Transocean Dividend in Danger?

Shares of always controversial Transocean (NYSE: RIG), the world's largest provider of offshore drilling services, are down 8.4% today on volume that has already doubled the daily average on news the company will issue 26 million new shares to retire $1.7 billion in convertible notes. The move, according to a note from Citigroup, may be aimed at keeping the company's investment grade credit rating, which already teeters on the brink of junk status.

A drop to junk could raise Transocean's borrowing costs by 200 basis points, the Citi note said. Earlier this month, Moody's Investors Service put the company on review for downgrade, citing a possible cash crunch and the impending February 2012 legal proceedings related to the Gulf of Mexico oil spill.

Transocean's potential liabilities for the largest oil spill in U.S. history are still unknown at this point, but the worst case scenario is bleak as the number could be in the tens of billions of dollars, according to reports from ratings agencies released earlier this year.

Then there is the matter of Transocean's $1.4 billion acquisition of Aker Drilling announced in October. All of these factors combine to make Transocean's dividend look quite vulnerable. Citi may have reiterated a Buy rating and $65 price target on Transocean today, but in that note, one of the sub-headers is “The Dividend Is a Major Question Mark.”

Yikes. At a rate of $3.16 per share per year and a yield of almost 7%, Transocean's dividend and yield are well above the norm for the oil services space. Even companies in this sector with strong cash positions currently come nowhere near Transocean's dividend.

Take Schlumberger (NYSE: SLB) and National Oilwell Varco (NYSE: NOV) as two examples. Combined, the dividends offered by those two companies are less than half of Transoceans. Combined, their yield is less than a third of Transocean's. All of that from two companies that are far less embattled and far better off with regards to cash.

Transocean also has an aging fleet of rigs and an aging fleet means higher costs, either through maintenance or buying new rigs. That's another potential overhang on the dividend. The company is planning to discuss the dividend over the coming weeks with a final decision in, oddly enough, February.

"We have indicated that we are committed to a sustained dividend," CFO Ricardo Rosa told Reuters. "But clearly we have to take all of the externalities into account.'' Doesn't sound too encouraging does it?

From the Citi note: “The current $3.16 per share annual dividend would require an annual cash outlay of approximately $1.1 billion after today's new share issuance. The board of directors may seek shareholder approval to continue payment of the dividend at the current rate at the annual shareholders meeting in May 2012. Alternatively, the board could propose a lower amount or recommend elimination of dividend payments altogether. The current dividend is not safe, in our view, until the company is operationally "back on track" and earning at least the amount of the annual dividend.”

At this juncture, what Transocean may be offering investors is the quintessential high-yield conundrum. Obviously, yield is appealing, almost mandatory in this environment. However, remember why dividend yields rise. Because stock prices fall. The controversy surrounding Transocean may be too much for the stock to absorb heading into February's legal proceedings and with the dividend already vulnerable, this stock clearly isn't an energy dividend play a la an Exxon Mobil (NYSE: XOM) or ConocoPhillips (NYSE: COP).

Bull case: Transocean settles with BP (NYSE: BP) before February and is able to maintain a cash position that is strong enough to keep the dividend alive at current levels. That or demand for rig's rises and more of the Transocean fleet is put back to work. That could help bolster the company's cash position.

Bear case: We've outlined the bear case for the dividend. For the stock, it's a dividend cut, elimination or suspension. Or the company could be slammed in court in February. Neither scenario is appealing, but investors with a taste for risk might want to have a look at this volatile stock if the legal clouds clear. Just don't treat the dividend as integral to your personal investment thesis. Treat it as icing on the cake, if it's even around in 90 days.