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My frequent readers know that I am a big advocate of thinking outside the box when it comes to producing yield. I am a big fan of covered call strategies, using leverage (responsibly), and various other strategies that can supercharge the yields generated by stocks you may already own. Today, I'd like to discuss one of my favorite dividend plays for the long term, Transocean (NYSE:RIG), then I want to propose a strategy that will produce a yield of 10% annualized on your original investment.

Transocean as a long-term play

With the Deepwater Horizon disaster mostly in its rear-view mirror, Transocean can begin to look to the future as one of the leaders in offshore mobile drilling units. The company owns a fleet of 82 drilling rigs, which it leases out to oil companies such as Chevron (NYSE:CVX) and BP, which happen to be Transocean's two biggest customers.

The company's near future looks extremely bright, with a $27.3 billion backlog of business as of July 2013. In fact, of the operating capacity of the company's entire fleet, 73% is already booked for 2014 and 44% is booked in 2015. Also, since those statistics were made public, the company announced contract extensions on two of its units, which add $1.93 billion (estimated) to the company's backlog.

Very cheap right now…

Shares are currently very cheap based on both valuation and yield. The consensus calls for Transocean to earn $4.10 per share this year, meaning that the stock trades for 11.6 times this year's anticipated earnings. Transocean's earnings are expected to grow to $5.55 and $6.15 in 2014 and 2015, respectively, on better cost efficiency and new projects that are scheduled to be completed in the coming years. So, the company's projected 22.9% average annual earnings growth over the next couple of years looks very appealing compared to its valuation.

The good news for dividend-seekers out there is that the company's management is under constant pressure from Carl Icahn to increase their dividend to a level he's satisfied with. After paying relatively low dividends for a couple of years, Icahn demanded a $4 per year dividend, given the company's excellent cash flow recently. He didn't quite get his way, but Transocean did meet him more than halfway with a $2.24 payout, which translates to a 4.7% annual yield. I can already see Icahn getting pretty bent out of shape if increases don't occur regularly in the future, so as long as he's there, you should see pretty steady raises, especially if Transocean meets the higher earnings expectations of the next few years.

Recent performance

Despite a recent gain, Transocean has drastically underperformed the market this year. Over the past four months, shares have shed about 14% of their value, despite the improving long-term outlook for contract drilling services.

The average 1-year price target of analysts covering the company is currently $55.44, which represents more than 16% upside over the current share price. With this target in mind (which I feel is very conservative), let's check out one strategy that could boost our returns while providing some safety for our portfolio.

How to boost your return (safely)

What I am proposing is to buy Transocean for its yield, and also to sell a significantly out-of-the-money call option against your shares. With our $55-ish price target in mind, I'm looking at the January 2015 $57.50 calls (currently selling for around $1.93). This way, if shares do rise as much as the analysts project, we don't get called out. And if we do, it'll be worth it. There are 3 scenarios when employing a strategy like this, and let's take a look at each one. For simplicity, we'll use a 100-share investment, which allows for one covered call to be sold.

  1. Worst case - Shares are below their current value at options expiration. Since the company's tangible book value is about $36, let's use this as the price floor. If you had simply bought 100 shares at the current price, your ending investment value would be $3600, or a loss of $1,158. If you had sold a call, your shares are worth $3,600, plus you get to keep the $193 collected for selling the call, limiting your loss to $965. Not to mention that you've also collected five quarterly dividends, or $280, in that time period. Put another way, including the dividend and your call premium, shares could drop about 10% to $42.85 and you would lose no money whatsoever (breakeven point)
  2. Most likely - Shares finish between their current price and the strike price of the call ($57.50). In this case, your shares make money, and you keep the $193 premium from the sale of the call. Since you also collected $280 in dividends, your total return is $473, or 10% on your original investment, plus your shares would have appreciated. You are now free to sell another call option on your shares.
  3. Also a good result - Shares rise over the strike price. You are forced to sell your shares for $57.50 in January 2015, for proceeds of $5,750. You also have collected $473 in options premium and dividends, bringing the total cash in your pocket to $6,223, or a 30.8% gain in less than a year and a half.

Regardless of whether or not you use my call-selling strategy, Transocean is a great play for the long-term. In addition to providing excellent current income, it should provide nice raises over time and increased share value as well.

Source: How To Achieve A 10% Yield With Transocean