SandRidge's Acquisition of Arena Resources Masks Deeper Problems

Includes: ARD, SD
by: Anthony Alfidi

SandRidge Energy (NYSE:SD) wants to buy oil and gas producer Arena Resources (ARD) for 4.7771 shares of SD plus $2.50 for each share of ARD. Is this deal worth doing?

Here are the pros:

SD expands its existing reach in the Permian Basin with ARD's reserves of 69.5mm BOE. Recent natural gas discoveries in North America will keep a ceiling on that commodity's price, so diversifying into a scarcer resource makes some sense.

Now for the cons:

The dilutive effect on existing SD shareholders (after issuing 185.3mm new SD shares brings the total shares outstanding to 395.71mm) is 53%. Existing shareholders are asked to surrender 47% of the combined company's earnings per share. SD earned -$1.776B in 2009 and ARD earned $42.29mm; this equates to an underwhelming -$4.38 EPS combined after dilution. Compared to SD's current EPS of a whopping -$10.20, that's hardly worth cheering.

This is at best a superficial improvement, as SD in its current form has experienced massively negative free cash flow for two years and has increased its long term debt for three years running, all while its net income turned severely negative. SD is therefore betting that the acquisition of a minor oil producer will mask its own operational difficulties long enough to try to put its own house in order. ARD shareholders are asked to surrender ownership in a marginally profitable oil driller for shares in a larger company where cash flow, net income, and retained earnings are all negative.

The market will gradually come to grips with these risk factors. SD closed at $7.85 on Apr. 1, before announcing this acquisition, and has closed below that price every day since then while its daily trading volume has spiked by 200% to 500%. It's hard not to believe that SD is largely in the hands of arbitrageurs looking for a quick buck. It's just as hard to see how SD plans to work its way out of its own operational problems. It's very hard to ask ARD owners to part with what they have in hand now.

Disclosure: No positions