Is Icahn Really The Rainmaker Transocean Needs?

Nov.15.13 | About: Transocean Ltd. (RIG)

Earlier this week Carl Icahn made it public that after a month's long proxy battle with Transocean (NYSE:RIG) a deal was finally struck between the activist investor and Transocean. The final deal has Transocean agreeing to increase the dividend payout to $3 per share as well as limit the number of board seats to 11 from 14. Of which Icahn will hold one of the eleven seats. Additionally, Transocean has committed to improving its operating margins by $800 million by the end of 2014. Part of the margin and financial improvement commitment will come in the form of a master limited partnership being created that the company will take public toward the middle part of 2014.

This is all good news for shareholders and these new actions should help bolster the stock's year-to-date struggling performance. For those that don't remember, Transocean owned the Deep Water Horizon rig that BP plc (NYSE:BP) ran that exploded, killing 11 workers, and caused millions of gallons of oil to leak into the Gulf of Mexico back in 2010. Since then the stock and company have struggled to return value to shareholders while still growing the company amongst the heat from the Deep Water Horizon disaster.

One of Icahn's biggest complaints with Transocean that helped drive the proxy battle was that he felt that the company had continually not been successful at any of its development strategies. As Icahn put it, "[Transocean] has destroyed billions of dollars of value, which is clearly reflected in the performance of the Transocean shares when compared to its competitors."

Since this news broke this week Transocean shares have been up, and up big. The stock has risen 15% in just the last 5 days. The market is very bullish on this news and that is now being priced into the stock. Couple that news with the fact that Transocean reported earnings this last week that beat on expectations by almost 30%. Investors are starting to take a second look at Transocean.

Given all of the positive news surround Transocean I still remain a bit cautious and wonder if the stock should really be holding the appeal that it currently does and whether the Icahn news is actually providing real value.

Bear Case:

There is no denying it that Icahn has helped out the shareholders significantly with this new deal and that without him the stock (even with a 30% earnings beat) would still be trading in the mid to high $40s compared to the current pricing in the mid-$50s. Yet, Icahn's 'new deal' still is going to take some time to play out. Most of the real impact is not going to be really felt by shareholders until mid to late next year. Additionally, the operating margin goal of $800 million is fairly aggressive and is up significantly from the original target of $400 million that the company had originally said would be feasible.

It is also important to note that even though Transocean may have the largest rig fleet, that fleet is also one of the oldest out there. Compared to competitors like Pacific Drilling (NYSE:PACD), Diamond Offshore Drilling (NYSE:DO), Seadrill Ltd (NYSE:SDRL), and Noble Corporation (NYSE:NE), Transocean's fleet requires much more capital to maintain and keep running, while still meeting new regulatory standards. Due to the age of Transocean's rig fleet, aside from eating the maintenance costs, the only other option for Transocean would be to sell their rigs and start from fresh. With almost $11 billion in debt on the balance sheet and growing that solution seems highly unlikely or that sensible of an option for them to consider.

Lastly, the continued aftermath of the Deep Water Horizon explosion is another lingering factor that plays into Transocean's ability to actually grow consistently and meet the new demands that Icahn has put forth. I will be the first to admit that the financial drain from the disaster most likely will not be as bad this year as it has been in prior years, but the lingering uncertainty still remains and leaves an open ended line item out there on the income statement of what those total costs could amount to be.

Bullish Case:

As negative and down beat on the stock as I may seem to be above, I will also be the first to admit that from a valuation standpoint (especially now) Transocean has a very compelling story. The stock, even after the recent run-up of 15% still sports an impressive 11.92 P/E ratio. The book value of the company is an astonishing $43.56 per share, meaning that at the current market value the stock trades for only 1.25 times book. Transocean has $3.35 billion in cash on hand and this last quarter posted earnings that were 30% above estimates. Additionally, when the company spins off an MLP next summer the amount of capital that will be generated from that will only further help the valuation story of this stock.

The company has committed per the deal with Icahn to try and increase its operating margin to $800 million by the end of 2014 and the dividend has now been raised to $3 per share, which increases the current yield to 5.5%, up from the previous 4.1%. Just by having Icahn on the board and him continuing to push the company to increase performance should help keep the stock price elevated.

From a valuation standpoint the stock seems compelling and quite interesting. If all of the above bullish items actually pan out the way Icahn hopes they do, I think there is a strong chance that Transocean trades back up into the mid to high $80 per share range.

Recommendation:

As much as I like having Icahn involved in the operations and strategic decision making process of Transocean, I still am not completely sold on the longer term benefit that he and Transocean claim that they can deliver. I think Transocean has the potential to deliver value to shareholders in the longer term, but I feel that the recent run up in the stock price has been too optimistic and aggressive given the timeframe that majority of the bullishness has yet to play out.

Instead I would be a strong buyer of Transocean in the mid-$40 per share range. At current valuations I feel that the stock is a bit overvalued and I personally would wait for the market to calm down a bit and let the hype with all the earnings and Icahn news get priced in and for the market to rethink its current valuation of the stock and for it come in a bit before buying.

Longer term Transocean has a lot of headwinds, but I think with the new direction management is taking and with Icahn working behind the scenes that the stock has a lot of potential. I just think that potential would be better realized in the mid $40 per share range.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in RIG, SDRL over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.