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Transocean Up 23% YTD, Icahn Seeking a Big Special Dividend: Why Worry?

Activist investor Carl Icahn likes Transocean (RIG) shares. Should you?

Icahn revealed that he boosted his interest in the offshore drilling company to 5.6% of the outstanding shares, a stake he began accumulating even as Transocean negotiated a $1.4 billion settlement of charges flowing from the Deepwater Horizon catastrophe of 2010. But even without the blow to Transocean’s reputation and the damage to its financial wellbeing by the explosion on the offshore drilling rig (which it owned), there are other reasons to be wary of following Icahn – and other hedge fund managers -- into this stock, especially if you’re hoping for the latest rally to continue indefinitely.

Certainly, the market expectation seems to be that the settlement and Icahn’s involvement in Transocean will be good news for the company’s stock price. The shares – which have never recovered to pre-Deepwater Horizon levels – have rallied sharply, gaining 23% since the beginning of 2013, sas seen in a stock chart, compared to only 2.3% for the S&P 500.

RIG Chart

RIG data by YCharts

The reason for that is clear to see. Quite aside from the settlement, Icahn is gunning for a big payout for himself and other investors, in the form of a dividend of at least $4 a share – and if the company doesn’t agree, he insists that he’ll take it to a vote, as Swiss law permits him to do. (Transocean is incorporated in Zug, Switzerland.) It wouldn’t be the first time in recent months that Icahn has taken a run at changing the dynamics with an energy company; he has become an active voice within the ranks of Chesapeake Energy (CHK) shareholders since taking a stake at that firm, and is credited for helping to finally push founder and former CEO Aubrey MacClendon to the exit and shake up the board.

RIG Cash and Equivalents Chart

RIG Cash and Equivalents data by YCharts

Icahn’s eyes are fixed on the company’s growing cash position, which has climbed 50% in the last 12 months alone. But while Transocean has a solid amount of cash on hand, it has no fixed dividend payout policy, making it a logical target.

There are other reasons to think seriously about Transocean as an investment, beyond the uncertain prospect of a big dividend payout in the future and the potentially short-lived interest on the part of some big hedge fund managers. (Icahn isn’t alone in his affection for the company: noted hedge fund investors like Ken Griffin of Citadel and Leon Cooperman of Omega Advisors have recently reported taking positions in the stock.) The company’s revenue is climbing, its operating earnings are already improving and analysts believe that net income will show gains on a quarter-over-quarter basis as well. It is trading at only about 11 times prospective 2013 earnings – the PE ratio is at a discount to the market – and is historically cheap by other valuation standards as well, including price to cash flow.

But historically, earnings and revenue growth has been negative on a quarter-over-quarter basis, and Transocean announced a loss for the third quarter, not the profit that analysts had been expecting. And even in the absence of accidents or tragedies like the Deepwater Horizon disaster, offshore oil drilling may face some headwinds going forward.

RIG Net Income QoQ Growth Chart

RIG Net Income QoQ Growth data by YCharts

Any investor seriously pondering following Icahn’s lead in hopes of a bid dividend payout should weigh the downside risk as well. That lies in the global economic picture – the IMF recently cut its global GDP growth forecast for this year and next yet again – and in the dynamics of oil and gas exploration and production.

Without global economic growth, demand for energy tapers off, or at least, doesn’t grow as rapidly. A large number of energy exploration and production companies (like Chesapeake) were caught off guard by sudden plunges in commodity prices after they had expanded their exploration programs and significantly increased their capital spending. That’s a trap that they and their peers will want to avoid tumbling into in the months to come, meaning that even if crude oil prices rise, energy companies may be wary about committing heavily to new exploration programs. That will have consequences for Transocean in the near term, even if more farsighted and deep pocked energy majors continue or expand their offshore drilling. While new pockets of shale oil and natural gas are transforming the economics of the energy industry, a large proportion of major new discoveries are likely to come from offshore drilling. And while new rules and regulations may make that more costly, that part of the risk scenario may be no different than the current upheaval surrounding fracking in the Marcellus or Bakken shale plays.

If you’re a believer in fossil fuel explorations, this may well be a stock that is easy to own at these levels, but be careful of following Icahn or any investor blindly into any company – and be aware of the short-term risks.

Suzanne McGee, a contributing editor at YCharts, spent nearly 14 years as a reporter at the Wall Street Journal, in Toronto, New York and London. She is also a columnist for The Fiscal Times, and author of "Chasing Goldman Sachs", named one of the best non-fiction books of 2010 by the Washington Post. She can be reached at editor@ycharts.com.

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