Summary of VALLEY NATIONAL GASES INC

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and Notes thereto appearing elsewhere in this report.
Forward-Looking Statements
This Form 10-Q contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The statements regarding Valley National Gases Incorporated contained in this release that are not historical in nature, particularly those that utilize terminology such as "may," "will," "should," "likely," "expects," "anticipates," "estimates," "believes" or "plans," or comparable terminology, are forward-looking statements based on current expectations and assumptions, and entail various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward-looking statements. Important factors known to Valley that could cause such material differences are identified and discussed from time to time in Valley's filings with the Securities and Exchange Commission, including Valley's ability to evaluate, negotiate, complete and integrate acquisitions, finance and manage future growth, maintain supply and customer relationships, retain key employees and comply with financial covenants in its credit facility; the prices and markets for gases, including propane; economic factors such as the level of economic activity nationally and in the regions Valley serves and political and economic conditions generally; the continued execution of

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operating improvements; competition; the outcome of litigation relating to product liability, employment law and other claims.
Valley undertakes no obligation to correct or update any forward-looking statements, whether as a result of new information, future events or otherwise. You are advised, however, to consult any future disclosure Valley makes on related subjects in future reports to the SEC.
OVERVIEW
OPERATIONS
We are a leading distributor of industrial, medical and specialty gases, and related welding equipment and supplies, in 14 states in the eastern United States. We also have a growing presence in the distribution of non-pipeline propane in our geographic markets.
We generate revenue through the sale of packaged industrial, medical and specialty gases and rental and delivery charges for the cylinders and tanks in which they are delivered, as well as through sale of related welding equipment and supplies. We sell packaged gases to customers for manufacturing, industrial, metal production and fabrication, construction, health care, mining, oil and chemicals and other applications. Sale of our packaged gases is generally not seasonal. We also sell propane to the residential, commercial and industrial markets. Typical residential and commercial uses include conventional space heating, water heating and cooking. Typical industrial uses include engine fuel for forklifts and other vehicles, metal cutting, brazing and heat treating. The distribution of propane is seasonal in nature and sensitive to variations in weather with consumption as a heating fuel peaking sharply in winter months. In the 2006 fiscal year, packaged gases and rental, together with related equipment and supplies, accounted for approximately 72% of our net sales, while propane accounted for approximately 28% of our net sales.
Our cost of products sold include the direct cost of industrial, medical and specialty gases pursuant to supply arrangements and open purchase orders with four out of the five major gas producers in the United States, the purchase of hard goods from a number of vendors and the purchase of propane from one of the three major propane suppliers. Although the cost of the gases we sell is subject to formula pricing and variation based on market prices for such gases, because packaging, delivery and other service constitutes a substantial portion of the cost and the value of the packaged gases we provide our customers, we believe that we are not significantly exposed to decreased margins because of those variations.
Our operating, distribution and administrative expenses primarily are composed of delivery expense, salaries, benefits, professional fees, transportation equipment operating costs, facility lease expenses and general office expenses. We believe that changes in these expenses as a percentage of sales should be evaluated over the long term rather than on a quarter-to-quarter basis due to the moderate seasonality of sales mentioned above and the generally fixed nature of these expenses. We also incur depreciation expense related to our fixed assets, including cylinders which are depreciated over a period of 12 to 30 years and delivery vehicles that we depreciate over a period of 3 to 7 years.
ACQUISITIONS
We believe that we have been successful in executing our strategy of growth through acquisitions, having completed over 33 acquisitions since 1997, the year of our initial public offering. The consideration for most acquisitions includes a combination of a cash payment at closing, seller financing and payments under covenants not to compete and consulting agreements. For many acquisitions, we believe that projections of future cash flows justify payment of amounts in excess of the book or market value of the assets acquired, resulting in goodwill being recorded. Some acquisitions have had, and we expect that some future acquisitions may have, a dilutive effect upon our income from operations and income before tax for a period

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following their consummation. This dilution can occur because some of the benefits of acquisitions, such as leveraging of operating and administrative expenses, improved product gross margins and expected sales growth, occur over time. In most cases, the operating cash flow of an acquired business has been positive in a relatively short period of time after consummation of the acquisition.
On September 1, 2006, Valley acquired Industrial Air Products Corporation, a distributor of packaged industrial gases and welding supplies from two locations in Florida. Valley acquired all of the common stock of Industrial Air Products for a purchase price of $3.0 million.
VARIABLE INTEREST ENTITIES
We lease buildings and equipment and rent cylinders from West Rentals, Inc., G.E.W. Real Estate, LLC, Real Equip-Lease LLC, Acetylene Products Corporation and Plymouth Holding, LLC, entities that are engaged primarily in the purchase, development, sale and/or lease of real estate and that are controlled by Gary West, our Chairman and majority shareholder. Under accounting interpretations that were effective for us on March 31, 2004, and because we are under common control with these entities, we were required to consolidate the financial statements of these related entities in our financial statements. In consolidation, the rent expense we pay to these entities is eliminated, resulting in us reporting slightly less operating, distribution and administrative expense and slightly more income from operations. Because some of the properties held by the variable interest entities are financed, and because of the amount of depreciable assets these entities hold, the consolidation results in us reporting slightly more interest and depreciation expense. Further, because we classify the rental income from third parties that these entities generate as "other income" for our purposes, these entities result in our reporting more other income. Substantially all of the effect of these entities on our net income is eliminated when we deduct the net effect as a minority interest. The real property and equipment held by these entities results in our reporting significantly higher balances of buildings and equipment on our balance sheet. Although these entities are controlled by related parties, we have no equity interest in any of them and the creditors and beneficial interest holders of these entities have no recourse to our general credit.
CRITICAL ACCOUNTING POLICIES
The preparation of our financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires us to make judgments, assumptions and estimates that affect the amounts we report in our consolidated financial statements and accompanying notes included herein. We describe the significant accounting policies and methods that we use to prepare our consolidated financial statements in Note 3. The most critical accounting matters in which we use estimates include our determination of the net carrying value of our trade receivables, inventories, goodwill, other intangible assets and employee health care benefit reserves. If our estimates have to be revised, we may be required to adjust the carrying value of these assets, affecting our results of operations during the period when the adjustment is recorded, and affecting our net assets and equity. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the consolidated financial statements.
TRADE RECEIVABLES
We estimate the collectability of our trade receivables. We have established an allowance for doubtful accounts to adjust the carrying value of trade receivables to fair value based on the amount of trade receivables that we estimate are uncollectible. We establish the allowance for doubtful accounts based on our historical experience, economic trends and our knowledge of significant accounts. Although we believe that the allowance for doubtful accounts as of September 30, 2006 is adequate, if a significant customer refuses to pay a large account, or if economic conditions cause a class of customers to be unable to pay accounts, we might be required to increase the provision for doubtful accounts, affecting our income.

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INVENTORIES Our inventories are stated at the lower of cost or market, cost being determined by the first-in first-out method. We write down our inventory for estimated obsolescence or unmarketable inventory equal to the difference between the cost of inventory and the estimated market value based upon its physical condition as well as assumptions about future demand and market conditions. If actual demand or market conditions in the future are less favorable than those estimated, additional inventory write-downs may be required. Estimates of physical losses of inventory are made on a quarterly basis based upon historical results.
GOODWILL AND OTHER INTANGIBLE ASSETS
We adopted SFAS No. 142, "Goodwill and Other Intangible Assets", as of July 1, 2001. SFAS No. 142 requires goodwill and intangible assets with indefinite useful lives not to be amortized, but instead to be tested for impairment at least annually. We have elected to perform our annual test for indications of goodwill impairment as of June 30th of each year. In testing the impairment of goodwill, we consider a variety of valuation methods, including formal criteria of the Uniform Standards of Professional Appraisal Practice ("USPAP") for assessment of the fair market value of a business as a whole. In accordance with USPAP, we use a discounted cash flow analysis including, where applicable, appropriate market-based deductions, control premiums and discounts, and take into account any extraordinary assumptions and hypothetical conditions which may have an impact on our determination. In addition to this approach for valuing our business as a whole, we also consider goodwill by location or groups of locations. The application of each of these methods involves a number of estimates and assumptions, and the weighting and balancing of the methods and their results also involves assumptions and the application of considerable judgment. We may be required to adjust our assumptions and estimates when events or changes in circumstances indicate that the carrying amount of goodwill may not be recoverable. To the extent we make this determination, we would be required to reduce the carrying value of our goodwill by taking a charge that will reduce our earnings in the period taken and reduce our equity at the end of the period. We cannot be certain that the assumptions and judgments we have made regarding the carrying value of our goodwill will prove accurate and that we will not be required to take impairment charges in the future. No triggering events occurred during the current fiscal year.
EMPLOYEE HEALTH CARE BENEFITS RESERVES We have self-funded health care benefit programs in place through which a third party administrator settles and pays claims by our employees on an on-going basis. We estimate the level of outstanding claims, at any point in time, including claims incurred but not reported, based upon historical payment patterns, knowledge of individual claims and estimates of health care costs. We have stop-loss insurance coverage in place to limit the extent of individual claims.
VALUATION OF LONG-LIVED ASSETS
Long-lived assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Estimates of the remaining useful lives of assets are reviewed at least annually at the close of the fiscal year. Determination of recoverability is based on an estimate of discounted or undiscounted future cash flows resulting from the use of the assets and their eventual disposition. Measurement of an impairment loss for long-lived assets that management expects to hold and use is based on the fair value of the assets.
INCOME TAXES
We account for income taxes in accordance with the provisions of SFAS No. 109, "Accounting for Income Taxes," under which deferred tax assets or liabilities are

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computed based on the difference between the financial statement and income tax bases of assets and liabilities using the estimated tax rate at the date of reversal. These differences are classified as current or non-current based upon the classification of the related asset or liability. For temporary differences that are not related to an asset or liability, classification is based upon the expected reversal date of the temporary difference. Valuation allowances are established, when necessary, to reduce deferred tax assets to the amount expected to be realized. We estimate and record additional tax expense based on uncertain tax positions taken by the Company within statutory limitations. This estimate is adjusted when tax audits are completed or when the statute of limitations expires on those recorded tax positions.

RESULTS OF OPERATIONS
   The following table presents information about our results of operations as a
percentage of net sales. Results for any one or more periods are not necessarily
indicative of continuing trends.

                                                           Three Months Ended
                                                             September 30,
                                                            2006         2005
        Net Sales                                           100.0 %      100.0 %

        Cost of products sold, excluding depreciation        49.4         47.8
        Operating, distribution and administrative           33.4         37.1
        Depreciation                                          4.0          4.3
        Amortization of intangibles                           0.5          0.5

        Total costs and expenses                             87.3         89.7

        Income from operations                               12.7         10.3

        Interest expense                                      2.3          2.2
        Other income, net                                     0.4          0.5

        Earnings before minority interest                    10.8          8.6
        Minority interest                                     0.3          0.6

        Net earnings before taxes                            10.5          8.0
        Provision for income taxes                            4.1          3.1

        Net earnings                                          6.4 %        4.9 %

Comparison of Three Months Ended September 30, 2006 and 2005 Our net sales increased $8.9 million or 21.5% to $50.6 million for the three months ended September 30, 2006, from $41.7 million for the three months ended September 30, 2005. Acquisitions provided approximately $6.4 million or 72.1% of the increase, with the balance of the increase related to same store sales of $2.5 million. Packaged gases represented 38.2% of net sales for the three months ended September 30, 2006 and hard goods represented 43.7% of net sales. In comparison, packaged gases represented 37.2% of net sales for the three months ended September 30, 2005 and hard goods represented 42.6% of net sales. Sales of hard goods increased $4.4 million or 24.5% from the three months ended September 30, 2005 to the three months ended September 30, 2006, reflecting increased demand from the improved economy, increased prices resulting from increased steel costs and increased sales volume. Acquisitions provided $3.1 million or 71.4% of the increase, with the balance provided by same store sales of $1.3 million. Packaged gases increased $3.8 million due to increased demand and higher prices. Acquisitions provided $3.1 million or 80.6% of the increase, with the balance provided by same store sales of $0.7 million. Propane sales represented 18.1% of net sales for the three months ended September 30, 2006 compared to 20.1% of net sales in the three months ended September 30, 2005. Propane sales increased $0.7 million or 8.7% in the three months ended September 30, 2006 compared to the three months ended September 30, 2005 due to price increases. Acquisitions provided $0.3 million or 39.8% of the increase, with the balance provided by same store sales of $0.4 million. Propane gallons sold were down 4.2% in the three months ended September 30, 2006 compared to three months ended September 30, 2005, reflecting higher prices of all energy sources and warmer temperatures in our markets compared to the prior year period.

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Our cost of products sold increased $5.1 million or 25.4% to $25.0 million for the three months ended September 30, 2006, compared to $19.9 million for the three months ended September 30, 2005. Cost of products sold as a percentage of net sales was 49.4% and 47.8% for the three months ended September 30, 2006 and 2005, respectively. Increased prices that we charged for hard goods, packaged gases and cylinder rental resulting from our efforts to standardize our product offerings and pricing were offset by higher propane costs as a percentage of net sales.
Operating, distribution and administrative expenses increased $1.4 million or 9.1% to $16.9 million in the three months ended September 30, 2006, compared to $15.5 million for the three months ended September 30, 2005. Increased personnel costs and increased delivery expense primarily due to acquisitions is the result of this increase. Operating, distribution and administrative expenses as a percentage of net sales were 33.4% for the three months ended September 30, 2006, compared to 37.1% for the three months ended September 30, 2005.
Depreciation expense increased $0.2 million to $2.0 million for the three months ended September 30, 2006, from $1.8 million for the three months ended September 30, 2005, reflecting depreciation from increased capital expenditures, acquisitions and the variable interest entities.
Amortization of intangibles remained the same at $0.2 million in the three months ended September 30, 2006 and September 30, 2005. This is the result of certain intangibles becoming fully amortized during the current fiscal year offset by the amortization of intangible assets related to acquisitions.
Interest expense increased $0.3 million for the quarter primarily as a result of increased outstanding debt due to recent acquisitions and increased interest rates in comparison to last year's first quarter.
Other income remained the same at $0.2 million for the three months ended September 30, 2006 and September 30, 2005.
Minority interest earnings reflect the elimination of net pre-tax income earned by the variable interest entities. The amount eliminated is primarily the reduction in operating expense noted above, partially offset by expenses incurred by the entities.
Our effective tax rate increased from 39.0% for the three months ended September 30, 2005 compared to 39.2% for the three months ended September 30, 2006.
For the reasons stated above, our net earnings increased $1.2 million or 59.6% to $3.2 million for the three months ended September 30, 2006, compared to $2.0 million for the three months ended September 30, 2005. Diluted earnings per share were $0.33 for the three months ended September 30, 2006, compared to $0.21 for the three months ended September 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
Historically, we have financed our operations, capital expenditures and debt service with funds provided from operating activities. Acquisitions have been financed by a combination of seller financing, bank borrowings and funds generated from operations.
At September 30, 2006, we had working capital of approximately $16.5 million, as compared to $12.7 million as of June 30, 2006, reflecting primarily an increase in accounts receivable and inventory levels resulting from acquisitions made during the previous twelve month period. Funds provided by operations for the three months ended September 30, 2006 were approximately $2.7 million as compared to $3.8 million for the three months ended September 30, 2005. Funds used for investing activities were approximately $4.9 million for the three months ended September 30, 2006 consisting primarily of capital spending and acquisitions, as compared to $2.6 million for the three months ended September 30, 2005 principally for capital spending. The Company anticipates capital expenditures of approximately $7.0 million for the remainder of

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fiscal year June 30, 2007. Funds provided for financing activities for the three months ended September 30, 2006 were approximately $2.3 million as net borrowings of $20.0 million were offset by debt repayment of $17.8 million. In addition, a distribution by the variable interest entities of $0.2 million were partially offset by funds received through the exercise of stock options totaling $0.1 million and the related tax benefit of $0.2 million.
At September 30, 2006, we had the following contractual obligations:

                                                         Payments Due By Period (In Thousands)
                                                       Less Than           1-3             4-5           More Than
Contractual Obligations                Total           9 Months           Years           Years           5 Years
Long-Term Debt Including
Current Maturities                   $  72,985        $     3,526        $ 65,561        $ 1,611        $     2,287
Estimated Interest Payments             17,445              4,645          12,379            324                 97
Interest Rate Swap Payments              1,550                750             800              -                  -
Interest Rate Swap Receipts             (2,093 )           (1,013 )        (1,080 )            -                  -
Operating Leases, Net of
Intercompany Eliminations               11,474              1,416           3,823          4,087              2,148
Purchase Obligations                     2,025              1,519             506              -                  -

Total Obligations                    $ 103,386        $    10,843        $ 81,989        $ 6,022        $     4,532

Certain of these obligations are sensitive to changes in interest rates, including interest rate swaps and debt obligations. For debt obligations, the table provides contractually obligated payment amounts, including estimated interest, by period due. For interest rate swaps, payments and receipts are calculated based upon notional amounts at weighted average rates by expected (contractual) maturity dates. Weighted average variable rates are based on the one month LIBOR rate in effect at the reporting date. No assumptions have been made for future changes in the one month LIBOR rate. Purchase obligations represent the total value of all open purchase orders for the purchase of inventory and distribution vehicles. Other long-term liabilities at September 30, 2006 and June 30, 2006 consist primarily of customer deposits related to cylinder rentals with an average term of seven to ten years, which has been excluded from the table above.
On April 30, 2004, Valley entered into an amended credit agreement establishing a $75 million revolving note with a maturity of five years, replacing the previous revolving and term notes. Covenant requirements under the amended agreement are not significantly different from those under the previous agreement. On October 31, 2005, the Company entered into an agreement to increase the outstanding credit available under the above revolving note by $15 million to $90 million.
The weighted average interest rate for substantially all of the borrowings under the credit facility was 6.4% as of September 30, 2006. As of September 30, 2006, availability under the revolving loan was approximately $26.4 million, with outstanding borrowings of approximately $63.2 million and outstanding letters of credit of approximately $0.4 million. The credit facility is secured by all of Valley's assets. The revolving loan is used primarily to fund acquisitions. Valley is not required to make principal payments on outstanding balances of the revolving loan as long as certain covenants are satisfied. Interest is charged on the revolving loan at either the lender's prime rate or various LIBOR rates, at Valley's discretion, plus an applicable spread.
The loan agreement for the credit facility, as amended, contains various financial covenants applicable to Valley, including covenants requiring minimum fixed charge coverage and maximum funded debt to EBITDA. As of September 30, 2006, Valley was in compliance with these covenants and believes that it will continue to be in compliance through at least the next twelve months.
The variable interest entities had outstanding debt, consisting primarily of asset-backed mortgages for real estate, of $6.1 million and demand notes payable of $2.4 million at September 30, 2006. The carrying value of the land and buildings that collateralize this debt was approximately $7.4 million as of September 30, 2006. This

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mortgage debt carries various interest rates ranging from 4.3% to 7.8% and various maturities from 2006 to 2016. Some of the mortgages on which the variable interest entities are obligated are personally guaranteed by Valley's Chairman.
We are obligated under various promissory notes related to the financing of acquisitions that have various rates of interest ranging from 5.75% to 11.0% per annum and maturities through 2010. The outstanding balance of these notes as of . . .