Update (June 2, 2010): Sec Approval was received this morning
Cano Petroleum (CFW)
Deep Value + Special Situations = A Favorable, High Probability Outcome
Cano Petroleum (CFW) is a classic merger arbitrage/special situation with a tremendous margin of safety and substantial near-term upside potential.
Given the size of the current spread (roughly 25%) and the fact that this company is currently trading hands at a discount to its liquidation value, not to mention that (1) the buyer is legitimate (2) the strategic rationale for the deal is sound (3) financing isn’t an issue and (4) there are no regulatory issues that could potentially derail the deal at this point, we think that the stars are aligning for bargain hunting investors to generate spectacular returns with relatively low risk.
Relevant Questions to be Considered
Q – What are the spreads between the price being paid and the closing price of the expected event?
A – With the acquirer Resaca (RSOX.L) shares at $0.60, the post reverse split price of Resaca equals $3.00. Considering that CFW shareholders are set to receive .42/share of RSOX for every share of CFW, then the closing value of the company today is $1.26 ($3.00 * 0.42).
Q – What are the time frames involved between when the money is invested and the final payment received?
A – Roughly 1 month’s time
Q – How likely is it that the deal will close under the original conditions (price and time period) of the event in question?
A – Very, all things considered.
Q – What are the odds of a better bid being received before the event is finalized?
A – Miniscule
Q – If the event does not occur, what next? How much will the stock price drop as a result?
A – The company would remain a standalone entity; so not much, given Cano’s (1) deeply discounted price (2) tremendous tangible asset base (3) relatively low leverage and (4) strategic value to similar businesses with more capable management team’s (like Resaca, for example). Our analysis leads us to believe that even under the most draconian scenario’s we can imagine investors at or around the current price are unlikely to lose money given they are willing to hold Cano and/or the combined company for the long-term.
Why is it Mis-priced?
Cano is an illiquid, underfollowed, and under-appreciated microcap. The mispricing further stems from the fact that the arbitrage community has steered clear of this deal due to the difficulty in locating a borrow on Resaca’s illiquid, London (AIM) listed shares (i.e., the arb funds can’t effectively execute the trade due to the difficulty in shorting the “groom”).
Quick and Dirty Merger Analysis
• Acquirer: Resaca Exploitation (RSOX.L)
• Target: Cano Petroleum (CFW)
• Announced date: September 30, 2009
• Closing date: June/July, 2010 (deal should close in roughly a month’s time)
• Closing value: $1.26 at time of writing
• Last price: $0.99 at time of writing
• Profit: Roughly 25% excluding fees
Details of the Transaction
The Resaca Corporation (RSOX.L) is set to acquire Cano Petroleum (CFW) at some point over the coming 30-60 days in a stock for stock exchange, with Resaca issuing .42/shares for each CFW share. Upon the completion of the deal, the surviving entity will be Resaca, with historical shareholders of the legacy companies each owning 50% of the combined entity.
Merger Arbitrage Checklist:
1. Due diligence by both parties
Non-issue – Given the friendly/strategic nature of the deal. For what it’s worth we feel that it is obvious that both firms are materially better off together than apart (see Appendix).
2. Financing approval
Done deal – On February 4, 2010 Resaca announced the signing of a new $200m committed senior credit facility with Union Bank North America and Natixas, removing what we believed at the time to be the biggest obstacle to getting a successful completion of the deal.
3. Get preliminary shareholder sentiment (or controlling shareholder approval)
With both management teams firmly behind the merger and roughly 75% of Cano’s preferred shareholders having already voted yes to the deal, it appears to be a near certainty that the deal will be approved.
4. Obtain regulatory approval (SEC)
Given that Resaca has filed the registration statement on Form S-4 and the amendments thereto with the Securities and Exchange Commission, regulatory approval is imminent in our opinion. Once approval is granted (and the S-4 becomes effective) both companies will finally be free to send out their proxies and get shareholder approval to consummate the deal. This is the remaining material issue facing the successful completion of the merger at this point, and the chances of the deal falling apart after they receive approval are essentially nil in our opinion.
5. Additional Conditions of Closing
Reverse Stock Split
NYSE Amex Listing – On March 30, 2010 the NYSE Amex approved Resaca’s request for the combined entity to be listed on the exchange (making this a non-issue going forward).
Currency Conversion – on April 1, 2010, Resaca changed the currency for its AIM listing to US Dollars (from British pounds). This change was necessary in order to facilitate the trading of the combined entity once merged and dually listed on both exchanges.
6. Final shareholder approval
Because the recently filed registration statement on Form S-4 serves as (1) both a prospectus for the Resaca shares to be issued upon consummation of the merger and (2) as a joint proxy statement for the shareholders of both firms to vote on the proposed merger, approval from the SEC is necessary before for the final shareholder meeting can take place.
Given that the financing has come through, Resaca has filed all of the SEC Form’s S-4, S-1 (and their various amendments), and the fact that we believe SEC approval will be granted in short order, we like the risk/reward here. Again, the issues outstanding to make this a “done deal” at this point are (1) the official announcement that the the SEC’s Form S-4 has become effective (which we expect anytime) (2) the immediate mailing of both sets of shareholders proxies, followed by the actual vote (3) managements plans to do a modest equity raise in conjunction with the merger and (4) Resaca’s need to execute a 5.1 reverse stock split in order to be eligible to re-register on the AIM (without the split they won’t be able to achieve a dual listing).
• Potential Upside: Roughly 25%+ (based on the present arb spread)
• Potential Downside: None (based on the stocks discount to liquidation value)
• Time: 1-2 months
• Probability of success: 85%
For what it’s worth, if you plug in the numbers above in a Kelly Formula Calculator, the Kelly percentage will equal 100%. What this means is that the formula recommends investors should allocate up to 100% of their portfolio to this particular investment given the above average odds of success involved. We aren’t that convinced the Kelly formula is all that useful, and we definitely wouldn’t put a 100% of our bankroll in this investment. Yet, we definitely do think the opportunity offers an above average odds chance of generating very attractive risk-adjusted returns and deserves a more appropriately sized position (say 3-4%).
A Classic Low-Risk, High-Reward Opportunity:
Thoughts on Arbitrage
Whether you are evaluating the attractiveness of a merger arbitrage opportunity or a plain vanilla value investment, the equation as we see it is ultimately the same. Arbitrage in our minds is just a simpler, “rapid fire” version of value investing. Success requires the same secret sauce, that is (1) successfully handicapping the odds (i.e., the ability to properly judge the various outcomes and the possible gains and losses associated under each) and (2) buying assets for significantly less than they are worth in order to ensure downside protection.
Anyhow, in both cases (i.e., traditional value investing and merger arbitrage) the idea is to look for those low-risk, high-return investments where the odds of success are stacked tremendously in your favor – where the difference between your purchase price and the true value of the asset is so wide that even if your initial thesis doesn’t play out as expected you will likely still do well given any reasonable outcome. With Cano, we think we have the best of both worlds, i.e., a potentially high payoff/significant downside protection even under a scorched earth scenario.
Thoughts on the potential range of outcomes
(1) What if the spread collapses, but the deal gets done and I am stuck with the company post merger?
If one is willing to hold the combined entity post merger – as we are – then the above shouldn’t be an issue. In fact, looking out 2-3 years from now it may very well turn out that this outcome was the most optimal of them all given shareholders could easily earn very attractive returns 2-3x their invested capital over the next few years.
Why? Because it trades at a deep discount to the value of its assets and normalized cash flows. For example, Resaca’s PV 10 (net of all debt and preferred stock) will be roughly 535m or roughly 2.80/share vs. the current $0.67. If you want to include probable reserves worth a couple of hundred million dollar+ the discount to true value is even higher. The bottom line is that if the spread collapses investors are still in a great position to generate incredibly attractive returns with low risk.
Again, we think it’s only a matter of time before the massive discount to PV10 and/or rapidly growing cash flows from the successful exploitation of their much improved, more diverse operational asset base causes investors to significantly re-rate the company’s equity to a more appropriate valuation. Also, given Resaca’s dual listings, larger market cap, and managements dedication to building awareness regarding the virtues of the combined company, it shouldn’t be too difficult to generate greater retail and institutional interest/awareness, so in our opinion the re-rating could happen sooner rather than later.
Keep in mind that post deal Resaca’s operations will be significantly enhanced and possess a much more valuable collection of attractive hard assets. Not only that, given the firm’s engineering capabilities/technical expertise and (1) huge new non-producing reserve base (2) improved scale and operational efficiency (3) increased liquidity and financial resources and (4) variety of low-risk near-term production enhancement/cost reduction opportunities, its normalized earnings power has been significantly enhanced. In other words, Resaca is not only a bigger company, but a meaningfully better one. If management is anywhere close to as successful as we think they will be in executing its plan, they should be able to unlock a tremendous amount of embedded value in the newly combined company’s asset base over time.
To reiterate, given the capable, seasoned, and fully incentivized management team and the (1) drastic discount to NAV (2) significantly improved normalized earning power and (3) variety of near to medium-term internal and external catalyst(s), Resaca shareholders post merger will likely do very well. Better yet, investors who own a piece of this already deeply discounted business at an even bigger discount through Cano will likely do even better.
Combined Asset Profile:
• 63.3 MMboe (1P)
*PV10 of 664.5m
• 91.7 MMboe (2P)
*PV10 of $1B
• ~1,900 boe/d production
• 75,000 gross/74,000 net acres
Combined Reserve Values Per Share:
Less: Debt and Pref. Stock (129.3)
Net Values 535.2
Net Value Per Share $2.78
(2) What if the deal collapses and I am stuck with Cano as a standalone company?
Consider for a moment that Cano as a standalone company has 49.1MMboe in proved reserves. What’s it worth? Well, at current prices the reserves are worth roughly $470M. Looked at a different way, the current value of Cano’s proven reserves is worth considerably more than twice the company’s current EV. The company actually trades at one of the widest discounts to the net present value of its proven reserves in the entire oil and gas industry. In other words, it’s incredibly cheap. If you want to go ahead and include the company’s probable reserves of another 100m+, then the company is stunningly cheap. So, on a certain level whether or not Cano remains a standalone entity or ends up merging with Resaca over the next month or so doesn’t really matter given that the market has priced this company for bankruptcy (granted, it would certainly be the least optimal outcome).
One of the obvious takeaways from today’s valuation is that market expectations can’t get much lower than they already are. Fortunately, the first observation is correct (expectations are as low as they go). Another takeaway is that the market clearly believes the company’s asset base is permanently impaired and/or it lacks a viable business model. Based on a wide of variety of readily observable, fully verifiable, and common sense observations, this second takeaway is just wrong (on both counts). While it is true that Cano as a standalone company would lack the cash flow to continue to develop and exploit its asset base (so financing concerns would be an issue in the short term), their relatively low leverage and tremendous asset base provides them with a lot of options. The ability to renegotiate their borrowing base, sell assets, sell themselves to another buyer, etc. should (1) provide the company with the breathing room they need to successfully navigate any potential storm that comes their way and (2) provide shareholders with some significant downside protection under such an adverse and unlikely outcome.
Bottom line, with an incredibly favorable, highly skewed risk/reward equation, Cano petroleum provides investors at or around the current price with significant downside protection and the opportunity to generate a substantial profit under a wide range of outcomes. If the spread stays at or around the current level and the deal gets done, clearly investors win. If the deal gets done and the spread collapses then investors will still win all things considered. If the spread collapses and the deal falls apart, investors end up holding an undervalued security with a tremendous asset base and significant potential.
Standalone Asset Profile:
• 21% proved Developed
• 79% Oil
• PV10 of $471.3M
As investors who like to uncover meaningful change within companies that make the business in question materially more valuable, and more importantly, that the market hasn’t yet noticed, we find insider buying on most occasions to be signal worth paying attention to (for obvious reasons).
With that said, we find it especially meaningful when those insiders own a huge percentage of the outstanding common and have a long paper trail of success and intelligent capital allocation. An even better signal is when we witness the Chairman/CEO (i.e., JP Bryan) buying stock at what amounts to a huge premium to the current price. Watching him consistently buying back the stock of Resaca as it was rising and when he could have simply purchased Cano instead at a huge discount says quite a bit (remember by purchasing Cano today investors are getting the chance to in effect purchase Resaca at a large discount to the current price). In our minds, that is some powerful confirmatory evidence about what he thinks about the value of his company’s stock and its future business prospects.
Any time we come across arbitrage situations where the value of the takeover target is suspiciously above the purchase price being offered, as is the case here, nine and a half times out of ten it’s an immediate pass. Occasionally though, when we are perusing amongst the less efficient areas of the market we come across an opportunity like Cano, where an irrationally low price that discounts nothing less than a scorched earth scenario is coupled with a potential payoff that is very high under any reasonable outcome going forward. Heads we win, tails we don’t lose.
February 2010 Merger Presentation
Case Study (Variant Perceptions)
Appendix (presentation slides):
In our opinion there is tremendous optionality in the post-merger business model. Success by Resaca on any of these fronts could unlock substantial value going forward, both gradually and in stair step fashion.
• Complimentary oil-focused properties with balanced growth opportunities – Resaca’s PDNP reserves with Cano’s PUD reserves
• Near-term low-risk identified production enhancement opportunities
• Accelerated exploitation strategy with focus on long-life reserves
• Estimated cost savings of approximately $4.5 – 5.0 million per year
• Increased institutional investor interest & capital market access
• Experienced management team
Strategic Rationale for Merger:
Complimentary Assets & Balanced Growth Opportunities
• Cano’s long-term growth potential with large undeveloped reserve base (PUDs)compliments Resaca’s near-term capacity to increase production (PDNPs)
• Ability to high grade combined cap-ex programs
Significant Cost Savings & Operational Efficiencies
• Operating efficiencies at the field and corporate levels
• Synergies and cost reductions expected to result in roughly 5m/year of G&A and LOE reductions vs. FY 2009
• Complementary technical and operational staffs
• Geographical synergies
• Economies of scale will result in CAPEX savings
Near-Term Low-Risk Production Enhancement
• Ability to increase productivity of combined company by 10-20% expected by applying proven engineering applications to identified prospects
• Both companies focused on explotation of known oil and gas reserves
• Engineering driven companies – no exploration risk
• Similar asset bases – mature, long-life oil production with secondary and tertiary potential
• Significant CO2 recovery potential on both companies properties
Combined Equity Considerations
• Very little overlap of institutional shareholder bases
• Dual U.S/Europe Listing
• Access to U.S. and European investor bases and increased size of entity will benefit combined company through (1) increased liquidity and trading volume (2) increased awareness of combined entity and (3) increased access to capital (debt and equity)
Competitive Strengths of Combined Company:
Common Strategy – Acquisition and exploitation of known reserves
Attractive asset base
• Large 1P & 2P reserve base with significant exploitation potential
• Long-life reserves in established basins, 80% oil
• Proximity to CO2 infrastructure
• Technical and operational staff averages >25 years of experience
• Executed dozens of secondary and tertiary projects
Diversified operations and operational control
• Properties in New Mexico, Oklahoma and 3 areas of Texas
• Over 1,900 wells producing from 25 different formations
• Operate 100% of current production
Highly experienced senior management with significant equity stake
• Senior management averages > 30 years of oil and gas experience
• Management and board will control roughly 9.5% of shares
Relationship with Torch Advisors