SGU

Business Context and Reporting Period

Company: Star Gas Partners, L.P. (Master Limited Partnership) and Star Gas Finance Company.
Reporting Period: Quarterly period ended December 31, 2006 (Fiscal Q1 2007).
Business Overview: Retail distributor of home heating oil and provider of related services in the Northeast and Mid-Atlantic regions, serving approximately 440,000 customers. The company operates through its subsidiary, Petro Holdings, Inc.

Key Financial Metrics

Per Unit Data: Net income per Limited Partner Unit was $0.06 for Q1 2007, compared to a loss of $0.78 for Q1 2006.

Material Changes vs. Prior Period

• Volume Decline: Retail home heating oil volume decreased 24.4% (32.0 million gallons) to 99.3 million gallons, primarily due to warmer weather (17.8% warmer than prior year) and net customer attrition of 4,100 accounts.
• Derivative Impact: The change in fair value of derivative instruments resulted in a $6.3 million charge in Q1 2007, a significant improvement from the $40.6 million charge in Q1 2006. This reduction was a primary driver of the turnaround from operating loss to profit.
• Restatement: Financial statements for periods prior to September 30, 2006, were restated to correct accounting for derivative transactions under SFAS 133 and pension expense amortization. The Q1 2006 figures presented are restated.
• Recapitalization Effects: Following an April 2006 recapitalization, total debt outstanding declined by approximately $100.7 million compared to the prior year, reducing interest expense by $2.4 million.
• Weather Insurance: The company recorded $7.2 million in weather insurance contract assets, offsetting some delivery and branch expenses.

Guidance, Outlook, and Risks

• Outlook: Management expects home heating oil volume for the remainder of fiscal 2007 to be substantially less than the comparable period in fiscal 2006 due to net customer attrition and conservation, excluding weather impacts.
• Liquidity: The company maintains a $260 million asset-based revolving credit facility (up to $310 million seasonally). As of December 31, 2006, availability was $151.0 million with no outstanding working capital borrowings. The fixed charge coverage ratio was 2.94 to 1.0.
• Capital Requirements: Estimated annual maintenance capital expenditures are $4–$6 million. Additional capital of $1.0–$1.5 million is required before October 2007 for EPA environmental compliance.
• Legal Proceedings: A consolidated class action lawsuit (In re Star Gas Securities Litigation) regarding disclosure failures and hedging practices was dismissed by the court in August 2006. Plaintiffs have moved for reconsideration; the matter is fully briefed and under court consideration.
• Management Changes: CEO Joseph Cavanaugh announced his retirement effective May 31, 2007. Daniel P. Donovan was named to succeed him.
• Internal Controls: A previously disclosed material weakness regarding derivative accounting was remediated in Q1 2007 by not designating derivatives for hedge accounting treatment. The company is evaluating future hedge accounting elections.

Investor Verification Checklist

• Derivative Accounting: Verify the company's ongoing strategy regarding SFAS 133 compliance and the potential volatility in earnings if derivatives are not designated as hedges.
• Customer Attrition: Monitor the trend of net customer losses (4,100 in Q1 2007) and the effectiveness of retention strategies amidst competition from natural gas conversions.
• Weather Sensitivity: Assess the impact of the $7.2 million weather insurance contract and the risk of reduced proceeds if winter 2007 remains warmer than the 10-year average.
• Litigation Status: Track the court's decision on the plaintiffs' motion for reconsideration in the securities class action lawsuit.
• Debt Covenants: Confirm continued compliance with the fixed charge coverage ratio and borrowing base limitations of the revolving credit facility.