Your worries about the spread are entirely understandable, especially in todays environment (as opposed to say early ’09, where one could reasonably assume that forced selling from various highly levered arbitrage funds, etc. were responsible for the abundance of “too good to be true” opportunities). I certainly wondered the same thing intially (how could you not?).
Anyways, after drilling down deeper into the opportunity my fear that I must be missing something here went away due to the following three reasons (and imo sufficiently explain the present mispricing)…
First, both Cano and its acquirer Resaca are under-followed micro caps and thus don’t appeal to larger funds and/or institutions. Notably – post merger – the combined company will be materially larger and more liquid, which should cause larger funds/institutions to finally begin to take notice. The larger, more liquid new co. should generate considerably more institutional interest than either company would have been able to achieve on a stand alone basis (which should almost immediately result in the business being much more appropriately priced).
The second reason I feel the mispricing exists is because neither company is currently generating meaningful cash flows and hence the new co. appears pricey on a pro forma earnings basis (both companies are in the early stages of their exploitation efforts – and therefore the new co. will not likely be breakeven on a cash basis for another couple quarters at minimum, as production for the combined entity won’t really begin to ramp up until some point in the back half of this year or early next).
Third (and perhaps most importantly), the arbitrage community has steered clear of this deal due to the illiquidity of Resaca and the inability to locate a borrow on its shares – hence the ridiculous spread (there is no one around to close it).
Also, financing doesn’t look to be an issue here (as it is essentially a done deal), nor does shareholder or regulatory approval (both of which appear to be in the bag so to speak). The typical concerns that usually derail similar deals and/or cause these types of spreads, all appear to be non-issues in CFW’s case.
Anyhow, the bottom line imo is that CFW is currently completely unknown, relatively illiquid, and at least for the moment doesn’t appeal to any logical shareholder base. It is this reality, in conjunction with the fact that by all indications this deal is highly likely to get done (with relative ease and in short order), that gives me comfort that there is no unpleasant surprises waiting around the bend. As always I could be wrong here, and would love to hear your thoughts…
Thanks for the long and thoughtful response. As you probably know, I have been following the situation for a while and wrote a long series on valuing reserves using Cano as an example @variantperceptions.
Point 3 is probably the most useful to explain the mispricing and it actually would be a good thing for the thesis. However point 2 is the one to worry about the entity going forward..
Cano probably resigned itself to a merger, and a cheap priced one, despite their large reserves because years of over promising caught up with them. Despite not being over leveraged I wonder if they were running of funding sources to exploit Cato and the Panhandle. If that is the case, my worry is that they are kicking the same over promising problems to the next entity.
The market may have a point on being cynical about waterfloods plays until they become reality, giving the pipe dreams sold and how cheap they have bought those properties.
So these are my speculations and the reason and I sold some weeks after the merger announcement and continue to procrastinate about loading the boat. I think any long thesis should be based on the reputations of the new management.
I actually had no idea you had written a series on CFW (pleasant surprise). I just finished reading it and as I have come to expect it was a fantastic read.
I agree with your thoughts, especially in regards to the new management team…luckily, it appears their reputation and track record is outstanding. Anyhow, it looks like its time to load the boat as Resaca announced this morning its new credit facility.
"While knowing how to value businesses is essential for investment success, the first and perhaps most important step in the investment process is knowing where to look for opportunities" - Seth Klarman