Jefferies Financial Group (JEF)

Jefferies Financial Group's spin-off of its subsidiary Vitesse Energy

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Welcome to Episode 37 of Special Situation Investing.

Today we are going to consider an announcement made by Jefferies Financial Group (NYSE: JEF). On July 19th, Jefferies gave a press release announcing a few strategic, corporate transactions with the goal of simplifying its corporate structure and enabling it to focus on building its investment banking and capitol markets businesses.

There are three proposed changes. The company announced, first, a tax-free spin-off of its holding of Vitesse Energy; second, the sale of its holdings in Idaho Timber; and lastly the merger of its two SEC reporting companies - Jefferies Group LLC and Jefferies Financial Group Inc.

The history of Jefferies Financial Group, begins in 1979 when the company’s two founders took control of Talcott National Corporation. A year later the company was renamed Lucadea National Corporation. Throughout its 40-year history, Lucadea acquired and divested numerous companies and interests mainly within the finance, mortgage and investment sectors. In 2013, the company merged with Jefferies Group - a global investment banking corporation - and in 2018, it rebranded itself as Jefferies Financial Group.

While the cursory research I did on Jefferies showed it to be a fascinating company in its own right, it’s not the topic of today’s episode. (One important reason is because it falls outside my circle of competence.) Our topic today is the proposed spin-off of Vitesse energy.

This spin-off is consistent with Jefferies goal of reducing what it calls its legacy merchant banking section - a collection of odds-and-ends investments acquired over the years of which Vitesse is a part. Jefferies’ latest investor’s presentation shows that this black sheep collection of investments includes oil and gas, telecom, real estate, wood products and other sundry investments. As it seeks to narrow its focus onto investment banking and capitol markets, Jefferies has slowly divesting these holdings over the years. As recently announced, Vitesse Energy and Idaho Timber are next on the chopping block.

Post spin-off, Vitesse Energy Inc will be a stand alone company listed on the NYSE. The spin-off is expected to be distributed tax-free on a pro rata basis to all shareholders of a date of record yet to be determined and completed by the end of 2022.

If you’ve listened to past episodes of this podcast, you’ll know that because of today’s environment of high inflation, we’re particularly interested in companies that can benefit from exposure to hard assets but also have low capex business models. Vitesse Energy initially caught my attention because its business model is based on what’s called non-operator working interests in the oil and gas sector. I was curious whether a non-operator business model is comparable to a business model based on royalties with hard asset exposure, but low capex.

Unfortunately, because Vitesse is a private company and subsidiary of Jefferies, detailed information on the company is not readily available. Beyond listing its executive team, board of directors and a collection of their quotes about the company, Vitesses’ website doesn’t provide much enlightening information. The little I was able to find, and more so from investor presentations, annual and quarterly reports, and press releases from Jefferies website, revealed the following data:

• Vitesse Energy is currently a 97% owned consolidated subsidiary of Jefferies that acquires, invests and monetizes non-operated working interests and royalties predominantly in the Bakken Shale of the Williston Basin in North Dakota.

• Vitesse Energy’s interests in flowing wells and Drilling Spacing Units (“DSUs”) are operated by many of the U.S.’s leading operators. The undeveloped acreage within its DSUs is expected to be developed via new horizontal wells in the future by Vitesse Energy’s operating partners. Vitesse Energy has acquired 47,200 net acres of leaseholds and has an interest in over 5,500 producing wells (120 net wells) with current production as of November 2021 of over 10,000 barrels of oil equivalent per day (over 80% of production is oil). Vitesse Energy also has 865 gross wells (19 net wells) that are currently drilling, completing, or permitted for future drilling.

• As of May 31, 2022, Vitesse had a net book value and net tangible book value of $427 million.

• Vitesse Energy has a revolving credit facility with a syndicate of banks that matures in April 2023 and has a maximum borrowing base of $140.0 million as of November 30, 2021.

• Vitesse was established in 2013 with an original equity investment of $50 million, which was increased to $350 million in 2014 and to $500 million in 2018. It has generated over $140 million in GAAP net income to-date from its assets.

So what in fact is a non-operator and what is a non-operator working interest? Well, Lawinsider.com defines a non-operator working interest as “an interest in any oil and natural gas lease held by a party who is a non-operator with respect to such oil and natural gas lease.” That didn’t help much, but further research was enlightening.

As it turns out, a large percentage of oil and gas projects are undertaken as joint ventures, or JVs. JVs are when two or more parties agree to work together on a project each with defined roles. The parties usually include one with operator working interests who execute the daily tasks onsite, and one, or more, other parties with non-operator working interests. These non-operators provide capitol and share in expenses, but do not participate in the daily onsite activity. So like royalty companies, non-operators provide capitol to the operators. But unlike royalty companies, that then just sit back and collect checks, non-operators are responsible for their share of ongoing expenses.

That fact alone reveals a large disadvantage within the non-operator model compared with that of a royalty model. The advantage of exposure to the increasing prices of hard assets during times of high inflation can be severely reduced, or even fully offset, by simultaneous increases in expenses. While reading the quarterly call transcript of a coal mining company earlier this week, I ran across a current example of the high expense increases operator-type companies are witnessing today. The company stated that they were seeing increases of 25-35% in “costs of operating supplies and materials, repairs and major equipment rebuilds.” Increases like that can severely eat into profit margins.

Next, I found a concrete comparison between a royalty company and a non-operator company instructive. Because I couldn’t find public financial reports on Vitesse Energy, I did the next best thing and used a comparable company.

Northern Oil and Gas Inc. (NYSE: NOG) is the largest non-operated E&P in the US and is a publicly listed company on the NYSE. In their Q2 report, they write: “Our primary strategy is to invest in non-operated minority working and mineral interests in oil and gas properties, with a core area of focus in the premier basins within the United States. [Sounds very similar to Vitesse Energy.] and they continue…Using this strategy, we had participated in 7,957 gross (735.0 net) producing wells as of June 30, 2022. As of June 30, 2022, we had leased approximately 251,409 net acres, of which approximately 87% were developed and all were located in the United States.

Comparing Northern Oil and Gas, as our non-operator company, and Texas Pacific Land (TPL), as our oil and gas royalty company, proves eye-opening. In the six months ending on June 30th of 2022, TPL produced a total revenue of $323mm, with total operating expenses of $48mm, resulting in a net income of $216mm. While over the same period, NOG produced revenues of $408mm, with operating expenses of $327mm, resulting in net income of $44mm. And importantly, these results were produced by TPL with zero debt, while NOG had $1.1b in debt on their books.

Taking it a step further, plugging the ticker symbols of both of these companies into stockrow.com and comparing their ten-year track records reveals TPLs record of positive and growing net income, while five out of the ten years, NOG had negative net income. And TPL’s outperformance required miniscule, if any debt at all.

This research answered my question about whether an oil & gas non-operator business model is comparable to a business model based on royalties - with hard asset exposure, but low capex.

While yes, both benefit from hard asset exposure, it’s clear that non-operator business models do not offer the same level of low capex advantage as do most royalty companies.

All that being said, Vitesse could prove to be a valuable buy for some investors given the right price. A helpful tactic in determining if a company is cheap is comparing it to a competitor or comparison company, for example, with Vitesse you could use Northern Oil and Gas.

Additionally, this spin-off situation has the potential to produce selling pressure on Vitesse post spin-off. A couple reasons for this: 1) the market cap of Vitesse is likely to be orders of magnitude smaller than that of Jefferies (, some owners of Jefferies stock may not be able or allowed to hold a stock of Vitesses' size; 2) some holders of Jefferies stock may simply not want to own an oil and gas stock, for some it will be outside their area of expertise, and for others it will not align with their ESG priorities.

For these reasons, we will be looking for more information to be released on Vitesse Energy in the months ahead, as well as watching for forced selling post spin-off. As always, we will continue to bring you episodes as this special situation unfolds.

That concludes today’s episode of the show. As always, we hope you enjoyed it and found it educational, and helpful as you build your own wealth. We look forward to bringing you more special investing situations, as well as financial independence tactics, in coming episodes.