Description

Cano Petroleum Inc. ("Cano", "CFW", or the "Company") is an E&P company with a long-lived reserve base focused primarily in Texas, New Mexico, and Oklahoma.  The Company is currently the target of a merger offer from AIM-listed Resaca Exploitation Inc. ("Resaca").  Cano shares currently trade at a 21% arb spread (i.e. 27% upside), primarily due to difficulty in borrowing shares of Resaca.  This margin of safety is further enhanced by the attractiveness of the merged entity upon consummation of the deal, which could itself prove to be a multi-bagger from current levels.  The deal is expected to close within the next 30 days.

Resaca, despite being AIM listed, is actually headquartered in Houston, TX and has a high degree of geographical correlation with Cano.  Resaca's primary assets are in Texas and New Mexico.  Like Cano, Resaca has a long-lived reserve base.  Both companies are focused on exploitation of known oil and gas reserves (secondary, tertiary) using waterflood and CO₂ injection techniques.  As such, both companies have negligible exploration risk.  Resaca was taken public roughly a year ago, prior to which it was controlled by Torch Energy Advisors, a privately-held energy company with a long and successful history of energy investing.  The new, merged, entity will be headed by JP Bryan (currently Chairman of Resaca, Chairman/CEO of Torch), an experienced energy executive and investor with ties to Gulf Canada, Nuevo Energy, and Bellwether Exploration.  JP has recently been a purchaser of shares of Resaca in the open market; a bullish sign from a savvy investor.  My belief is that JP would have preferred to be purchasing CFW shares (given the additional arb discount), but was likely restricted to Resaca purchases given the differential treatment for what constitutes a prohibited insider transaction in the UK vs. the US.

The proposed transaction is a stock-for-stock deal, with Resaca issuing 2.1 shrs for each CFW share.  Post-transaction, CFW and Resaca shareholder will each own roughly 50% of the surviving entity.  Management expects to do a modest equity raise either in conjunction with, or shortly following, the merger.  Proceeds would likely be used to fund a combination of debt paydown and acquisition of additional properties (Resaca has been in ongoing discussions for the potential acquisition of two additional tuck-in properties for close to a year now).  On a pro forma (combined) basis, and assuming 25mm new Resaca shares issued at current market prices, the new company will have 63 MMboe of proved reserves, a PV10 of $653mm, net debt of roughly $100mm, and 213mm shrs outstanding.  Thus, on a per-share Resaca basis, PV-10 would equal $2.60, or roughly $1.80/shr fully-taxed.  Applying the 2.1 share exchange ratio, this implies $3.80/shr on a CFW share basis (compared to the currently market price of $0.90/shr).  The stated PV-10 is based on $69.89 per bbl oil and $3.71 per mcf gas.  As an aside, there is another 25-30 MMboe of probable reserves.  Given the high degree of both geographic and functional overlap between the two companies, there should be a relatively painless $5mm of cost takeouts that can be implemented in short order.

From a deal perspective, outside of customary approvals the primary remaining hurdles are the shareholder vote and negotiation of a new credit agreement for the merged company.  Neither of these should prove difficult; shareholders from both companies are generally supportive of the deal and lender relationships are strong.  CIT is a lender to Resaca, which is a negative, but the new facility is highly likely to come from the Cano side of the table.  The new company plans to have a dual listing (NYSE Amex and AIM), and the increased market cap should enhance both liquidity and the public profile of the new company.

The primary wrinkle in the investment is current cash flow.  Both Cano and Resaca are in the early stages of their exploitation efforts, and current (combined) EBITDA will be a relatively scant $15-20mm.  Thus, although the pro forma company looks very cheap on an asset basis $3.05/BOE, it looks pricey on a cash flow multiple basis (10x).  At current commodity prices, the merged entity should be cash flow breakeven within 6-12 mos of deal closure, and should see a rapid ramp in production towards late 2010/early 2011.

Given the long-lived nature of the assets, and the projected production profile, one could view CFW/Resaca as a long dated call option on energy prices, with a substantial margin of safety and numerous catalysts for value realization over the next 6-18 mos.

Catalyst

Closure of Resaca deal.  Increased production.  Sell-side coverage.  Additional accretive asset deals.