This writeup is rather long since there are a lot of details I would like to share

Thesis:

On July 19th Genie Energy (GNE) announced an exchange offer, offering to exchange approximately one-third of outstanding Class B common shares for a new series of preferred stock. The interesting thing is, the chairman of the board and controlling shareholder, Mr. Howard Jonas, will not exchange any of his shares.

Background Information:

GNE was spun out of IDT last Oct. IDT had all sorts of unrelated businesses: telecommunication, calling cards, debt collection, Internet portal, energy and so on.

GNE has two business lines:

1) IDT Energy – a retail energy provider supplying electricity and natural gas to residential and small business customers in the Northeastern United States. This is currently the only revenue, profit and cash flow generating part of the business

2) Shale Assets – the company has highly speculative shale plays in Colorado and Israel. The Colorado asset, American Shale Oil, is a JV with Total SA.

Howard Jonas is controlling shareholder and chairman of the board of both IDT and GNE, he is also the CEO of IDT.

Mr. Jonas had quite an exciting career, the following article provides some color:

http://www.forbes.com/forbes/2010/1220/focus-howard-jonas-idt-rupert-murdoch-cheney-not-just-business.html

The Exchange Offer and the (real) Motivation Behind it

Currently there are two classes of common stock. Class A has super voting power and is completely owned by Howard Jonas and his affiliates. As of August 1, 2012, 21,415,060 shares of Class B common stock and 1,574,326 shares of Class A common stock were issued and outstanding.

The exchange offer allows Class B common holders to swap their shares on a 1 for 1 basis for the newly issued preferred share (GNE.PR). The preferred will have liquidation value of $8.5 and annual dividend yield of 7.5%, plus additional dividend based on performance of IDT Energy. (7.5% * ((IDT Energy EBITDA >$32M)/8.75m)) The preferred would be redeemable after four years at 101% of liquidation value or five years at 100% of liquidation value.

The offer will exchange a maximum of 8,750,000 shares and minimum of 4,375,000 shares. As shares controlled by Howard Jonas will not participate the exchange, the minimum condition represents 50% of the amount of shares available for exchange. The minimum condition is waivable.

The company expects dividends on preferred will be funded by cash flow generated by IDT Energy and cash on hand.

According to the company:

“On a pro forma basis, earnings per share attributable to Genie for the three months ended March 31, 2012 was $0.03 per diluted share. Assuming 8,750,000 shares of Class B Common Stock are validly tendered at the beginning of the period in the Exchange Offer, pro forma earnings per share attributable to Genie for the same period would decrease by $0.10 per diluted share. Earnings per share attributable to Genie for the five-month period ended December 31, 2011 were $0.04 per diluted share. Assuming 8,750,000 shares of Class B Common Stock are validly tendered at the beginning of the period in the Exchange Offer, pro forma earnings per share attributable to Genie for the same period would decrease by $0.26 per diluted share.”

As part of the transaction, the company is canceling the current $0.05 common dividend on the Class B shares. But it did not mention canceling the dividend for the Class A shares.

The Exchange Offer will expire at 5:00 p.m., New York City time, on September 5, 2012, unless the offer is extended or earlier terminated.

So why such an offer?  According to the management:

"The principal reason for the Exchange Offer is to create two securities that seek to address the preferences of our two principal constituencies of stockholders. The Preferred Stock is designed to appeal to investors focused on the cash generating and dividend paying aspects of certain of our operations, who prefer receiving regular dividends and having seniority on liquidation. The remaining Class B Common Stock will provide investors with increased participation in the future growth of our unconventional oil and gas and other businesses at the expense of subordination of the right to future dividends and on receipt of proceeds from liquidation. The Exchange Offer is designed to meet the desires and expectations of stockholders with different priorities and investment objectives, while maintaining the advantages and synergies of having our different business units within the same corporate structure.”

Basically they are claiming three reasons:

   1. some investors prefer retail energy business, some investors prefer shale oil business

   2. some prefer stable income and dividend, some prefer growth and capital appreciation    

   3. some want to be senior in the capital structure

I think this is BS.

If some investors prefer the retail energy business while others prefer shale oil assets, the cleanest way is another spin off. Management claims synergy, I am not sure what kind of synergy there is between a retail energy business selling electricity and natural gas on the east coast and early stage shale oil operations located in Colorado and Israel.

More importantly, GNE was specifically designed to have two parts: cash flow generated by retail energy business was supposed to support investments in shale oil. Since current shareholders did not sell after the IDT spin, they are probably happy with the current structure, with the stable business offering some downside protection and shale assets as free option. Why suddenly force shareholders to choose between the two?

During FQ22011 conference call, management said the following:

"Considered in its totality, Genie Energy marries the strong cash generating power of IDT Energy to the longer-term opportunities in shale. That combination will help Genie meet its capital requirements in the near term and ensure that shareholders realize the full potential of oil shale over the long-run."

"Our plan right now is to spin-off Genie Energy with approximately $115 million in cash. That cash, along with future cash flows, and potentially funding provided by partners, will be used to fund our investments in oil shale and other unconventional oil and gas projects as well as additional expansions at IDT Energy."

Management also claimed that some investors might prefer stable income and dividend (who does not?) therefore the preferred, but why don't they simply increase dividend on common stock? Is Howard Jonas being generous since he won't own any preferred?

I find the management's excuse that some shareholders might prefer a more senior position in the capital structure not convincing either. These people already own common shares and obviously are fine with it. If they want a more senior security, they can easily buy something else from a different company. The management is trying too hard to “satisfy” shareholder needs.

As for listening to the shareholder, several years ago IDT was in trouble and the stock was trading below its net cash. Shareholders rightfully demanded share buybacks. Here is what the management said then:

"Many of you have argued eloquently that we should be using at least a portion of our cash to buy back the company stock. Back in June, Howard Jonas comment that this is a very attractive proposition. Since then, the share price has continued to slide and now we face the threat of de-listing. The rational for stock buy-back has never been stronger; however, let me tell you why we have not yet initiated a buy-back program and why we may not do so for some time to come.

In sum, our discussion on whether to buy back stock is a fundamental question about the appropriate allocation of the company’s capital. If we do not immediately enter the market, no one should misinterpret this as reflecting management’s judgment about the stock’s current price or our company’s prospects for the future. "

Note Howard Jonas controlled and still controlls IDT and many current GNE management members came from IDT.

By the way, instead of buying back shares when it was trading less than net cash, Howard Jonas chose to receive stock as compensation for three years to "align" his interests with shareholders:

"Under the agreement between Mr. Jonas and the Company, Mr. Jonas - who is entitled to annual base salary of $856,000 but has been accepting only $750,000 - will be paid his base compensation for calendar years 2009 through 2011 in IDT Common Stock (NYSE: IDT-C) rather than in cash. Mr. Jonas will receive 1,704,545 shares (all of which will vest on January 5th, 2012) based on the stock's September 3rd, 2008 closing price of $1.32 per share. "

Oh, IDT stock only went up to $29 in 2011.

Here is what an angry investor said during one conference call:

"Okay. So I’m trying to understand the thought process -- you say the stock is absurdly low, you issue stock in lieu of cash compensation, but yet you have money sitting in hedge funds and as of right now, you say you don’t have a lot of excess cash to be able to go in and buy stock back. Am I missing something or could you help me understand that?

Right. I guess what I’m trying to understand is if it is absurdly low like you say, and I take you at you word, why wouldn’t you look to exit some of the hedge funds and use some of that money to reduce the dilutive effect of issuing stock to you and Howard?"

I don’t think it is too harsh to say that Mr. Jonas will screw his fellow shareholders given the chance, preferably legally. So it is probably better to stay on his side.

Even if we give management the benefit of the doubt, they cannot possibly argue with the fact that the company needs cash now. The shale plays will need $60-$80 million in the next couple of years and much more after that. What is the point of distributing cash to some shareholders now?

I believe the real motivation behind the exchange offer is for Jonas to increase his share of common stocks therefore exposure to the shale oil investments without him having to pay another penny. The company essentially foots the bill of buying people out. It is even better than buyback since no hard cash needs to be paid right away. Also preferred can be redeemed after 4-5 years.

Currently the Jonas group owned approximately 3,902,873 shares of Class B common stock, representing 18% of Class B common stock and 1,574,326 shares of Class A common stock, representing 100% of Class A common stock, together representing approximately 74.5% of the combined voting power.

If 8,750,000 or more shares of Class B common stock held by Genie’s stockholders are tendered in the exchange offer. The Jonas group will continue to beneficially own 3,902,873 shares of Class B common stock, representing approximately 31% of  outstanding Class B common stock and 1,574,326 shares of Class A common stock representing 100% of Class A common stock, will own none of preferred stock and will beneficially own shares representing approximately 74.5% of the combined voting power.

Insiders also made open market purchases earlier this year at prices above $9

Although the management insists that it does not offer fairness opinion regarding the exchange, the languages used in the offering document show an strong tendency to persuade people to exchange. They mentioned many negatives about the common stock: junior to preferred, possible delisting, potential decrease of price and so on. Still, the important question is why Howard Jonas decided to keep his?

Another thing I find interesting, according to the company:

“On May 7, 2012, the Audit Committee of our Board of Directors held a meeting with members of management attending, where the concept of an exchange offer was introduced. On May 16, 2012, the Board of Directors held a meeting, with members of management attending, where they discussed and approved in principle for management to move forward with an exchange offer of the Class B Common Stock on the principal terms of the Exchange Offer”

So it took the board about a week from first hearing the idea to deciding on it. They claimed their decision was based on “discussions with stockholders, potential investors, research and anecdotal evidence”. I wonder how much discussion they could have had and research conducted. They must be really efficient.

Shale Oil Investments:

I don't know much about this industry so I was hoping the more knowledgeable VIC members could chip in.                  

For people who don't know, Oil shale is an organic-rich fine-grained sedimentary rock and contains significant amounts of kerogen (a solid mixture of organic chemical compounds) from which liquid hydrocarbons can be extracted.

GNE has two shale oil investments, one in Colorado, the other in Israel.  

Colorado:  American Oil Shale (AMOS)

According to reports from the United States Department of Energy, oil shale resources in the United States are estimated at over 2 trillion barrels, and could potentially supply the U.S.’s demand for liquid fuel over the next 100 years. In March 2009, the U.S. Geological Survey reported that the total “in-place” oil in the Colorado’s Piceance Basin is approximately 1.525 trillion barrels. The majority of those deposits are found in the Green River Formation of Colorado (Piceance Creek Basin), Utah (Uinta Basin) and Wyoming (Green River and Washakie Basins).

In 2005, the U.S. Bureau of Land Management, or the BLM, began seeking proposals from the private sector to develop the oil shale resources in economically and environmentally responsible ways. In June 2005, nominations were solicited and twenty proposals were submitted, including the proposal of E.G.L, LLC (which was later acquired by AMSO LLC, a division of IDT). The proposals, which included technical operational plans, were evaluated by an inter-disciplinary team including representatives from the affected states, as well as the Department of Energy and the Department of Defense. Further, proposals were subjected to environmental analysis under the terms of the National Environmental Policy Act and brought before public meetings in Colorado and Utah. The BLM issued a Finding of No Significant Impact for AMSO, LLC’s proposed plan of operations, and effective January 1, 2007, AMSO, LLC received a lease for research, development and demonstration in western Colorado. Out of twenty applications for RD&D Leases submitted, three companies were awarded leases in Colorado to test in-situ technologies (Shell, Chevron and AMSO, LLC), and one company in Utah (OSEC) was awarded a lease for testing above ground retorting processes. 

The RD&D lease awarded to AMSO, LLC by the BLM covers an area of 160 acres. The lease runs for a ten-year period beginning on January 1, 2007, and is subject to an extension of up to five years if AMSO, LLC can demonstrate that a process leading to the production of commercial quantities of shale oil is diligently being pursued. Once AMSO, LLC demonstrates the economic and environmental viability of its technology, it will have the opportunity to submit a one-time payment pursuant to the applicable regulations and convert its RD&D lease to a commercial lease on 5,120 acres which overlap and are contiguous with the 160 acres covered by its RD&D lease. The area covered by the potential commercial lease is estimated to hold up to 10 billion barrels of oil shale. AMSO, LLC’s initial plan is to target the “illite” mining interval (where the “illite” rich oil shale is located), which could potentially yield production levels of up to 100 thousand barrels per day for twenty-five years, beginning in the fourth year of commercial production.

In 2009, TOTAL acquired a 50% interest in AMSO in exchange for cash paid of $3.2 million and Total's commitment to fund the majority of AMSO's research, development and demonstration expenditures. Total will lead the planning of the commercial development and will assume management responsibilities during the subsequent commercial phase.

Investment project this magnitude is naturally carried out in stages:  field study and survey -> pilot -> larger scale demonstration -> commercial production

Over the past two years, AMSO has constructed a pilot facility designed to validate key characteristics of its in-situ oil shale recovery process and has received all permits required for pilot test operations. In January 2012, AMSO initiated a fully integrated commissioning test of the above and below ground pilot test facilities to determine their readiness for operations. The test showed certain details to the facilities that must be corrected prior to proceeding with the pilot test and identified weaknesses in certain diagnostic equipment. Fixes to all identified issued are in progress. The pilot might start as early as next year.

Israel: Israel Energy Initiatives (IEI)

In March 2008, IDT formed Israel Energy Initiatives, Ltd., an Israeli company. IEI holds an exclusive Shale Oil Exploration and Production License awarded in July 2008 by the Israeli Ministry of National Infrastructure. The three-year License (which can be extended to a total of seven years) covers approximately 238 square kilometers in the South of the Shfela region in Israel, which is estimated to hold approximately 40 billion barrels of oil equivalent in the form of oil shale, and grants IEI an exclusive right to demonstrate in-situ technologies for potential commercial shale oil production. Under the terms of the License, IEI is to conduct a geological appraisal study across the License area, characterize the resource and select a location for a pilot plant in which it will demonstrate its in-situ technology. Assuming IEI successfully demonstrates a commercially viable technology, IEI intends to apply for a long-term commercial lease from the Israeli government and build a commercial facility. Under the Israeli petroleum law, long term leases are typically for a term of 30 years, with a possible extension for an additional 20 years.

Similar to AMOS, the project will be carried out in stages: field survey -> pilot (2-3 years) -> larger scale demonstration (3-4 years) -> commercial production

On August 15, 2010, the Israel Union for Environmental Defense filed a petition with the Supreme Court of Israel to stop the project. The Court has rejected the petitioner's request for an injunction. There will be a hearing on 10/29 this year.

During 2Q12, the government of Israel promulgated new regulations pursuant to its Petroleum Law. IEI is preparing key pilot test permit applications consistent with the new regulations. The permits must be obtained before pilot test construction can begin, and they are not likely to be issued before early next year. In the interim, IEI continues to perform resource appraisal work as well as key design and engineering functions necessary for the construction of test facilities.

Though vary in details, Colorado and Israel projects share the same core technology: in situ retorting, which involves heating the oil shale while it is still underground, then pumping the resulting liquid and or gases to the surface, as compare to surface retorting, which means mine the oil shale first then heat it.

The in situ retorting idea is not new, For nearly three decades, Royal Dutch Shell has been trying to heat shale below ground in Colorado, with limited success.

On August 31, 2010, Genie Energy formed a Strategic Advisory Board to advise management, strategic, financial, operational, and public policy matters related to Genie’s shale oil ventures. Members include Harold Vinegar, former Chief Scientist of Shell, Alan K. Burnham, Former research scientist at Lawrence Livermore National Laboratory, Eugene A. Renna, former Senior Vice President of Exxon Mobile, Jacob Rothschild, Michael Steinhardt , Rupert Murdoch , and Dick Cheney. Full list:

http://www.genieoilgas.com/strategic_advisory_board.php

Also, Rothschild and Murdoch separately purchased equity positions equivalent to a cumulative 5.5% stake in Genie Oil and Gas Inc., which consists of GNE's interests in American Shale Oil, LLC (AMSO), and Israel Energy Initiatives, Ltd., (IEI), for a total of $11.0 million dollars. Michael Steinhardt invested in Genie Oil and Gas as well.

So what could possibly happen that would justify Howard Jonas' increasing bet on shale oil ventures? Commercial production in either field is at least seven years away, if they ever get there. Even the pilot results are too uncertain. Then there is the lawsuit pending in Israel. My best guess is that some big oil companies are willing to buy  stakes in IEI, maybe at a premium of what the current market price implies. If that is the case, it would be wise for the management to consolidate before the dilution.

It is also possible that the company has some new venture that will excite the market. It is mentioned in recent filing that “We recently signed an agreement with an Asian country (China?) for a joint geological survey of certain of that country’s oil shale deposits, and have applied for a license to explore a potential onshore, tight oil resource in the Middle East.”

There is always the possibility that Mr. Jonas is simply too optimistic about the shale oil ventures and increased his bet without good reasons.

Valuation and Downside Protection:

Since the shale oil ventures could turn out to be huge or nothing, it is comforting to know the retail energy business provides some downside protection. Let's examine this segment on a stand alone basis.

IDT Energy resells natural gas and electrical power to residential consumers and small businesses in NY, NJ, and PA. IDT Energy does not own electrical power generation, transmission or distribution facilities, or natural gas production pipeline or distribution facilities, but instead purchases in the wholesale market. The electricity and natural gas IDT Energy sells is generally metered and delivered to customers by the local utilities. The local utilities also provide billing and collection services on IDT's behalf. The positive difference between the sales price of energy to customers and the sum of the whole sale cost of energy supplies, transmission costs and ancillary services costs provides gross profit margin. Selling expenses consist primarily of sales commissions paid to independent agents and advertising costs.

So essentially IDT Energy provides financing between wholesale market and end customers, there isn't much depreciation or maintenance CapEx.

IDT started the energy business in 2004, here are some historical numbers:

(in millions, except meter number)

Assuming maximum number (8,750,000) of Common Class B shares exchange into the new preferred, GNE has an EV of about $185M. Note I did not deduct cash on the balance sheet when calculating EV, I expect cash will be spent on shale oil projects. There is no debt.

With a normalized EBIT of $25M - $30M,  EV/EBIT is between 6 and 7.5

Corporate overhead has been about $1.5M, I expect it to go up somewhat since GNE is independent now.

So far this year EBIT has decreased meaningfully, this is mainly due to SG&A expenses increasing 54% year over year. The increase primarily reflects increased customer acquisition costs and related marketing expense. The company has entered a new state: Maryland.

Risks:

There are many.

First of all, these shale oil ventures are highly speculative, there are significant technical, environmental, economical, and regulatory hurdles involved.

Second, I have a mixed feeling toward Howard Jonas. He is certainly a successful entrepernuer, but he can be very promotional at times. I also don't like the fact that he took advantage of other shareholders by compensating himself with shares and refusing to buy back stocks when IDT shares were trading below net cash. Moreover, Howard Jonas appointed his son Samuel, a 29-year-old, as chief operating officer of IDT. His sister Joyce is general counsel and corporate secretary. I am certainly hoping the involvement of people like Michael Steinhardt, Jacob Rothschild, and Rupert Murdoch will prevent him from doing something outrageous again.

Third, the common stock could face some pressure in the near term as earnings might turn negative in the next few quarters as the preferred dividends soak up the income. There isn't much coverage on the name so poor numbers will likely turn people off. Also, liquidity might dry up.

There are some tax audits going on and you can get more details from the filings. IDT was fined big time by IRS several years ago. I am not sure why they keep messing with the wrong people.

Conclusion:

This investment essentially comes down to betting alongside insiders on something very speculative. Although the retail energy business does provide some downside protection, without a better understanding of what the insiders have in mind, this probably should only be categorized as "lottery ticket" and positioned accordingly.

Investment by major oil firm in Israel venture

Successful pilot tests in both Colorado and Israel