_ _

 

SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

 

FORM 10-K

 

 

Commission file number 1-6841

 

DELEK US HOLDINGS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Registrant’s telephone number, including area code

(615) 771-6701

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:
None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments of this Form 10-K.  o

 

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

Large accelerated filer o     Accelerated filer o     Non-accelerated filer þ

 

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

 

The aggregate market value of the Common Stock held by non-affiliates at June 30, 2006 was approximately $173,067,200, based upon the closing sale price of the registrant’s Common Stock on the New York Stock Exchange on that date. For purposes of this calculation only, all directors, officers subject to Section 16(b) of the Securities Exchange Act of 1934, and 10% stockholders are deemed to be affiliates.

 

At February 23, 2007, there were 51,139,869 shares of Common Stock, $.01 par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the registrant’s definitive Proxy Statement to be delivered to stockholders in connection with the 2007 Annual Meeting of Stockholders, which will be filed with the Securities and Exchange Commission within 120 days after December 31, 2006, are incorporated by reference into Part III of this Form 10-K.

 

 

TABLE OF CONTENTS

 

Unless otherwise indicated or the context requires otherwise, the terms “Delek,” “we,” “our” “company” and “us” are used in this report to refer to Delek US Holdings, Inc. and its consolidated subsidiaries. Statements in this Annual Report on Form 10-K, other than purely historical information, including statements regarding our plans, strategies, objectives, beliefs, expectations and intentions are forward looking statements. These forward looking statements generally are identified by the words “may,” “will,” “should,” “could,” “would,” “predicts,” “intends,” “believes,” “expects,” “plans,” “scheduled,” “goal,” “anticipates,” “estimates” and similar expressions. Forward- looking statements are based on current expectations and assumptions that are subject to risks and uncertainties, including those discussed below and in Item 1A, Risk Factors, which may cause actual results to differ materially from the forward-looking statements. See also “Forward-Looking Statements” included in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, of this Annual Report on Form 10-K.

 

Company 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 394 company-operated retail fuel and convenience stores located in Alabama, Arkansas, Georgia, Kentucky, Louisiana, Mississippi, Tennessee and Virginia. We focus on creating value in our existing and acquired assets through disciplined financial management and operating expense and loss prevention controls, effective utilization of information technology and implementation of new marketing strategies and by fostering a culture of dedication and teamwork among our employees.

 

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 2005, we expanded our scope of operations to include complementary petroleum refining and wholesale and distribution businesses by acquiring the Tyler refinery. We initiated operations of our marketing segment during the third quarter of 2006 with the purchase of assets from Pride Companies LP and affiliates. We are also a controlled company under the rules and regulations of the New York Stock Exchange because an indirect, wholly-owned subsidiary of Delek Group Ltd., owns approximately 77.0% of our outstanding common stock. Delek Group Ltd. is 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).

 

Acquisitions

 

We have been successful in rapidly integrating our refinery acquisition, five large retail fuel and convenience store acquisitions, a pipeline and terminal acquisition and several smaller acquisitions since our formation in 2001. Our principal acquisitions since inception are summarized below:

 

 

 

 

In the first quarter of 2007 we signed a purchase and sale agreement to acquire 107 stores from Calfee Company of Dalton, Inc. and affiliates for $65.0 million plus inventory. We anticipate that, subject to government approval, this acquisition will close in the second quarter of 2007. We expect to continue to review acquisition and organic growth opportunities in the refining, marketing, retail fuel and convenience store markets as well as opportunities to acquire other petroleum sale and distribution logistical assets such as pipelines, terminals and fuel storage facilities.

 

Information About Our Segments

 

As a result of our acquisition of refined petroleum product terminals, seven pipelines, storage tanks and idle refinery equipment, beginning in the third quarter of 2006 we added a third operating segment, marketing, to complement our refining and retail segments. Segment information is prepared on the same basis that management reviews financial information for operational decision making purposes. Additional segment and financial information is contained in our segment results included in Item 6, Selected Financial Data, Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and in Note 10, Segment Data, of our consolidated financial statements included in Item 8 of this Annual Report on Form 10-K.

 

Refining Segment

 

We operate a high conversion, moderate complexity independent refinery with a design crude distillation capacity of 60,000 bpd, along with an associated crude oil pipeline and light products loading facilities. The refinery is located in the city of Tyler in East Texas, and is the only supplier of a full range of refined petroleum products within a radius of approximately 115 miles.

 

The Tyler refinery is situated on approximately 100 out of a total of approximately 600 contiguous acres of land (excluding pipelines) that we own in Tyler and adjacent areas. The Tyler refinery includes a fluidized catalytic cracking unit and a delayed coker, enabling us to produce over 92% light products and has a Nelson complexity of 8.9. It has the ability to produce and sell a full range of gasoline, diesel, jet fuels, liquefied petroleum gas (LPG) and natural gas liquids (NGLs). For 2006, gasoline accounted for approximately 53% and diesel and jet fuels accounted for approximately 39% of the Tyler refinery’s production.

 

The inland location of the Tyler refinery provides a degree of protection from the effects of tropical weather. While Hurricane Rita caused significant property damage and resulted in a substantial period of down time for numerous refiners in Southern Texas, the Tyler refinery maintained stable operations throughout, and was the sole supplier of refined petroleum products in East Texas during late September 2005, as competing terminals in our region ran out of supply.

 

Fuel Customers.  We have the advantage of being able to deliver nearly all of our gasoline and diesel fuel production into the local market via our terminal at the refinery. Our customers have strong credit profiles and include major oil companies, independent refiners and marketers, jobbers, distributors, utility and transportation companies, and independent retail fuel operators. Our refinery’s ten largest customers, excluding U.S. government contracts, accounted for $904.7 million, or 57.5%, of net sales for the refining segment for 2006. Our customers include ExxonMobil, Valero Marketing and Supply, Murphy Oil USA, Truman Arnold and Chevron, among others. Although none of our customers account for 10% or more of our consolidated net sales in 2006, ExxonMobil accounted for approximately 13% of net sales for the refining segment for 2006. Our product pipeline sales are specific to Chevron and represent 6.4% of the refining segment’s sales. Additionally, during the second quarter of 2006, we were awarded a contract with the U.S. government to supply jet fuel (JP8) to various military facilities for a one year period. The government solicits competitive bids for this contract annually. Sales under this contract totaled $51.5 million, or 3.3%, of the refining segment’s 2006 net sales.

 

The Tyler refinery does not generally supply fuel to our retail fuel and convenience stores, since it is not located in the same geographic region as our stores.

 

Refinery Design and Production.  The Tyler refinery has a crude oil processing unit with a 60,000 bpd atmospheric column and a 18,000 bpd vacuum tower. The other major process units at the Tyler refinery include a 20,200 bpd fluid catalytic cracking unit, a 6,500 bpd delayed coking unit, a 21,000 bpd naphtha hydrotreating unit, a 22,000 bpd distillate hydrotreating unit, a 17,500 bpd continuous regeneration reforming unit, a 5,000 bpd isomerization unit, and an alkylation unit with a capacity of 4,700 bpd.

 

The Tyler refinery was designed to mainly process light, sweet crude oil, which is a higher quality, more expensive crude oil than heavy, sour crude oil. Our owned and leased pipelines are connected to five crude oil pipeline systems that allow us access to East Texas, West Texas and foreign sweet crude oils. A small amount of local East Texas crude oil is also delivered to the refinery by truck. The table below sets forth information concerning crude oil received at the Tyler refinery in 2006:

 

 

Upon delivery to the Tyler refinery, crude oil is sent to a distillation unit, where complex hydrocarbon molecules are separated into distinct boiling ranges. The processed crude oil is then treated in specific units of the refinery, and the resulting distilled and treated fuels are pumped to blending units to create the desired finished fuel product. A more detailed summary of our production output for the year ended 2006 follows:

 

 

 

The table below sets forth information concerning the historical throughput and production at the Tyler refinery for the last three years. The data for periods prior to April 29, 2005 have been derived from the internal financial records of the previous owner.

 

 

 

 

During the third quarter of 2006, two significant capital projects were completed that allowed us to produce 100% of our diesel pool as ultra low sulfur diesel and provided improved and more reliable sulfur handling capability at the refinery. These projects were comprised of the expansion and modification of the distillate de-sulfurization unit and the installation of a new 35 long ton per day sulfur recovery unit and tail gas treating unit. The completion of these two projects concluded the first phase of our Clean Fuels capital program.

 

Profitability Improvements.  Delek conducted a feasibility study to identify opportunities to improve the profitability of the refinery. This study identified three low complexity projects with estimated potential returns on investment of approximately 50%. The projects are designed to provide incremental refining segment contribution margin by allowing the processing of a lower cost crude slate, as well as reducing current operational bottlenecks in certain processing units. As with any capital project, we may experience increases in the cost and/or timing to obtain necessary equipment required to complete the project. Additionally, the scope and/or cost of employee and/or contractor labor expense related to the installation of equipment could increase. We are moving forward with these projects and they are expected to be fully implemented in the second half of 2008.

 

Storage Capacity.  Storage capacity at the Tyler refinery, including tanks along our pipeline, totals approximately 2.7 million barrels, consisting of approximately 1.2 million barrels of crude oil storage and 1.5 million barrels of refined and intermediate product storage.

 

Supply and Distribution.  The majority of the crude oil purchased for the Tyler refinery is East Texas crude oil. Most of this East Texas crude oil processed in our refinery is delivered by truck or through our pipeline and

leased pipeline from Nettleton Station in Longview, Texas. This represents an inherent cost advantage due to our ability to purchase crude oil on its way to market, as opposed to purchasing from a market or trade location. The crude oil is purchased during the trading month and priced during the calendar month to achieve the refinery crack spread of the day. The proximity of the refinery to receive both domestic and foreign barrels affords us the opportunity to replace barrels with financially advantaged alternatives on short notice.

 

Our ability to access West Texas intermediate (WTI) or foreign sweet crude oil, when they are available at competitive prices, has helped significantly to maintain the refinery’s competitive supply cost advantage. These alternate supply sources allow us to optimize the refinery operation and utilization while also allowing us to more favorably negotiate the cost and quality of the local East Texas crude oil we purchase.

 

The McMurrey Pipeline System, which we own, consists of approximately 65 miles of 6-inch crude oil lines that transports crude oil to the Tyler refinery. We currently operate the main trunk line, and the following pump stations and terminals that are also owned by us:

 

 

The vast majority of our transportation fuels and other products are sold via truck directly from the refinery. We operate a nine lane transportation fuels truck rack with a wide range of additive options, including proprietary packages dedicated for use by our major oil company customers. LPG, NGLs, and clarified slurry oil are also sold via truck from dedicated loading facilities at the refinery. We also have a pipeline connection for the sale of propane into a facility owned by Texas Eastman. Petroleum coke is sold primarily via rail from the refinery, with occasional truck loading for specialty or excess product.

 

The remainder of our transportation fuels are sold via pipeline to a single, pipeline-connected terminal owned by Chevron. We transport these products on TEPPCO pipeline to a point of interconnection to a Chevron-owned pipeline terminating in Big Sandy, Texas.

 

Competition.  The refining industry is highly competitive and includes fully integrated national or multinational oil companies engaged in many segments of the petroleum business, including exploration, production, transportation, refining, marketing and convenience stores. Our principal competitors are Texas Gulf Coast refiners, product terminal operators in our region and Calumet Lubricants in Shreveport, Louisiana. The principal competitive factors affecting our refinery operations are crude oil and other feedstock costs, refinery product margins, refinery efficiency, refinery product mix and distribution and transportation costs. Certain of our larger competitors operate refineries that are larger and more complex and in different geographies, and, as a result, could have lower per barrel costs or higher margins per barrel of throughput than us. We have no crude oil reserves and are not engaged in exploration. We believe, however, that we are a strong competitor in our defined market because our manufactured products are not readily made available by our competitors and our location allows for a realized margin that is favorable in comparison to the reported Gulf Coast 5-3-2 crack spread because our production process yields a high percentage of high margin light distillate products.

 

Marketing Segment

 

Formed initially in connection with the acquisition of the assets of the Pride Companies LP and its affiliates in 2006, the marketing segment represents the next step in our strategy of becoming a fully integrated provider of fuels and related products. Through this segment, we sell refined products on a wholesale basis in west Texas through company-owned and third party operated terminals. In order to grow our presence in this segment, we intend to implement the following initiatives: further develop and leverage our existing marketing and distribution capabilities and experience using the assets acquired from the Pride Companies, more fully utilize our favorable supply contract with Magellan Asset Services LP (Magellan), develop exchange opportunities between our segments and expand our base of operations through acquisitions.

 

Our marketing segment generates net sales through five integrated activities:

 

 

A description of the assets we use to generate these net sales include:

 

Petroleum Product Marketing Terminals.  The marketing segment markets its products through three owned terminals in San Angelo, Abilene and Tyler, Texas and third-party terminaling operations in Aledo, Odessa and Big Springs, Texas. The San Angelo terminal began operations in 1991 and has operated continuously. The Abilene terminal began operations in the 1950’s and has undergone routine upgrading. At each terminal, products are loaded on two loading lanes each having four bottom-loading arms. The loading racks are fully automated and unmanned during the night. The Tyler terminal was built in the 1970’s and was most recently expanded in 1994. It is currently operated by our refining segment and includes nine loading lanes and is fully automated and unmanned at night. We have in excess of 1,000,000 barrels of combined refined product storage tank capacity at Tye station and our terminals in Abilene and San Angelo.

 

Pipelines.  We own seven product pipelines of approximately 114 miles between our refined product terminals in Abilene and San Angelo, Texas, which includes a line connecting our facility to Dyess Air Force Base. These refined product pipelines are:

 

 

Supply Agreements.  Substantially all of our petroleum products are purchased from Magellan under two separate supply contracts. Under the terms of the first supply contract, we can purchase up to 20,350 bpd of petroleum products to the Abilene terminal for sales and exchange at Abilene and San Angelo. The primary term is through December 31, 2007, however, the agreement may be renewed for five additional terms of two years. Additionally, we can purchase up to an additional 7,000 bpd of refined products into the Magellan pipeline system in East Houston under a separate contract that expires in 2015. While the primary purpose of this second contact is to supply products at Magellan’s Aledo, Texas terminal, the agreement allows us to redirect products to other terminals along the Magellan pipeline. In the five months subsequent to our purchase of the Pride Companies’ assets, we purchased approximately 96% of our marketing segment’s petroleum products from Magellan under these two agreements.

 

Customers.  We have various types of customers including major oil companies such as ExxonMobil, independent refiners and marketers such as Murphy Oil, jobbers, distributors, utility and transportation companies and independent retail fuel operators. In general, marketing customers typically come from within a 100-mile radius of our terminal operations. Our customers include Flying J, Murphy Oil, ExxonMobil, and Town & Country Food. None of our customers in the marketing segment accounted for 10% or more of our consolidated or segment net sales in 2006. The top ten customers accounted for just over half of the marketing segment sales in 2006. In October 2006, our marketing segment also began providing marketing and sales services for customers of the Tyler refinery.

In return for these services to customers of the Tyler refinery, the marketing segment receives a monthly fee from the refining segment plus a sharing of marketing margin above predetermined thresholds. Net fees received under this arrangement were $3.4 million in 2006, and eliminate in consolidation.

 

Competition.  Our company-owned refined product terminals compete with other independent terminal operators as well as integrated oil companies on the basis of terminal location, price, versatility and services provided. The costs associated with transporting products from a loading terminal to end users limit the geographic size of the market that can be served economically by any terminal. The two key markets in west Texas that we serve from our company-owned facilities are Abilene and San Angelo, TX. While we have direct competition from an independent refiner that markets through another terminal in the Abilene market, there are no competitive fuel loading terminals within approximately 90 miles of our San Angelo terminal.

 

Retail Segment

 

We operate 394 retail fuel and convenience stores, which are located in Alabama, Arkansas, Georgia, Kentucky, Louisiana, Mississippi, Tennessee and Virginia, primarily under the MAPCO Express^®, MAPCO Mart^tm, East Coast ^®, Fast Food and Fuel^tm and Discount Food Mart^tm brands. In 2006 we purchased 43 stores from Fast Petroleum, Inc. and affiliates that strengthened our presence in key core markets located in southeastern Tennessee and northern Georgia and re-imaged all stores purchased in the BP acquisition. We also completed four store “raze and rebuilds”, opened two new stores, which we constructed, and retrofitted four existing stores using our next generation, MAPCO Mart concept. The MAPCO Mart store with GrilleMarx^tm is designed to offer premium amenities and products, such as a proprietary made-to-order food program with touch-screen order machines, indoor and outdoor seating, expanded coffee and hot drink bars, an expanded cold and frozen drink area where customers can customize their drink flavors, a walk-in beer cave and an expanded import and micro brew beer section. Due to the initial success of these stores in our Nashville market, we plan to continue our “raze and rebuild” program into other of our core markets in 2007.

 

Our retail segment also includes a wholesale fuel distribution operation that supplies more than 50 dealer-operated retail locations. We believe that we have established strong brand recognition and market presence in the major retail markets in which we operate. Approximately 87% of our stores are concentrated in Tennessee, Alabama and Virginia. In terms of number of retail fuel and convenience stores, we rank in the top-three in major markets such as Nashville, Memphis, northern Alabama and Richmond.

 

We operate a business model that we believe enables us to generate higher per gallon gas margins than the industry average as well as drive merchandise sales that are higher than the industry average. Our stores are positioned in high traffic areas (approximately 79% of our stores are located at street corner locations) and we employ a localized marketing strategy that focuses on the demographics surrounding each store and customizing the product mix and promotional strategies to meet the needs of customers in those demographics. Our management approach also incorporates a strong focus on controlling operating expenses and loss prevention, which has been an important element in the successful development of our retail segment.

 

Company-Operated Stores.  Of our sites, approximately 66% are open 24 hours per day and the remaining sites are open at least 16 hours per day. Our average store size is approximately 2,360 square feet with approximately 69% of our stores being more than 2,000 square feet.

 

Our retail fuel and convenience stores typically offer tobacco products and immediately consumable items such as beer, non-alcoholic beverages and a large variety of snacks and prepackaged items. A significant number of the sites also offer state sanctioned lottery games, ATM services and money orders. While several of our locations include well recognized national quick service food chains such as Subway ^®, we have begun to change our focus in food service to providing proprietary, made to order food offerings under our GrilleMarx^tm brand. We have chosen this strategy because we believe it best fits our neighborhood store strategy of offering products that meet the customs and tastes of each community we serve. Our GrilleMarx^tm program gives us significant flexibility in site selection, the ability to control product consistency and tailor our food offerings to local tastes. In addition, our proprietary fresh food program allows us a unique product offering without paying royalties typically charged by the branded programs. In 2006 we added the GrilleMarx^tm food program to 10 locations and rolled out a premium coffee and frozen beverage programs to most locations. We also introduced private label products to our soft drink,

sandwich, water and automotive categories which provide points of differentiation and enhanced margins. Our plans are to add at least one new private label offering per quarter during 2007.

 

All of our locations are retail fuel and convenience stores. The majority of our retail fuel and convenience stores have 4 to 5 multi-pump fuel dispensers with credit card readers. Virtually all of our company-operated locations have a canopy to protect self-service customers from rain and to provide street appeal by creating a modern, well-lit and safe environment.

 

Fuel Operations.  For the years ended December 31, 2006, 2005 and 2004, our net fuel sales were 76.3%, 73.4% and 69.5%, respectively, of net sales for our retail segment. The following table highlights certain information regarding our fuel operations for the years ended December 31, 2006, 2005 and 2004:

 

 

We currently operate a fleet of delivery trucks to deliver approximately 57% of the fuel sold at our retail fuel and convenience stores. We purchased approximately 33% of the fuel sold at our retail fuel and convenience stores in 2006 from Valero Marketing and Supply under a contract that extends through the second quarter of 2008. We also purchase fuel under contracts with BP, ExxonMobil, Shell, Conoco Phillips and Chevron, and purchase the balance of our fuel from a variety of independent fuel distributors. The price of fuel purchased is generally based on contracted differentials to local and regional price benchmarks. The initial terms of our supply agreements range from one year to 15 years and generally contain minimum monthly or annual purchase requirements. To date, we have met substantially all our purchase commitments under these contracts.

 

Merchandise Operations.  For 2006, 2005 and 2004, our merchandise sales were 23.7%, 26.6%, and 30.5% respectively, of net sales for our retail segment. The following table highlights certain information with respect to our merchandise sales for the years ended December 31, 2006, 2005 and 2004:

 

 

We purchased approximately 69% of our general merchandise, including most tobacco products and grocery items for 2006 from a single wholesale grocer, McLane Company, Inc., a wholly-owned subsidiary of Berkshire Hathaway. Our contract with McLane expires at the end of 2007, but may be renewed at our option for an additional two year period. Other major suppliers and manufacturers include Coca-Cola, Pepsi-Cola, Frito Lay, Gatorade, Hershey’s, Kraft/Nabisco and Oscar Mayer.

 

Technology and Store Automation.  We continue to invest in our technological infrastructure to enable us to better address the expectations of our customers and improve our operating efficiencies and inventory management. In 2006 we completed the implementation of a scan out management system that integrates with our point-of-sale (POS) systems in all company-operated stores.

 

Most of our stores are connected to a high speed data network and provide nearly real-time information to our supply chain management, inventory management and security systems. We believe that our systems provide many of the most desirable features commercially available today in the information software market, while providing more rapid access to data, customized reports and greater ease of use. Our information technology systems help us manage our inventory, optimize our marketing strategy and reduce cash and merchandise shortages. Our

information technology systems allow us to improve our profitability and strengthen operating and financial performance in multiple ways, including by:

 

 

Dealer Operations.  Our retail segment also includes a wholesale fuel distribution network that supplies more than 50 dealer-operated retail locations. For 2006 and 2005, our dealer net sales were approximately 5% of net sales for our retail segment. Our business arrangements with dealers include contractual arrangements in which we pay a commission to the dealer based on profits from the fuel sales, contractual arrangements in which we supply fuel and invoice the dealer for its cost of fuel plus an agreed upon margin and non-contractual arrangements in which dealers order fuel from us at their discretion.

 

Competition.  The retail fuel and convenience store business is highly competitive. We compete on a store-by-store basis with other independent convenience store chains, independent owner-operators, major petroleum companies, supermarkets, drug stores, discount stores, club stores, mass merchants, fast food operations and other retail outlets. Major factors of competition include location, ease of access, pricing, product and service selections, customer service, fuel brands, store appearance, cleanliness and safety. We believe we are able to effectively compete in the markets in which we operate because our market concentration in most of our markets allows us to gain better vendor support. In addition, approximately 79% of our stores are located at street corner locations that generally experience greater customer traffic and generate higher sales per store than non-corner locations. We utilize customized merchandising strategies in each of our stores rather than implementing one merchandising strategy for all of our stores as some of our competitors do. Finally, we use proprietary information technology that allows us to manage our fuel sales and margin more effectively than competitors without access to comparable technology.

 

Governmental Regulation and Environmental Matters

 

We are 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 extremely difficult to reasonably quantify future environmental-related expenditures, we anticipate that continuing capital investments will be required over the next several years to comply with existing regulations.

 

Based upon environmental evaluations performed by third parties subsequent to our purchase of the Tyler refinery, we recorded a liability of approximately $7.9 million as of December 31, 2006 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 acquisition as discussed in Notes 4 and 12 to the Consolidated Financial Statements included elsewhere herein. 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 $0.4 million of the undiscounted liability is expected to be expended by the end of 2007 with the remaining balance of $7.5 million expendable by 2016.

 

Other than certain enforcement actions under discussion with the Texas Commission on Environmental Quality (TCEQ), the U.S. Environmental Protection Agency (EPA) and the U.S. Department of Justice (DOJ), and for which appropriate reserves have been accrued or for which we believe the outcome will be immaterial, we have not been named as defendant in any environmental, health or safety litigation.

 

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. We applied for a waiver from the EPA postponing requirements for the lowest gasoline sulfur standards, which was granted in the second quarter of 2005.

 

Contemporaneous with our refinery purchase, we became a party to a waiver and Compliance Plan with the EPA that extended the implementation deadline until December 2007 or May 2008, depending on which 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. In order to achieve this goal, we needed to complete the modification and expansion of an existing diesel hydrotreater. Due to construction delays which were the result of the impact of Hurricanes Katrina and Rita on the availability of construction resources, we requested, and received, a modification to our Compliance Plan which, among other things, granted us an additional three months in which to complete the project. This project was completed in the third quarter of 2006.

 

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

 

The EPA has proposed changes in gasoline formulation that would require further reductions in benzene content by 2011. The Energy Policy Act of 2005 requires increasing amounts of renewable fuel be incorporated into the gasoline pool through 2010. Although final rules implementing the Act have not been promulgated, we believe that as a small refinery we could be exempt from renewable fuel standards until 2010.

 

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. Waste is generated in the course of the refinery’s ordinary operations, 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 purchase agreement, we did not assume any liability for wastes disposed of prior to our ownership of the refinery.

 

Our business is also subject to other laws and regulations including, but not limited to, employment laws and regulations, regulations governing the sale of alcohol and tobacco, minimum wage requirements, working condition requirements, public accessibility requirements, citizenship requirements, gaming laws and other laws and regulations. A violation or change of these laws could have a material adverse effect on our business, financial condition and results of operations.

Employees

 

As of December 31, 2006, we had 3,064 employees, of which 247 were employed in our refining segment, 14 were employed in our marketing segment and 2,803 were employed either full or part-time by our retail segment. As of December 31, 2006, 147 of the operations and maintenance hourly employees at the refinery and 21 truck drivers at the refinery were represented by United Steel, Paper and Forestry, Rubber, Manufacturing, Energy, Allied Industrial and Service Workers International Union and its Local 202 and were covered by collective bargaining agreements. None of our employees in our marketing or retail segments or in our corporate offices are represented by a union. We consider our relations with our employees to be satisfactory.

 

Trade Names, Service Marks and Trademarks

 

We regard our intellectual property as being an important factor in the marketing of goods and services in our retail segment. We own, have registered or applied for registration of a variety of trade names, service marks and trademarks for use in our business. We own the following registrations issued by the United States Patent and Trademark Office: MAPCO EXPRESS & Design^®, EAST COAST^®, CAFÉ EXPRESS FINEST COFFEE IN TOWN MAPCO & Design^®, GUARANTEED RIGHT! MAPCO EXPRESS & Design^®, FAST FOOD AND FUEL^tm, FLEET ADVANTAGE^® and DELTA EXPRESS^®. Our pending registrations include GRILLE MARX^tm and MAPCO MART^tm and MAPCO^tm. While we do not have and have not applied for a federally registered mark for DISCOUNT FOOD MART^tm, we do claim common law trademark rights in the name. Our right to use the “MAPCO” name is limited to the retail fuel and convenience store industry. We are not otherwise aware of any facts which would negatively impact our continuing use of any of our trade names, service marks or trademarks.

 

Available Information

 

Our internet website address is http://www.delekus.com. Information contained on our website is not part of this Annual Report on Form 10-K. Our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K filed with (or furnished to) the Securities and Exchange Commission (SEC) are available on our internet website (in the “Investor Relations” section), free of charge, as soon as reasonably practicable after we file or furnish such material. We also post our corporate governance guidelines, code of business conduct and ethics and the charters of our board’s committees in the same website location. Our governance documents are available in print to any stockholder that makes a written request to Kent Thomas, General Counsel and Secretary, Delek US Holdings, Inc., 830 Crescent Centre Drive, Suite 300, Franklin, Tennessee 37067. Contained in Exhibits 31.1 and 31.2 of this Annual Report on Form 10-K, are our chief executive officer’s and chief financial officer’s certifications regarding the quality of our public disclosures under Section 302 of the Sarbanes-Oxley Act of 2002.

 

 

We are subject to numerous known and unknown risks, many of which are presented below and elsewhere in this Annual Report on Form 10-K. Any of the risk factors described below or additional risks and uncertainties not presently known to us, or that we currently deem immaterial, could have a material adverse effect on our business, financial condition and results of operations.

 

Risks Relating to Our Industry

 

We operate an independent refinery and may not be able to withstand volatile market conditions, compete on the basis of price or obtain sufficient crude oil in times of shortage to the same extent as integrated, multinational oil companies.

 

We compete with a broad range of companies in our refining and petroleum product marketing operations.

 

Many of these competitors are integrated, multinational oil companies that are substantially larger than we are. Because of their diversity, integration of operations, larger capitalization, larger and more complex refineries and greater resources, these companies may be better able to withstand volatile market conditions relating to crude oil and refined product pricing, to compete on the basis of price and to obtain crude oil in times of shortage.

 

We are subject to loss of market share or pressure to reduce prices in order to compete effectively with a changing group of competitors in a fragmented retail industry.

 

The industry in which we operate our retail fuel and convenience stores is highly competitive and marked by ease of entry and constant change in the number and type of retailers offering the products and services found in our stores. We compete with other convenience store chains, gas stations, supermarkets, drug stores, discount stores, club stores, mass merchants, fast food operations and other retail outlets. In some of our markets, our competitors have been in existence longer and have greater financial, marketing and other resources than we do. As a result, our competitors may be able to respond better to changes in the economy and new opportunities within the industry.

 

In recent years, several non-traditional retailers, such as supermarkets, club stores and mass merchants, have affected the convenience store industry by entering the retail fuel business. These non-traditional gasoline retailers have obtained a significant share of the motor fuels market and we expect their market share to grow. Because of their diversity, integration of operations, experienced management and greater resources, these companies may be better able to withstand volatile market conditions or levels of low or no profitability in the retail segment. In addition, these retailers may use promotional pricing or discounts, both at the pump and in the store, to encourage in-store merchandise sales. These activities by our competitors could pressure us to offer similar discounts, adversely affecting our profit margins. Additionally, the loss of market share by our retail fuel and convenience stores to these and other retailers relating to either gasoline or merchandise could have a material adverse effect on our business, financial condition and results of operations.

 

Independent owner-operators can operate stores with lower overhead costs than ours. Should significant numbers of independent owner-operators enter our market areas, retail prices in some of our categories may be negatively affected, as a result of which our profit margins may decline at affected stores.

 

Our stores compete, in large part, based on their ability to offer convenience to customers. Consequently, changes in traffic patterns and the type, number and location of competing stores could result in the loss of customers and reduced sales and profitability at affected stores. Other major competitive factors include ease of access, pricing, timely deliveries, product and service selections, customer service, fuel brands, store appearance, cleanliness and safety.

 

We operate in a highly regulated industry and increased costs of compliance with, or liability for violation of, existing or future laws, regulations and other requirements could significantly increase our costs of doing business, thereby adversely affecting our profitability.

 

Our industry is subject to extensive laws, regulations and other requirements including, but not limited to, those relating to the environment, employment, labor, immigration, minimum wages and overtime pay, health benefits, working conditions, public accessibility, the sale of alcohol and tobacco and other requirements. A violation of any of these requirements could have a material adverse effect on our business, financial condition and results of operations.

 

Under various federal, state and local environmental requirements, as the owner or operator of our locations, we may be liable for the costs of removal or remediation of contamination at our existing or former locations, whether we knew of, or were responsible for, the presence of such contamination. We have incurred such liability in the past and several of our current and former locations are the subject of ongoing remediation projects. The failure to timely report and properly remediate contamination may subject us to liability to third parties and may adversely affect our ability to sell or rent our property or to borrow money using our property as collateral. Additionally, persons who arrange for the disposal or treatment of hazardous substances also may be liable for the costs of removal or remediation of these substances at sites where they are located, regardless of whether the site is owned or operated by that person. We typically arrange for the treatment or disposal of hazardous substances in our refining operations. We do not typically do so in our retail operations, but we may nonetheless be deemed to have arranged for the disposal or treatment of hazardous substances. Therefore, we may be liable for removal or remediation costs, as well as other related costs, including fines, penalties and damages resulting from injuries to persons, property and natural resources.

 

In the future, we may incur substantial expenditures for investigation or remediation of contamination that has not been discovered at our current or former locations or locations that we may acquire. In addition, new legal requirements, new interpretations of existing legal requirements, increased legislative activity and governmental enforcement and other developments could require us to make additional unforeseen expenditures. Companies in the petroleum industry, such as us, are currently a particular target of investigative activity. For example, in the aftermath of Hurricanes Katrina and Rita in 2005, the Federal Trade Commission launched an investigation of gasoline pricing among producers and suppliers of petroleum products, including us, and state officials commenced price gouging investigations of retail operators, including us. The assessment of fines and penalties against us or damaging publicity as a result of these or similar investigations, or our need to incur costs associated with complying with any resulting new legal or regulatory requirements that are substantial and not adequately provided for, could have a material adverse effect on our business, financial condition and results of operations.

 

Our refining margins may decline as a result of increases in the prices of crude oil and other feedstocks.

 

Our earnings, cash flow and profitability from our refining operations depend on the margin above fixed and variable expenses (including the cost of refinery feedstocks, such as crude oil) at which we are able to sell refined petroleum products. Refining margins historically have been and are likely to continue to be volatile, as a result of numerous factors beyond our control, including the supply of and demand for crude oil, other feedstocks, gasoline and other refined petroleum products. Such supply and demand are affected by, among other things:

 

 

Our fuel gross profit may decline as a result of increases in the prices of crude oil, other feedstocks and refined petroleum products.

 

Significant increases and volatility in costs of crude oil, other feedstocks and refined petroleum products could result in significant increases in the retail price of refined petroleum products and in lower retail fuel gross margin per gallon. Increases in the retail price of refined petroleum products could impact consumer demand for fuel. In addition, the volatility in costs of fuel, principally natural gas, and other utility services, principally electricity, used by our refinery and other operations affect our operating costs. Fuel and utility prices have been, and will continue to be, affected by factors that are beyond our control, such as supply and demand for fuel and utility services in both local and regional markets. This volatility makes it extremely difficult to predict the impact future wholesale cost fluctuations will have on our business, financial condition and results of operations. These factors could impact materially our fuel gallon volume, fuel gross profit and overall customer traffic, which in turn would adversely impact our merchandise sales.

 

If the market value of our inventory declines to an amount less than our LIFO basis, we would record a write-down of inventory and a non-cash charge to cost of sales, which would adversely affect our earnings.

 

The nature of our business requires us to maintain substantial quantities of crude oil, refined petroleum product and blendstock inventories. Because crude oil and refined petroleum products are commodities, we have no control over the changing market value of these inventories. Because our refinery inventory is valued at the lower of cost or market value under the last-in, first-out, or LIFO, inventory valuation methodology, if the market value of our inventory were to decline to an amount less than our LIFO basis, we would record a write-down of inventory and a non-cash charge to cost of sales.

 

Anti-smoking measures, increases in tobacco taxes and wholesale cost increases of tobacco products could reduce our tobacco product sales.

 

Sales of tobacco products accounted for approximately 9%, 10% and 12% of net sales of our retail segment for the years ended December 31, 2006, 2005 and 2004, respectively. Significant increases in wholesale cigarette costs, increased taxes on tobacco products, declines in the percentage of smokers in the general population, additional legal restrictions on smoking in public or private establishments, future legislation and national and local campaigns to discourage smoking in the United States have had an adverse effect on the demand for tobacco products and could have a material adverse effect on our business, financial condition and results of operations. Competitive pressures in our markets can make it difficult to pass price increases on to our customers. This could materially and adversely affect our retail price of cigarettes, cigarette unit volume and net sales, merchandise gross profit and overall customer traffic. Because we derive a significant percentage of our net sales from tobacco products, a decline in net sales from the sale of tobacco products or decrease in margins on our tobacco product sales could have a material adverse effect on our business, financial condition and results of operations.

 

A terrorist attack on our refinery assets, or threats of war or actual war, may hinder or prevent us from conducting our business.

 

Terrorist attacks in the United States and the war with Iraq, as well as events occurring in response or similar to or in connection with them, may harm our business. Energy-related assets (which could include refineries, pipelines and terminals such as ours) may be at greater risk of future terrorist attacks than other possible targets in the United States. In addition, the State of Israel, where our majority stockholder, Delek Group Ltd., is based, has suffered armed conflicts and political instability in recent years. We may be more susceptible to terrorist attack as a result of our connection to an Israeli owner. On the date of this report, half of our directors reside in Israel. Our business may be harmed if armed conflicts or political instability in Israel cause one or more of our directors to become unavailable to serve on our board of directors.

 

A direct attack on our assets or the assets of others used by us could have a material adverse effect on our business, financial condition and results of operations. In addition, any terrorist attack could have an adverse impact on energy prices, including prices for our crude oil, other feedstocks and refined petroleum products, and an adverse impact on the margins from our refining and petroleum product marketing operations. In addition, disruption or significant increases in energy prices could result in government-imposed price controls.

 

Risks Relating to Our Business

 

Due to the concentration of our stores in the southeastern United States, an economic downturn in that region could cause our sales and the value of our assets to decline.

 

Substantially all of our stores are located in the southeastern United States. As a result, our results of operations are subject to general economic conditions in that region. An economic downturn in the Southeast could cause our sales and the value of our assets to decline and have a material adverse effect on our business, financial condition and results of operations.

 

We may not be able to successfully execute our strategy of growth through acquisitions.

 

A significant part of our growth strategy is to acquire assets such as our refinery, pipeline and terminals, and our retail fuel and convenience stores that complement our existing sites or broaden our geographic presence, and if attractive opportunities arise, assets in complementary new lines of business. From our inception in 2001 through December 31, 2006, we acquired our refinery and our refined products terminals in Tyler, we acquired 394 retail fuel and convenience stores and we developed our wholesale fuel business, in seven major transactions and several smaller transactions. We expect to continue to acquire retail fuel and convenience stores, refinery assets and product terminals and pipelines as a major element of our growth strategy, however:

 

 

Acquisitions involve risks that could cause our actual growth or operating results to differ adversely compared with our expectations.

 

Due to our emphasis on growth through acquisitions, we are particularly susceptible to transactional risks. For example:

 

 

We are relatively new to the refining business and may enter new lines of business in which we are inexperienced.

 

In April 2005, we acquired the Tyler refinery, and our pipeline and other refining, product terminal and crude oil pipeline assets located in Tyler, Texas. Prior to this acquisition, we were not involved in refining operations. As a result of our recent entry into the refining business, we may not be able to successfully enter into advantageous business relationships with other refinery, pipeline or terminal operators, or wholesale marketers comparable to those which more established refiners may be able to enter. Therefore, we may be unable to take full advantage of business opportunities for the refining business and we may encounter difficulties in meeting our expectations or the expectations of investors for the operating results of the refining business.

 

We continually evaluate strategic opportunities for growth, which may include opportunities in new lines of business, in which we currently have no operations and lack experience. Our ability to succeed in any new line of business will depend upon our ability to address and overcome limitations in our experience.

 

We may incur significant costs and liabilities with respect to investigation and remediation of existing environmental conditions at our refinery.

 

Prior to our purchase of the refinery and pipeline, the previous owner had been engaged for many years in the investigation and remediation of liquid hydrocarbons which contaminated soil and groundwater at the purchased facilities. Upon purchase of the facilities, we became responsible and liable for certain costs associated with the continued investigation and remediation of known and unknown impacted areas at the refinery. In the future, it may be necessary to conduct further assessments and remediation efforts at the refinery and pipeline locations. In addition, we have identified and self-reported certain other environmental matters subsequent to our purchase of the refinery. Based upon environmental evaluations performed by third parties subsequent to our purchase of the Tyler refinery, we recorded an environmental liability of approximately $7.9 million at the acquisition date for the estimated costs of environmental remediation for our refinery and crude oil pipeline. We expect remediation of soil and groundwater at the refinery to continue for the foreseeable future. The need to make future expenditures for these purposes that exceed the amounts we estimate and accrue for could have a material adverse effect on our business, financial condition and results of operations.

 

We may incur significant costs and liabilities in connection with new environmental regulations and prior non-compliance with air emission regulations.

 

We anticipate that compliance with new regulations, lowering the permitted level of sulfur in gasoline, will require us to spend approximately $64.8 million in capital costs between 2007 and the end of 2008. In addition, as part of a national initiative, the EPA inspected the Tyler refinery in 2003 and alleged that the prior owner did not comply with certain air emission regulations. A settlement with the EPA could result in required capital expenditures and potential penalties. We currently estimate that these settlement costs and additional capital expenditures to comply with the requirements of the EPA will be approximately $10.0 million from 2007 to the end of 2010. The need to make future expenditures for these purposes that exceed the amounts we estimated for them could have a material adverse effect on our business, financial condition and results of operations.

 

A disruption in the supply or an increase in the price of light sweet crude oil would significantly affect the productivity and profitability of our refinery.

 

Our refinery mainly processes light sweet crude oils efficiently. Due to increasing demand for lower sulfur fuels, light sweet crude oils are more costly and less readily available to us than heavy sour crude oils. An inability to obtain an adequate supply of light sweet crude oils to operate our refinery at full capacity or an increase in the cost of light sweet crude oils could have a material adverse effect on our business, financial condition and results of operations.

 

The dangers inherent in our refining operations could cause disruptions and expose us to potentially significant costs and liabilities.

 

Our refining operations are subject to significant hazards and risks inherent in refining operations and in transporting and storing crude oil, intermediate and refined petroleum products. These hazards and risks include, but are not limited to, natural disasters, fires, explosions, pipeline ruptures and spills, third party interference and mechanical failure of equipment at our or third-party facilities, and other events beyond our control, any of which could result in production and distribution difficulties and disruptions, environmental pollution, personal injury or wrongful death claims and other damage to our properties and the properties of others.

 

We are particularly vulnerable to disruptions in our refining operations, because all of our refining operations are currently conducted at a single facility.

 

Because all of our refining operations are currently conducted at a single refinery, any of such events at our refinery could significantly disrupt our storage, production and distribution of crude and refined petroleum products and could have a material adverse effect on our business, financial condition and results of operations.

 

We are subject to interruptions in supply and delivery as a result of our reliance on pipelines for transportation of crude oil.

 

Our refinery receives substantially all of its crude oil through pipelines. We could experience an interruption of supply and delivery, or an increased cost of receiving crude oil, if the ability of these pipelines to transport crude oil is disrupted because of accidents, governmental regulation, terrorism, other third-party action or other events beyond our control. The unavailability for our use for a prolonged period of time of any of the pipelines that are used to transport crude oil to our refinery could have a material adverse effect on our business, financial condition and results of operations.

 

Our existing inbound pipeline capacity will be insufficient to support materially increased production from our refinery.

 

We rely on our pipeline and a leased pipeline to transport crude oil to our refinery. Due to the capacity limitations, we may be unable to draw sufficient crude oil from the inbound pipelines to support increases in our refining output. If we wish to materially increase our refining output, we will need to upgrade or supplement the inbound pipelines, which would require us to make substantial additional capital expenditures.

 

Our refinery has only limited access to an outbound pipeline, which we do not own, for distribution of our refined petroleum products.

 

During the year ended December 31, 2006, approximately 89% of our refinery sales were completed through a rack system located at our refinery. Unlike other refiners, we do not own, and have limited access to, an outbound pipeline for distribution of our refinery products to our customers. Our lack of an outbound pipeline may undermine our ability to attract new customers for our refined petroleum products or increase sales of our refinery products.

 

If the price of crude oil increases significantly, we may not be able to finance the purchase of enough crude oil to operate our refinery at full capacity.

 

We rely in part on our ability to borrow to collateralize or purchase crude oil for our refinery. If the price of crude oil increases significantly, we may not have sufficient borrowing capacity, and may not be able to sufficiently increase borrowing capacity, under our existing credit facilities to purchase enough crude oil to operate our refinery at full capacity. Our failure to operate our refinery at full capacity could have a material adverse effect on our business, financial condition and results of operations.

 

An interruption or termination of supply and delivery of refined products to our wholesale business could result in a decline in our sales and earnings.

 

Our marketing segment sells refined products produced by refineries owned by third parties. Further, in 2006, Magellan supplied 96% of the products sold by our marketing segment. We could experience an interruption or termination of supply or delivery of refined products if these refineries or Magellan partially or completely shut down their operations, temporarily or permanently. The ability of these refineries and Magellan to supply refined products to us could be disrupted by anticipated events such as scheduled upgrades or maintenance, as well as events beyond their control, such as unscheduled maintenance, fires, floods, storms, explosions, power outages, accidents, acts of terrorism or other catastrophic events; labor difficulties and work stoppages; governmental or private party litigation; or legislation or regulation that adversely impacts refinery operations. In addition, any reduction in capacity of other pipelines that connect with Magellan’s pipelines or our pipelines due to testing, line repair, reduced operating pressures, or other causes could result in reduced volumes of refined product supplied to our marketing business. A reduction in the volume of refined products supplied to our marketing segment could adversely affect our sales and earnings.

 

An increase in competition in the market in which we sell our refined products could lower prices and adversely affect our sales and profitability.

 

Our Tyler refinery is the only supplier of a full range of refined petroleum products within a radius of approximately 115 miles of its location and there are no competitive fuel loading terminals within approximately 90 miles of our San Angelo terminal. If a refined petroleum products delivery pipeline is built in or around the Tyler, Texas area, or a competing terminal is built closer to the San Angelo area we could lose our niche market advantage, which could have a material adverse effect on our business, financial condition and results of operations.

 

We may be unable to negotiate market price risk protection in contracts with unaffiliated suppliers of refined products.

 

In 2006, we obtained 96% of our supply of refined products for our marketing segment under contracts that contain provisions that mitigate the market price risk inherent in the purchase and sale of refined products. We cannot assure you that we will be able to negotiate similar market price protections in other contracts that we enter into for the supply of refined products. To the extent that we purchase refined product inventory at prices that do not compare favorably to the prices at which we are able to sell refined products, our sales and margins may be adversely affected.

 

Our debt levels may limit our flexibility in obtaining additional financing and in pursuing other business opportunities.

 

We have a significant amount of debt. As of December 31, 2006, we had total consolidated debt, including current maturities, of $286.6 million. In addition to our outstanding debt, as of December 31, 2006, our borrowing availability under our various credit facilities was $142.4 million.

 

Our significant level of debt could have important consequences for us. For example, it could:

 

 

 

In addition, a substantial portion of our debt has a variable rate of interest, which increases our vulnerability to interest rate fluctuations.

 

If we are unable to meet our debt (principal and interest) and lease obligations, we could be forced to restructure or refinance our obligations, seek additional equity financing or sell assets, which we may not be able to do on satisfactory terms or at all. Our default on any of those obligations could have a material adverse effect on our business, financial condition and results of operations. In addition, if new debt is added to our current debt levels, the related risks that we now face would intensify.

 

Our subsidiaries’ debt agreements contain operating and financial restrictions that might constrain our business and financing activities.

 

The operating and financial restrictions and covenants in our subsidiaries’ credit facilities and any future financing agreements could adversely affect our ability to finance future operations or capital needs or to engage, expand or pursue our business activities. For example, to varying degrees our credit facilities restrict our subsidiaries’ ability to:

 

 

Other restrictive covenants require that we meet fixed charge coverage, interest charge coverage and leverage tests as described in the credit facility agreements. Our ability to comply with the covenants and restrictions contained in our debt instruments may be affected by events beyond our control, including prevailing economic, financial and industry conditions. If market or other economic conditions deteriorate, our ability to comply with these covenants and restrictions may be impaired. If we breach any of the restrictions or covenants in our debt agreements, a significant portion of our indebtedness may become immediately due and payable, and our lenders’ commitments to make further loans to us may terminate. We might not have, or be able to obtain, sufficient funds to make these immediate payments. In addition, our obligations under our credit facilities are secured by substantially all of our assets. If we are unable to repay our indebtedness under our credit facilities when due, the lenders could seek to foreclose on the assets or Delek may be required to contribute additional capital to its subsidiaries. Any of these outcomes could have a material adverse effect on our business, financial condition and results of operations.

 

We may seek to grow by opening new retail fuel and convenience stores in new geographic areas.

 

Since our inception, we have grown primarily by acquiring retail fuel and convenience stores in the southeastern United States. We may seek to grow by selectively pursuing acquisitions or by opening new retail fuel and convenience stores in states adjacent to those in which we currently operate, or in which we currently have a relatively small number of stores. This growth strategy would present numerous operational and competitive challenges to our senior management and employees and would place significant pressure on our operating systems. In addition, we cannot assure you that consumers located in the regions in which we may expand our retail fuel and convenience store operations would be as receptive to our retail fuel and convenience stores as consumers in our existing markets. The achievement of our expansion plans will depend in part upon our ability to:

 

 

 

We cannot assure you that we will achieve our expansion goals, manage our growth effectively, or operate our existing and new retail fuel and convenience stores profitability. The failure to achieve any of the foregoing could have a material adverse effect on our business, financial condition and results of operations.

 

Adverse weather conditions or other unforeseen developments could damage our facilities, reduce customer traffic and impair our ability to produce and deliver refined petroleum products or receive supplies for our retail fuel and convenience stores.

 

The regions in which we operate are susceptible to severe storms including hurricanes, thunderstorms, extended periods of rain, ice storms and snow, all of which we have experienced in the past few years. Inclement weather conditions, as well as severe storms such as Hurricanes Katrina and Rita, could damage our facilities, have a significant adverse impact on consumer behavior, travel and retail fuel and convenience store traffic patterns or impede our ability to operate our locations. If such conditions prevail in Texas, they could undermine our ability to produce and transport products from our refinery and receive and distribute products at our terminals. Regional occurrences such as energy shortages or increases in energy prices, fires and other natural disasters, could also hurt our business. The occurrence of any of these developments could have a material adverse effect on our business, financial condition and results of operations.

 

Our operating results are seasonal and generally lower in the first and fourth quarters of the year for our refining segment and in the first quarter of the year for our retail segment. We depend on favorable weather conditions in the spring and summer months.

 

Demand for gasoline and other merchandise is generally higher during the summer months than during the winter months due to seasonal increases in highway traffic. As a result, the operating results of our refining segment and wholesale fuel segment are generally lower for the first and fourth quarters of each year. Seasonal fluctuations in highway traffic also affect sales of motor fuels and merchandise in our retail fuel and convenience stores. As a result, the operating results of our retail segment are generally lower for the first quarter of the year.

 

Weather conditions in our operating area also have a significant effect on our operating results. Customers are more likely to purchase higher profit margin items at our retail fuel and convenience stores, such as fast foods, fountain drinks and other beverages and more gasoline during the spring and summer months, thereby typically generating higher revenues and gross margins for us in these periods. Unfavorable weather conditions during these months and a resulting lack of the expected seasonal upswings in highway traffic and sales could have a material adverse effect on our business, financial condition and results of operations.

 

We depend on one supplier for a significant portion of our retail fuel supply.

 

We purchased approximately 33% of our fuel for our retail fuel and convenience stores for the year ended December 31, 2006 from a single supplier, Valero Marketing and Supply. Our contract with Valero expires in 2008 and provides us with discounts that may not be available to us from other suppliers. We cannot assure you that we will be able to renew our contract with Valero on terms that are satisfactory to us, if at all, or that we would be able to secure equally favorable terms from another supplier. A change of fuel supplier, a disruption in supply or a significant change in our relationship with this fuel supplier could lead to an increase in our fuel costs and could have a material adverse effect on our business, financial condition and results of operations.

 

We depend on one wholesaler for a significant portion of our convenience store merchandise.

 

We purchased approximately 69% of our merchandise, including most tobacco products and grocery items, for the year ended December 31, 2006 from a single wholesale grocer, McLane Company, Inc., a wholly-owned subsidiary of Berkshire Hathaway Inc. A change of merchandise suppliers, a disruption in supply or a significant change in our relationship or pricing with our principal merchandise supplier could lead to an increase in our cost of goods or a reduction in the reliability of timely deliveries and could have a material adverse effect on our business, financial condition and results of operations.

 

In addition, we believe that our arrangements with vendors, including McLane, with respect to allowances, payment terms and operational support commitments, have enabled us to decrease the operating expenses of convenience stores that we acquire. If we are unable to maintain favorable arrangements with these vendors, we may be unable to continue to effect operating expense reductions at convenience stores we have acquired or will acquire.

 

If our proprietary technology systems are ineffective in enabling our managers to efficiently manage our operations, our operating performance will decline.

 

We invest in and rely heavily upon our proprietary information technology systems to enable our managers to access real-time data from our supply chain and inventory management systems, our security systems and to monitor customer and sales information. For example, our proprietary technology systems enable our managers to view data for our stores, merchandise or fuel on an aggregate basis or by specific store, type of merchandise or fuel product, which in turn enables our managers to quickly determine whether budgets and projected margins are being met and to make adjustments in response to any shortfalls. In the absence of this proprietary information technology, our managers would be unable to respond as promptly in order to reduce inefficiencies in our cost structure and maximize our sales and margins.

 

Our insurance policies do not cover all losses, costs or liabilities that we may experience, and insurance companies that currently insure companies in the energy industry may cease to do so or substantially increase premiums.

 

We maintain significant insurance coverage, including property insurance capped at $500.0 million for our refinery, pipelines, and marketing terminals, and $35.0 million for our retail fuel and convenience stores. However, our insurance coverage does not cover all potential losses, costs or liabilities, and our business interruption insurance coverage does not apply unless a business interruption exceeds 45 days. We could suffer losses for uninsurable or uninsured risks or in amounts in excess of our existing insurance coverage.

 

The energy industry is highly capital intensive, and the entire or partial loss of individual facilities can result in significant costs to both industry participants, such as us, and their insurance carriers. In recent years, several large energy industry claims have resulted in significant increases in the level of premium costs and deductible periods for participants in the energy industry. For example, during 2005, Hurricanes Katrina and Rita caused significant damage to several petroleum refineries along the Gulf Coast, in addition to numerous oil and gas production facilities and pipelines in that region. As a result of large energy industry claims, insurance companies that have historically participated in underwriting energy-related facilities may discontinue that practice, or demand significantly higher premiums or deductible periods to cover these facilities. If significant changes in the number or financial solvency of insurance underwriters for the energy industry occur, or if other adverse conditions over which we have no control prevail in the insurance market, we may be unable to obtain and maintain adequate insurance at reasonable cost.

 

In addition, we cannot assure you that our insurers will renew our insurance coverage on acceptable terms, if at all, or that we will be able to arrange for adequate alternative coverage in the event of non-renewal. The unavailability of full insurance coverage to cover events in which we suffer significant losses could have a material adverse effect on our business, financial condition and results of operations.

 

A substantial portion of our refinery workforce is unionized, and we may face labor disruptions that would interfere with our operations.

 

As of December 31, 2006, we employed 247 people at our Tyler refinery and pipeline and had collective bargaining agreements covering 147 of our operations and maintenance hourly employees and 21 of our refinery’s truck drivers, which agreements expire on January 1, 2009 and January 31, 2009, respectively. Although these collective bargaining agreements contain provisions to discourage strikes or work stoppages, we cannot assure you that strikes or work stoppages will not occur. A strike or work stoppage could have a material adverse effect on our business, financial condition and results of operations.

 

We are dependent on gasoline sales at our retail fuel and convenience stores which makes us susceptible to increases in the cost of gasoline and interruptions in fuel supply.

 

Fuel sales represented approximately 76%, 73% and 70% of our net sales of our retail segment for the years ended December 31, 2006, 2005 and 2004, respectively. Our dependence on fuel sales makes us susceptible to increases in the cost of gasoline. As a result, fuel profit margins have a significant impact on our earnings. The volume of fuel sold by us and our fuel profit margins are affected by numerous factors beyond our control, including the supply and demand for fuel, volatility in the wholesale fuel market and the pricing policies of competitors in local markets. Although we can rapidly adjust our pump prices to reflect higher fuel costs, a material increase in the price of fuel could adversely affect demand. A material, sudden increase in the cost of fuel that causes our fuel sales to decline could have a material adverse effect on our business, financial condition and results of operations.

 

Our dependence on gasoline sales makes us susceptible to interruptions in fuel supply. We typically have no more than a five-day supply of fuel at each of our retail fuel and convenience stores. Our fuel contracts do not guarantee an uninterrupted, unlimited supply in the event of a shortage. In addition, gasoline sales generate customer traffic to our retail fuel and convenience stores. As a result, decreases in gasoline sales, in the event of a shortage or otherwise, could adversely affect our merchandise sales. A serious interruption in the supply of gasoline could have a material adverse effect on our business, financial condition and results of operations.

 

We may incur losses as a result of our forward contract activities and derivative transactions.

 

We occasionally use derivative financial instruments, such as interest rate swaps and interest rate cap agreements, and fuel related derivative transactions, and we expect to continue to enter into these types of transactions. We cannot assure you that the strategies underlying these transactions will be successful. If any of the instruments we utilize to hedge our exposure to various types of risk are not effective, we may incur losses.

 

If we violate state laws regulating our sale of tobacco and alcohol products, or if these laws are changed, our results of operations will suffer.

 

We sell tobacco products in all of our stores and alcohol products in approximately 95% of our stores. Our net sales from the sale of tobacco and alcohol products were $178.9 million, $161.9 million and $144.6 million for the years ended December 31, 2006, 2005 and 2004, respectively. State laws regulate our sale of tobacco and alcohol products. For example, state and local regulatory agencies have the power to approve, revoke, suspend or deny applications for, and renewals of, permits and licenses relating to the sale of these products or to seek other remedies. Certain states regulate relationships, including overlapping ownership, among alcohol manufacturers, wholesalers and retailers and may deny or revoke licensure if relationships in violation of the state laws exist. In addition, certain states have adopted or are considering adopting “warm beer laws” that seek to discourage driving under the influence of alcohol by prohibiting the sale of refrigerated beer. Our violation of state laws regulating our sale of tobacco and alcohol products or a change in these laws, such as the adoption of a “warm beer laws” in one or more of the states we operate, could have a material adverse effect on our business, financial condition and results of operations.

 

If we fail to meet our obligations under our long-term branded gasoline supply agreement with BP, we may incur penalties and/or the agreement may be terminated.

 

In December 2005, we entered into a branded gasoline jobber supply agreement with BP, to purchase a portion of our gasoline products for a minimum of 15 years. The agreement requires us to purchase specified minimum quantities of branded gasoline products annually, which quantities escalate on a yearly basis. Under this agreement, in the year ended December 31, 2006, BP locations accounted for approximately 11% of our total gasoline sales volume. If we fail to purchase the applicable annual minimum quantities, BP may terminate the agreement and we could be required to pay BP damages equal to the difference between the specified contractual minimum annual gallons of gasoline products and the amount actually purchased by us, multiplied by a specified per gallon amount. The termination of the agreement by BP and the imposition of damages could have a material adverse effect on our business, financial condition and results of operations.

 

If we are unable to continue using the BP, Exxon, Shell, Conoco or Chevron brand names or if there is negative publicity concerning any of these major oil companies, sales at certain of our stores may suffer.

 

Branded stores, i.e., BP, Exxon, Shell, Conoco and Chevron, represent 26% of the total fuel sales volume from our retail locations. If these stores lose the right to use these brand names (and accompanying brand advertising), or if there is negative publicity concerning any of these major oil companies, we could suffer a decline in sales at these stores.

 

It may be difficult to serve process on or enforce a United States judgment against those of our directors who reside in Israel.

 

On the date of this report, half of our directors reside in the State of Israel. As a result, you may have difficulty serving legal process within the United States upon any of these persons. You may also have difficulty enforcing, both in and outside the United States, judgments you may obtain in United States courts against these persons in any action, including actions based upon the civil liability provisions of United States federal or state securities laws, because a substantial portion of the assets of these directors is located outside of the United States. Furthermore, there is substantial doubt that the courts of the State of Israel would enter judgments in original actions brought in those courts predicated on U.S. federal or state securities laws.

 

If we are, or become, a U.S. real property holding corporation, special tax rules may apply to a sale, exchange or other disposition of common stock and non-U.S. holders may be less inclined to invest in our stock as they may be subject to U.S. federal income tax in certain situations.

 

A non-U.S. holder will be subject to U.S. federal income tax with respect to gain recognized on the sale, exchange or other disposition of common stock if we are, or were, a “U.S. real property holding corporation,” or a USRPHC, at any time during the shorter of the five-year period ending on the date of the sale or other disposition and the period such non-U.S. holder held our common stock (the shorter period referred to as the “lookback period”). In general, we would be a USRPHC if the fair market value of our “U.S. real property interests,” as such term is defined for U.S. federal income tax purposes, equals or exceeds 50% of the sum of the fair market value of our worldwide real property interests and our other assets used or held for use in a trade or business. Based on our estimates of the fair market value of our U.S. real property interests, we believe that, as of December 31, 2006, less than 27% of our assets constituted U.S. real property interests. However, because the test for determining USRPHC status is applied on certain specific determination dates and is dependent upon a number of factors, some of which are beyond our control (including, for example, fluctuations in the value of our assets); it is possible that we will become a USRPHC in the future. In addition, it is possible that the Internal Revenue Service will not agree with our conclusions regarding the valuation of our assets or our current USRPHC status. If we are or become a USRPHC, so long as our common stock is regularly traded on an established securities market (such as the New York Stock Exchange (NYSE)), only a non-U.S. holder who, actually or constructively, holds or held during the lookback period more than 5% of our common stock will be subject to U.S. federal income tax on the disposition of our common stock.

 

The costs, scope and timelines of our capital improvement projects may deviate significantly from our original plans and estimates.

 

We may experience unanticipated increases in the cost, scope and completion time for our capital improvement projects, including capital improvement projects at the refinery undertaken to comply with government regulations. Equipment that we require to complete capital improvement projects may be unavailable to us at expected costs or within expected time periods, increasing project costs or causing delays. Additionally, employee or contractor labor expense may exceed our expectations. The inability to complete our capital improvement projects within the cost parameters and timelines we anticipate due to these or other factors beyond our control could have a material adverse effect on our business, financial condition and results of operations.

 

Risks Related to Our Common Stock

 

The price of our common stock may fluctuate significantly, and you could lose all or part of your investment.

 

The market price of our common stock may be influenced by many factors, some of which are beyond our control, including:

 

 

In recent years, the stock market has experienced extreme price and volume fluctuations. This volatility has had a significant impact on the market price of securities issued by many companies, including companies in our industry. The changes frequently appear to occur without regard to the operating performance of these companies. The price of our common stock could fluctuate based upon factors that have little or nothing to do with our company, and these fluctuations could materially reduce our stock price.

 

In the past, some companies that have had volatile market prices for their securities have been subject to securities class action suits filed against them. The filing of a lawsuit against us, regardless of the outcome, could have a material adverse effect on our business, financial condition and results of operations, as it could result in substantial legal costs and a diversion of our management’s attention and resources.

 

You may suffer substantial dilution.

 

You will suffer dilution if stock, restricted stock units, restricted stock, stock options, warrants or other equity awards, whether currently outstanding or subsequently granted, are exercised.

 

We are a “controlled company” within the meaning of the NYSE rules and, as a result, will qualify for, and intend to rely on, exemptions from certain corporate governance requirements.

 

A company of which more than 50% of the voting power is held by an individual, a group or another company is a “controlled company” and may elect not to comply with certain corporate governance requirements of the NYSE, including:

 

 

 

We utilize all of these exemptions. Accordingly, you will not have the same protections afforded to stockholders of companies that are subject to all of the corporate governance requirements of the NYSE.

 

Our controlling stockholder, Delek Group Ltd., may have conflicts of interest with other stockholders in the future.

 

At December 31, 2006, Delek Group Ltd. owned approximately 77% of our outstanding common stock. As a result, Delek Group Ltd. and its controlling shareholder, Mr. Sharon (Tshuva), will continue to be able to control the election of our directors, influence our corporate and management policies (including the declaration of dividends) 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. So long as Delek Group Ltd. continues to own a significant amount of the outstanding shares of our common stock, Delek Group Ltd. will continue to be able to influence or effectively control our decisions, including whether to pursue or consummate potential mergers or acquisitions, asset sales, and other significant corporate transactions. We cannot assure you that the interests of Delek Group Ltd. will coincide with the interests of other holders of our common stock.

 

Future sales of our common stock by our controlling stockholder, Delek Group Ltd., could depress the price of our common stock.

 

The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market after this offering or the perception that these sales could occur. These sales, or the possibility that these sales may occur, also might make it more difficult for us to sell equity securities in the future at a time and at a price that we deem appropriate. At December 31, 2006, 39,389,869 of our shares of common stock were controlled by Delek Group, Ltd. In addition, Delek Group Ltd. will be able to register under the Securities Act, subject to specified limitations, common stock it owns, pursuant to a registration rights agreement with us. The registration rights we granted to Delek Group Ltd. apply to all shares of our common stock owned by Delek Group Ltd. and entities it controls.

 

We depend upon our subsidiaries for cash to meet our obligations and pay any dividends.

 

We are a holding company. Our subsidiaries conduct substantially all of our operations and own substantially all of our assets. Consequently, our cash flow and our ability to meet our obligations or pay dividends to our stockholders depend upon the cash flow of our subsidiaries and the payment of funds by our subsidiaries to us in the form of dividends, tax sharing payments or otherwise. Our subsidiaries’ ability to make any payments will depend on many factors, including their earnings, the terms of their indebtedness, tax considerations and legal restrictions.

 

We may be unable to pay future dividends in the anticipated amounts and frequency set forth herein.

 

We will only be able to pay dividends from our available cash on hand and funds received from our subsidiaries. Our ability to receive dividends from our subsidiaries is restricted under the terms of their senior secured credit facilities. The declaration of future dividends on our common stock will be at the discretion of our board of directors and will depend upon many factors, including our results of operations, financial condition, earnings, capital requirements, restrictions in our debt agreements and legal requirements. Although we currently intend to pay quarterly cash dividends on our common stock at an annual rate of $0.15 per share, we cannot assure you that any dividends will be paid in the anticipated amounts and frequency set forth herein, if at all.

 

Provisions of Delaware law and our organizational documents may discourage takeovers and business combinations that our stockholders may consider in their best interests, which could negatively affect our stock price.

 

In addition to the fact that Delek Group Ltd. owns the majority of our common stock, provisions of Delaware law and our amended and restated certificate of incorporation and amended and restated bylaws may have the effect

of delaying or preventing a change in control of our company or deterring tender offers for our common stock that other stockholders may consider in their best interests.

 

Our certificate of incorporation authorizes us to issue up to 10,000,000 shares of preferred stock in one or more different series with terms to be fixed by our board of directors. Stockholder approval is not necessary to issue preferred stock in this manner. Issuance of these shares of preferred stock could have the effect of making it more difficult and more expensive for a person or group to acquire control of us and could effectively be used as an anti-takeover device. On the date of this report, no shares of our preferred stock are outstanding.

 

Our bylaws provide for an advance notice procedure for stockholders to nominate director candidates for election or to bring business before an annual meeting of stockholders and require that special meetings of stockholders be called only by our chairman of the board, president or secretary after written request of a majority of our board of directors.

 

The anti-takeover provisions of Delaware law and provisions in our organizational documents may prevent our stockholders from receiving the benefit from any premium to the market price of our common stock offered by a bidder in a takeover context. Even in the absence of a takeover attempt, the existence of these provisions may adversely affect the prevailing market price of our common stock if they are viewed as discouraging takeover attempts in the future.

 

We are exposed to risks relating to evaluations of internal controls required by Section 404 of the Sarbanes-Oxley Act of 2002.

 

We are in the process of evaluating our internal controls systems to allow management to report on, and our independent auditors to audit, our internal controls over financial reporting. We will be performing the system and process evaluation and testing (and any necessary remediation) required to comply with the management certification and auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act of 2002. We will be required to comply with Section 404 by no later than December 31, 2007. However, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of the same on our operations.

 

Furthermore, upon completion of this process, we may identify control deficiencies of varying degrees of severity under applicable SEC and Public Company Accounting Oversight Board rules and regulations that remain unremediated. As a public company, we are required to report, among other things, control deficiencies that constitute a “material weakness” or changes in internal controls that, or are reasonably likely to, materially affect internal controls over financial reporting. A “material weakness” is a significant deficiency, or combination of significant deficiencies that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected. We are aware that we need, and we intend, to hire additional accounting personnel in order to comply with the rules and regulations that will apply to us as a public company.

 

If we fail to implement the requirements of Section 404 in a timely manner, we might be subject to sanctions or investigation by regulatory authorities such as the SEC or the NYSE. Additionally, failure to comply with Section 404 or the report by us of a material weakness may cause investors to lose confidence in our financial statements and our stock price may be adversely affected. If we fail to remedy any material weakness, our financial statements may be inaccurate, we may face restricted access to the capital markets, and our stock price may decline.

 

None.

 

We own our refinery in Tyler, Texas, which is used by our refining segment and is situated on approximately 100 out of a total of approximately 712 acres of land owned by us, along with an associated crude oil pipeline and light products loading facilities. We also own terminals in San Angelo and Abilene, Texas, which are used by our marketing segment, along with 114 miles of refined product pipelines and light product loading facilities.

 

As of December 31, 2006, we owned the real estate at 237 retail fuel and convenience store locations, and leased the real property at 179 stores. Of the stores owned or leased by us, 21 were either leased or subleased to third party dealers; 40 other dealer sites are owned or leased independently by dealers.

 

The following table summarizes the real estate position of our retail segment.

 

 

 

 

Most of our retail fuel and convenience store leases are net leases requiring us to pay taxes, insurance and maintenance costs. Of the leases that expire in less than three years, we anticipate that we will be able to negotiate acceptable extensions of the leases for those locations that we intend to continue operating. We believe that none of these leases is individually material.

 

We lease our corporate headquarters at 830 Crescent Centre Drive, Suite 300, Franklin, Tennessee. The lease is on a month-to-month basis and will expire on April 1, 2007. We have entered into a new lease for our future corporate headquarters at 7102 Commerce Way, Brentwood, Tennessee. The new lease is for 54,000 square feet of office space of which we will occupy 34,000 square feet and anticipate sub-leasing the remaining space. The lease has a 15 year term and expires in March 2022. We anticipate completing our move to the new corporate headquarters by April 1, 2007.

 

We are 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 currently known will not have a material adverse effect on our business, financial condition and results of operations in future periods.

 

None.

 

Market Information

 

Our common stock is traded on the NYSE under the symbol “DK.”

 

The following table sets forth the quarterly high and low sales prices of our common stock for each quarterly period since our common stock began trading on the New York Stock Exchange on May 4, 2006:

 

 

Holders

 

As of March 1, 2007, there were approximately 12 common stockholders of record.

 

Dividends

 

In connection with our initial public offering, our Board of Directors announced its intention to pay a regular quarterly cash dividend of $0.0375 per share of our common stock beginning in the fourth quarter of 2006. On each of December 7, 2006 and March 7, 2007, we paid a cash dividend of $0.0375 per share of our common stock to the record holders of our common stock. The dividends paid in 2006 totaled $1.9 million. We intend to continue to pay quarterly cash dividends on our common stock at an annual rate of $0.15 per share. The declaration and payment of future dividends to holders of our common stock will be at the discretion of our board of directors and will depend upon many factors, including our financial condition, earnings, legal requirements, restrictions in our debt agreements and other factors our board of directors deems relevant. We have paid no other cash dividends on our common stock during the two most recent fiscal years.

 

Recent Sales of Unregistered Securities

 

None.

 

Use of Proceeds from Registered Securities

 

On May 3, 2006, the Securities and Exchange Commission declared effective our registration statement on Form S-1 (Registration No. 333-131675) related to our initial public offering of common stock. Approximately $4.9 million was used to pay offering expenses related to the initial public offering, and approximately $12.0 million was used to pay underwriting discounts and commissions. Net proceeds of the offering after payment of offering expenses and underwriting discounts and commissions were approximately $166.9 million.

 

As of December 31, 2006, we used the net proceeds from the offering as follows:

 

 

The remaining net proceeds from the offering continue to be invested in investment grade, short-term investments.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

None.

Performance Graph

 

The following Performance Graph and related information shall not be deemed “soliciting material” or to be “filed” with the Securities and Exchange Commission, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933 or Securities Exchange Act of 1934, each as amended, except to the extent that we specifically incorporate it by reference into such filing.

 

The following graph and table compares cumulative total returns for our stockholders since May 4, 2006 (the date on which trading in Delek’s common stock on the NYSE commenced) to the Standard and Poor’s 500 Stock Index and a peer group selected by management, assuming a $100 investment made on May 4, 2006. Each of the three measures of cumulative total return assumes reinvestment of dividends. The peer group is comprised of Alon USA Energy, Inc., Frontier Oil Corp., Holly Corp., Pantry, Inc., Sunoco, Inc., Tesoro Corp., Valero Energy Corp. and Western Refining, Inc. The stock performance shown on the graph below is not necessarily indicative of future price performance.

 

COMPARISON OF CUMULATIVE TOTAL RETURN

 

 

 

The following selected financial data should be read in conjunction with Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data, of this Annual Report on Form 10-K.

 

 

 

 

Segment Data⁽¹⁾:

 

 

 

 

 

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 Delek’s consolidated financial statements and related notes included elsewhere in this Annual Report on Form 10-K. 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 Annual Report 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 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 394 company-operated retail fuel and convenience stores located in Alabama, Arkansas, Georgia, Kentucky, Louisiana, Mississippi, Tennessee and Virginia. The following presents certain significant acquisitions and pivotal events in our history:

 

 

Strategic Initiatives

 

We are committed to improving stockholder value while maintaining financial stability and flexibility by continuing to:

 

 

 

To accomplish the foregoing goals, we have taken the following actions in 2006:

 

 

Market Trends

 

The results of operations from our refining segment are significantly affected by the cost of commodities.

 

The volatility in the energy markets that we experienced in 2005 has continued in 2006 with the US Gulf Coast 5-3-2 crack spread for 2006 averaging $10.16 per barrel, but ranging from a high of $21.50 per barrel to a low of $1.07 per barrel, compared to an average of $10.58 per barrel in 2005. High demand for refined products, a strengthening economy, production interruptions and the phase out of methyl tert-butyl ether (MTBE), resulted in increases in product prices that outpaced increases in crude oil and oil products prices in 2006 compared to 2005.

 

Volatility in the wholesale cost of fuel has also increased significantly over the past year due to the factors noted above. Our average fuel cost to our retail fuel and convenience stores increased from $2.05 per gallon in 2005 to $2.34 per gallon in 2006. 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 pressure on in-store merchandise margins.

 

The cost of natural gas used for fuel in our refinery has also shown historic volatility. Our average cost of natural gas, per million British Thermal Units (MMBTU) decreased from $10.13 per MMBTU in the second half of 2005 to $7.10 per MMBTU in the second half of 2006.

 

Factors Affecting Comparability

 

The comparability of our results of operations for the year ended December 31, 2006 compared to the years ended December 31, 2005 and 2004 is affected by the following factors:

 

 

Results of Operations

 

Consolidated Results of Operation — Comparison of the Year Ended December 31, 2006 versus the Year Ended December 31, 2005

 

For the years ended December 31, 2006 and 2005, we generated net sales of $3,207.7 million and $2,031.9 million, respectively, and net income of $93.0 million and $64.1 million, respectively. The increase in both net sales and net income was primarily due to the inclusion of a full year of sales from the Tyler refinery and BP stores which were acquired in 2005, and the contribution from the acquisitions of the Fast stores and the Pride assets in the third quarter of 2006.

 

Of the $1,175.8 million increase in net sales, $611.6 million resulted from the inclusion of a full year of sales from acquisitions completed in 2005, $284.6 million of the increase was due to acquisitions completed during 2006, and the remaining increase resulted from an 8.7% increase in barrels sold per day at our refinery and higher average retail fuel prices and merchandise sales at our convenience stores.

 

Cost of goods sold was $2,818.3 million for 2006, compared to $1,731.6 million for 2005, an increase of $1,086.7 million or 63%. Of this increase, $527.7 million resulted from the inclusion of a full year of sales from acquisitions made in 2005, $275.2 million of the increase was due to acquisitions completed during 2006, and the remaining increase was due to higher costs of crude in our refining segment and higher costs of fuel in our retail segment.

 

Operating expenses were $173.2 million for 2006 compared to $133.1 million for 2005, an increase of $40.1 million or 30%. Of this increase, $30.6 million resulted from the inclusion of a full year of sales from acquisitions made in 2005 and $5.3 million was due to acquisitions completed during 2006. Also contributing to the higher operating expenses were credit card expenses at our retail segment, which increased nearly $1.8 million over 2005 as a result of higher credit card transaction amounts due primarily to higher fuel prices, as well as increases in interchange fees charged by several credit card providers.

 

General and administrative expenses were $38.2 million for 2006 compared to $23.5 million for 2005, an increase of $14.7 million or 63%. We do not allocate general and administrative expenses to the segments. The increase associated with this overhead expense was primarily due to recognition of share-based compensation

associated with the implementation of Statement of Financial Accounting Standards (SFAS) No. 123 (revised 2004), Share-Based Payment (SFAS 123R), additional bonuses associated with our initial public offering activity, increases in personnel, professional support and contractors as a result of being a public company and our efforts with Sarbanes Oxley compliance, consulting costs associated with several projects at the refinery and an increase in accrued liability related to general liability insurance. Delek has efforts underway toward meeting its requirement to certify compliance with the internal control requirements of Sarbanes-Oxley in 2007.

 

Depreciation and amortization was $22.8 million for 2006 compared to $16.1 million for 2005. This increase was primarily due to the inclusion of a full year of depreciation expense associated with the refinery compared to eight months of expense in 2005, the BP stores acquired during 2005 and the Fast stores acquired in the third quarter of 2006 which have no comparative depreciation in 2005.

 

During 2005, the sale of one convenience store, partially offset by the write-off of associated goodwill, netted a pre-tax gain of $1.6 million. There were no such sales or asset disposals in 2006.

 

During August and September 2005, we entered into forward fuel contracts to fix the purchase price of crude oil and sales price of finished grade fuel for a predetermined number of units at a future date, which had fulfillment terms of less than 60 days. We realized losses of $9.1 million during 2005, which were included as losses on forward contract activities. There were no forward contracts for fuel in 2006.

 

Interest expense was $24.2 million in 2006 compared to $17.4 million for 2005, an increase of $6.8 million. This increase was due to increased indebtedness associated with the acquisitions completed in 2006, a full year of interest associated with acquisitions completed in 2005 and higher short-term interest rates. Interest income was $7.2 million for 2006 compared to $2.1 million for 2005, an increase of $5.1 million. This increase was due primarily to higher cash and short-term investment balances as a result of the refinery’s favorable operations, as well as the proceeds received from our initial public offering in May 2006. Interest expense from related party notes payable for 2006 decreased to $1.0 million from $3.0 million in 2005. This decrease was due largely to the payment of all related party debt from proceeds received in our initial public offering in May 2006.

 

During the second quarter of 2005, we wrote off $3.5 million of deferred financing costs associated with the refinancing of a portion of our long-term debt. In 2006, we recognized only a nominal loss in the fair market value of our interest rate derivatives as compared to a $1.5 million gain for 2005.

 

In 2006, we recorded a $0.2 million expense in connection with guarantee fees payable to Delek Group Ltd. relating primarily to the guaranty of a portion of our debt incurred in connection with the acquisition of the Tyler refinery, compared to $0.6 million expense in 2005. These guarantees were eliminated during the second quarter of 2006.

 

Income tax expense was $44.0 million for 2006, compared to $34.9 million for 2005, an increase of $9.1 million. This increase primarily resulted from our higher taxable income in 2006 compared to 2005. Our effective tax rate was 32.1% for 2006, compared to 35.1% for 2005. Therefore, the increase in pre-tax income was partially offset by a decrease in our effective rate.

 

In 2006 we benefited from other tax incentives relating to our refinery operations. Substantially all of our refinery operations are conducted through a Texas limited partnership, which is not subject to Texas franchise tax. The limited partnership’s 0.1% general partner was subject to Texas franchise tax on its 0.1% share of refining operations. Additionally, all other Texas activity, including the marketing segment, has occurred in a limited partnership entity, also not subject to Texas franchise tax. Accordingly, the effective tax rate applicable to the refining and marketing segments is the federal tax rate plus a nominal amount of state franchise tax. Consequently, our consolidated effective tax rate was reduced by their proportionate contribution to our consolidated pretax earnings. Delek benefited from other tax incentives related to its refinery operations. Specifically, Delek was entitled to the benefit of the domestic manufacturer’s production deduction for federal tax purposes. Additionally, Delek was entitled to federal tax credits related to the production of ultra low sulfur diesel fuel. The combination of these two items further reduced Delek’s effective federal tax rate. The taxation of earnings in Texas is subject to change due to new legislation which will be effective January 1, 2007. This legislation will require taxation of all or a portion of a limited partnership’s earnings.

 

Consolidated Results of Operation — Comparison of the Year Ended December 31, 2005 versus the Year Ended December 31, 2004

 

For the years ended December 31, 2005 and 2004, we generated net sales of $2,031.9 million and $857.9 million, respectively, and net income of $64.1 million and $7.3 million, respectively. The increase in both net sales and net income was due primarily to the acquisition of the Tyler refinery on April 29, 2005.

 

Of the $1,174.0 million increase in net sales, $930.5 million was generated from the 2005 acquisition of the Tyler refinery, with the rest of the increase resulting from higher average retail fuel prices at our convenience stores and the inclusion of a full year of sales from the acquisition of Williamson Oil stores compared to only eight months in 2004.

 

Cost of goods sold was $1,731.6 million for 2005, compared to $730.8 million for 2004, an increase of $1,000.8 million or 137%. Of this increase, $776.4 million was due to the cost of goods sold from the Tyler refinery acquisition in 2005, $70.1 million was due to the inclusion of a full year of results of operations from the acquisition of Williamson Oil stores compared to only eight months in 2004, and the remaining increase was primarily due to an increase in the average fuel price at our retail fuel and convenience stores.

 

Operating expenses were $133.1 million for 2005, compared to $80.1 million for 2004, an increase of $53.0 million or 66%. Of this increase, $45.8 million was due to operating costs from the 2005 Tyler refinery acquisition, which approximated $3.63 per barrel sold. In addition, we had an increase of $7.1 million in store operating costs from the inclusion of a full year of results of operations from the acquisition of Williamson Oil stores compared to only eight months in 2004. The ratio of operating expenses to merchandise sales plus total gallons sold in our retail operations declined slightly to 13.2% in 2005 from 13.3% in 2004 due to a focus on operating expense control.

 

General and administrative expenses were $23.5 million for 2005, compared to $15.1 million for 2004, an increase of $8.4 million or 55.6%. This increase was primarily due to additional salary and related expenses in our retail segment due in part to the inclusion of a full year of results of operations from the acquisition of Williamson Oil stores compared to only eight months in 2004, and general and administrative expenses from the acquisition of the Tyler refinery in 2005.

 

Depreciation and amortization was $16.1 million for 2005, compared to $12.4 million for 2004. This increase was primarily due to $1.4 million in depreciation associated with the Tyler refinery along with approximately $1.2 million in additional depreciation resulting from the inclusion of a year of depreciation from the acquisition of Williamson Oil stores compared to only eight months in 2004.

 

During 2005, we recognized a net pre-tax gain of $1.6 million associated with the sale of one convenience store partially offset by the write-off of associated goodwill, compared to $0.9 million pre-tax gain for 2004 primarily associated with the sale of one convenience store and one undeveloped property.

 

During August and September 2005, we entered into forward fuel contracts to fix the purchase price of crude oil and sales price of finished grade fuel for a predetermined number of units at a future date, which had fulfillment terms of less than 60 days. We realized losses of $9.1 million during 2005, which are included as losses on forward contract activities.

 

Interest expense was $17.4 million for 2005, compared to $7.1 million for 2004, an increase of $10.3 million. This increase was due to increased indebtedness, letter of credit fees associated with the 2005 purchase of the Tyler refinery and higher short-term interest rates. Interest income was $2.1 million for 2005 and immaterial for 2004. This increase was due to higher cash balances and new short-term investments resulting from cash flow provided by the Tyler refinery operations. Interest expense from related party notes payable for 2005 increased to $3.0 million from $1.2 million in 2004 due to borrowings incurred in conjunction with the Tyler refinery acquisition. In addition, a $1.5 million increase in unrealized gains on interest rate derivative instruments was recorded in 2005, compared to an unrealized loss of $0.7 million for 2004.

 

We also wrote-off deferred financing charges of $3.5 million in 2005 associated with the refinancing of a portion of our long-term debt.

 

In 2005, we recorded a $0.6 million expense in connection with guarantee fees payable to Delek Group Ltd. relating primarily to the guaranty of a portion of our debt incurred in connection with the acquisition of the Tyler refinery.

 

Income tax expense was $34.9 million for 2005, compared to $4.1 million for 2004, an increase of $30.8 million. This increase primarily resulted from our higher taxable income in 2005 compared to 2004. Our effective tax rate was 35.1% for 2005, compared to 36.0% for 2004. Substantially all of our refinery operations are conducted through a Texas limited partnership, which is not subject to Texas franchise tax. The limited partnership’s 0.1% general partner was subject to Texas franchise tax on its 0.1% share of refining operations. Accordingly, the effective tax rate applicable to our refining operations is the federal tax rate plus a nominal amount of state franchise tax. Consequently, our consolidated effective tax rate was reduced by our refinery’s proportionate contribution to our consolidated pretax earnings.

 

Operating Segments

 

We review operating results in three reportable segments: refining, marketing and retail. The refining segment was created in April 2005 with the acquisition of the Tyler refinery. In the third quarter of 2006, we added a third segment, marketing, to track the activity associated with the sales of refined products on a wholesale basis. Marketing operations were initiated on August 1, 2006 in conjunction with the acquisition of the Pride assets.

 

Refining Segment

 

 

Operations in our refining segment began with the acquisition of the refinery on April 29, 2005. Net sales were $1,593.6 million for 2006 compared to $931.4 million for 2005, an increase of $662.2 million or 71.1%. Of this

increase, $507.4 million resulted from the inclusion of a full year of sales from the acquired refinery compared to only eight months in 2005. Additionally, total sales volume for 2006 averaged 55,523 bpd compared to 51,096 bpd for the eight months we operated the refinery in 2005, an increase of 4,427 bpd or 8.7%. Average sales price per barrel rose to $78.64 per barrel for 2006 compared to $73.80 per barrel in 2005, an increase of 6.6%.

 

Cost of goods sold for our refining segment in 2006 was $1,367.4 million compared to $776.4 million for the period from April 29, 2005 through December 31, 2005. Of this increase, $436.0 million resulted from the inclusion of a year of cost of goods sold from the refinery compared to only eight months in 2005. The remaining cost increase was due to a 8.7% increase in average barrels sold per day and a 9.8% increase in crude and feedstock cost per barrel in 2006 compared to the average barrels sold and cost per barrel for the eight months we operated the refinery in the same period in 2005.

 

In conjunction with the Pride acquisition and the formation of our marketing segment in the third quarter of 2006, our refining business entered into a services agreement with our marketing segment on October 1st, which among other things, required it to pay service fees 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 services agreement lowered the refining margin achieved by our refining segment $0.16 per barrel in 2006 to $11.00 per barrel. Without this fee, the refining segment would have achieved a refining operating margin of $11.16 per barrel in 2006 which was 109.8% of the U.S. Gulf Coast crack spread compared to $12.29 per barrel for the period operated last year which was 100.8% of the U.S. Gulf Coast crack spread.

 

Operating expenses were $69.6 million for 2006 or $3.44 per barrel sold compared to $45.8 million for the period of April 29, 2005 through December 31, 2005 or $3.63 per barrel sold. The reduction in operating expense per barrel was due primarily to lower natural gas costs which averaged $6.89 per MMBTU in 2006 compared to $10.13 per MMBTU during the time we operated the refinery in 2005. Segment contribution margin for the refining segment for 2006 represented 71% of our total segment contribution margin, or $153.2 million.

 

Marketing Segment

 

We initiated operations in our marketing segment during the third quarter of 2006 with the acquisition of the Pride assets. In this segment we sell refined products on a wholesale basis in west Texas through company-owned and third-party operated terminals.

 

 

Net sales for the marketing segment were $221.6 million for the period from August 1, 2006, the date operations commenced, through December 31, 2006. Total sales volume averaged 17,758 barrels per day during this period. Net sales also included $3.4 million of net service fees paid by our refining segment to our marketing segment for marketing, sales and customer support services.

 

Cost of goods sold was $216.0 million for the period from August 1, 2006 through December 31, 2006, approximating a cost per barrel sold of $79.49. This cost per barrel resulted in an average gross margin per barrel of $2.06. Included in costs during this period are losses generated of $2.7 million associated with the purchase of initial inventory which required payment at a spot price rather than more favorable terms under our long-term purchase

contracts, and which then had an immediate drop in market value prior to the ultimate sale of such inventory. Additionally, we recognized losses during 2006 of $1.3 million associated with settlement of nomination differences under long-term purchase contracts.

 

Operating expenses in the marketing segment were approximately $0.3 million for the period from August 1, 2006 through December 31, 2006, primarily due to marketing salaries and insurance costs. Segment contribution margin for the marketing segment for 2006 represented 2% of our total segment contribution margin or $5.3 million.

 

Retail Segment