When I was a high school and college student, abortion was illegal in most States and "shotgun weddings" were commonplace. Everybody knew something important was bound to happen in seven or eight months, but we all respected a genteel social pretense that the healthy 7.5-pound babies were premature.
Similar genteel pretenses exist in the financial world. One of the most common pretenses arises when a public company is facing an unavoidable default on a loan agreement or other debt unless it arranges takeout financing to repay the problem creditor.
That's exactly what happened when Tesla Motors (TSLA) repaid its $451.8 million DOE loan on May 22, 2013. Tesla's press release proclaimed that it was the "Only American Car Company To Have Paid Back Government," however the simple truth is that a December 31, 2013 default was inevitable unless Tesla agreed to a shotgun wedding.
It would be perfectly reasonable for an investor to ask, "Since the DOE loan was paid off early and the threat of default is gone, why should I care?" The answer is simple. Tesla's management knew that it would have to refinance the DOE loan before year-end to avoid a certain default, but it didn't adequately disclose that fact to the market.
Tesla's Form 10-K for the year ended December 31, 2012 said:
"We expect that our current sources of liquidity, including cash, cash equivalents, cash held in our dedicated DOE account, together with our current projections of cash flow from operating activities, will provide us adequate liquidity until we reach expected profitability in 2013, based on our current plans. These capital sources will enable us to fund our ongoing operations, continue research and development projects, including those for our planned Model X crossover, establish sales and service centers and to make the investments in tooling and manufacturing capital required to introduce Model X."
Tesla's Form 10-Q for the quarter ended March 31, 2013 included a similar but not identical disclosure:
"We expect that our current sources of liquidity, including cash, cash equivalents, cash held in our dedicated DOE account, together with our current projections of cash flow from operating activities, will continue to provide us with adequate liquidity based on our current plans. These capital sources will enable us to fund our ongoing operations, continue research and development projects, including those for our planned Model X crossover, establish and expand our stores, service centers and Supercharger network and to make the investments in tooling and manufacturing capital required to introduce Model X. If market conditions are favorable, we may evaluate alternatives to opportunistically pursue liquidity options."
References to "expected profitability in 2013" disappeared, the Supercharger network was added as a spending priority and fuzzy disclosure was added to describe a remote-sounding possibility that Tesla might seek additional financing if opportunities presented themselves.
There was no disclosure in either filing that Tesla's wondrous financing product for Model S buyers would virtually guarantee a default on the DOE loan by year-end unless it was able to renegotiate or repay the loan. When Adam Jonas of Morgan Stanley asked about the need for a capital increase during Tesla's Q1 conference call on May 7, 2013, Mr. Musk said:
"Well, we don't have any plans right now to raise funding. Potentially we expect to be - we were positive cash flow in Q1 and we expect to be there relatively sort of neutral on cash flow in Q2. But if it was possible, we could be optimistic about raising a round, but we have spent no time on that at all. So if we were to do a round, it would be for the reasons that you mentioned which is to ensure that if there was some unexpected supply interruption, some sort of risk event, but should potentially protect against a portion of your event that there could be some merit to doing a round."
Eight days later Tesla announced a billion dollar public offering underwritten by Goldman Sachs (GS), Morgan Stanley (MS) and JPMorgan (JPM) that gave it the wherewithal to pay off the DOE loan, eliminate the looming default threat and shore up a dismally feeble balance sheet that had $124.7 million of equity and a $14.2 million working capital deficit on December 31, 2012 and $168.6 million of equity and a $9.6 million working capital deficit on March 31, 2013.
Are Tesla investors that chronologically challenged? Does anybody believe Tesla could conceive, negotiate, document and sell a billion dollar public offering in 10 days?
While I'm the first to concede that parsing loan covenants and understanding their impact on a company's financial condition is both complex and tedious, it's also crucially important work for the lawyers and accountants who are paid to help management fully and fairly disclose the facts about a company's financial condition together with all known trends and uncertainties that are likely to materially impact financial condition in the next 12 months.
The big problem Tesla faced with its DOE loan covenants was the Leverage Ratio embodied in Annex 9.1 to the original DOE loan agreement that prohibited total consolidated debt in excess of 6.5 times EBITDA for Q4-12 and 4.5 times EBITDA for each quarter in 2013. This covenant was a daunting business challenge, which is why it was renegotiated on two separate occasions.
The first waiver on February 22, 2012 delayed the effective date of the Leverage Ratio to Q3-13, but required Tesla to deposit its December 15, 2012 loan payment into a segregated account by February 29, 2012 and further required Tesla to deposit its March 15, and June 15, 2013 loan payments into the segregated account by October 15, 2013.
The second waiver on March 1, 2013 delayed the effective date of the Leverage Ratio to Q4-13, but accelerated Tesla's repayment obligations and required additional pre-payments equal to 20% of its excess cash flow in 2015, if any, and 35% of any excess cash flow thereafter.
Both waivers were presented to the market as triumphs of financial engineering, but they were basically an upmarket equivalent of a credit card issuer increasing minimum payments for a troubled cardholder.
The key financial metric for an analysis of Tesla's covenants under the DOE loan is EBITDA, a widely used and highly standardized non-GAAP measure of financial performance that the vast majority of public companies provide as supplemental information when they report earnings.
Under the DOE loan agreement, which precisely tracks normal calculations for US companies, EBITDA was defined as GAAP Net Income adjusted for the sum of:
- Interest expense;
- Provisions for taxes based on income;
- Depreciation of tangible assets;
- Amortization of intangible assets;
- Gains and losses from certain asset dispositions;
- Income and losses from minority interests;
- Gains and losses from discontinued operations;
- Gains and losses from currency fluctuations;
- Other non-cash items like stock option and warrant costs: and
- Extraordinary gains and losses.
I recently criticized Tesla's abandonment of standardized EBITDA in favor of hypothetical earnings that ignore the requirements of lease accounting, convert corporate borrowings to revenue and present pro-forma data for a company with a different business model. While I don't want to reopen that can of worms, it is important for investors to understand the changes required to conform Tesla's non-GAAP fairy tale to standardized EBITDA.
At March 31, 2013, Tesla's consolidated total debt was $975 million and it knew the planned finance program for Model S buyers would increase its consolidated total debt by at least $75 million per quarter assuming a financing take rate of 30%. Therefore it was a virtual certainty that Tesla's consolidated debt would be in the $1.2 billion dollar range by year-end.
To avoid a default in the Leverage Ratio on December 31, 2013, Tesla would have to report EBITDA of roughly $220 million during 2013. With standardized EBITDA of $9 million in Q1 and clear visibility for another $7 million of standardized EBITDA in Q2, the writing was on the wall in big block letters.
If Tesla didn't promptly renegotiate or repay the DOE loan, it would be in default by year-end. Instead of fully and fairly disclosing that risk and discussing management's plans to mitigate it, Tesla relied on vague half-truths in its SEC filings and deliberately hid the ball when a caller asked about the need for additional financing in its Q1-13 conference call.
As bloggers go, I'm what you'd call a pedantic plodder. I examine one aspect of a company's business model in depth, identify the red flags, and then move on to another issue. Whenever I write about Tesla, I'm inundated with vitriolic comment about why a particular red flag doesn't matter in the grand scheme of the utopian EV vision. Now that the EV landscape is beginning to bear a striking resemblance to a Christo and Jeanne-Claude artwork with red flags everywhere, I think it's high time for sensible investors who care about growing their portfolios and avoiding losses to carefully weigh the huge downside risks of all those red flags against the limited upside opportunity in Tesla's common stock.