all of our derivatives are supported by actively traded futures markets.

 

Exchange-cleared financial and commodity options are valued using exchange closing prices and are classified as Level 1. Financial OTC swaps are valued using industry-standard models that consider various assumptions, including quoted forward prices for interest rates, time value, volatility factors and contractual prices for the underlying instruments, as well as other relevant economic measures. The degree to which these inputs are observable in the forward markets determines the classification as Level 2 or 3.

 

The fair value hierarchy for our financial assets and liabilities accounted for at fair value on a recurring basis at September 30, 2008, was (in millions):

 

 

The derivative values above are based on analysis of each contract as the fundamental unit of account as required by SFAS 157. Derivative assets and liabilities with the same counterparty are not netted, where the legal right of offset exists. This differs from the presentation in the financial statements which reflects the company’s policy under the guidance of FSP 39-1, wherein we have elected to offset the fair value amounts recognized for multiple derivative instruments executed with the same counterparty. As of September 30, 2008, $0.6 million of net derivative positions are included in other current assets and $8.0 million are included in other current liabilities, and as of December 31, 2007, $0.6 million is included in other current assets and $0.2 million is included in other current liabilities on the accompanying condensed consolidated balance sheets. As of September 30, 2008, $0.7 million of cash collateral is held by counterparty brokerage firms. These amounts have been netted against the net derivative positions with each counterparty.

 

Delek holds $5.6 million of Auction Rate Securities (ARS) which have a maturity date of May 2027 and which typically have 90 day interest rate resets. Beginning in February 2008, the auction mechanism that normally provided liquidity for this ARS investment began to fail. The three auction dates in 2008 for our investments were failed auctions. These securities are fully collateralized by floating rate non-cumulative preferred stock (series 5) of Merrill Lynch and Co., Inc. (Merrill Lynch Preferred Shares). The securities have continued to pay interest in accordance with the contractual terms of the instruments.

 

As of September 30, 2008, the ARS market remained illiquid; therefore, observable market information for the securities backed by the Merrill Lynch Preferred Shares was not available to determine the fair value of Delek’s ARS investments. We estimated the fair value relying on Level 3 inputs including those based on

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

collateral values, assessments of counterparty credit quality, default risk underlying the securities and market interest rates. The valuation of these investments is subject to uncertainties that are difficult to predict. The ongoing strength and quality of many of the factors which we used to assess fair value as of September 30, 2008, will continue to impact the value in the future. Because of the nature of the market value inputs, Delek reclassified its auction rate securities from Level 2 to Level 3 in the third quarter of 2008.

 

The following table presents the changes to Level 3 assets measured at fair value on a recurring basis for the three and nine months ended September 30, 2008 (in millions).

 

 

Gain/Loss Recognition

 

Delek uses swaps, options, futures, forwards and other derivative instruments for risk management purposes. A discussion of the accounting for each type of derivative follows.

 

Swaps

 

In December 2007, in conjunction with providing renewable E-10 products in our retail markets, we entered into a series of OTC swaps based on the futures price of ethanol as quoted on the Chicago Board of Trade which fixed the purchase price of ethanol for a predetermined number of gallons at future dates from April 2008 through December 2009. We also entered into a series of OTC swaps based on the future price of unleaded gasoline as quoted on the NYMEX which fixed the sales price of unleaded gasoline for a predetermined number of gallons at future dates from April 2008 through December 2009. Delek recorded unrealized gains (losses) of $9.3 million and $(1.1) million, respectively, during the three and nine months ended September 30, 2008, and a realized loss of $0.6 million and $0.7 million during the three and nine months ended September 30, 2008, respectively, which were included as an adjustment to cost of goods sold in the accompanying condensed consolidated statements of operations.

 

In March 2008, we entered into a series of OTC swaps based on the future price of West Texas Intermediate Crude (WTI) as quoted on the NYMEX which fixed the purchase price of WTI for a predetermined number of barrels at future dates from July 2008 through December 2009. We also entered into a series of OTC swaps based on the future price of Ultra Low Sulfur Diesel (ULSD) as quoted on the Gulf Coast ULSD PLATTS which fixed the sales price of ULSD for a predetermined number of gallons at future dates from July 2008 through December 2009.

 

In accordance with SFAS No. 133, the WTI and ULSD swaps have been designated as cash flow hedges and the change in fair value between the execution date and the end of period has been recorded in other comprehensive income. For the three and nine months ended September 30, 2008, Delek recorded unrealized gains (losses) as a component of other comprehensive income of $14.2 million ($8.8 million, net of deferred taxes) and $(8.1) million ($(5.4) million, net of deferred taxes), respectively, related to the change in the fair value of these swaps. The fair value of these contracts has been recognized in income beginning in July 2008, at the time the positions are closed and the hedged transactions are recognized in income. As of September 30, 2008, Delek had total unrealized losses, net of deferred income taxes, in accumulated other comprehensive income of $5.1 million associated with its cash flow hedges.

 

There were no outstanding swaps during the three or nine months ended September 30, 2007.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Forward Fuel Contracts

 

From time to time, Delek enters into forward fuel contracts with major financial institutions that fix the purchase price of finished grade fuel for a predetermined number of units at a future date and have fulfillment terms of less than 90 days. Delek recognized gains of $2.1 million and $1.7 million, respectively, during the three and nine months ended September 30, 2008 and less than $0.1 million and $0.5 million, respectively, during the three and nine months ended September 30, 2007, which are included as an adjustment to cost of goods sold in the accompanying condensed consolidated statements of operations.

 

Options

 

In the first quarter of 2008, Delek entered into a put option with a major financial institution that fixes the sales price of crude oil for a predetermined number of units, which expires in December 2008. Delek recorded unrealized gains (losses) of $0.3 million and $(0.1) million, respectively, during the three and nine months ended September 30, 2008, which are included as an adjustment to cost of goods sold in the accompanying condensed consolidated statements of operations. There were no option contracts outstanding during the three or nine months ended September 30, 2007.

 

Futures Contracts

 

In the first quarter of 2008, Delek entered into futures contracts with major financial institutions that fix the purchase price of crude oil and the sales price of finished grade fuel for a predetermined number of units at a future date and have fulfillment terms of less than 90 days. Delek recognized gains (losses) of $2.2 million and $(5.4) million, respectively, during the three and nine months ended September 30, 2008, which are included as an adjustment to cost of goods sold in the accompanying condensed consolidated statements of operations. There were no futures contracts outstanding during the three or nine months ended September 30, 2007.

 

Interest Rate Instruments

 

From time to time, Delek enters into interest rate swap and cap agreements that are intended to economically hedge floating rate debt related to our current borrowings. These interest rate derivative instruments are discussed in conjunction with our long term debt in Note 6.

 

 

Litigation

 

Delek is subject to various claims and legal actions that arise in the ordinary course of business. In the opinion of management, the ultimate resolution of any such matters known by management will not have a material adverse effect on Delek’s financial position or results of operations in future periods.

 

Self-insurance

 

Delek is self-insured for employee medical claims up to $0.1 million per employee per year or an aggregate cost exposure of approximately $5.5 million per year.

 

Delek is self-insured for workers’ compensation claims up to $1.0 million on a per accident basis. We self-insure for general liability claims up to $4.0 million on a per occurrence basis. We self-insure for auto liability up to $4.0 million on a per accident basis.

 

We have umbrella liability insurance available to each of our segments in an amount determined reasonable by management.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Environmental, Health and Safety

 

Delek is subject to various federal, state and local environmental laws. These laws raise potential exposure to future claims and lawsuits involving environmental matters which could include soil and water contamination, air pollution, personal injury and property damage allegedly caused by substances which we manufactured, handled, used, released or disposed. While it is often difficult to quantify future environmental-related expenditures, Delek anticipates that continuing capital investments will be required over the next several years to comply with existing regulations. We have not been named as defendant in any environmental, health or safety litigation.

 

Based upon environmental evaluations performed internally and by third parties subsequent to our purchase of the Tyler refinery, we have recorded a liability of approximately $7.8 million as of September 30, 2008 relative to the probable estimated costs of remediating or otherwise addressing certain environmental issues of a non-capital nature which were assumed in connection with the refinery acquisition. This liability includes estimated costs for on-going investigation and remediation efforts for known contaminations of soil and groundwater which were already being performed by the former owner, as well as estimated costs for additional issues which have been identified subsequent to the purchase. Approximately $2.6 million of the liability is expected to be expended over the next 12 months with the remaining balance of $5.2 million expendable by 2022.

 

In late 2004, the prior refinery owner began discussions with the Environmental Protection Agency (EPA) Region 6 and the Department of Justice (DOJ) regarding certain air quality requirements at the refinery. The prior refinery owner expected to settle the matter with EPA and the DOJ by the end of 2005, however, EPA did not present a consent decree and no discussions occurred in 2006. Nonetheless, Delek completed certain capital projects at the refinery that EPA indicated would likely be addressed in a consent decree. These projects include a new electrical substation to increase operational reliability and additional sulfur removal capacity to address upsets at the refinery.

 

In June 2007, EPA Region 6 and DOJ resumed negotiations and presented the former owner and Delek with the initial draft of the consent decree in August 2007. The companies provided comments at that time and received a revised draft consent decree in April 2008. The revised draft consent decree addresses capital projects that have either been completed or will not have a material adverse effect upon our future financial results. In addition, the proposed consent decree requires certain on-going operational changes that will increase future operating expenses at the refinery. EPA Region 6 and the DOJ have advised Delek that a final consent decree should be lodged with the United States District Court for the Eastern District of Texas by the end of 2008. At this point in time, we believe any such costs will not have a material adverse effect upon our business, financial condition or operations.

 

In October, 2007, the Texas Commission on Environmental Quality (TCEQ) approved an Agreed Order in which the Tyler refinery resolved alleged violations of air rules dating back to the acquisition of the refinery. The Agreed Order required the refinery to pay a penalty and fund a Supplemental Environmental Project for which we had previously reserved adequate amounts. In addition, the refinery was required to implement certain corrective measures, which the company has completed, with one exception. Delek has advised the TCEQ of the exception, which we believe will not result in a material adverse effect on our business, financial condition or results of operations.

 

The Federal Clean Air Act (CAA) authorizes the EPA to require modifications in the formulation of the refined transportation fuel products manufactured in order to limit the emissions associated with their final use. In December 1999, the EPA promulgated national regulations limiting the amount of sulfur to be allowed in gasoline at future dates. The EPA believes such limits are necessary to protect new automobile emission control systems that may be inhibited by sulfur in the fuel. The new regulations required the phase-in of gasoline sulfur standards beginning in 2004, with the final reduction to the sulfur content of gasoline to an annual average level of 30 parts-per-million (ppm), and a per-gallon maximum of 80 ppm to be completed by January 1, 2006. The regulation also included special provisions for small refiners or those receiving a waiver.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

Contemporaneous with the refinery purchase, Delek became a party to a Waiver and Compliance Plan with the EPA that extended the implementation deadline for low sulfur gasoline to May 2008, based on the capital investment option we chose. In return for the extension, we agreed to produce 95% of the diesel fuel at the refinery with a sulfur content of 15 ppm or less by June 1, 2006 through the remainder of the term of the Waiver. In order to achieve this goal, we needed to complete the modification and expansion of an existing diesel hydrotreater by June 1, 2006. Due to construction delays, which resulted from the impacts of Hurricanes Katrina and Rita on the availability of construction resources, Delek requested, and received, a modification to our Compliance Plan which, among other things, granted an additional three months to complete the project. This project was completed in the third quarter of 2006. As required by the modification to the compliance plan, Delek purchased and retired diesel sulfur credits to offset the volume of high sulfur diesel produced during the three month extension. During the first quarter of 2008, it became apparent to us that the construction of our gasoline hydrotreater would not be completed by the original deadline of May 31, 2008 due to the continuing shortage of skilled labor and ongoing delays in the receipt of equipment. We began discussions with EPA regarding this potential delay in completing the gasoline hydrotreater and agreed to an extension to certain provisions of the Waiver that allowed us to exceed the 80 ppm per-gallon sulfur maximum for up to two months past the original May 31, 2008, compliance date. Construction and commissioning of the gasoline hydrotreater was completed in June 2008 with all gasoline meeting low sulfur specifications by the end of June. As a condition of the Waiver, Delek may have to purchase gasoline sulfur credits, but we do not believe that any such purchase of credits will result in a material adverse effect on our business, financial condition or results of operations.

 

Regulations promulgated by the TCEQ required the use of only Low Emission Diesel (LED) in counties east of Interstate 35 beginning in October 2005. Delek received approval to meet these requirements through the end of 2007 by selling diesel that meets the criteria in an Alternate Emissions Reduction Plan on file with the TCEQ and through the use of approved additives either before or after December 2007.

 

The EPA has issued final rules for gasoline formulation that will require further reductions in benzene content by 2011. We are in the process of identifying and evaluating options for complying with this requirement.

 

The Energy Policy Act of 2005 requires increasing amounts of renewable fuel be incorporated into the gasoline pool through 2012. Under final rules implementing this Act (the Renewable Fuel Standard), the Tyler refinery is classified as a small refinery exempt from renewable fuel standards through 2010. Although temporarily exempt from this rule, the Tyler refinery began supplying an E-10 gasoline-ethanol blend in January 2008. The Energy Independence and Security Act of 2007 increased the amounts of renewable fuel required by the Energy Policy Act of 2005. The EPA has not yet promulgated implementing rules for the 2007 Act so it is not yet possible to determine what the Tyler refinery compliance requirement will be.

 

The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA), also known as “Superfund,” imposes liability, without regard to fault or the legality of the original conduct, on certain classes of persons who are considered to be responsible for the release of a “hazardous substance” into the environment. These persons include the owner or operator of the disposal site or sites where the release occurred and companies that disposed or arranged for the disposal of the hazardous substances. Under CERCLA, such persons may be subject to joint and several liabilities for the costs of cleaning up the hazardous substances that have been released into the environment, for damages to natural resources and for the costs of certain health studies. It is not uncommon for neighboring landowners and other third parties to file claims for personal injury and property damage allegedly caused by hazardous substances or other pollutants released into the environment. Analogous state laws impose similar responsibilities and liabilities on responsible parties. In the course of the refinery’s ordinary operations, waste is generated, some of which falls within the statutory definition of a “hazardous substance” and some of which may have been disposed of at sites that may require cleanup under Superfund. At this time, we have not been named a party at any Superfund sites and under the terms of the refinery purchase agreement, we did not assume any liability for wastes disposed of prior to our ownership.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

During 2007, the Department of Homeland Security (DHS) promulgated Chemical Facility Anti-Terrorism Standards (CFATS) to regulate the security of “high risk” chemical facilities. In compliance with this rule, we submitted certain required information concerning our Tyler refinery and Abilene and San Angelo terminals to the DHS. We do not believe the outcome of any requirements imposed by DHS will have a material effect on our business.

 

In June 2007, the U.S. Department of Labor’s Occupational Safety & Health Administration (OSHA) announced it was implementing a National Emphasis Program addressing workplace hazards at petroleum refineries. Under this program, OSHA expects to conduct inspections of process safety management programs over the next two years at approximately 80 refineries nationwide. On February 19, 2008, OSHA commenced an inspection at our Tyler, Texas refinery. In August, OSHA concluded its inspection and issued citations assessing an aggregate penalty of less than $0.1 million. We are contesting the citations and do not believe that the outcome will have a material effect on our business.

 

Vendor Commitments

 

Delek maintains an agreement with a significant vendor that requires the purchase of certain general merchandise exclusively from this vendor over a specified period of time. Additionally, we maintain agreements with certain fuel suppliers which contain terms which generally require the purchase of predetermined quantities of third-party branded fuel for a specified period of time. In certain fuel vendor contracts, penalty provisions exist if minimum quantities are not met.

 

SemCrude Bankruptcy

 

On July 22, 2008, SemCrude, L.P. (SemCrude), filed a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code. SemCrude is a contractual counterparty to Refining in certain July 2008 crude oil exchanges totaling approximately 21,000 barrels. Refining has taken what it believes to be appropriate steps in the bankruptcy proceedings to mitigate its monetary exposure, if any, under the contract.

 

Letters of Credit

 

As of September 30, 2008, Delek had in place letters of credit totaling approximately $184.0 million with various financial institutions securing obligations with respect to its workers’ compensation and general liability self-insurance programs, as well as purchases of crude oil for the refinery, purchases of refined product for our marketing segment and fuel for our retail fuel and convenience stores. No amounts were outstanding under these facilities at September 30, 2008.

 

 

At September 30, 2008, Delek Group Ltd. controlled approximately 73.4% of our outstanding common stock. As a result, Delek Group Ltd. and its controlling shareholder, Mr. Sharon (Tshuva), will continue to control the election of our directors, influence our corporate and management policies and determine, without the consent of our other stockholders, the outcome of any corporate transaction or other matter submitted to our stockholders for approval, including potential mergers or acquisitions, asset sales and other significant corporate transactions.

 

On January 22, 2007, we granted 28,000 stock options to Gabriel Last, one of our directors, under our 2006 Long-Term Incentive Plan. These options vest ratably over four years, have an exercise price of $16.00 per share and will expire on January 22, 2017. The grant to Mr. Last was a special, one-time grant in consideration of his supervision and direction of management and consulting services provided by Delek Group to us. The grant was not compensation for his service as a director. This grant does not mark the adoption of a policy to compensate our non-employee related directors and we do not intend to issue further grants to Mr. Last in the future.

 

Delek US Holdings, Inc.

 

Notes to Condensed Consolidated Financial Statements (Unaudited) — (Continued)

 

On December 10, 2006, we granted 28,000 stock options to Asaf Bartfeld, one of our directors, under our 2006 Long-Term Incentive Plan. These options vest ratably over four years and have an exercise price of $17.64 per share and will expire on December 10, 2016. The grant to Mr. Bartfeld was a special, one-time grant in consideration of his supervision and direction of management and consulting services provided by Delek Group, Ltd. to us. The grant was not compensation for his service as a director. This grant does not mark the adoption of a policy to compensate our non-employee related directors and we do not intend to issue further grants to Mr. Bartfeld in the future.

 

Effective January 1, 2006, Delek entered into a management and consulting agreement with Delek Group, pursuant to which key management personnel of Delek Group provide management and consulting services to Delek, including matters relating to long-term planning, operational issues and financing strategies. The agreement has an initial term of one year and will continue thereafter until either party terminates the agreement upon 30 days’ advance notice. As compensation, the agreement provides for payment to Delek Group of $125 thousand per calendar quarter payable within 90 days of the end of each quarter and reimbursement for reasonable out-of-pocket costs and expenses incurred.

 

As of May 1, 2005, Delek entered into a consulting agreement with Greenfeld-Energy Consulting, Ltd., (Greenfeld) a company owned and controlled by one of Delek’s directors. Under the terms of the agreement, the director personally provides consulting services relating to the refining industry and Greenfeld receives monthly consideration and reimbursement of reasonable expenses. From May 2005 through August 2005, Delek paid Greenfeld approximately $7 thousand per month. Since September 2005, Delek has paid Greenfeld a monthly payment of approximately $8 thousand. In April 2006, Delek paid Greenfeld a bonus of $70 thousand for services rendered in 2005. Pursuant to the agreement, on May 3, 2006, we granted Mr. Greenfeld options to purchase 130,000 shares of our common stock at $16.00 per share, our initial public offering price, pursuant to our 2006 Long-Term Incentive Plan. These options vest ratably over five years. The agreement continues in effect until terminated by either party upon six months advance notice to the other party.

 

On January 12, 2006, we entered into a consulting agreement with Charles H. Green, the father of one of our named executive officers, Frederec Green. Under the terms of the agreement, Charles Green provides assistance and guidance, primarily in the area of electrical reliability, at our Tyler refinery, and is paid $100 per hour for services rendered. We paid $0.1 million and $0.2 million for these services during the nine months ended September 30, 2008 and 2007, respectively. Mr. Green’s services concluded in August 2008.

 

 

Dividend Declaration

 

On November 4, 2008, Delek’s Board of Directors declared a quarterly cash dividend of $0.0375 per share, payable on December 16, 2008 to stockholders of record on November 25, 2008.

 

Amendment to Fifth Third Revolver

 

On October 17, 2008, we entered into the first amendment to the amended and restated $75.0 million revolving credit facility with Fifth Third Bank as administrative agent. Among other things, the amendment increased the letter of credit sublimit from $25.0 million to $35.0 million and allowed the borrower, Marketing, to pay a $20.0 million cash dividend to us on October 17, 2008.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (MD&A) is management’s analysis of our financial performance and of significant trends that may affect our future performance. The MD&A should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this Form 10-Q and in the Form 10-K filed on March 3, 2008. Those statements in the MD&A that are not historical in nature should be deemed forward-looking statements that are inherently uncertain.

 

Forward-Looking Statements

 

This Form 10-Q contains “forward looking statements” that reflect our current estimates, expectations and projections about our future results, performance, prospects and opportunities. Forward-looking statements include, among other things, the information concerning our possible future results of operations, business and growth strategies, financing plans, expectations that regulatory developments or other matters will not have a material adverse effect on our business or financial condition, our competitive position and the effects of competition, the projected growth of the industry in which we operate, and the benefits and synergies to be obtained from our completed and any future acquisitions, and statements of management’s goals and objectives, and other similar expressions concerning matters that are not historical facts. Words such as “may,” “will,” “should,” “could,” “would,” “predicts,” “potential,” “continue,” “expects,” “anticipates,” “future,” “intends,” “plans,” “believes,” “estimates,” “appears,” “projects” and similar expressions, as well as statements in future tense, identify forward-looking statements.

 

Forward-looking statements should not be read as a guarantee of future performance or results, and will not necessarily be accurate indications of the times at, or by which, such performance or results will be achieved. Forward-looking information is based on information available at the time and/or management’s good faith belief with respect to future events, and is subject to risks and uncertainties that could cause actual performance or results to differ materially from those expressed in the statements. Important factors that could cause such differences include, but are not limited to:

 

 

 

In light of these risks, uncertainties and assumptions, our actual results of operations and execution of our business strategy could differ materially from those expressed in, or implied by, the forward-looking statements, and you should not place undue reliance upon them. In addition, past financial and/or operating performance is not necessarily a reliable indicator of future performance and you should not use our historical performance to anticipate results or future period trends. We can give no assurances that any of the events anticipated by the forward-looking statements will occur or, if any of them do, what impact they will have on our results of operations and financial condition.

 

Forward-looking statements speak only as of the date the statements are made. We assume no obligation to update forward-looking statements to reflect actual results, changes in assumptions or changes in other factors affecting forward-looking information except to the extent required by applicable securities laws. If we do update one or more forward-looking statements, no inference should be drawn that we will make additional updates with respect thereto or with respect to other forward-looking statements.

 

Overview

 

We are a diversified energy business focused on petroleum refining, wholesale sales of refined products and retail marketing. Our business consists of three operating segments: refining, marketing and retail. Our refining segment operates a high conversion, moderate complexity independent refinery in Tyler, Texas, with a design crude distillation capacity of 60,000 barrels per day (bpd), along with an associated crude oil pipeline and light products loading facilities. Our marketing segment sells refined products on a wholesale basis in west Texas through company-owned and third-party operated terminals. Our retail segment markets gasoline, diesel, other refined petroleum products and convenience merchandise through a network of 495 company-operated retail fuel and convenience stores located in Alabama, Arkansas, Georgia, Kentucky, Louisiana, Mississippi, Tennessee and Virginia. Additionally, we own a minority equity interest in Lion Oil Company, a privately-held Arkansas corporation, which operates a 75,000 bpd moderate complexity crude oil refinery and other pipeline and product terminals. The refinery is located in El Dorado, Arkansas.

 

The cost to acquire feedstocks and the price of the refined petroleum products we ultimately sell from our refinery depend on numerous factors beyond our control, including the supply of, and demand for, crude oil, gasoline and other refined petroleum products which, in turn, depend on, among other factors, changes in domestic and foreign economies, weather conditions such as the recent Gulf Coast hurricanes, domestic and foreign political affairs, global conflict, production levels, the availability of imports, the marketing of competitive fuels and government regulation. Other significant factors that influence our results in our refining segment include the cost of crude, our primary raw material, the refinery’s operating costs, particularly the cost of natural gas used for fuel and the cost of electricity, seasonal factors, refinery utilization rates and planned or unplanned maintenance activities or turnarounds.

 

The pricing of our refined petroleum products fluctuate significantly with movements in both crude oil and refined petroleum product markets. Both the spread between crude oil and refined petroleum product prices, and more recently the time lag between the fluctuations in those prices, affect our earnings. We compare our per barrel refining operating margin to certain industry benchmarks, specifically the U.S. Gulf Coast 5-3-2 crack spread. The U.S. Gulf Coast 5-3-2 crack spread represents the differential between Platt’s quotations for 3/5 of a barrel of U.S. Gulf Coast Pipeline 87 Octane Conventional Gasoline and 2/5 of a barrel of U.S. Gulf Coast Pipeline No. 2 Heating Oil (high sulfur diesel), on the one hand, and the first month futures price of 5/5 of a barrel of light sweet crude oil on the New York Mercantile Exchange, on the other hand.

Finally, while the increases in the cost of crude oil are reflected in the changes of light refined products, the value of heavier products, such as fuel oil, asphalt and coke, have not moved in parallel with crude cost. This causes additional pressure on our refining margins.

 

The cost to acquire the refined fuel products we sell to our wholesale customers in our marketing segment and at our convenience stores in our retail segment depends on numerous factors beyond our control, including the supply of, and demand for, crude oil, gasoline and other refined petroleum products which, in turn, depends on, among other factors, changes in domestic and foreign economies, weather conditions such as the recent Gulf Coast hurricanes, domestic and foreign political affairs, production levels, the availability of imports, the marketing of competitive fuels and government regulation. Our retail merchandise sales are driven by convenience, customer service, competitive pricing and branding. Motor fuel margin is sales less the delivered cost of fuel and motor fuel taxes, measured on a cents per gallon basis. Our motor fuel margins are impacted by local supply, demand, weather, competitor pricing and product brand.

 

As part of our overall business strategy, we regularly evaluate opportunities to expand and complement our business and may at any time be discussing or negotiating a transaction that, if consummated, could have a material effect on our business, financial condition, liquidity or results of operations.

 

Executive Summary of Recent Developments

 

Refining segment activity

 

At the refinery, we are in compliance with the Federal Clean Air Act regulations requiring a reduction in sulfur content in gasoline. Our gasoline hydrotreater (GHT) project, which had a capitalized spend of $75.1 million, became operational in June 2008.

 

Our average throughput for the third quarter of 2008 was 56,600 barrels per day compared to 56,500 for the third quarter of 2007. Our utilization rate equaled 86.0% for the third quarter of 2008 compared to 92.4% during the third quarter of 2007. The lower utilization rate reflects the use of more intermediate feedstocks in third quarter 2008 production.

 

Sales volume for the third quarter of 2008 was 55,900 versus 53,200 barrels for the comparable period in the prior year. The increase in sales volume is primarily due to the refinery remaining operational throughout the Gulf Coast hurricanes in the third quarter of 2008. As one of few refineries with product, we were able to expand our markets.

 

Our margin realization, adding back intercompany service fees, was $12.16 per barrel sold in the third quarter of 2008 versus $10.45 in the comparable period in 2007. This increase was due to a 25.4% increase in the U.S. Gulf Coast 5-3-2 crack spread, which reflect the near record increases in prices due to the Gulf Coast hurricanes.

 

Continued optimization of the refinery operation, including the introduction of a linear programming model in the second quarter of 2008, allowed us to run 6,300 barrels per day of sour crude through the refinery in the third quarter of 2008 as compared to 4,600 barrels per day in the third quarter of 2007. Our realization rate on light, high-value products was 91.7% in the third quarter of 2008 versus 90.9% in the third quarter of 2007.

 

Marketing segment activity

 

Our marketing segment generated net sales for the 2008 third quarter of $224.9 million on sales of more than 16,900 barrels per day of refined products compared to $164.5 million on sales of approximately 18,200 barrels per day in the third quarter of 2007. The increase in sales was primarily driven by an increase in the average sales prices of products sold during the quarter.

 

Retail segment activity

 

The Gulf Coast hurricanes shut-in a number of refineries supplying the Colonial pipeline. This reduced capacity in early September limited production available to the Southeastern United States. The product

shortages in the Southeastern United States impacted the unbranded stores throughout our footprint, as well as certain branded locations being put on allocation. This lack of product was the primary driver of lower total gasoline volume sold during the third quarter as reflected in our average retail gallons per average number of stores of 232,000 gallons in the third quarter of 2008 versus 252,000 gallons in the third quarter of 2007.

 

We saw a sharp decline in wholesale fuel prices during August and September, excluding the period of product shortages related to the hurricanes. This resulted in improved retail fuel margins in the third quarter of 2008, increasing 57.2% to $0.239 per gallon, compared to $0.152 per gallon in the third quarter of 2007.

 

Market Trends

 

Our results of operations are significantly affected by the cost of commodities. Sudden change in petroleum prices is our primary source of market risk. Our business model is affected more by the volatility of petroleum prices than by the cost of the petroleum that we sell.

 

We continually experience volatility in the energy markets. Concerns about the U.S. economy and continued uncertainty in several oil-producing regions of the world resulted in increases in the price of crude oil which outpaced product prices in the 2008 and 2007 third quarters. The average price of crude oil in the third quarters of 2008 and 2007 was $118.70 and $75.17 per barrel, respectively. The U.S. Gulf Coast 5-3-2 crack spread ranged from a high of $67.63 per barrel to a low of $0.88 per barrel during the third quarter of 2008. The 5-3-2 crack spread averaged $15.08 per barrel during the third quarter of 2008 compared to an average of $12.02 per barrel in the 2007 third quarter.

 

We also continue to experience high volatility in the wholesale cost of fuel. The U.S. Gulf Coast price for unleaded gasoline ranged from a low of $2.61 per gallon to a high of $4.75 per gallon in the third quarter of 2008 and averaged $3.12 per gallon in the third quarter of 2008, which compares to an average of $2.09 per gallon in the 2007 third quarter. If this volatility continues and we are unable to fully pass our cost increases on to our customers, our retail fuel margins will decline. Additionally, increases in the retail price of fuel could result in lower demand for fuel and reduced customer traffic inside our convenience stores in our retail segment. This may place downward pressure on in-store merchandise sales and margins. Finally, the higher cost of fuel has also resulted in higher credit card fees as a percentage of sales and gross profit. As fuel prices increase, we see increased usage of credit cards by our customers and pay higher interchange costs since credit card fees are paid as a percentage of sales.

 

The cost of natural gas used for fuel in our Tyler refinery has also shown historic volatility. Our average cost of natural gas increased to $9.12 per million British Thermal Units (MMBTU) in the 2008 third quarter from $6.18 per MMBTU in the 2007 third quarter.

 

As part of our overall business strategy, management determines, based on the market and other factors, whether to maintain, increase or decrease inventory levels of crude or other intermediate feedstocks.

 

Factors Affecting Comparability

 

The comparability of our results of operations for the three and nine months ended September 30, 2008 compared to the three and nine months ended September 30, 2007 is affected by the following factors:

 

 

Summary Financial and Other Information

 

The following table provides summary financial data for Delek.