**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

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** **

**FORM 10-Q**

**(Mark One)**

**x** QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

#### **Forthe quarterly period ended September 30, 2006**

**OR**

**o**** TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the transition period from                  to                 **

**CommissionFile Number 1-32940**

**VALERO GP HOLDINGS, LLC**

(Exact name ofregistrant as specified in its charter)

 

| **Delaware**                     | ** ** | **85-0470977**       |
|----------------------------------|------------|----------------------|
| (State or other  jurisdiction of |       | (I.R.S. Employer     |
| incorporation or  organization)  |       | Identification  No.) |

 

**One Valero Way**

**SanAntonio, Texas**

(Address ofprincipal executive offices)

 

**78249**

(Zip Code)

 

Telephone number: **(210) 345-2000**

(Registrant’stelephone number, including area code)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  **Yes****o No  ****x**

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer.  The definition of “accelerated filer andlarge accelerated filer” is in Rule 12b-2 of the Securities Exchange Act.(Check one):

| Large accelerated filer o |   | Accelerated  filer o |   | Non-accelerated  filer x |
|--------------------------------|--------|---------------------------|--------|-------------------------------|

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

**Yes ****oNo ****x**

The number of units outstanding as of November 1, 2006was 42,500,000.

 

 

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**VALERO GPHOLDINGS, LLC AND SUBSIDIARIES**

**FORM 10-Q**

**TABLE OFCONTENTS**

 
| **PART I – FINANCIAL  INFORMATION**                                                                                   |       |
|----------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                                 | ** ** |
| **Item 1.Financial Statements:**                                                                                           | ** ** |
| **Consolidated  Balance Sheets as of September 30, 2006 and December 31, 2005**                                            | ** ** |
| **Consolidated  Statements of Income for the Three and Nine Months Ended September 30, 2006 and 2005** | ** ** |
| **Consolidated  Statements of Cash Flows for the Nine Months Ended September 30, 2006 and  2005**                          | ** ** |
| **Condensed Notes to Consolidated Financial Statements**                                                                   | ** ** |
| **Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations**                    | ** ** |
| **Item 4. Controls and Procedures**                                                                                        | ** ** |
| **PART  II - OTHER INFORMATION**                                                                                           | ** ** |
| **Item 1. Legal Proceedings**                                                                                              | ** ** |
| **Item 6. Exhibits**                                                                                                       | ** ** |
| **SIGNATURES**                                                                                                             | ** ** |

2

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**PART I**– FINANCIAL INFORMATION

**Item1.  Financial Statements**

###### **VALERO GP HOLDINGS, LLC**

###### **CONSOLIDATED BALANCE SHEETS**

**(Thousandsof Dollars)**

** **
| ** **                                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                  | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| ** **                                  | ** ** | **(Unaudited)**        | ** ** | ** **            | ** ** |
| **Assets**                                  | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current assets:                             |       |                   |       |                  |       |
| Cash                                        |       | $                      | 1,116      |                  | $          | 121 |   |
| Receivable from  Valero L.P.                |       | 11,089                 |       | 1,151                 |       |
| Receivable from  Valero Energy.             |       | 1,092                  |       | —                |       |
| Income taxes  receivable.                   |       | 227                    |       | —                |       |
| Total current  assets                       |       | 13,524                 |       | 1,272                 |       |
| ** **                                  | ** ** | ** **             | ** ** | ** **            | ** ** |
| Investment in Valero  L.P.                  |       | 561,235                |       | 408,744               |       |
| Long-term receivable  from Valero L.P.      |       | 5,812                  |       | —                |       |
| Deferred tax asset                          |       | 1,174                  |       | 298                   |       |
| Total assets                                |       | $                      | 581,745    |                  | $          | 410,314 |   |
| ** **                                  | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Liabilities  and Members’ Equity**   | ** ** | ** **             | ** ** | ** **            | ** ** |
| Current liabilities:                        |       |                   |       |                  |       |
| Accounts payable                            |       | $                      | 98         |                  | $          | 2 |   |
| Payable to  Valero Energy                   |       | 9,226                  |       | —                |       |
| Income taxes  payable                       |       | —                 |       | 11                    |       |
| Accrued  liabilities                        |       | 1,993                  |       | 2,560                 |       |
| Total current  liabilities                  |       | 11,317                 |       | 2,573                 |       |
|                                        |       |                   |       |                  |       |
| Long-term debt                              |       | 1,000                  |       | —                |       |
| Notes payable to  affiliates                |       | —                 |       | 265,961               |       |
| Other long-term  liabilities                |       | 9,695                  |       | —                |       |
|                                        |       |                   |       |                  |       |
| Members’ equity                        |       | 559,733                |       | 141,780               |       |
| Total  liabilities and members’ equity |       | $                      | 581,745    |                  | $          | 410,314 |   |

 

See Condensed Notes toConsolidated Financial Statements.

3

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###### **VALERO GP HOLDINGS, LLC**

###### **CONSOLIDATED STATEMENTS OF INCOME**

**(Unaudited,Thousands of Dollars, Except Unit and Per Unit Data)**

** **
| ** **                                            | ** ** | **Three Months Ended**

**September 30,** | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|-------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equity in  earnings of Valero L.P.                    |       | $                                                        | 11,637     |                                                    | $          | 12,203 |   | $ | 32,141 |   | $ | 29,543 |   |
|                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| General and  administrative expenses                  |       | (877                                                     | )          | —                                                  |       | (903 | ) | (16 | ) |
| Other expense,  net                                   |       | (286                                                     | )          | 5                                                       |       | (249 | ) | 447 |   |
| Interest income  – affiliated                    |       | —                                                   |       | 36                                                      |       | 53 |   | 73 |   |
| Interest expense  – affiliated                   |       | (901                                                     | )          | (4,417                                                  | )          | (10,368 | ) | (13,293 | ) |
| Interest and  debt expense                            |       | (6                                                       | )          | —                                                  |       | (6 | ) | — |   |
|                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Income before  income tax expense                     |       | 9,567                                                    |       | 7,827                                                   |       | 20,668 |   | 16,754 |   |
| Income tax expense (benefit)                          |       | (130                                                     | )          | 21                                                      |       | 273 |   | 65 |   |
| Net income                                            |       | $                                                        | 9,697      |                                                    | $          | 7,806 |   | $ | 20,395 |   | $ | 16,689 |   |
| ** **                                            | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic net income  per unit                            |       | $                                                        | 0.23       |                                                    | $          | 0.18 |   | $ | 0.48 |   | $ | 0.39 |   |
| ** **                                            | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average  number of basic units outstanding   |       | 42,500,000                                               |       | 42,500,000                                              |       | 42,500,000 |   | 42,500,000 |   |
|                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Diluted net  income per unit                          |       | $                                                        | 0.23       |                                                    | $          | 0.18 |   | $ | 0.48 |   | $ | 0.39 |   |
|                                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  number of diluted units outstanding |       | 42,500,626                                               |       | 42,500,000                                              |       | 42,500,211 |   | 42,500,000 |   |

 

See Condensed Notes toConsolidated Financial Statements.

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**VALERO GPHOLDINGS, LLC**

###### **CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited,Thousands of Dollars)**

 
| ** **                                                                          | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|-------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                          | ** ** | **2006**                                                | ** ** | **2005** | ** ** |
| **Cash  Flows from Operating Activities:**                                          | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Net income                                                                          |       | $                                                       | 20,395     |   | $ | 16,689 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities:  | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Equity in earnings of Valero L.P.                                                   |       | (32,141                                                 | )          | (29,543 | ) |
| Distributions of equity income from Valero L.P.                                     |       | 32,141                                                  |       | 29,543 |   |
| Loss (gain) on sale of Valero L.P. units in  connection with employee benefit plans |       | 249                                                     |       | (447 | ) |
| Provision for deferred income taxes                                                 |       | 100                                                     |       | (151 | ) |
| Changes in current assets and liabilities:                                          |       |                                                    |       |   |   |
| Increase in receivable from Valero L.P.                                             |       | (10,291                                                 | )          | (31 | ) |
| Increase in receivable from Valero Energy                                           |       | (72                                                     | )          | — |   |
| Increase in income taxes receivable.                                                |       | (227                                                    | )          |   |   |
| Increase in payable to Valero Energy                                                |       | 9,820                                                   |       | — |   |
| Decrease in accounts payable and accrued liabilities                                |       | (481                                                    | )          | — |   |
| Increase  (decrease) in other long-term liabilities                                 |       | 1,838                                                   |       | (684 | ) |
| Other                                                                               |       | 2                                                       |       | — |   |
| **Net cash provided by operating activities**                                       |       | 21,333                                                  |       | 15,376 |   |
| ** **                                                                          | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| **Cash  Flows from Investing Activities:**                                          |       |                                                    |       |   |   |
| Distributions in  excess of equity in earnings of Valero L.P.                       |       | 7,408                                                   |       | 2,533 |   |
| Contribution to  Valero L.P.                                                        |       | (1,636                                                  | )          | (29,748 | ) |
| Proceeds from  sale of Valero L.P. units in connection with employee benefit plans  |       | 1,812                                                   |       | 2,797 |   |
| **Net cash provided by (used in) investing  activities**                            |       | 7,584                                                   |       | (24,418 | ) |
| ** **                                                                          | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| **Cash  Flows from Financing Activities:**                                          |       |                                                    |       |   |   |
| Increase  (decrease) in notes payable to affiliates                                 |       | 689                                                     |       | (10,925 | ) |
| Long-term debt  borrowings                                                          |       | 1,000                                                   |       | — |   |
| Contributions  from Valero Energy                                                   |       | —                                                  |       | 29,199 |   |
| Distributions to  Valero Energy                                                     |       | (29,611                                                 | )          | (9,231 | ) |
| **Net cash provided by (used in) financing  activities**                            |       | (27,922                                                 | )          | 9,043 |   |
|                                                                                |       |                                                    |       |   |   |
| Net increase in  cash                                                               |       | 995                                                     |       | 1 |   |
| Cash at the  beginning of the period                                                |       | 121                                                     |       | 120 |   |
| Cash at the end  of the period                                                      |       | $                                                       | 1,116      |   | $ | 121 |   |
| ** **                                                                          | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| **Supplemental  cash flow information:**                                            | ** ** | ** **                                              | ** ** | ** ** | ** ** |
| Cash paid during  the period for interest                                           |       | $                                                       | 10,368     |   | $ | 13,293 |   |
| Cash paid during  the period for income taxes                                       |       | $                                                       | 37         |   | $ | — |   |

 

See CondensedNotes to Consolidated Financial Statements.

 

5

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**VALERO GP HOLDINGS, LLC**

**CONDENSEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. ORGANIZATION, BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES**

***Organization***

Valero GP Holdings, LLC(Valero GP Holdings), a Delaware limited liability company, was formed in June2000 as UDS Logistics, LLC (UDS Logistics). Valero Energy Corporation (ValeroEnergy) (NYSE: VLO), a publicly held independent refining and marketingcompany, acquired UDS Logistics in connection with its December 31, 2001acquisition (UDS Acquisition) of Ultramar Diamond Shamrock Corporation (UDS).UDS Logistics changed its name to Valero GP Holdings in January 2006. On July19, 2006, our existing membership interests consisted of 10,000,000 unitsrepresenting limited liability company interests, and a 4.25-for-1 unit splitwas effected, resulting in 42,500,000 total units outstanding, all of whichwere owned by Valero Energy and its subsidiaries, maintaining their pre-splitownership percentages.****Immediately subsequent to the unit split, certain subsidiaries ofValero Energy sold 17,250,000 units of Valero GP Holdings (NYSE: VEH) in an initialpublic offering (IPO) for a price to the public of $22.00 per unit.  We did not receive any proceeds from the IPO.Subsequent to the IPO, subsidiaries of Valero Energy owned 25,250,000 units orapproximately 59% of our outstanding units.

 

As used in this report,references to “we,” “us,” or “our” collectively refer, depending on thecontext, to Valero GP Holdings, LLC or a wholly ownedsubsidiary.

On January 25,2006, Valero GP Holdings formed a wholly owned subsidiary, Riverwalk Holdings,LLC (Riverwalk Holdings), and Valero GP Holdings contributed its 99.9% limitedpartner interest in Riverwalk Logistics, L.P. (Riverwalk Logistics) and itssubordinated units and common units of Valero L.P. to Riverwalk Holdings.

On June 1, 2006, ValeroEnergy contributed its ownership interest in Valero GP, LLC to Valero GPHoldings in exchange for an additional ownership interest in Valero GPHoldings.  As a result, Valero GP, LLC,Riverwalk Logistics, and Riverwalk Holdings are wholly owned subsidiaries ofValero GP Holdings.

On September 30, 2006,Valero GP Holdings owned approximately 23.4% of Valero L.P., consisting of thefollowing:

·                  the 2% generalpartner interest in Valero L.P.;

·                  100%of the incentive distribution rights issued by Valero L.P., which entitles usto receive increasing percentages of the cash distributed by Valero L.P.,currently at the maximum percentage of 23%; and

·                  10,219,282common units of Valero L.P. representing a 21.4% limited partner interest inValero L.P.

Valero L.P. (NYSE: VLI)is a publicly traded Delaware limited partnership engaged in the crude oil andrefined product transportation, terminalling and storage business. Valero L.P.has terminal facilities in the United States, the Netherland Antilles, Canada,Mexico, the Netherlands and the United Kingdom.

***Basisof Presentation***

These unauditedconsolidated financial statements include the accounts of Valero GP Holdingsand subsidiaries in which it has a controlling interest. Intercompany balancesand transactions have been eliminated in consolidation. Prior to June 1,2006, these financial statements combined the consolidated financial statementsof Valero GP Holdings with the financial statements of Valero GP, LLC. Theconsolidated financial statements of Valero GP Holdings included the financialstatements of Riverwalk Logistics and Riverwalk Holdings. Intercompanytransactions and balances between the combined companies have been eliminated.

 

We account for ourownership interest in Valero L.P. using the equity method. Therefore, ourfinancial results reflect a portion of Valero L.P.’s net income based on ourownership interest in Valero L.P. We have no separate operating activities apartfrom those conducted by Valero L.P. and therefore generate no revenues fromoperations.

These unauditedconsolidated financial statements have been prepared in accordance with UnitedStates generally accepted accounting principles (GAAP) for interim financialinformation and with the instructions to Form 10-Q and Article 10 of RegulationS-X of the Securities Exchange Act of 1934. Accordingly, they do not includeall of the information and notes required by GAAP for complete consolidatedfinancial statements. In the opinion of management, all adjustments considerednecessary for a fair presentation have been included. All such adjustments areof a normal

6

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recurring natureunless disclosed otherwise. Financial information for the three and nine monthsended September 30, 2006 and 2005 included in these Condensed Notesto Consolidated Financial Statements is derived from our unaudited consolidatedfinancial statements. Operating results for the three and nine months endedSeptember 30, 2006 are not necessarily indicative of the results thatmay be expected for the year ending December 31, 2006.

The consolidatedbalance sheet as of December 31, 2005 has been derived from the auditedconsolidated financial statements as of that date. You should read these consolidatedfinancial statements in conjunction with the consolidated financial statementsand notes thereto included in Valero GP Holdings’ registration statement onForm S-1, as amended.

***SignificantAccounting Policy***

Securities and ExchangeCommission (SEC) Staff Accounting Bulletin No. 51, “Accounting for Salesof Stock by a Subsidiary” (SAB 51), provides guidance on accountingfor the effect of issuances of a subsidiary’s stock on the parent’s investmentin that subsidiary. SAB 51 allows registrants to elect an accountingpolicy of recording such increases or decreases in a parent’s investment(SAB 51 credits or charges, respectively) either in income or in equity. In accordance with the election provided inSAB 51, we adopted a policy of recording such SAB 51 credits orcharges directly to members’ equity.

 

**2. ACCOUNTING PRONOUNCEMENTS**

***EITFIssue No. 04-5***

In June 2005, theFinancial Accounting Standards Board (FASB) ratified its consensus on EmergingIssues Task Force (EITF) Issue No. 04-5, “Determining Whether a GeneralPartner, or the General Partners as a Group, Controls a Limited Partnership orSimilar Entity When the Limited Partners Have Certain Rights” (EITF No. 04-5),which requires the general partner in a limited partnership to determinewhether the limited partnership is controlled by, and therefore should beconsolidated by, the general partner. The guidance in EITF No. 04-5 waseffective after June 29, 2005 for general partners of all new partnershipsformed and for existing limited partnerships for which the partnershipagreements are modified. For general partners in all other limitedpartnerships, the guidance in EITF No. 04-5 was effective no later thanJanuary 1, 2006.  We adopted EITFNo. 04-5 effective January 1, 2006, the adoption of which had no impact onthe accounting for our investment in Valero L.P.

 

***FASBInterpretation No. 48***

In June 2006, the FASBissued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—aninterpretation of FASB Statement No. 109” (FIN 48).  FIN 48 clarifies the accounting for uncertainincome tax positions recognized in an enterprise’s financial statements inaccordance with FASB Statement No. 109, “Accounting for Income Taxes,” bydefining a recognition threshold and measurement attribute for the financialstatement recognition and measurement of a tax position taken or expected to betaken in a tax return. An enterprise recognizes a tax position if it ismore-likely-than-not that the tax position will be sustained, based on thetechnical merits of the position, upon examination. An uncertain tax positionis measured in the financial statements at the largest amount of benefit thatis more-likely-than-not to be realized. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006 and we are continuing to evaluate its effecton our financial position or results of operations.

 

***FASBStatement No. 157***

In September 2006, theFASB issued Statement No. 157, “Fair Value Measurements.”  StatementNo. 157 defines fair value, establishes a framework for measuring fairvalue under GAAP, and expands disclosures about fair value measures.  Statement No. 157 is effectivefor fiscal years beginning after November 15, 2007, with early adoptionencouraged.  The provisions of StatementNo. 157 are to be applied on a prospective basis, with the exception ofcertain financial instruments for which retrospective application isrequired.  The adoption of StatementNo. 157 is not expected to materially affect our financial position orresults of operations.

 

***FASBStatement No. 158***

In September 2006, theFASB issued Statement No. 158, “Employers’ Accounting for Defined Benefit andOther Postretirement Plans,” which amends Statement No. 87, “Employers’Accounting for Pensions,” Statement No. 88, “Employers’ Accounting forSettlements and Curtailments of Defined Benefit Pension Plans and forTermination Benefits,” Statement No. 106, “Employers’ Accounting forPostretirement Benefits Other Than Pensions,” Statement No. 132 (revised2003), “Employers’ Disclosures about Pensions and Other Postretirement Benefits”and other related accounting literature.

 

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Statement No. 158 requires an employer to recognize the overfundedor underfunded status of a defined benefit postretirement plan as an asset or aliability in the statement of financial position and to recognize changes inthat funded status through comprehensive income in the year the changes occur.This statement also requires an employer to measure the funded status of a planas of the date of the employer’s year-end statement of financial position. Thefunded status recognition and related disclosure requirements of StatementNo. 158 are effective for us as of the end of the fiscal year ending afterDecember 15, 2006. The requirement to measure plan assets and benefit obligationsas of the date of the employer’s year-end statement of financial position iseffective for fiscal years ending after December 15, 2008. Earlierapplication of the recognition or measurement date provisions is encouraged. Weare currently evaluating the impact of Statement No. 158 on our financialposition.

**3. INVESTMENT IN VALERO L.P.**

As of September30, 2006 and December 31, 2005, we owned 23.4% of Valero L.P., which wascomposed of a 2% general partner interest, incentive distribution rights and a21.4% limited partner interest in Valero L.P. Valero L.P. has issued common units to the public on three separateoccasions, which has diluted our ownership percentage. These three issuanceshave resulted in increases (or credits) in our proportionate share of ValeroL.P.’s capital because, in each case, the issuance price per unit exceeded ourcarrying amount per unit at the time of issuance. We had not recognized any SAB51 credits in our consolidated financial statements through March 31, 2006and were not permitted to do so until our subordinated units converted tocommon units. In conjunction with the conversion of the subordinated units heldby us into common units in the second quarter, we recognized the entire balanceof $158.2 million in SAB 51 credits as an increase in our investmentin Valero L.P. and an increase to members’ equity.

***Summary FinancialInformation***

Condensed financial information reported by ValeroL.P. is summarized below:

 
| ** **                                  | ** ** | **September 30, 2006**     | ** ** | **December 31, 2005** | ** ** |
|---------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                  | ** ** | **(Thousands of Dollars)** | ** ** |
|                                        |       |                                 |       |                            |       |
| **Balance  Sheet Information:**             | ** ** | ** **                           | ** ** | ** **                      | ** ** |
| Current assets                              |       | $                                    | 201,599    |                            | $          | 295,411 |   |
| Property and  equipment, net                |       | 2,172,582                            |       | 2,160,213                       |       |
| Goodwill                                    |       | 774,966                              |       | 767,587                         |       |
| Other long-term  assets, net                |       | 151,395                              |       | 143,781                         |       |
| Total assets                                |       | $                                    | 3,300,542  |                            | $          | 3,366,992 |   |
|                                        |       |                                 |       |                            |       |
| Current  liabilities                        |       | $                                    | 138,618    |                            | $          | 205,588 |   |
| Long-term debt,  less current portion       |       | 1,178,476                            |       | 1,169,659                       |       |
| Other long-term  liabilities                |       | 96,777                               |       | 90,966                          |       |
| Total liabilities                           |       | 1,413,871                            |       | 1,466,213                       |       |
|                                        |       |                                 |       |                            |       |
| Partners’ equity                       |       | 1,886,671                            |       | 1,900,779                       |       |
|                                        |       |                                 |       |                            |       |
| Total liabilities and partners’ equity |       | $                                    | 3,300,542  |                            | $          | 3,366,992 |   |

 
| ** **                            | ** ** | **Three Months Ended**

**September 30,** | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|---------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                            | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                            | ** ** | **(Thousands of Dollars)**                     | ** ** |
|                                  |       |                                                     |       |                                                    |       |   |   |   |   |
| **Statement  of Income Information:** | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                              |       | $                                                        | 291,023    |                                                    | $          | 258,385 |   | $ | 844,995 |   | $ | 373,326 |   |
| Operating income                      |       | 54,380                                                   |       | 56,007                                                  |       | 157,663 |   | 105,031 |   |
| Net income                            |       | 41,169                                                   |       | 45,167                                                  |       | 112,173 |   | 83,283 |   |
|                                       |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

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***Other***

As of September 30, 2006 and December 31, 2005, ourinvestment in Valero L.P. (representing both the 2% general partner interestand the 21.4% limited partner interest) reconciles to Valero L.P.’s totalpartners’ equity as follows:

 
| ** **                                                                                                           | ** ** | **September 30, 2006**     | ** ** | **December 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                           | ** ** | **(Thousands of Dollars)** | ** ** |
|                                                                                                                 |       |                                 |       |                            |       |
| Valero L.P.  total partners’ equity                                                                             |       | $                                    | 1,886,671  |                            | $          | 1,900,779 |   |
| Valero GP  Holdings’ ownership interest in Valero L.P.                                                          |       | 23.4                                 | %          | 23.4                            | %          |
| Valero GP  Holdings’ share of Valero L.P.’s partners’ equity                                          |       | 441,481                              |       | 444,782                         |       |
| Unrecognized SAB  51 credits                                                                                         |       | —                               |       | (158,170                        | )          |
| Step-up in basis  related to Valero L.P.’s assets and liabilities, including equity method  goodwill, and other |       | 119,754                              |       | 122,132                         |       |
| Investment in  Valero L.P.                                                                                           |       | $                                    | 561,235    |                            | $          | 408,744 |   |

 

The step-up in basisrelated to Valero L.P.’s assets and liabilities, including equity methodgoodwill, reflected in the table above relates to purchase accountingadjustments resulting from Valero Energy’s UDS Acquisition.  The amount represents the unamortized excessof the fair value over carrying amount applicable to Valero Energy’sproportionate 73.6% interest in Valero L.P.’s identifiable assets andliabilities as of December 31, 2001. This amount also includes the portion ofgoodwill resulting from the UDS Acquisition that was attributed to Valero GPHoldings’ investment in Valero L.P. Since 26.4% of the equity interest inValero L.P. was owned by public unitholders as of the date of the UDSAcquisition, a significant portion of the total ownership interest in ValeroL.P. was deemed to be held by the public under generally accepted accountingprinciples, thereby precluding the inclusion of these fair value adjustments inthe reported financial statements of Valero L.P.

**4. RELATED PARTY TRANSACTIONS**

***Relationships***

We manage Valero L.P.through our ownership of Valero GP, LLC, and Riverwalk Holdings, which ownRiverwalk Logistics, the general partner of Valero L.P. Our officers are alsoofficers of Valero GP, LLC. The Chairman of our Board of Directors, William E.Greehey, is also the Chairman of the Board of Directors of Valero GP, LLC andValero Energy. The Board of Directors of Valero GP, LLC is responsible foroverseeing Valero GP, LLC’s role as the owner of the general partner of ValeroL.P., and we, as the sole owner of Valero GP, LLC, must also approve mattersthat have or would reasonably be expected to have a material effect on ourinterests as the sole owner of Valero GP, LLC.

 

Valero GP, LLC providesemployee services to Valero L.P. to perform operating and maintenance serviceswith respect to Valero L.P. assets for which Valero GP, LLC receivesreimbursement from Valero L.P. In addition, subsidiaries of Valero Energy,other than Valero GP Holdings or Valero GP, LLC, provide administrativeservices for which an annual fee is charged to Valero L.P. Effective January 1,2006, the services agreement was amended and now provides for fewer services byValero Energy subsidiaries due to the transfer to Valero GP, LLC of asubstantial number of Valero Energy employees who had previously providedservices to Valero L.P. under the prior services agreement. For purposes of thesefinancial statements, for the period prior to the initial public offering, nocorporate costs have been allocated to Valero GP Holdings by Valero Energy asmanagement has determined that no such corporate costs were incurredspecifically on behalf of Valero GP Holdings.

As of September 30, 2006and December 31, 2005, Valero GP Holdings had a receivable from Valero L.P. of$11.1 million and $1.2 million, respectively, with both amountsrepresenting payroll and related benefit plan costs for employees. Valero GPHoldings also has a long-term receivable of $5.8 million from Valero L.P.related to amounts payable for retiree medical benefits and otherpost-employment benefits.

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The following tablesummarizes the results of transactions with Valero L.P.:
| ** **                                             | ** ** | **Three Months Ended**

**September 30,** | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|--------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | **(Thousands of Dollars)**                     | ** ** |
|                                                   |       |                                                     |       |                                                    |       |   |   |   |   |
| Expenses charged by  Valero GP Holdings to Valero L.P. |       | $                                                        | 29,155     |                                                    | $          | 24,350 |   | $ | 80,625 |   | $ | 44,701 |   |
|                                                        |            |                                                          |            |                                                         |            |  |  |  |  |  |  |  |  |

 

***AdministrationAgreement***

*** ***OnJuly 19, 2006, in connection with the IPO, Valero GP Holdings entered intoan administration agreement with Valero GP, LLC (the Administration Agreement).The Administration Agreement provides, among other things, that Valero GP, LLCwill provide all executive management and other administrative services toValero GP Holdings.  Valero GP Holdingsdoes not have any employees.

 

Valero GP Holdingswill pay annual charges under the Administration Agreement of $0.5 million toValero GP, LLC. This amount will be increased annually to reflect Valero GP,LLC’s annual merit increases. Any other adjustments to the annual fee, such asadjustments to reflect changes in the levels of service provided to Valero GPHoldings or Valero GP, LLC’s actual payroll cost, are subject to the approvalof Valero GP, LLC’s conflicts committee. Valero GP Holdings will also reimburseValero GP, LLC for all direct public company costs and any other direct costs,such as outside legal and accounting fees, that Valero GP, LLC incurs while providingservices to Valero GP Holdings pursuant to the Administration Agreement.

The AdministrationAgreement will terminate on December 31, 2011, with automatic two-yearrenewals unless terminated by either party on six months’ written notice.Valero GP Holdings may cancel or reduce the services provided under theAdministration Agreement on 60 days’ written notice. The AdministrationAgreement will terminate upon a change of control of either Valero GP Holdingsor Valero GP, LLC. Valero GP, LLC’s conflicts committee has approved the termsof the Administration Agreement.

***2006 OmnibusAgreement***

On March 31, 2006, ValeroL.P. entered into an amended and restated omnibus agreement (the 2006 Omnibus Agreement) by and amongValero L.P., Riverwalk Logistics, Valero Energy, Valero GP, LLC, and ValeroLogistics Operations, L.P., a  whollyowned subsidiary of Valero L.P. The conflicts committee of the board ofdirectors of Valero GP, LLC approved the terms of the 2006 Omnibus Agreement onMarch 10, 2006. The 2006 Omnibus Agreement supersedes the omnibus agreementamong the parties dated effective April 16, 2001.

 

Under the 2006Omnibus Agreement, Valero Energy has agreed, and will cause its controlledaffiliates, including us, to agree not to engage in the business oftransporting crude oil and other feedstocks or refined products, includingpetrochemicals, or operating crude oil storage facilities or refined productterminalling assets in the United States for so long as Valero Energy or itscontrolled affiliates owns 20% or more of Valero L.P. or Riverwalk Logistics.This restriction does not apply to:

·                  anybusiness retained by UDS as of April 16, 2001, the closing of Valero L.P.’sinitial public offering, or any business owned by Valero Energy at the date ofthe UDS Acquisition;

·                  anybusiness with a fair market value of less than $10 million;

·                  anybusiness acquired by Valero Energy in the future that constitutes less than 50%of the fair market value of a larger acquisition, provided Valero L.P. has beenoffered and declined the opportunity to purchase the business; and

·                  anynewly constructed pipeline, terminalling or storage assets that Valero L.P. hasnot offered to purchase at fair market value within one year of construction.

Also under the2006 Omnibus Agreement, Valero Energy has agreed to indemnify Valero L.P. forenvironmental liabilities related to the assets transferred to Valero L.P. inconnection with Valero L.P.’s initial public offering, provided that suchliabilities arose prior to and are discovered within ten years after that date(excluding liabilities resulting from a change in law after April 16, 2001).

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***Non-Compete Agreement***

On July 19, 2006, inconnection with the IPO, we entered into a non-compete agreement with ValeroL.P., Riverwalk Logistics, and Valero GP, LLC (the Non-Compete Agreement).The Non-Compete Agreement will become effective when we are no longer subjectto the 2006 Omnibus Agreement described above. Under the Non-Compete Agreement,we will have a right of first refusal with respect to the potential acquisitionof general partner and other equity interests in publicly traded partnershipsunder common ownership with the general partner interest. Valero L.P. will havea right of first refusal with respect to the potential acquisition of assetsthat relate to the transportation, storage or terminalling of crude oil,feedstocks or refined petroleum products (including petrochemicals) in theUnited States and internationally. With respect to any other businessopportunities, neither we nor Valero L.P. are prohibited from engaging in anybusiness, even if we and Valero L.P. would have a conflict of interest withrespect to such other business opportunity. The Non-Compete agreement remainsin effect for so long as Valero GP Holdings or any of its affiliates own 20% ormore of Valero GP, LLC or Riverwalk Logistics.

 

***EmployeeBenefits Transition Agreement***

On October 13, 2006,Valero GP Holdings entered into an Employee Benefits Transition Agreementeffective as of July 1, 2006 (the Transition Agreement). Prior to July 1,2006, the employees of Valero GP, LLC were included in the various employeebenefit plans of Valero Energy. These plans include a defined benefit pensionplan, a retiree welfare benefit plan, health and welfare benefits, a definedcontribution retirement plan, equity incentive plans and nonqualified deferredcompensation plans. In accordance with the Transition Agreement and inconnection with the initial public offering on July 19, 2006, employees ofValero GP, LLC began participating in newly enacted, comparable plans sponsoredby Valero GP, LLC.

 

In connection withthis transition, Valero Energy and certain of its subsidiaries transferredrelated liabilities and assets totaling $7.9 million to Valero GP Holdings. Inaddition, Valero Energy, at its cost and expense, agreed to assist Valero GP,LLC in the design, preparation and initial implementation of Valero GP, LLC’semployee benefit plans. Under the Transition Agreement, Valero Energy willcontinue to provide the transition services and arrangements described thereinthrough the earlier of the completion of such services and arrangements or theeffective date of the final sale by Valero Energy of its remaining membershipinterest in Valero GP Holdings, unless the parties otherwise agree.

***NotesPayable to Affiliates***

Our notes payable toaffiliates (the Notes) reflected the allocation to us of a portion of the debtincurred by Valero Energy to fund the UDS Acquisition, as well as theeffect of cash inflows and outflows resulting from our normal operations.Effective July 19, 2006, in conjunction with the initial public offering,Valero Energy made a capital contribution to us of the outstanding balance ofthe Notes, including accrued interest.

 

**5.  DISTRIBUTIONS FROMVALERO L.P.**

Valero L.P.’s partnershipagreement, as amended, determines the amount and priority of cash distributionsthat Valero L.P.’s common unitholders and general partner may receive. Thegeneral partner is entitled to incentive distributions if the amount ValeroL.P. distributes with respect to any quarter exceeds $0.60 per unit, with themaximum percentage of 23% of the amount of any quarterly distribution in excessof $0.66 per unit. The general partner also receives a 2% distribution withrespect to its general partner interest.

 

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The following tablereflects the allocation of Valero L.P.’s cash distributions earned for theperiod indicated among its general and limited partners:

 
| ** **                                                  | ** ** | **Three Months Ended**

**September 30,**                       | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|-------------------------------------------------------------|------------|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                  | ** ** | **2006**                                                                       | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                  | ** ** | **(Thousands of Dollars, Except Per Unit Data)** | ** ** |
|                                                        |       |                                                                           |       |                                                    |       |   |   |   |   |
| General partner  interest (2%)                              |       | $                                                                              | 955        |                                                    | $          | 879 |   | $ | 2,787 |   | $ | 2,157 |   |
| General partner  incentive distribution                     |       | 3,909                                                                          |       | 3,049                                                   |       | 10,869 |   | 7,210 |   |
| Total general  partner distribution                         |       | 4,864                                                                          |       | 3,928                                                   |       | 13,656 |   | 9,367 |   |
| Valero GP Holdings’  limited partner distribution      |       | 9,350                                                                          |       | 8,740                                                   |       | 27,447 |   | 25,675 |   |
| Total  distributions to Valero GP Holdings                  |       | 14,214                                                                         |       | 12,668                                                  |       | 41,103 |   | 35,042 |   |
| Public unitholders’  distributions                     |       | 33,480                                                                         |       | 31,282                                                  |       | 98,237 |   | 72,803 |   |
| Total cash  distributions                                   |       | $                                                                              | 47,694     |                                                    | $          | 43,950 |   | $ | 139,340 |   | $ | 107,845 |   |
| Cash distributions per  unit applicable to limited partners |       | $                                                                              | 0.915      |                                                    | $          | 0.855 |   | $ | 2.685 |   | $ | 2.510 |   |

 

On October 26, 2006, Valero L.P. declared cashdistributions related to the third quarter of 2006 of $0.915 per unit to bepaid on November 14, 2006 to unitholders of record on November 7,2006.

**7.  CREDITFACILITY**

On July 19,2006, we entered into a three-year revolving credit facility with a borrowingcapacity of up to $20 million (the Credit Facility).  Of the Credit Facility’s $20 millioncommitment, up to $10 million may be available for letters of credit. Ourobligations under the Credit Facility are unsecured. The Credit Facilitycontains customary covenants and provisions including limitations onindebtedness, liens, dispositions of material property, mergers and assettransfers. Borrowings under the Credit Facility bear interest, at our option,at either: (i) the higher of (a) JPMorgan Chase Bank, N.A.’s primerate or (b) the federal funds effective rate plus one-half percent; or(ii) the Eurodollar rate, as adjusted for statutory reserve requirementsfor Eurocurrency liabilities, plus an applicable margin that varies based uponour credit rating. During the three months ended September 30, 2006, weborrowed $1.0 million under the Credit Facility, which bears interest at 5.9%.As of September 30, 2006, we had $19.0 million available for borrowing underthe Credit Facility.

Under the terms ofthe Credit Facility, Valero L.P. must maintain a total debt-to-EBITDA ratio of lessthan 4.75 to 1.0 for any four consecutive quarters, subject to adjustmentfollowing certain acquisitions.  We arealso required to receive cash distributions of at least $25.0 million inrespect to our ownership interests in Valero L.P. for the preceding four fiscalquarters ending on the last day of each fiscal quarter.

Additionally, theCredit Facility contains customary events of default, including a “change incontrol,” that could result in the acceleration of all amounts and cancellationof all commitments outstanding under the Credit Facility. A “change in control”is defined to mean any of the following events: (i) Valero GP Holdings ceases,indirectly or directly, to own all of the issued and outstanding equityinterests of the general partner(s) of Valero L.P., or we no longer have thepower, directly or indirectly, to direct or to cause the direction of themanagement or the policies of Valero L.P.; or (ii) the occurrence of anytransaction that results in any person or group, other than Valero Energy or anentity with unsecured senior debt with an investment grade rating, becoming thebeneficial owner of more than 50% of our equity interests.

**8. COMMITMENTS AND CONTINGENCIES**

***Litigationand Environmental Matters***

We are not currently a party to any material legalproceedings. However, Valero L.P. is subject to certain loss contingencies, theoutcome of which could have an effect on Valero L.P.’s results of operationsand ability to pay

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distributions, which would impact our results ofoperations and ability to pay distributions. Valero L.P.’s most significantcontingent liabilities resulting from various litigation, claims andcommitments are discussed below.

*Grace Energy Corporation Matter.*In1997, Grace Energy Corporation (Grace Energy) sued subsidiaries of Kaneb inTexas state court. Valero L.P. acquired Kaneb Services LLC (KSL) and Kaneb PipeLine Partners, L.P. (KPP, and, together with KSL, Kaneb) on July 1, 2005.  The complaint sought recovery of the cost ofremediation of fuel leaks in the 1970s from a pipeline that had once connecteda former Grace Energy terminal with Otis Air Force Base in Massachusetts (OtisAFB). Grace Energy alleges the Otis AFB pipeline and related environmentalliabilities had been transferred in 1978 to an entity that was part of Kaneb’sacquisition of Support Terminal Services, Inc. and its subsidiaries from GraceEnergy in 1993. Kaneb contends that it did not acquire the Otis AFB pipelineand never assumed any responsibility for any associated environmental damage.

In 2000, the court entered final judgment that: (i)Grace Energy could not recover its own remediation costs of $3.5 million,(ii) Kaneb owned the Otis AFB pipeline and its related environmentalliabilities and (iii) Grace Energy was awarded $1.8 million in attorney costs.Both Kaneb and Grace Energy appealed the trial court’s final judgment to theTexas Court of Appeals in Dallas. In 2001, Grace Energy filed a petition inbankruptcy, which created an automatic stay of actions against Grace Energy.Once that stay is lifted, we intend to resume vigorous prosecution of theappeal.

The Otis AFB is a part of a Superfund Site pursuant tothe Comprehensive Environmental Response Compensation and Liability Act(CERCLA). The site contains a number of groundwater contamination plumes, twoof which are allegedly associated with the Otis AFB pipeline.  Relying on the Texas state court’s finaljudgment assigning ownership of the Otis AFB pipeline to Kaneb, the U.S.Department of Justice advised Kaneb in 2001 that it intends to seekreimbursement from Kaneb for the remediation costs associated with the twospill areas. In 2002, the Department of Justice asserted that it had incurredover $49.0 million in costs and expected to incur additional costs ofapproximately $19.0 million for remediation of the two spill areas. TheDepartment of Justice has not filed a lawsuit against us on this matter and wehave not made any payments toward costs incurred by the Department of Justice.

*Port of Vancouver Matter. *Valero L.P. owns a chemical and refined products terminal onproperty owned by the Port of Vancouver, and leases the land under the terminalfrom the Port of Vancouver. Under an Agreed Order entered into with theWashington Department of Ecology when Kaneb purchased the terminal in 1998,Kaneb agreed to investigate and remediate groundwater contamination by theterminal’s previous owner and operator originating from the terminal.  Investigation and remediation at the terminalare ongoing, in compliance with the Agreed Order.  In April 2006, the Washington Department ofEcology commented on Valero L.P.’s site investigation work plan and assertedthat the groundwater contamination at the terminal was commingled with agroundwater contamination plume under other property owned by the Port ofVancouver.  Valero L.P. disputed thisassertion.  No lawsuits have been filedagainst Valero L.P. in this matter, and Valero L.P. has not made any paymentstoward remediation of the allegedly commingled plume.  Factors that could affect estimatedremediation costs include whether Kaneb will be found to have ultimateresponsibility for some portion of the allegedly commingled plume, the Port ofVancouver’s contribution to the remediation effort and the amount the Port ofVancouver actually receives from other potentially responsible parties.

*St.Eustatius Tax Agreement. *OnJune 1, 1989, the governments of the Netherlands Antilles and St. Eustatiusapproved a Free Zone and Profit Tax Agreement retroactive to January 1, 1989,which expired on December 31, 2000. This agreement required a subsidiary of Kaneb, which Valero L.P.acquired on July 1, 2005, to pay the greater of 2% of taxable income, asdefined therein, or 500,000 Netherlands Antilles guilders (approximately $0.3million) per year.  The agreement furtherprovided that any amounts paid in order to meet the minimum annual payment wereavailable to offset future tax liabilities under the agreement to the extentthat the minimum annual payment is greater than 2% of taxable income.

On February 22,2006, Valero L.P. entered into a revised agreement (the 2005 Tax and MaritimeAgreement) with the governments of St. Eustatius and the NetherlandsAntilles.  The 2005 Tax and MaritimeAgreement is effective beginning January 1, 2005 and expires on December31, 2014.  Under the terms of the2005 Tax and Maritime Agreement, Valero L.P. agreed to make a one-timepayment of five million Netherlands Antilles guilders (approximately$2.8 million) in full and final settlement of all of our liabilities,taxes, fees, levies, charges, or amounts otherwise (including settlement ofaudits) due or potentially due to St. Eustatius.  Valero L.P. further agreed to pay an annualminimum profit tax to St. Eustatius of one million Netherlands Antillesguilders (approximately $0.6 million), beginning as ofJanuary 1, 2005.  Valero L.P.agreed to pay the minimum annual profit tax in twelve equal monthlyinstallments.  To the extent the minimumannual profit tax exceeds 2% of taxable profit (as defined in the 2005 Tax andMaritime

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Agreement), ValeroL.P. can carry forward that excess to offset future tax liabilities.  If the minimum annual profit tax is less than2% of taxable profit, Valero L.P. agreed to pay that difference.

***Other***

Valero L.P. is also a party to additional claims andlegal proceedings arising in the ordinary course of business. Valero L.P.believes the possibility is remote that the final outcome of any of theseclaims or proceedings to which they are a party would have a material adverseeffect on the Valero L.P. financial position, results of operations orliquidity; however, due to the inherent uncertainty of litigation, there can beno assurance that the resolution of any particular claim or proceeding wouldnot have a material adverse effect on Valero L.P.’s results of operations,financial position or liquidity.

 

**9. MEMBERS’ EQUITY AND NET INCOME PER UNIT**

As discussed previously, on July 19, 2006, ourexisting membership interests were represented by 10,000,000 units and a4.25-for-1 unit split was effected, resulting in total outstanding units of42,500,000 with the members of Valero GP Holdings maintaining theirownership percentages after the unit split. Prior to those transactions, we had no outstanding units.  Our net income per unit amounts assumethat 42,500,000 units were outstanding for all periods presented.

We calculate basicnet income per unit by dividing net income by the weighted average number ofunits outstanding for the period. Diluted net income per unit is calculated by dividing net income by theweighted average number of units outstanding and the effect of non-vestedrestricted units granted under the Valero GP Holdings, LLC 2006 Long-TermIncentive Plan calculated using the treasury stock method. Net income per unitamounts were computed as follows (dollars in thousands, except unit data andper unit amounts):

 
| ** **                                              | ** ** | **Three Months Ended**

**September 30,** | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Basic  Net Income per Unit:**                         | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                              |       | $                                                        | 9,697      |                                                    | $          | 7,806 |   | $ | 20,395 |   | $ | 16,689 |   |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  number of basic units outstanding     |       | 42,500,000                                               |       | 42,500,000                                              |       | 42,500,000 |   | 42,500,000 |   |
| ** **                                              | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic net income  per unit                              |       | $                                                        | 0.23       |                                                    | $          | 0.18 |   | $ | 0.48 |   | $ | 0.39 |   |
| ** **                                              | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Diluted  Net Income per Unit:**                       | ** ** | ** **                                               | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income                                              |       | $                                                        | 9,697      |                                                    | $          | 7,806 |   | $ | 20,395 |   | $ | 16,689 |   |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Weighted average  number of basic units outstanding     |       | 42,500,000                                               |       | 42,500,000                                              |       | 42,500,000 |   | 42,500,000 |   |
| Effect of  dilutive securities - restricted unit grants |       | 626                                                      |       | —                                                  |       | 211 |   | — |   |
| Weighted average  number of diluted units outstanding   |       | 42,500,626                                               |       | 42,500,000                                              |       | 42,500,211 |   | 42,500,000 |   |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Diluted net  income per unit                            |       | $                                                        | 0.23       |                                                    | $          | 0.18 |   | $ | 0.48 |   | $ | 0.39 |   |

 

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Thefollowing table presents changes to our members’ equity (in thousands):

 

| Balance as of December 31,  2005                       |   | $       | 141,780 |   |
|--------------------------------------------------------|--------|---------|---------|--------|
| Net income                                             |   | 20,395  |    |
| Distributions to Valero Energy                         |   | (29,611 | )       |
| Contributions from Valero Energy                       |   | 267,198 |    |
| SAB 51 credits                                         |   | 158,170 |    |
| Share of Valero L.P.’s other comprehensive income |   | 1,801   |    |
| Balance as of September  30, 2006                      |   | $       | 559,733 |   |

 

***ComprehensiveIncome***

For the three and ninemonths ended September 30, 2006, the difference between our net income and ourcomprehensive income resulted from our proportionate share of Valero L.P.’sother comprehensive income.  Our totalcomprehensive income was as follows:

 

|                                                         | ** ** | **Three Months Ended**

**September 30,** | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|---------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                                 | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                              | ** ** | **(Thousands of Dollars)**                     | ** ** |
|                                                    |       |                                                     |       |                                                    |       |   |   |   |   |
| Net income                                              |       | $                                                        | 9,697      |                                                    | $          | 7,806 |   | $ | 20,395 |   | $ | 16,689 |   |
| Share of Valero  L.P.’s other comprehensive income |       | (24                                                      | )          | —                                                  |       | 1,801 |   | — |   |
| Comprehensive income                                    |       | $                                                        | 9,673      |                                                    | $          | 7,806 |   | $ | 22,196 |   | $ | 16,689 |   |

 

***CashDistributions***

On October 30, 2006, wedeclared, for the period from our initial public offering on July 19, 2006 toSeptember 30, 2006, a prorated initial quarterly distribution of$0.2574 per unit, which is based on a quarterly distribution of $0.32 per unit.Total cash distributions to be paid for the period from July 19, 2006 toSeptember 30, 2006 are $10.9 million. The distribution is expected to be paidon November 17, 2006 to holders of record as of November 7, 2006.

 

The cashdistribution to be paid on November 17, 2006 to Valero Energy for the first 18days of the quarter is $2.7 million.

***Second Amended and Restated Limited Liability CompanyAgreement***

On July 19, 2006, inconnection with the IPO, we amended and restated our limited liability companyagreement (the Second Amended and Restated Limited Liability CompanyAgreement).  The material provisions of theSecond Amended and Restated Limited Liability Company Agreement include thedistributions of available cash, rights of unitholders, the election of membersof our board of directors and allocations of taxable income and other matters.

 

We have historically madedistributions to Valero Energy affiliates in accordance with our limitedliability company agreement, under which cash receipts less cash expendituresare distributed on a quarterly or more frequent basis to our members. TheSecond Amended and Restated Limited Liability Company Agreement requires that,within 50 days after the end of each quarter beginning with the quarter endingSeptember 30, 2006, we distribute all of our available cash to the holders ofrecord of our units on the applicable record date.  Available cash is defined as all cash on handat the end of any calendar quarter less the amount of cash reserves necessaryor appropriate, as determined in good faith by our board of directors.

***Rights Agreement***

On July 19, 2006, weentered into a rights agreement with Computershare Investor Services, LLC (theRights Agreement) under which one preferred unit purchase right (“Right”) isattached to each of our outstanding units. The Rights become exercisable underspecified circumstances, including any person or group (an “acquiring person”)becoming the beneficial owner of 15% or more of our outstanding units, subjectto specified exceptions. Each Right entitles the registered holder to purchasefrom us one one-hundredth of a unit of junior participating preferred units,series I, (Preferred Units) at an exercise price of $100, subject toadjustment under specified circumstances. If events specified in the RightsAgreement occur, each holder of Rights other than the acquiring person canexercise their Rights.

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When a holder exercises aRight, the holder will be entitled to receive units valued at a multiple of theexercise price of the Right specified in the Rights Agreement. In some cases,the holder will receive cash, property or other securities instead ofunits.  We may redeem the Rights for$0.001 per Right at any time prior to the tenth day after a person or groupbecomes an acquiring person.

 

The Rights willexpire on June 30, 2016, unless extended or earlier redeemed or exchanged, andare protected by customary anti-dilution provisions.  Preferred Units purchasable upon exercise ofthe Rights will not be redeemable.  EachPreferred Unit will be entitled to share in our distributions of available cashpro rata with the units.  In the event ofliquidation, the holders of the Preferred Units will be entitled to a minimumpreferential liquidation payment of $100 per unit.  Each Preferred Unit will have 100 votes,voting together with the units.  Finally,in the event of any merger, consolidation or other transaction in which unitsare exchanged, each Preferred Unit will be entitled to receive 100 times theamount received per unit.

**8. EMPLOYEE BENEFIT PLANS**

In connection with our initial public offering and theTransition Agreement, Valero GP, LLC established new benefit plans foremployees as follows:

***Valero GP, LLCThrift Plan***

Effective June 26, 2006,we established the Valero GP, LLC Thrift Plan (the Thrift Plan), which is aqualified employee profit-sharing plan. Participation in the Thrift Plan isvoluntary and is open to substantially all of our employees in the UnitedStates who become eligible to participate upon date of hire.

 

Thrift Planparticipants can make basic contributions from 1% up to 8% of their totalannual compensation, which includes overtime and cash bonuses. In addition,participants who make a basic contribution of 8% can also make a supplementalcontribution of up to 22% of their total annual compensation.  The maximum match by us is 75% of eachparticipant’s basic contributions up to 8% based on the participant’s totalannual compensation excluding cash bonuses.

***Valero GP, LLCPension Plan***

Effective July 1, 2006,we established the Valero GP, LLC Pension Plan, a qualified non-contributorydefined benefit plan (the Pension Plan). The Pension Plan covers substantiallyall of our employees in the United States and generally provides eligibleemployees with retirement income based on years of service and compensationduring specific periods.

 

Substantially allof our employees may become eligible to receive benefits after five years ofservice, including service recognized by Valero Energy for vesting purposesunder the Valero Energy pension plan. All benefit obligations associated withemployees’ service through June 30, 2006, including the effect of future salaryincreases, are the responsibility of Valero Energy.  All benefit obligations related to service onor after July 1, 2006 will be covered by the Pension Plan.

***Long-Term IncentivePlans***

On July 19, 2006,our board of directors adopted the Valero GP Holdings, LLC Long-Term IncentivePlan (the 2006 LTIP) for our employees, consultants and directors and employeesand consultants of our affiliates who perform services for us or ouraffiliates.  The 2006 LTIP allows for theawarding of (i) unit options; (ii) performance units;(iii) restricted units; (iv) phantom units; (v) unit grants; and(vi) unit appreciation rights. The 2006 LTIP permits the granting of awardstotaling an aggregate of 2,000,000 units. The 2006 LTIP will be administered bythe compensation committee of our board of directors.

 

Our board ofdirectors, or its compensation committee, in its discretion may terminate,suspend or discontinue the 2006 LTIP at any time with respect to any award thathas not yet been granted. Our board of directors, or its compensationcommittee, also has the right to alter or amend the 2006 LTIP or any part ofthe 2006 LTIP from time to time, including increasing the number of units thatmay be granted subject to unitholder approval as required by the exchange uponwhich the units are listed at that time. However, no change in any outstandinggrant may be made that would materially impair the rights of the participantwithout the consent of the participant.

On August 22,2006, we granted 2,886 restricted units of Valero GP Holdings to our directors.One third of the units granted will vest on the anniversary of the grant overthree years.

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***Excess Thrift Plan, ExcessPension Plan and SERP***

Effective July 1, 2006, Valero GP, LLC established anexcess thrift plan (the Excess Thrift Plan), an excess pension plan (the ExcessPension Plan) and a supplemental executive retirement plan (the SERP).  Effective as of July 1, 2006, eligible ValeroGP, LLC employees ceased accruing additional benefits under Valero Energy’sexcess pension plan (the Prior Excess Pension Plan) and Valero Energy’ssupplemental executive retirement plan (the Prior SERP), and ceasedparticipating in Valero Energy’s  excessthrift plan.

 

The Excess ThriftPlan provides benefits to those employees of Valero GP, LLC whose annualadditions under the Thrift Plan are subject to the limitations on such annualadditions as provided under §415 of the Internal Revenue Code of 1986, asamended (the Code), and/or who are constrained from making maximumcontributions under the Thrift Plan by §401(a)(17) of the Code, which limitsthe amount of an employee’s annual compensation which may be taken into accountunder that plan.  The Excess Thrift Planis comprised of two separate components, consisting of (1) an “excess benefitplan” as defined under §3(36) of The Employee Retirement Income Security Act of1974, as amended (ERISA) and (2) a plan that is unfunded and maintainedprimarily for the purpose of providing deferred compensation for a select groupof management or highly compensated employees. Each component of the Excess Thrift Plan shall consist of a separateplan for purposes of Title I of ERISA.

The Excess Pension Planprovides benefits to those employees of Valero GP, LLC whose pension benefitsunder the Pension Plan and the Valero Energy pension plan (where applicable)are subject to limitations under the Code, or who are otherwise indirectlyconstrained by the Code from realizing the maximum benefit available to themunder the terms of the Pension Plan and the Valero Energy pension plan (whereapplicable).  The Excess Pension Plan isan “excess benefit plan” as defined under §3(36) of ERISA, for those benefitsprovided in excess of Section 415 of the Code.  Benefits provided as a result of otherstatutory limitations are limited to a select group of management or otherhighly compensated employees.  The ExcessPension Plan will assume the liabilities of the Prior Excess Pension Plan as ofJuly 1, 2006 with respect to Valero GP, LLC employees, and will provide asingle, nonqualified defined benefit to those Valero GP, LLC employees fortheir pre-July 1, 2006 benefit accruals under the Prior Excess Pension Plan andtheir post-July 1, 2006 benefit accruals under the Excess Pension Plan.

The SERP provides thosehighly compensated, management personnel of Valero GP, LLC who were accruingbenefits under the Prior SERP up until July 1, 2006, and those who maysubsequently become eligible, with a supplement to the retirement benefit theymay otherwise receive under the Pension Plan and the Valero Energy pension plan(where applicable). Benefits under the SERP are limited to a select group ofmanagement or other highly compensated employees.  The SERP will assume the liabilities of thePrior SERP as of July 1, 2006 with respect to Valero GP, LLC employees, andwill provide a single, nonqualified defined benefit to those Valero GP, LLCemployees for their pre-July 1, 2006 benefit accruals under the Prior SERPand their post-July 1, 2006 benefit accruals under the SERP.

None of the Excess ThriftPlan, the Excess Pension Plan or the SERP is intended to constitute either aqualified plan under the provisions of Section 401 of the Code or a fundedplan subject to ERISA.

Valero GP, LLC assumedthe liabilities accrued under the Prior Excess Pension Plan and the Prior SERPrelated to its employees, totaling $0.2 million and $0.9 million, respectively.

In addition to theliabilities associated with the new benefit plans, Valero GP, LLC also retainedthe liabilities for the benefit obligations related to the post-retirementmedical benefits for those employees that are not “retirement eligible”(employees over 55 years old with 5 years of service and eligible to receivebenefits under the Valero Energy pension plan) on July 19, 2006, and certainlong-term disability benefits (LTD) under the Valero Energy flex benefits plantotaling $6.1 million and $0.6 million, respectively, as of July 1, 2006.  Valero Energy retained the responsibility forthe post-retirement medical benefit obligation for employees who are retirementeligible on July 19, 2006, and those who subsequently become retirementeligible and elect to receive a benefit on or before December 31, 2006 underthe Valero Energy pension plan.  Weexpect to adopt a post-retirement medical benefits plan to be effective July 1,2006 from which benefits will become payable to eligible employees beginningJanuary 1, 2007.

Medical and other welfarebenefits will continue to be provided to Valero GP, LLC employees under theValero Energy flex benefits plan through December 31, 2006, at which time a newwelfare benefit plan will be established by Valero GP, LLC for the followingplan year.  Valero GP, LLC will reimburseValero Energy for the medical and other welfare benefits provided to Valero GP,LLC employees through December 31, 2006. Valero L.P. will continue to reimburse us for the cost of medical andother welfare benefits.

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All costs incurred byValero GP Holdings related to these employee benefit plans, excludingcompensation expense related to the long-term incentive plans, were and willcontinue to be reimbursed by Valero L.P. at cost. Long-term incentive plancompensation expense pertaining to employees of Valero GP, LLC was reimbursedby Valero L.P., while such compensation expense pertaining to corporateofficers of Valero Energy was reimbursed by Valero Energy affiliates other thanus. Prior to July 19, 2006, any liability of ours related to the variousemployee benefit plans, other than the bonus plans and the long-term incentiveplans, was reflected in “notes payable to affiliates” in our consolidatedbalance sheets.  The liability for thebonus plans was recorded by Valero L.P., and the obligation under the long-termincentive plans is reflected in “accrued liabilities” in our consolidatedbalance sheets. Subsequent to July 19, 2006, our liability for these employeebenefits is included in “other long-term liabilities” on our consolidatedbalance sheet.

The components of netperiodic benefit cost related to our defined benefit plans, which arereimbursed to us by Valero L.P., were as follows for the three months endedSeptember 30, 2006 (in thousands):

 

|                                             | ** ** | ** **                      | ** ** | **Other Postretirement** | ** ** |
|---------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                  | ** ** | **Pension Plans (a)** | ** ** | **Benefit Plans**        | ** ** |
| **Three  months ended September 30, 2006:** | ** ** | ** **                      | ** ** | ** **                    | ** ** |
| Components of  net periodic benefit cost:   |       |                            |       |                          |       |
| Service cost                                |       | $                               | 1,588      |                          | $          | 130 |   |
| Interest cost                               |       | 22                              |       | 95                            |       |
| Amortization of net loss                    |       | 5                               |       | —                        |       |
| Net periodic benefit  cost                  |       | $                               | 1,615      |                          | $          | 225 |   |

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(a)             Includesamounts related to the Pension Plan, Excess Pension Plan and SERP.

There have been nocontributions to our defined pension plans or other postretirement benefitplans for the three months ended September 30, 2006.

In addition to thebenefit plans discussed above, Valero GP, LLC had previously adopted thefollowing long-term incentive plans:

·                  ValeroGP, LLC adopted the 2000 Long-Term Incentive Plan (the 2000 LTIP) under whichValero GP, LLC may award up to 250,000 common units to certain key employees ofValero Energy’s affiliates providing services to us and to directors andofficers of Valero GP, LLC.  Awards underthe LTIP can include unit options, restricted units, performance awards,distribution equivalent rights (DERs) and contractual rights to receive commonunits.

·                  InJune 2003, Valero GP, LLC adopted the 2003 Employee Unit Incentive Plan (theUIP) under which Valero GP, LLC may award up to 500,000 common units toemployees of Valero GP, LLC or its affiliates, excluding officers and directorsof Valero GP, LLC and its affiliates. Awards under the UIP can include unit options, restricted units anddistribution equivalent rights (DERs).

·                  ValeroGP, LLC adopted the 2002 Unit Option Plan (the UOP) under which Valero GP, LLCmay award up to 200,000 unit options to officers and directors of Valero GP,LLC or its affiliates.

Valero L. P. haspreviously and will continue to reimburse us for the cost of the 2000 LTIP, theUIP and the UOP.

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***Amended and Restated 2000Long-Term Incentive Plan***

Effective October 1,2006, the Valero GP, LLC 2000 Long-Term Incentive Plan was amended as follows:

 

·                  increase the number of units authorizedfor issuance under the Plan from 250,000 units (of which 223,147 have beengranted to date) to 1,500,000 units;

·                  permit the “cashless-broker” exercise ofoptions;

·                  provide that if an award under the Planexpires, is cancelled, exercised, paid or otherwise terminates without thedelivery of units then the units covered by such award, to the extent of suchexpiration, cancellation, exercise, payment or termination, shall again beunits with respect to which awards under the Plan may be granted;

·                  amend the Plan to meet the requirementsof, and facilitate compliance with, Section 409A of the Internal RevenueCode;

·                  and amend the definition of “Change ofControl” to reflect that as a result of its recently completed initial publicoffering, Valero GP Holdings, LLC is now the 100% owner of the general partnerof Valero L.P.

**9. INCOME TAXES**

On August 14, 2006,Valero GP, LLC made an entity classification election to be treated as acorporation for federal income tax purposes under Treasury Regulation§301.7701-3(a).   Beginning in the thirdquarter of 2006, our financial statements reflected Valero GP, LLC’s treatmentas a separate taxable corporate subsidiary of Valero GP Holdings.  We accounted for income taxes under the assetand liability method.  Under this method,deferred tax assets and liabilities are recognized for the future tax consequencesattributable to differences between the financial statement carrying amounts ofexisting assets and liabilities and their respective tax bases.  Deferred taxes are measured using enacted taxrates expected to apply to taxable income in the year those temporarydifferences are expected to be recovered or settled.

The realization ofdeferred tax assets recorded as of September 30, 2006 is dependent upon ourability to generate future taxable income in the United States. We believe thatit is more likely than not that the deferred tax assets as of September 30,2006 will be realized, based upon expected future taxable income and potentialtax planning strategies.

 

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**Item2.  Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

**FORWARD-LOOKINGSTATEMENTS**

*This Form 10-Q contains certainestimates, predictions, projections, assumptions and other forward-lookingstatements that involve various risks and uncertainties.  While these forward-looking statements, andany assumptions upon which they are based, are made in good faith and reflectour current judgment regarding the direction of our business, actual resultswill almost always vary, sometimes materially, from any estimates, predictions,projections, assumptions or other future performance suggested in this report.These forward-looking statements can generally be identified by the words “anticipates,”“believes,” “expects,” “plans,” “intends,” “estimates,” “forecasts,” “budgets,”“projects,” “could,” “should,” “may” and similar expressions.  These statements reflect our current viewswith regard to future events and are subject to various risks, uncertaintiesand assumptions. Please read our**quarterlyreport on Form 10-Q for the quarter ended June 30, 2006, Part II, Item 1A, “Risk Factors,” for a discussion ofcertain of those risks, uncertainties and assumptions.*

 

*If one or more of these risks or uncertaintiesmaterialize, or if the underlying assumptions prove incorrect, our actualresults may vary materially from those described in any forward-lookingstatement.  Other unknown orunpredictable factors could also have material adverse effects on our futureresults.  Readers are cautioned not toplace undue reliance on this forward-looking information, which is as of thedate of the Form 10-Q.  We do not intendto update these statements unless it is required by the securities laws to doso, and we undertake no obligation to publicly release the result of anyrevisions to any such forward-looking statements that may be made to reflectevents or circumstances after the date of this report or to reflect theoccurrence of unanticipated events.*

**Overview**

We were formed in June 2000 as UDS Logistics,LLC.  We changed our name to Valero GPHoldings, LLC in January 2006. In anticipation of our initial public offering,we transferred our ownership of 614,572 common units and 9,599,322 subordinatedunits of Valero L.P., a publicly traded Delaware limited partnership (NYSEsymbol: VLI) to Riverwalk Holdings, LLC, our wholly owned subsidiary.  On May 8, 2006, all of the subordinated unitsconverted into Valero L.P. common units on a one-for-one basis in accordancewith the terms of the Valero L.P. partnership agreement.

 

Our only cash generatingassets are our indirect ownership interests in Valero L.P.  Our aggregate ownership interests in ValeroL.P. consist of the following:

·                  the2% general partner interest in Valero L.P., which we hold through our 100%ownership interest in Riverwalk Logistics, L.P.;

·                  100%of the incentive distribution rights issued by Valero L.P., which entitle us toreceive increasing percentages of the cash distributed by Valero L.P.,currently at the maximum percentage of 23%; and

·                  10,219,282common units of Valero L.P. representing a 21.4% limited partner interest inValero L.P.

We account for ourownership interest in Valero L.P. using the equity method.  Therefore, our financial results reflect aportion of Valero L.P.’s net income based on our ownership interest in ValeroL.P.  We have no separate operatingactivities apart from those conducted by Valero L.P. and therefore generate norevenues from operations.

Valero L.P. conductssubstantially all of its business through its operating partnerships and whollyowned subsidiaries, Valero Logistics Operations, L.P. and Kaneb Pipe LineOperating Partnership, L.P. Through its subsidiaries, Valero L.P. is engaged inthe crude oil and refined product transportation, terminalling and storagebusiness in the United States, the Netherland Antilles, Canada, Mexico, theNetherlands and the United Kingdom.

Valero L.P. is requiredby its partnership agreement to distribute all of its available cash at the endof each quarter, less reserves established by its general partner in its solediscretion to provide for the proper conduct of Valero L.P.’s business or toprovide funds for future distributions. Similarly, we are required by our limited liability company agreement todistribute all of our available cash at the end of each quarter, less reservesestablished by our board of directors.

**Recent Developments**

On July 19, 2006, ourexisting membership interests consisted of 10,000,000 units representinglimited liability company interests, and a 4.25-for-1 unit split was effected,resulting in 42,500,000 total units outstanding, all of which were

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owned by subsidiaries ofValero Energy, maintaining their pre-split ownership percentages.******Immediatelysubsequent to the unit split, certain subsidiaries of Valero Energy sold17,250,000 units in an initial public offering (IPO) for a price to the publicof $22.00 per unit.  We did notreceive any proceeds from this offering. Subsequent to the IPO, subsidiaries of Valero Energy own 25,250,000units or approximately 59.4% of our outstanding units.

 

Valero L.P. hasissued common units to the public on three separate occasions, which hasdiluted our ownership percentage.  Thesethree issuances have resulted in increases (or credits) in our proportionate shareof Valero L.P.’s capital because, in each case, the issuance price per unitexceeded our carrying amount per unit at the time of issuance.  We had not recognized any SAB 51 credits inour consolidated financial statements through March 31, 2006 and were notpermitted to do so until our subordinated units converted to Valero L.P. commonunits.  In conjunction with theconversion of the subordinated units held by us to common units on May 8, 2006,we recognized the entire balance of $158.2 million in SAB 51 creditsas an increase in our investment in Valero L.P. and an increase to members’equity.

**Resultsof Operations**

***Three and Nine Months Ended September 30, 2006 Compared to Three andNine Months Ended September 30, 2005***

 
| ** **                                            | ** ** | **Three Months Ended**

**September 30,**                                          | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                            | ** ** | **2006**                                                                                          | ** ** | **2005**                                                | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                            | ** ** | **(Thousands of Dollars, Except Unit and Per Unit Data)** | ** ** |
| ** **                                            | ** ** | ** **                                                                                        | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Equity in  earnings of Valero L.P.                    |       | $                                                                                                 | 11,637     |                                                    | $          | 12,203 |   | $ | 32,141 |   | $ | 29,543 |   |
|                                                  |       |                                                                                              |       |                                                    |       |   |   |   |   |
| General and  administrative expenses                  |       | (877                                                                                              | )          | —                                                  |       | (903 | ) | (16 | ) |
| Other income  (expense), net                          |       | (286                                                                                              | )          | 5                                                       |       | (249 | ) | 447 |   |
| Interest income –  affiliated                    |       | —                                                                                            |       | 36                                                      |       | 53 |   | 73 |   |
| Interest expense  – affiliated                   |       | (901                                                                                              | )          | (4,417                                                  | )          | (10,368 | ) | (13,293 | ) |
| Interest and  debt expense                            |       | (6                                                                                                | )          | —                                                  |       | (6 | ) | — |   |
|                                                  |       |                                                                                              |       |                                                    |       |   |   |   |   |
| Income before  income tax expense                     |       | 9,567                                                                                             |       | 7,827                                                   |       | 20,668 |   | 16,754 |   |
| Income tax expense (benefit)                          |       | (130                                                                                              | )          | 21                                                      |       | 273 |   | 65 |   |
| Net income                                            |       | $                                                                                                 | 9,697      |                                                    | $          | 7,806 |   | $ | 20,395 |   | $ | 16,689 |   |
| ** **                                            | ** ** | ** **                                                                                        | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Basic net income  per unit                            |       | $                                                                                                 | 0.23       |                                                    | $          | 0.18 |   | $ | 0.48 |   | $ | 0.39 |   |
| ** **                                            | ** ** | ** **                                                                                        | ** ** | ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** |
| Weighted average  number of basic units outstanding   |       | 42,500,000                                                                                        |       | 42,500,000                                              |       | 42,500,000 |   | 42,500,000 |   |
|                                                  |       |                                                                                              |       |                                                    |       |   |   |   |   |
| Diluted net  income per unit                          |       | $                                                                                                 | 0.23       |                                                    | $          | 0.18 |   | $ | 0.48 |   | $ | 0.39 |   |
|                                                  |       |                                                                                              |       |                                                    |       |   |   |   |   |
| Weighted average  number of diluted units outstanding |       | 42,500,626                                                                                        |       | 42,500,000                                              |       | 42,500,211 |   | 42,500,000 |   |

 

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As discussedabove, we account for our investment in Valero L.P. using the equitymethod.  As a result, our equity inearnings of Valero L.P., our only source of income, directly fluctuates withthe amount of Valero L.P.’s distributions, which determines the amount of ourincentive distribution earnings, and the results of operations of Valero L.P,which determines the amounts of earnings attributable to our general partnerand limited partner interests.  Thefollowing table summarizes Valero L.P.’s results of operations and our equityin earnings of Valero L.P. for the three and nine months ended September 30,2006 and 2005:

 
| ** **                                                                                | ** ** | **Three Months Ended**     | ** ** | **Nine Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                | ** ** | **September 30,**               | ** ** | **September 30,**          | ** ** |
| ** **                                                                                | ** ** | **2006**                             | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                                                                | ** ** | **(Thousands of Dollars)** | ** ** |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| **Valero  L.P. Statement of Income Data:**                                                | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                                                                  |       | $                                    | 291,023    |                            | $          | 258,385 |   | $ | 844,995 |   | $ | 373,326 |   |
| Operating income                                                                          |       | 54,380                               |       | 56,007                          |       | 157,663 |   | 105,031 |   |
| Income from  continuing operations                                                        |       | 41,169                               |       | 40,861                          |       | 112,550 |   | 78,977 |   |
| Net income                                                                                |       | 41,169                               |       | 45,167                          |       | 112,173 |   | 83,283 |   |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| Net income per  unit applicable to limited partners                                       |       | 0.79                                 |       | 0.88                            |       | 2.13 |   | 2.45 |   |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| Cash  distributions per unit applicable to limited partners                               |       | 0.915                                |       | 0.855                           |       | 2.685 |   | 2.510 |   |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| **Valero  GP Holdings’ Equity in Earnings of Valero L.P.:**                          | ** ** | ** **                           | ** ** | ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** |
| General partner  interest                                                                 |       | $                                    | 753        |                            | $          | 843 |   | 2,033 |   | $ | 1,553 |   |
| General partner  incentive distribution                                                   |       | 3,909                                |       | 3,049                           |       | 10,869 |   | 5,662 |   |
| Direct charges  to Valero GP Holdings, LLC                                                |       | (352                                 | )          | —                          |       | (352 | ) | — |   |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| General  partner’s interest in net income and incentive distributions of Valero L.P. |       | 4,310                                |       | 3,892                           |       | 12,550 |   | 7,215 |   |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| Valero GP  Holdings’ limited partner interest in net income of Valero L.P.           |       | 8,048                                |       | 9,032                           |       | 21,754 |   | 24,491 |   |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| Amortization of  step-up in basis related to Valero L.P.’s assets and liabilities    |       | (721                                 | )          | (721                            | )          | (2,163 | ) | (2,163 | ) |
|                                                                                      |       |                                 |       |                            |       |   |   |   |   |
| Valero GP  Holdings’ equity in earnings of Valero L.P.                               |       | $                                    | 11,637     |                            | $          | 12,203 |   | $ | 32,141 |   | $ | 29,543 |   |

 

***Three Months Ended September 30, 2006 and 2005***

ValeroL.P.’s income from continuing operations for the three months ended September30, 2006 increased slightly compared to the three months ended September 30,2005, despite a decline in consolidated segmental operating income.  Lower income tax expense for the three monthsended September 30, 2006, compared to the three months ended September 30,2005, offset the decline in consolidated segmental operating income and highergeneral and administrative expense. Net income decreased for the three monthsended September 30, 2006 compared to the three months ended September 30, 2005due to the effect of income from discontinued operations in 2005.

 

Lower earnings atValero L.P. for the three months ended September 30, 2006 decreased our equityin earnings related to our general partner interest for the three months endedSeptember 30, 2006 compared to that period of 2005.

Valero L.P.’s perunit distributions for the three months ended September 30, 2006 increased to$0.915 from $0.855 compared to the same period of 2005, which resulted inValero L.P. increasing its total cash distributions. Because our

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incentivedistribution rights entitle us to an increasing amount of Valero L.P.’s cashdistributions, our equity in earnings related to our incentive distribution rightsincreased.

Our equity inearnings of Valero L.P. related to our limited partner units decreased for thethree months ended September 30, 2006 compared to the three months endedSeptember 30, 2005 due to the decline in Valero L.P.’s net income per unitduring that period.

General and administrative expenses increased for thethree months ended September 30, 2006 compared to the same period in 2005 dueto the costs we incurred as a separate publicly traded company, includingcertain one-time costs associated with our initial public offering. For theperiod prior to our initial public offering on July 19, 2006, no corporatecosts were allocated to us by Valero Energy as management determined that nosuch corporate costs were incurred specifically on our behalf.

Affiliated interest expense decreased for the threemonths ended September 30, 2006 compared to the three months ended September 30,2005 due to Valero Energy’s capital contribution to us of the outstandingbalance of the Notes effective July 19, 2006, in conjunction with the IPO.

***Nine Months Ended September 30, 2006 and 2005***

ValeroL.P.’s income from continuing operations for the nine months ended September30, 2006 increased $33.6 million compared to the nine months endedSeptember 30, 2005 due to higher consolidated segmental operating incomeand higher equity earnings in joint ventures, partially offset by increasedgeneral and administrative expense and increased interest expense.  All of these increases predominantly resultedfrom the Kaneb Acquisition.

Higher earnings at Valero L.P. for the nine monthsended September 30, 2006 caused an increase in our equity earnings related toour general partner interest for the nine months ended September 30, 2006compared to that period of 2005.

Valero L.P.’s per unit distributions for the ninemonths ended September 30, 2006 increased compared to the same period of 2005to $2.685 from $2.510. That increase coupled with an increase in the number ofValero L.P. units outstanding resulting from the issuance of units inconjunction with the Kaneb Acquisition resulted in Valero L.P. increasing itstotal cash distributions. Because our incentive distribution rights entitle usto an increasing amount of Valero L.P.’s cash distributions, our equity inearnings of Valero L.P. related to our incentive distribution rights alsoincreased for that period.

Our equity in earnings of Valero L.P. related to ourlimited partner units decreased for the nine months ended September 30, 2006compared to the nine months ended September 30, 2005 due to the decline inValero L.P.’s net income per unit during that period.

General and administrative expenses increased for thenine months ended September 30, 2006 compared to the same period in 2005 due tothe costs we incurred as a separate publicly traded company, including certainone-time costs associated with our initial public offering. For the periodprior to our initial public offering on July 19, 2006, no corporate costs wereallocated to us by Valero Energy as management determined that no suchcorporate costs were incurred specifically on our behalf.

Affiliated interest expense decreased for the ninemonths ended September 30, 2006 compared to the nine months ended September 30,2005 due to Valero Energy’s capital contribution to us of the outstandingbalance of the Notes effective July 19, 2006, in conjunction with the IPO.

Income tax expense (benefit) for the three and ninemonths ended September 30, 2006 and 2005, relates to federal and state incomeand withholding taxes currently payable and deferred federal and state incometaxes resulting from temporary differences between financial statement and taxbases of assets and liabilities when such differences exist.

***Technical Termination under IRC §708(b)(1)(B)***

Valero Energy has statedits intention to sell its remaining interests in us, pending marketconditions.  If Valero Energy completesthe sale of its remaining interests such that 50% or more of the totalinterests in our capital and profits are sold within a twelve-month period, ourpartnership will “terminate” for federal income tax purposes. A technical “termination”is a federal income tax concept that has no impact on the day-to-day businessor operations of a partnership.  A technical termination of our

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partnership for tax purposes will result in a deemed sale or exchangeof our interests in Valero L.P.’s capital and profits.  This deemed saleor exchange of our interests in Valero L.P.’s capital and profits will alsocause the technical termination of Valero L.P.’s partnership for federal incometax purposes if this deemed sale, together with all other sales of ValeroL.P.’s units, results in a sale or exchange of 50% or more of its capital andprofits interest within a twelve-month period.  A technical terminationwould, among other things, result in the closing of our taxable year for allunitholders and would result in a deferral of depreciation and costrecovery deductions allowable in computing our taxable income.  Thus, ifthis occurs, our unitholders will be allocated an increased amount of federaltaxable income for the year in which we are considered to be terminated, andfor future years, as a percentage of the cash distributed to unitholders withrespect to that period.  The technicaltermination of our partnership and Valero L.P.’s partnership for federal incometax purposes would have no effect on our or Valero L.P.’s financial position orresults of operations.

 

***Outlook***

For the remainder of 2006, we expect Valero L.P.’sresults of the fourth quarter of 2006 to be lower than the third quarter of2006 due to higher maintenance expenses and lower expected throughputs due toseasonality.

 

Valero L.P.’s results for the first quarter of 2007are expected to be lower than the fourth quarter of 2006 due to several plannedoutages at its customer’s refineries and continued lower expected throughputsdue to seasonality.

Despite lower expectations for Valero L.P.’s firstquarter of 2007, we expect Valero L.P.’s 2007 annual results to be comparableto 2006. However, we expect operating income to increase by $15 to $20 million in2007 compared to the latest estimate of 2006 operating income. This expectedimprovement in operating income includes the adverse impact on operating incomeof higher depreciation of approximately $15 million.  Operating income and depreciation expense areexpected to increase primarily due to the effects of the following:

·                  a full year ofoperations in 2007 of the St. James crude oil terminal as Valero L.P. expectsto complete the acquisition in the fourth quarter of 2006;

·                  a full year ofoperations in 2007 of the Burgos project which was completed in July 2006; and

·                  terminalexpansion projects at St. Eustatius in the Caribbean and Amsterdam in theNetherlands as well as other internal growth projects that are expected tostart contributing to Valero L.P.’s results of operations in 2007.

In addition, we expect higher interest expense tooffset the increase in operating income due to higher debt balances, includingborrowings related to funding the acquisitions and capital expendituresdescribed above.

Since we expect Valero L.P.’s results for the fourthquarter to be lower than the third quarter of 2006, we expect our equity inearnings of Valero L.P to be lower. We expect our administrative expenses to behigher compared to historical amounts as we continue to incur additional administrativeexpenses as a separate publicly traded company.

On July 19, 2006,Valero Energy made a capital contribution to us of the outstanding balance ofour notes payable to affiliates, and therefore, we will no longer incurinterest expense on the outstanding balance of the notes payable toaffiliates.  Accordingly, ourinterest expense in future periods will depend upon the amount ofoutstanding borrowings and the interest rate related to our three-yearrevolving credit facility with a borrowing capacity of up to $20 million.  During the three months ended September 30,2006, we borrowed $1.0 million under the Credit Facility.

On August 14,2006, Valero GP, LLC, our wholly owned subsidiary, made an entityclassification election to be treated as a corporation for federal income taxpurposes under Treasury Regulation §301.7701-3(a).   Beginning in the third quarter of 2006, ourfinancial statements reflected Valero GP, LLC’s treatment as a separate taxablecorporate subsidiary of Valero GP Holdings.

**LIQUIDITY AND CAPITAL RESOURCES**

***General***

Our cash flows consist of distributions from ValeroL.P. on our partnership interests, including all of the incentive distributionrights that we own.  Due to our ownershipof Valero L.P.’s incentive distribution rights, our portion of Valero L.P.’stotal distributions may exceed our percentage ownership interest of 23.4%.  Our primary cash requirements are fordistributions to members, capital contributions to maintain RiverwalkLogistics, L.P.’s 2% general partner interest in Valero L.P. in the eventValero L.P. were to issue additional units, debt service requirements, if any,and general and administrative expenses. In addition, because Valero GP, LLCelected to be treated as a taxable entity, we may be required to pay incometaxes, depending upon the taxable income of Valero GP, LLC. These tax paymentsmay exceed the amount of tax expense recorded on the Consolidated FinancialStatements. We expect to fund our cash

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requirements primarily with the quarterly cash distributionswe receive from Valero L.P. and borrowings on our three-year revolving creditfacility, if necessary.

 

***Cash Flows for theNine Months Ended September 30, 2006 and 2005***

Net cash provided byoperating activities for the nine months ended September 30, 2006 was $21.3million compared to $15.4 million for the nine months ended September 30, 2005primarily due to higher net income.  Netcash provided by investing activities for the nine months ended September 30,2006 was $7.6 million compared to cash used in investing activities of $24.4million for the nine months ended September 30, 2005.  The variance was primarily due to acontribution of $29.7 million to Valero L.P. in 2005, including $29.2 millionto maintain our 2% general partner interest in Valero L.P. as a result of theKaneb Acquisition by Valero L.P. Net cash used in financing activities for thenine months ended September 30, 2006 was $27.9 million compared to cashprovided by financing activities of $9.0 million for the nine months ended September30, 2005 primarily due to the contribution from Valero Energy of $29.2 millionin 2005, which was used to maintain the 2% general partner interest in ValeroL.P. as a result of the Kaneb Acquisition.

 

***Cash Distributions***

Our limited liability company agreement requires that,within 50 days after the end of each quarter beginning with the quarter endingSeptember 30, 2006, we distribute all of our available cash to the holders ofrecord of our units on the applicable record date.  Available cash is defined as all cash on handat the end of any calendar quarter less the amount of cash reserves necessaryor appropriate, as determined in good faith by our board of directors, to funddebt we may incur, if any, general and administrative expenses, future distributionsand other miscellaneous uses of cash.

 

Thetable set forth below shows the cash distributions earned for the periods shownwith respect to our ownership interests in Valero L.P. and incentivedistribution rights (dollars and units in thousands, except per unit amounts):

 
| ** **                                                           | ** ** | **Cash Distributions Made by Valero L.P. (a)** | ** ** |
|----------------------------------------------------------------------|------------|------------------------------------------------------------------------------|------------|
| ** **                                                           | ** ** | **Three Months Ended**

**September 30,**                     | ** ** | **Nine Months Ended**

**September 30,** | ** ** |
| ** **                                                           | ** ** | **2006**                                                                     | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Cash  distributions per unit                                         |       | $                                                                            | 0.915      |   | $ | 0.855 |   | $ | 2.685 |   | $ | 2.510 |   |
| Average number  of Valero L.P. limited partner units outstanding (b) |       | 46,810                                                                       |       | 46,810 |   | 46,810 |   | 38,887 |   |
| Total cash  distributions made by Valero L.P. to all partners        |       | $                                                                            | 47,694     |   | $ | 43,950 |   | $ | 139,340 |   | $ | 107,845 |   |
| Cash  distributions we received from Valero L.P.:                    |       |                                                                         |       |   |   |   |   |   |   |
| Distributions on general partner interest (2%)                       |       | $                                                                            | 955        |   | $ | 879 |   | $ | 2,787 |   | $ | 2,157 |   |
| Distributions on incentive distribution rights                       |       | 3,909                                                                        |       | 3,049 |   | 10,869 |   | 7,210 |   |
| Distributions on our limited partnership interests                   |       | 9,350                                                                        |       | 8,740 |   | 27,447 |   | 25,675 |   |
| Total cash  distributions received by us                             |       | $                                                                            | 14,214     |   | $ | 12,668 |   | $ | 41,103 |   | $ | 35,042 |   |
| Distributions to us as  a percentage of total cash distributions     |       | 29.8                                                                         | %          | 28.8 | % | 29.5 | % | 32.5 | % |

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(a)             Distributionsdeclared for a quarter are paid by Valero L.P. within 45 days following the endof each quarter based on the partnership interests outstanding as of a recorddate that is set after the end of each quarter.

(b)            Averagenumber of Valero L.P. limited partner units outstanding on the distributionrecord dates for the periods presented.

***Long-TermContractual Obligations***

***Credit Facility***

On July 19, 2006, weentered into a three-year revolving credit facility with a borrowing capacityof up to $20 million (the Credit Facility) to enable us to manage our cashflow obligations. For example, we expect to fund capital contributions inValero L.P. to maintain our 2% general partner interest in the event ValeroL.P. issues additional units through borrowings under the Credit Facility, andwe may initially meet other liquidity and capital resource requirements throughborrowings under the Credit Facility.

 

Of the CreditFacility’s $20 million commitment, up to $10 million may be available forletters of credit. Our obligations under the Credit Facility are unsecured. TheCredit Facility contains customary covenants and provisions including

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limitations onindebtedness, liens, dispositions of material property, mergers and assettransfers. Borrowings under the Credit Facility bear interest, at our option,at either: (i) the higher of (a) JPMorgan Chase Bank, N.A.’s primerate or (b) the federal funds effective rate plus one-half percent; or(ii) the Eurodollar rate, as adjusted for statutory reserve requirementsfor Eurocurrency liabilities, plus an applicable margin that will vary between0.27% and 0.70% based upon our credit rating.

Under the terms ofthe Credit Facility, Valero L.P. will be required to maintain a totaldebt-to-EBITDA ratio of less than 4.75-to-1.0 for any four consecutivequarters, subject to adjustment following certain acquisitions.  We are also required to receive cashdistributions of at least $25.0 million in respect to our ownership interestsin Valero L.P. for the preceding four fiscal quarters ending on the last day ofeach fiscal quarter.

Additionally, the CreditFacility contains customary events of default, including in the event of a “changein control,” that could result in the acceleration of all amounts andcancellation of all commitments outstanding under the Credit Facility. A “changein control” is defined to mean any of the following events: (i) we cease,indirectly or directly, to own all of the issued and outstanding equityinterests of the general partner(s) of Valero L.P., or we no longer have thepower, directly or indirectly, to direct or to cause the direction of themanagement or the policies of Valero L.P.; or (ii) the occurrence of anytransaction that results in any person or group, other than Valero Energy or anentity with unsecured senior debt with an investment grade rating, becoming thebeneficial owner of more than 50% of our equity interests.

During the three monthsended September 30, 2006, we borrowed $1.0 million under the Credit Facility,which bears interest at 5.9%. As of September 30, 2006, we had $19.0 millionavailable for borrowing under the Credit Facility.

***AdministrationAgreement***

We entered into an Administration Agreement withValero GP, LLC on July 19, 2006. The Administration Agreement provides, amongother things, that:

 

·                  ValeroGP, LLC provides all employees for us; and

·                  ValeroGP, LLC provides us with all executive management and other administrativeservices.

The annual charges to bepaid under the Administration Agreement will be $0.5 million. This amount willbe increased annually to reflect Valero GP, LLC’s annual merit increases. Anyother adjustments to the annual fee, such as adjustments to reflect changes inthe levels of service provided to us or Valero GP, LLC’s actual payroll cost,are subject to the approval of Valero GP, LLC’s conflicts committee. We willalso reimburse Valero GP, LLC for all direct public company costs and any otherdirect costs, such as outside legal and accounting fees, that Valero GP, LLCincurs while providing services to us pursuant to the Administration Agreement.

The AdministrationAgreement will terminate on December 31, 2011, with automatic two-year renewalsunless terminated by either party on six months’ written notice.  We may cancel or reduce the services providedunder this agreement on 60 days written notice. The Administration Agreement will terminate upon the change of controlof either us or Valero GP, LLC.

***Employee Benefits***

On October 13, 2006,Valero GP Holdings entered into an Employee Benefits Transition Agreementeffective as of July 1, 2006 (the Transition Agreement). Prior to July 1, 2006,the employees of Valero GP, LLC were included in the various employee benefitplans of Valero Energy. These plans include a defined benefit pension plan, aretiree welfare benefit plan, health and welfare benefits, a definedcontribution retirement plan, equity incentive plans and nonqualified deferredcompensation plans. In accordance with the Transition Agreement and inconnection with the initial public offering on July 19, 2006, employees ofValero GP, LLC began participating in newly enacted, comparable plans sponsoredby Valero GP, LLC.

 

In connection withthis transition, Valero Energy and certain of its subsidiaries transferredrelated liabilities and assets totaling $7.9 million to Valero GP Holdings. Inaddition, Valero Energy, at its cost and expense, agreed to assist Valero GP,LLC in the design, preparation and initial implementation of Valero GP, LLC’semployee benefit plans. Under the transition agreement, Valero Energy willcontinue to provide the transition services and arrangements described thereinthrough the earlier of the completion of such services and arrangements or theeffective date of the final sale by Valero Energy of its remaining membershipinterest in Valero GP Holdings, unless the parties otherwise agree.

 

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Valero GP, LLC established new benefit plans foremployees as follows:

***Valero GP, LLCThrift Plan***

Effective June 26, 2006,we established the Valero GP, LLC Thrift Plan (the Thrift Plan), which is aqualified employee profit-sharing plan. Participation in the Thrift Plan isvoluntary and is open to substantially all of our employees in the UnitedStates who become eligible to participate upon date of hire.

 

Thrift Planparticipants can make basic contributions from 1% up to 8% of their totalannual compensation, which includes overtime and cash bonuses. In addition,participants who make a basic contribution of 8% can also make a supplementalcontribution of up to 22% of their total annual compensation.  The maximum match by us is 75% of eachparticipant’s basic contributions up to 8% based on the participant’s totalannual compensation excluding cash bonuses.

***Valero GP, LLCPension Plan***

Effective July 1, 2006,we established the Valero GP, LLC Pension Plan, a qualified non-contributorydefined benefit plan (the Pension Plan). The Pension Plan covers substantiallyall of our employees in the United States and generally provides eligibleemployees with retirement income based on years of service and compensationduring specific periods.

 

Substantially allof our employees may become eligible to receive benefits after five years ofservice, including service recognized by Valero Energy for vesting purposesunder the Valero Energy pension plan. All benefit obligations associated withemployees’ service through June 30, 2006, including the effect of future salaryincreases, are the responsibility of Valero Energy.  All benefit obligations related to service onor after July 1, 2006 will be covered by the Pension Plan.

***Long-Term IncentivePlans***

On July 19, 2006,our board of directors adopted the Valero GP Holdings, LLC Long-Term IncentivePlan (the 2006 LTIP) for our employees, consultants and directors and employeesand consultants of our affiliates who perform services for us or ouraffiliates.  The 2006 LTIP allows for theawarding of (i) unit options; (ii) performance units;(iii) restricted units; (iv) phantom units; (v) unit grants; and(vi) unit appreciation rights. The 2006 LTIP permits the granting of awardstotaling an aggregate of 2,000,000 units. The 2006 LTIP will be administered bythe compensation committee of our board of directors.

 

Our board ofdirectors, or its compensation committee, in its discretion may terminate,suspend or discontinue the 2006 LTIP at any time with respect to any award thathas not yet been granted. Our board of directors, or its compensationcommittee, also has the right to alter or amend the 2006 LTIP or any part ofthe 2006 LTIP from time to time, including increasing the number of units thatmay be granted subject to unitholder approval as required by the exchange uponwhich the units are listed at that time. However, no change in any outstandinggrant may be made that would materially impair the rights of the participantwithout the consent of the participant.

On August 22, 2006,we granted 2,886 restricted units of Valero GP Holdings to our directors. Onethird of the units granted will vest on each anniversary of the grant overthree years.

***Excess Thrift Plan, ExcessPension Plan and SERP***

Effective July 1, 2006, Valero GP, LLC established anexcess thrift plan (the Excess Thrift Plan), an excess pension plan (the ExcessPension Plan) and a supplemental executive retirement plan (the SERP).  Effective as of July 1, 2006, eligible ValeroGP, LLC employees ceased accruing additional benefits under Valero Energy’sexcess pension plan (the Prior Excess Pension Plan) and Valero Energy’ssupplemental executive retirement plan (the Prior SERP), and ceasedparticipating in Valero Energy’s  excessthrift plan.

 

The Excess ThriftPlan provides benefits to those employees of Valero GP, LLC whose annualadditions under the Thrift Plan are subject to the limitations on such annualadditions as provided under §415 of the Internal Revenue Code of 1986, asamended (the Code), and/or who are constrained from making maximumcontributions under the Thrift Plan by §401(a)(17) of the Code, which limitsthe amount of an employee’s annual compensation which may be taken into accountunder that plan.  The Excess Thrift Planis comprised of two separate components, consisting of (1) an “excess benefitplan” as defined under §3(36) of The Employee Retirement Income Security Act of1974, as amended (ERISA) and (2) a plan that is unfunded and maintainedprimarily for the purpose of providing deferred compensation for a select groupof management or highly compensated employees. Each component of the Excess Thrift Plan shall consist of a separateplan for purposes of Title I of ERISA.

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The Excess Pension Planprovides benefits to those employees of Valero GP, LLC whose pension benefitsunder the Pension Plan and the Valero Energy pension plan (where applicable)are subject to limitations under the Code, or who are otherwise indirectlyconstrained by the Code from realizing the maximum benefit available to themunder the terms of the Pension Plan and the Valero Energy pension plan (whereapplicable).  The Excess Pension Plan isan “excess benefit plan” as defined under §3(36) of ERISA, for those benefitsprovided in excess of Section 415 of the Code.  Benefits provided as a result of otherstatutory limitations are limited to a select group of management or otherhighly compensated employees.  The ExcessPension Plan will assume the liabilities of the Prior Excess Pension Plan as ofJuly 1, 2006 with respect to Valero GP, LLC employees, and will provide asingle, nonqualified defined benefit to those Valero GP, LLC employees fortheir pre-July 1, 2006 benefit accruals under the Prior Excess Pension Plan andtheir post-July 1, 2006 benefit accruals under the Excess Pension Plan.

The SERP provides thosehighly compensated, management personnel of Valero GP, LLC who were accruingbenefits under the Prior SERP up until July 1, 2006, and those who maysubsequently become eligible, with a supplement to the retirement benefit theymay otherwise receive under the Pension Plan and the Valero Energy pension plan(where applicable). Benefits under the SERP are limited to a select group ofmanagement or other highly compensated employees.  The SERP will assume the liabilities of thePrior SERP as of July 1, 2006 with respect to Valero GP, LLC employees, andwill provide a single, nonqualified defined benefit to those Valero GP, LLCemployees for their pre-July 1, 2006 benefit accruals under the Prior SERP andtheir post-July 1, 2006 benefit accruals under the SERP.

None of the Excess ThriftPlan, the Excess Pension Plan or the SERP is intended to constitute either aqualified plan under the provisions of Section 401 of the Code or a fundedplan subject to ERISA.

Valero GP, LLC assumedthe liabilities accrued under the Prior Excess Pension Plan and the Prior SERPrelated to its employees, totaling $0.2 million and $0.9 million, respectively.

In addition to theliabilities associated with the new benefit plans, Valero GP, LLC also retainedthe liabilities for the benefit obligations related to the post-retirementmedical benefits for those employees that are not “retirement eligible”(employees over 55 years old with 5 years of service and eligible to receivebenefits under the Valero Energy pension plan) on July 19, 2006, and certainlong-term disability benefits (LTD) under the Valero Energy flex benefits plantotaling $6.1 million and $0.6 million, respectively, as of July 1, 2006.  Valero Energy retained the responsibility forthe post-retirement medical benefit obligation for employees who are retirementeligible on July 19, 2006, and those who subsequently become retirementeligible and elect to receive a benefit on or before December 31, 2006 underthe Valero Energy pension plan.  Weexpect to adopt a post-retirement medical benefits plan that will providecomparable benefits to our employees beginning January 1, 2007.

Medical and other welfarebenefits will continue to be provided to Valero GP, LLC employees under theValero Energy flex benefits plan through December 31, 2006, at which time a newwelfare benefit plan will be established by Valero GP, LLC for the followingplan year.  Valero GP, LLC will reimburseValero Energy for the medical and other welfare benefits provided to Valero GP,LLC employees through December 31, 2006. Valero L.P. will continue to reimburse us for the cost of medical andother welfare benefits.

All costs incurred byValero GP Holdings related to these employee benefit plans, excludingcompensation expense related to the long-term incentive plans, were and willcontinue to be reimbursed by Valero L.P. at cost. Long-term incentive plancompensation expense pertaining to employees of Valero GP, LLC was reimbursedby Valero L.P., while such compensation expense pertaining to corporateofficers of Valero Energy was reimbursed by Valero Energy affiliates other thanus. Prior to July 19, 2006, any liability of ours related to the variousemployee benefit plans, other than the bonus plans and the long-term incentiveplans, was reflected in “notes payable to affiliates” in our consolidatedbalance sheets.  The liability for thebonus plans was recorded by Valero L.P., and the obligation under the long-termincentive plans is reflected in “accrued liabilities” in our consolidatedbalance sheets. Subsequent to July 19, 2006, our liability for these employeebenefits is included in “other long-term liabilities” on our consolidatedbalance sheet.

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In addition to thebenefit plans discussed above, Valero GP, LLC had previously adopted thefollowing long-term incentive plans:

·                  ValeroGP, LLC adopted the 2000 Long-Term Incentive Plan (the 2000 LTIP) under whichValero GP, LLC may award up to 250,000 common units to certain key employees ofValero Energy’s affiliates providing services to us and to directors andofficers of Valero GP, LLC.  Awards underthe LTIP can include unit options, restricted units, performance awards,distribution equivalent rights (DERs) and contractual rights to receive commonunits.

·                  InJune 2003, Valero GP, LLC adopted the 2003 Employee Unit Incentive Plan (theUIP) under which Valero GP, LLC may award up to 500,000 common units toemployees of Valero GP, LLC or its affiliates, excluding officers and directorsof Valero GP, LLC and its affiliates. Awards under the UIP can include unit options, restricted units anddistribution equivalent rights (DERs).

·                  ValeroGP, LLC adopted the 2002 Unit Option Plan (the UOP) under which Valero GP, LLCmay award up to 200,000 unit options to officers and directors of Valero GP,LLC or its affiliates.

Valero L. P. haspreviously and will continue to reimburse us for the cost of the 2000 LTIP, theUIP and the UOP.

***Amendedand Restated 2000 Long-Term Incentive Plan***

Effective October 1,2006, the Valero GP, LLC 2000 Long-Term Incentive Plan was amended as follows:

 

·                  increase the number of units authorizedfor issuance under the Plan from 250,000 units (of which 223,147 have beengranted to date) to 1,500,000 units;

·                  permit the “cashless-broker” exercise ofoptions;

·                  provide that if an award under the Planexpires, is cancelled, exercised, paid or otherwise terminates without thedelivery of units then the units covered by such award, to the extent of suchexpiration, cancellation, exercise, payment or termination, shall again beunits with respect to which awards under the Plan may be granted;

·                  amend the Plan to meet the requirementsof, and facilitate compliance with, Section 409A of the Internal RevenueCode;

·                  and amend the definition of “Change ofControl” to reflect that as a result of its recently completed initial publicoffering, Valero GP Holdings, LLC is now the 100% owner of the general partnerof Valero L.P.

***Other Contingencies***

As previously discussed, our only cash-generatingassets are our indirect ownership interests in Valero L.P. Valero L.P. issubject to certain loss contingencies (see Part II, Item 1. “Legal Proceedings”),the outcome of which could have an effect on Valero L.P.’s cash flows.  Specifically, Valero L.P. may be required tomake substantial payments to the U.S. Department of Justice for certainremediation costs.

 

**CRITICAL ACCOUNTING POLICIES**

**Thepreparation of financial statements in accordance with United States generallyaccepted accounting principles requires management to make estimates andassumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. Actual results could differ from those estimates.  Our critical accounting policies aredisclosed in our registration statement on Form S-1, as amended.**

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**Item 4. Controls andProcedures**

*(a)**       Evaluationof disclosure controls and procedures.*

 

Our management has evaluated, with the participationof our principal executive officer and principal financial officer, theeffectiveness of our disclosure controls and procedures (as defined in Rule13a-15(e) under the Securities Exchange Act of 1934) as of the end of theperiod covered by this report, and has concluded that our disclosure controlsand procedures were effective as of September 30, 2006.

*(b)**       Changes in internal controlover financial reporting.*

There has been no change in our internal control overfinancial reporting that occurred during our last fiscal quarter that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

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**PART II - OTHERINFORMATION**

**Item1.  Legal Proceedings**

ValeroGP Holdings, LLC is not currently a party to any material legalproceedings.  However, our subsidiariesare named as a defendant in litigation relating to their normal businessoperations, including regulatory and environmental matters. As used in thisPart II of this report (unless otherwise specified), “we,” “us” and “our” referto Valero GP Holdings, LLC and its subsidiaries.  We are insured against various business risksto the extent we believe is prudent; however, there can be no assurance thatthe nature and amount of such insurance will be adequate, in every case, toindemnify us against liabilities arising from future legal proceedings as aresult of our ordinary business activity.

Theinformation below describes new proceedings or material developments inproceedings that we previously reported in our annual report on Form 10-K forthe year ended December 31, 2005, or our quarterly report on Form 10-Q for thequarter ended June 30, 2006.

***Environmental Enforcement Matters***

Aswe first reported in our quarterly report on Form 10-Q for the quarter endedJune 30, 2006, the California Bay Area Air Quality Management District proposedpenalties totaling $494,000 for alleged air violations at the MartinezTerminal. The Martinez Terminal was sold to Pacific Energy Group LLC, asubsidiary of Pacific Energy Partners, L.P., on September 30, 2005. Aspart of the asset purchase agreement, Pacific Energy Group LLC, a subsidiary ofPacific Energy Partners, L.P., assumed responsibility for the notices ofviolation at the Martinez Terminal.  Asettlement agreement has been signed by all parties, and Pacific will pay thetotal amount of penalty assessed.

We arealso a party to additional claims and legal proceedings arising in the ordinarycourse of business. We believe that the possibility is remote that the finaloutcome of any of these claims or proceedings to which we or our subsidiariesare a party would have a material adverse effect on our financial position,results of operations or liquidity; however, due to the inherent uncertainty oflitigation, there can be no assurance that the resolution of any particularclaim or proceeding would not have a material adverse effect on our results ofoperations, financial position or liquidity.

**Item6.  Exhibits**
| +Exhibit 10.01  |   | Form of Non-employee Director Restricted Unit  Agreement under Valero GP Holdings, LLC Long-Term Incentive Plan- incorporated  by reference to Exhibit 10.02 to Valero GP Holdings, LLC’s Current Report on  Form 8-K dated August 22, 2006 and filed August 25, 2006. |
|-----------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| +*Exhibit 10.02 |   | Employee Benefit Transition Agreement, effective as  of July 1, 2006, between Valero Energy Corporation, Valero GP Holdings, LLC  and Valero GP, LLC.                                                                                                                       |
| *Exhibit 31.01  |   | Rule 13a-14(a) Certifications (under Section 302 of  the Sarbanes-Oxley Act of 2002).                                                                                                                                                                                       |
|            |   |                                                                                                                                                                                                                                                                        |
| *Exhibit 32.01  |   | Section 1350 Certifications (as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002).                                                                                                                                                                        |

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*                    Filedherewith.

+                    Identifiesmanagement contracts or compensatory plans or arrangements required to be filedas an exhibit hereto.

 

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

**VALERO GP Holdings, LLC**

**(Registrant)**

 
| **By:**    | **/s/ Curtis V. Anastasio**               | ** ** | ** ** | ** ** | ** ** |
|------------|-------------------------------------------|------------|------------|------------|------------|
| ** ** | ** **                                | ** ** | ** ** | ** ** | ** ** |
| ** ** | **Curtis V. Anastasio**                   | ** ** | ** ** | ** ** | ** ** |
| ** ** | **President and Chief Executive Officer** | ** ** | ** ** | ** ** | ** ** |
| ** ** | **November 8, 2006**                      | ** ** | ** ** | ** ** | ** ** |

 
|            | ** **                                                                                                                                                                                                                                             | ** ** | ** ** |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------|
| **By:**    | **/s/ Steven A.  Blank                                     ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** ** | ** **                                                                                                                                                                                                                                             | ** ** | ** ** | ** ** |
| ** ** | **Steven A. Blank**                                                                                                                                                                                                                                    | ** ** | ** ** | ** ** |
| ** ** | **Senior Vice President, Chief  Financial Officer and Treasurer**                                                                                                                                                                                      | ** ** | ** ** | ** ** |
| ** ** | **November 8, 2006**                                                                                                                                                                                                                                   | ** ** | ** ** | ** ** |
|            |                                                                                                                                                                                                                                                        |            |            |  |  |  |

 
|            | ** **                        | ** ** | ** ** | ** ** |
|------------|-----------------------------------|------------|------------|------------|
| **By:**    | **/s/ Thomas R. Shoaf**           | ** ** | ** ** | ** ** | ** ** |
| ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** |
| ** ** | **Thomas R. Shoaf**               | ** ** | ** ** | ** ** | ** ** |
| ** ** | **Vice President and Controller** | ** ** | ** ** | ** ** | ** ** |
| ** ** | **November 8, 2006**              | ** ** | ** ** | ** ** | ** ** |

 

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