The three cardinal rules of entrepreneurial corporate finance are:
- Take the money because projects always take longer and cost more than the plan contemplates;
- Never promise to repay the money if you don't have the current operating liquidity to service both interest and principal; and
- Obey the securities laws.
While Tesla Motors (NASDAQ:TSLA) has a firm grasp on the first and third rules, it has ignored the second rule and created a capital structure from the seventh circle of investor hell.
After Friday's close, Tesla filed a 424(b)(5) prospectus for $800 million in convertible senior notes due 2019 and another $1,200 million in convertible senior notes due 2019. Since I believe the underwriters will exercise their over-allotment option, I expect Tesla's Q1-14 balance sheet to reflect the following core capital structure (in millions):
Convertible notes due 2018 (face amount)
Convertible notes due 2019 (face amount)
Convertible notes due 2021 (face amount)
Total long-term debt
Stockholders' equity (net of conversion features)
That means each share of Tesla's common stock represents $3 of hard net worth and $241 of hopes and dreams, encumbered by $24 in hard debt that must be paid come hell or high water. Tesla's stock price is 98.75% air, resulting in a BS to book ratio of 80. The only way to fix the problem and give Tesla a sensible and rational capital structure is to raise a billion or two in new equity by selling shares of common stock, lots of shares.
The justification for Tesla's immense debt offering was a quintessential Silicon Valley presentation (a/k/a back of a napkin) for a proposed lithium-ion battery Gigafactory that will:
- Vertically integrate the production process and potentially give rise to economies by bringing everything under one roof;
- Make cylindrical 18650 cells that nobody else uses because they're the battery equivalent of a floppy disk;
- Double global manufacturing capacity from 35 to 70 GWh;
- Triple the current supply glut from 15 to 50 GWh; and
- Create incredible supply chain pressures for key raw materials.
Tesla essentially wants to turn an existing capacity glut into a Gigaglut and transform nagging supply chain issues into gargantuan supply chain problems. It may drive down costs through vertical integration, but it will savage everybody's profitability in the process, including its own.
If everything comes together perfectly, Tesla will ramp its EV sales from 22,500 units in 2013 to 500,000 units in 2020, the $660 million in 2018 notes will be converted into 5.3 million common shares, the $920 million in 2019 notes will be converted into 2.6 million common shares, and the $1,380 million in 2021 notes will be converted into 3.8 million common shares. In that scenario, stockholders will own 91% of a successful niche player in the global automotive market.
If everything doesn't come together perfectly and Tesla doesn't have a big enough equity cushion to carry it through the glut phase, the note holders will force Tesla into Chapter 11 and stockholders will be lucky if they end up owning 5% of a viable niche player in the luxury car segment.
The crazy part of the entire exercise is that if the Gigafactory is built, then Tesla will have 5 to 8 billion reasons to resist further progress in battery technology that might make the Gigafactory obsolete.
A hundred and thirty years ago, Thomas Edison observed, "The storage battery is one of those peculiar things which appeals to the imagination, and no more perfect thing could be desired by stock swindlers than that very selfsame thing." Today it seems that the same can be said for proposed Gigafactories that boggle the mind with their sheer scale and complexity.
Frankly I find Tesla's Ray Kinsella approach, "if we build it they will come," more than a bit disconcerting. In fact, it strikes me as a recipe for disaster.
Every few years a business concept comes along that fires the market's imagination and results in parabolic stock price charts that are completely divorced from business reality. Examples include Ballard Power (NASDAQ:BLDP), Plug Power (NASDAQ:PLUG), Pacific Ethanol (NASDAQ:PEIX) and a host of others. The phenomenon is so common and so repetitive that scholars have studied the progression, identified the principal phases and developed graphs like this one from Jean-Paul Rodrique of Hofstra University that bears a striking resemblance to Tesla's three-year price chart. Maybe that's why I'm seeing so many articles proclaiming that a new paradigm has arrived.
A slightly less theoretical and far more relevant example of the phenomenon shows what happened shortly after I started blogging when another famous billionaire invested in another company that planned to make electric cars and batteries to power them.
Over the last six years, I've written about one catastrophic failure after another in the battery industry. A complete archive of my work is available here on Seeking Alpha. The common problem in all the major failures was too much leverage and not enough equity.
Archimedes said, "Give me a lever long enough and a fulcrum on which to place it, and I shall move the world." Tesla has the lever thing down pat, but the only relevant fulcrum for financial leverage is equity and that is sorely lacking.
Inexperienced investors always argue that it's different this time. Seasoned professionals always remember that Albert Einstein defined insanity as "doing the same thing over and over again and expecting different results."
Tesla may be able to pull all the pieces together, build a Gigafactory, realize planned economies of vertical integration, find willing markets for its products and survive the financial bloodbath of a Gigaglut, but it can't possibly accomplish those goals without enough stockholders' equity.
Since there will be blood in the streets, I'll be sitting on the sidelines trying to keep my feet dry.