The Model 3 Reveal: Tesla Appears Poised To Issue Debt And $2 Billion In Equity

| About: Tesla Motors (TSLA)

Summary

As Tesla prepares to accept Model 3 reservations, bears should be wary of some positive developments, and bulls should take note of some negative ones.

Tesla is likely to raise at least $300 million from Model 3 deposits and then another $2 billion or so in an April or May equity offering.

Several recent developments are difficult to interpret. While they ultimately could prove either good or bad, right now they appear worrisome and merit careful watching.

By the way, Tesla just announced a three-year delay in its Gigafactory timetable. It broke the news so quietly that you probably didn't even notice.

The impending Model 3 reveal has some Tesla (NASDAQ:TSLA) bulls in a fever pitch of frenzied glee. Tesla enthusiasts are proudly announcing that they will reserve one, three, a half-dozen or more and give them to their parents, their children and their friends.

These are not empty promises. Tesla may well have the most loyal customer base of any automobile company on earth. Tesla owners (who often are shareholders as well) are committed to the firm's mission and eager to help assure its success.

Click to enlarge

(Tesla Supercharger in Bozeman, MT; Montana Skeptic photo)

The Tesla faithful expect the company to raise hundreds of millions of dollars in Model 3 deposits. They are almost surely right about that.

They also believe the tsunami of Model 3 reservations will be a triumphant vindication of their faith in the firm's fundamental value. They are almost surely wrong about that.

The advent of the Model 3 presents an opportune moment to survey the landscape. As we do so, we identify several promising factors that are good for Tesla and several concerning developments that are bad.

We also see portents that might ultimately prove either good or bad but that now have a decidedly disquieting cast.

I. The Good

Let's begin with a few factors that are decidedly positive for the company's business prospects:

Tesla will raise $300 million or more in Model 3 deposits.

Tesla will likely secure at least 300,000 Model 3 reservations within a month of the March 31 prototype reveal (which would translate to $300 million in deposits). Indeed, I would not be surprised to see 400,000 reservations, or more, during Q2.

The resulting $400 million in cash will be most welcome. Tesla is likely to incur further operating losses during Q1. Assuming that during the balance of the year the company can break even on operations (which I define as operating cash flow plus cash flow from leasing, but excluding capex and ABL or other financing), then $400 million in Model 3 reservations would cover almost 30% of Tesla's promised $1.5 billion in 2016 capital expenditures.

Every dollar in the company's coffers is another dollar that's not borrowed on its asset-backed line of credit, and hence represents an interest savings as well.

Tesla is likely to meet its Q1 delivery guidance.

Tesla's 16,000 Q1 delivery guidance represents a drop-off from the deliveries achieved last quarter and is 4,000 cars fewer than the 20,000 quarterly average needed to achieve its low-end 2016 low-end guidance of 80,000.

However, even though the Q1 guidance is modest, Tesla watchers will likely give the firm some credit for meeting it. And it now appears more likely that the company will do so, thanks to a recent and rapid ramp-up of Model X deliveries.

Here's how things stack up:

  • About 90% of Model X orders in the U.S. are for the P90D or 90D versions. Tesla is giving top priority to deliveries of its performance version 90kWh Model X cars (the P90D). It appears that by the end of March, Tesla will have delivered essentially all of the P90Ds.
  • Next up are the California non-performance 90Ds. It appears that those also will be delivered this month.
  • The third priority is for 90Ds outside California. It looks as if a fair number of those will be delivered this month as well.

While I doubt Model S Q1 deliveries will total more than 12,500, it looks increasingly likely that the company will deliver close to 3,500 Model X cars. So, my earlier prediction that Tesla would strain to deliver 15,000 cars in Q1 is likely to be wrong.

Tesla's stock price has recovered nicely over the past month.

In the short term, the prices of many publicly traded stocks are much more the function of emotion than rational calculation. That is certainly true of Tesla, whose stock price is highly volatile and completely unmoored from fundamentals.

I like the metaphor suggested by "bulbtrader," who posts at the Yahoo Tesla message board. bulbtrader believes that the stock prices eventually arrive at fundamental value, but describes the path there as one taken by an untrained dog off its leash. In following its owner, the dog continually veers off the path to sniff over here and then bound over there.

Over any short distance, a map of the dog's path appears as crazy zigs and erratic zags. Only over a lengthy jaunt does the true destination become apparent.

For that reason, I usually pay little attention to Tesla's day-to-day, week-to-week, or even month-to-month stock price. However, right now, I think it's highly significant that the price has risen sharply since it dipped below $145 in early February.

It's significant because (as discussed later) Tesla will surely issue more stock in 2016 in order to raise $1 billion or more. The higher the stock price, the lower the dilution. The recovery in stock price over the past several weeks is undeniably a big plus for Tesla shareholders.

II. The Bad

If you want only happy talk about Tesla, you can skip the rest of the article. However, if you want to weigh the good with the bad, consider these:

Model 3 deposits will mask Model S and X demand weakness.

Tesla is going to begin accepting Model 3 deposits on the final day of Q1.

Consider for a moment that had the company waited until the first day of Q2, then the Q1 "customer deposits" figure would offer a far clearer indication of the strength of Model S and X demand. Is it any accident that Model 3 deposits will be accepted starting on March 31?

I don't think so. Combine the March 31 Model 3 deposit date with the decision to stop reporting the number of Model X reservations in the most recent 10-K, and you have a company that appears eager to hide some dismal information.

The Model X backlog is rapidly shrinking.

How refreshing it would be to hear an analyst pose the following simple question to CEO Elon Musk at the upcoming May conference call: "How many Model X reservations do you now have?"

And how refreshing it would be if Musk were to answer the question without evasion.

Ah, well, one can dream.

While we're unlikely to hear either the question or the answer, I'm confident that the truthful answer would be, "Fewer than 2,000." It might well be, "Fewer than 1,000."

I have recently reported on the low yield Tesla is experiencing on Model X reservations. The company is not only failing to report this low yield, it is cleverly disguising it. Consider the claim in the February 10 Shareholder Letter:

Model X reservations grew over 75% as compared to the prior year despite extremely limited initial exposure for this vehicle.

For this statistic to be meaningful, Tesla would need to disclose the reservation totals for 2014 and 2015. It has disclosed neither.

A higher number of Model X reservations in 2015 than 2014 was entirely predictable. The heaviest concentration of Model X reservations came in 2012, after the prototype was revealed in February of that year. Reservation activity then tailed off during the next two years as additional delays became apparent.

Finally, on September 29, 2015, Tesla revealed its production model and began opening its online "Design Studio." In the immediate build-up to, and wake of, the September 29 event, it was entirely foreseeable that Model X reservations would increase.

Putting aside the company's misleading 75% growth statistic, the data continues to support my calculation of a Model X yield on original sequence reservations of no more than 25%.

Will non-U.S. reservations save the day? Not in Canada - the Canadian reservation yield so far appears meager, even relative to the skinny U.S. result, despite recent price cuts.

Perhaps Europe will be better, though it's hard to imagine why. If Model S demand is a proxy for demand, then there is trouble ahead in Europe.

With the expiration of a substantial tax exemption, Model S demand in Denmark has all but evaporated. It appears that Tesla will deliver fewer than 40 Model S cars in Denmark this quarter, compared to 219 in Q1 2015.

Model S sales also appear to be suffering in Tesla's largest European market, Norway. There, the company is unlikely to match its Q1 2015 delivery number of 1,532. It may fall far short.

It's not the low yield on earlier Model X reservations that's most ominous. It's the thin ongoing demand.

New Model X reservations are arriving at a rate of fewer than 100 per week, compared to the 800-1,000 per week promised by Musk. This is a difference not merely in numbers, but in magnitude.

Assuming Tesla at least matches its March Model X production rate in Q2, then by mid-May, the company will have caught up with any Model X reservation backlog. After that, it will be lucky to average even as many as 200 Model X sales per week.

It's time to face facts: this car is very expensive and idiosyncratic. It may be, as one of my Canadian friends calls it, the fastest minivan out there, but it is finding very thin demand and is plagued with quality issues. It is likely to be a big money loser.

The dark side of meeting Q1 delivery guidance...

Tesla is achieving its Q1 guidance by pushing problem-plagued Model X cars out the door. Don't take my word for it - read the comments from some disappointed Model X buyers.

As these comments make clear, the company's mad dash to deliver Model X cars in Q1 is already creating a boomerang effect as cars prepared and delivered by Service Centers come right back days later, accompanied by lengthy punch lists.

Those Service Centers, already stretched thin by Model S appointment backlogs and the extensive preparation required for Model X deliveries, are likely to see an even greater strain over the next several months as they continue to resolve the issues raised by attentive Model X buyers.

The loss of goodwill from what had been unwaveringly loyal Tesla customers is unlikely to enhance the Model X's prospects.

Tesla will issue more capital soon.

I've done the math many times. Tesla needs more than a billion dollars more just for Model 3 development and production tooling. It needs another billion to finish the Gigafactory.

On top of that, as it has recognized, the company needs more Service Centers and Superchargers.

And as the Model S approaches its fourth anniversary and sees flattening demand, it may be due for a significant refresh. A typical "mid-cycle action" would include new fascias, front and rear, fenders, headlamps, tail lamp, hood, possibly the deck lid and any affected valance and trim panels. It also would include new wheels and an updated interior consisting of new console, instrument panel, door panels, and possibly, seats.

A rough estimate for such a mid-cycle action, which would be good for another three years or so of production, is anywhere from $150 million to $300 million. A less expensive "incremental" refresh would include only a fascia change, but would be less potent in enhancing demand.

(For the record, I think the Model S exterior is stunningly attractive. It's among the most attractive sedans ever built. To me, the changes that could make the most difference would be to the interior.)

Meanwhile, Tesla continues to lose money just on operations. Its promise of an imminent positive free cash flow status is like the fruit that Tantalus eternally stretches to grasp. It is said to be close, but somehow manages to be always out of reach.

When is the most auspicious time for the next capital raise? I think it's soon after the Model 3 reveal, when Tesla can boast of hundreds of thousands of reservations, but before the release of Q1 financial results. So, at some point in April or early May.

How much will Tesla raise? Much more than the $738 million of net proceeds it raised last August. The company knows that after the Model 3 release, it faces a long dry spell punctuated by disappointing delivery numbers and operating results.

What form will it take? It won't be straight debt. Tesla's asset-backed loan agreement restricts debt issuance. More fundamentally, its bonds that mature in 2019 and 2021 are trading at discounts that imply a yield of 10% or so on new debt.

That would seem to leave straight equity, or equity with an attractive conversion feature, or preferred stock. I can promise you that even as Patrick Archambault maintains his TSLA price targets despite having continuously and embarrassingly overestimated the company's operating results, his investment banking colleagues at Goldman Sachs & Co. are hard at work cooking up the next secondary offering.

Ah, you say, but in its February 10 Shareholder Letter Tesla explicitly stated that it would not raise any capital in 2016:

We plan to fund about $1.5 billion in capital expenditures without accessing any outside capital other than our existing sources that support our leasing and finished goods inventory.

The company has said similar things on two prior occasions, and has immediately thereafter done that which it said it would not do. The details are here (interchange with Adam Jonas) and here (interchange with John J. Murphy).

There's another name for those Model 3 deposits.

I call Model 3 deposits "$1,000 non-interest bearing, 30-day demand notes." Calling them by that (accurate) name illuminates some important implications.

First, the deposit maker can demand a refund at any time. If, and to the extent that, Tesla shareholders make deposits in an attempt to "game" the system and inflate the stock price, as Anton Wahlman has speculated may happen, those deposits can be recovered at any time.

I have no idea whether such gaming actually will occur (and neither do you, because if it happens, it's unlikely to be apparent to any outsider, and it may not be apparent even to Tesla). If such gaming does occur, though, then investors snapping up newly issued TSLA stock this April or May on the strength of hundreds of thousands of Model 3 reservations may later discover that some of their invested funds will have been used to refund Model 3 reservations.

Even if there is little or no reservation gaming, there will be refunds down the road as some reservation holders see their circumstances change and others become frustrated by the wait time (on the TMC forum boards, "Tesla time" is not a complimentary term), and others are disappointed to learn that the only Model 3s initially available will be fully-loaded versions costing more than $50,000, and yet others realize their car is unlikely to qualify for the $7,500 federal income tax credit.

Moreover, a deposit is not revenue for income statement purposes. It is a liability for balance sheet purposes. The cash will quickly be consumed, but the liability will remain on the balance sheet.

This has two consequences. If Tesla survives long enough to make the Model 3, the $1,000 deposit credited on each purchase price will reduce the revenues from a car that is sure to have slim margins.

Second, if the company does not survive that long, equity holders will have yet another class of creditors who will have to be paid in full before the equity claims are even considered.

III. The Ugly

There are some developments which, while too early to label as bad, seem just plain ugly.

About your luxury loaner car...

With great fanfare, Tesla announced in 2013 that its loaner cars would all be "the top-end, most luxurious Model S Performance version with the 85-kilowatt-hour battery pack and punchier acceleration than lesser models."

With no fanfare at all, the company has now moved into its loaner pool most or all of its CPO cars listed at under $60,000.

Perhaps this was another decision by "cash is king" CFO Jason Wheeler, and perhaps it makes sense in a short-term bean counter way. However, most OEMs in the traditional automobile industry, (for which Musk has shown contempt) would take a dim view of this practice.

Might the traditional auto industry view be the product of some wisdom gained from experience? Might the traditional practice better align with customer expectations or enhance the efficiency and reputation of a CPO program? Tesla will soon find out.

10kWh Powerwalls: Off the hook yesterday, off the menu today

A year ago, Elon Musk described Powerwall demand as "off the hook," and his company claimed that in the space of several days, it had collected 38,000 pre-orders (no deposit required) from distributors around the world.

More recently, Tesla quietly removed all references to the 10kWh Powerwall from its website and press pack.

It turns out that the 10kWh Powerwall is not economically practical as a back-up source when the power goes down. Gee, who could have seen that coming?

Tesla is still offering the 7kWh battery (which, it turns out, stores only 6.4 kWh of energy). With a 55-year payback period, it should succeed famously.

Musk has repeatedly made extravagant projections about revenues and margins for the Tesla Power business. Only last year, he predicted Tesla Energy revenues of $40-45 million in 2015, up to $450 million this year and "at least a few billion dollars" in 2017. He promised margins would start at 15% and climb significantly as the ramp-up occurred.

(See interchanges with Rod Lache here and Colin Langan here.)

Musk's projections did not pan out last year, are not panning out this year and are highly unlikely to pan out next year. Absent all 50 states adopting subsidy programs as wasteful and costly as California's Self-Generation Incentive Program (SGIP), those projections will never pan out.

(And even California - like Puerto Rico, Illinois, Kentucky and Connecticut - is about to discover that it has been spending money that it doesn't have.)

Insider stock sales

Does anyone think it's a positive sign that Kimbal Musk just sold $3 million worth of Tesla stock?

Has anyone noticed that Kimbal's options did not have to be exercised before June 2019, and that he appears to sell as soon as his options vest down to about the number of shares he has pledged on his personal loans from the banking affiliates of Tesla's underwriters?

What might that suggest?

And could it be possible that even though his divorce lawyer is now Tesla's general counsel, Elon Musk did not have a prenuptial agreement with Talulah Riley?

If Ms. Riley is awarded Tesla shares (and the bulk of Elon Musk's wealth is in such shares), then what might be the consequences?

The departed

Earlier this month, Tesla announced the departure of its vice president of Global Communications, Ricardo Reyes.

Last week, as Seeking Alpha Contributor Bill Maurer has discussed, came word that the firm's executive vice president of Finance and Worldwide Controller, Michael Zanoni, was returning to Amazon (NASDAQ:AMZN).

These developments may be typical of Silicon Valley turnover, but they certainly cannot be viewed as positive events this close to the Model 3 launch. At a minimum, the departures highlight how Tesla faces increasing competition for engineering and financial talent not just from Silicon Valley tech companies, but from automobile OEMs and parts manufacturers as well.

Many of the firms in the Silicon Valley roster of auto industry competitors may not have Tesla's "cool" factor, but most of them are consistently profitable, and hence, may appear more stable as employers.

Where are those 70D Model Xs?

You know, the ones that were going to start at $81,200 (but without features that for many will be "must-have," such as third-row seats, Autopilot, air suspensions and Sirius XM capability)?

Does it seem a bit odd that Tesla hasn't invited any 70D reservation holders to configure and order? Its Model X web pages now omit any reference to the 70D; only 90s are being offered right now.

Is the Model X 70 about to join the Model S 40 and Model S 60 in the Tesla history museum? Will this be yet another instance in which the company announces some feature or product with great fanfare, and then quietly changes course with nary a word said?

Tesla can't escape the most ineluctable law...

Despite all my legal training and experience, there remains one law I will forever be unable to master, anticipate, or evade: the law of unintended consequences. I'm not alone - all of us are helpless in the face of this law.

Perhaps you're ecstatic about the coming flood of Model 3 reservations. But have you asked yourself, what if the Model 3 reservations cannibalize Model S demand?

And what happens when the Model 3 finally arrives? Tesla may find itself with Model 3 reservations totaling 300,000 or more, but with only 50,000 or so $7,500 federal income tax credits remaining.

Moreover, it will have on hand Model S and Model X orders to consider. The margin on a fully-loaded $140,000 Model X is probably much higher than the margin on even a fully-loaded Model 3. As the tax credit clock ticks down, which delivery does Tesla favor?

If Model S and Model X experience are any guides, order sequence will have little to do with who gets the first deliveries. Instead, those cars may go to buyers opting for the highest-margin cars, or buyers closest to Fremont or buyers located close enough to enable Tesla to meet the then-current quarter's delivery guidance.

Months ago, I suggested that Tesla needs to provide a detailed written policy for its delivery priority, and to make full disclosures of the risks of making a deposit. (See Part E here).

It's a good thing I'm not sensitive, because Tesla has ignored my advice. The only guidance the company has given about how it will solve these problems is to say that it will deliver North American Model 3 cars first, starting on the West Coast and then moving east. It has not said anything about how it will choose between Model S, Model X and Model 3 orders or how it will prioritize between base versions and higher-priced versions.

Consequently, when the Model 3 finally does arrive, the company is likely to face a public relations nightmare. Is it just possible that Ricardo Reyes saw this coming?

Yeah, we were just kidding about finishing the Gigafactory in 2017.

I wrote several pieces outlining how Tesla is far behind in its Gigafactory construction and has also failed to keep its promises to the State of Nevada about how many construction workers and Gigafactory workers it would employ.

I took a bit deal of grief from commenters who insisted it was not so.

Tesla recently confirmed that I was correct, when it toured journalists through the Gigafactory. During the tour, a company spokesman (the journalists were not allowed to identify him) stated that Tesla has adjusted its schedule: completion of the entire (13.6 million square feet) factory, originally scheduled for October 2017, has been pushed to some time in 2020:

Originally, we were going to build the whole building all at once, but that didn't make a lot of sense. We needed to begin producing faster. We are stepping into it in modular fashion so that as we build we can learn from what we've built.

Do you buy that explanation? I don't.

All along, we have been told that the Gigafactory is essential to the enormous savings Tesla promises to achieve on the Model 3, which is promised for 2017. Now we learn construction has stopped after only 1.9 million square feet (14% of the promised total), and the company won't even complete the Gigafactory until three years after the Model 3 is to begin production.

Also, could Tesla have chosen a more casual, anonymous, off-hand way to acknowledge something so fundamental as a three-year delay to its much-ballyhooed Gigafactory?

If the portion of the financial press that is not totally in the bag for the company were awake, it would prominently report this news. If Tesla's "analysts" were other than a collection of deeply conflicted underwriters, on the one hand, and infatuated schoolgirls (yes, we're pointing at you, Andrea James and Trip Chowdhry), on the other, they would promptly revise their price targets.

Is Tesla building throwaway cars?

Russell Graves recently published an intriguing and well-researched blog post asking that question. His post is deservedly getting a lot of attention.

I recommend a close read. Then ask yourself, how on earth will Tesla be able to service several hundred thousand Model 3s without vastly expanding its repair network?

I would add one point to those made by Mr. Graves. As the company's cars on the road continue to age, auto insurance may be another factor that contributes to a Tesla's throwaway attributes.

The cost of insuring a Model S has been rising as insurance companies discover how expensive the car is to repair and how easy it is total. The cost of insuring a Model X is significantly higher than that of the Model S.

That's no problem for affluent Tesla new car buyers. Most don't even notice - for them, an extra thousand or two dollars per year for insurance is a rounding error.

For those whose only hope of driving a Tesla is to pick up a four- or five-year-old Model S for less than $40,000, however, the extra cost will bite much deeper.

Yes, we continue to doubt that the Model 3, in any configuration anyone wants to own, will cost $45,000 or more. But even if a Model 3 version actually comes to market (before incentives) for the promised $35,000, the same Model S problems outlined by Russell Graves will apply even more forcefully to the Model 3.

Just how special are Tesla's patents (and how truly "green" is the car)?

A firm called Devonshire Research Group recently published a lengthy and seemingly well-researched report on Tesla Motors (you can find it here, under the "Research" tab).

The Devonshire report does a thorough job of arguing the case for why TSLA is highly overvalued, though that has been done many times before, and the stock price has been impressively impervious to such analyses.

The especially new and intriguing parts of the report are: (1) an examination of the company's intellectual property and engineering capability (spoiler: Tesla has few patents of value, and has less capacity for innovation than its competitors); and (2) a discussion of why, viewed from cradle to grave, electric vehicles create numerous types of environmental harm.

I know nothing about Devonshire Research Group. I have not attempted to evaluate the soundness of its research. Obviously, as Devonshire discloses it has a short position in Tesla, one should read its work with that bias in mind.

But the report was obviously prepared with care and has some fascinating graphics. Whether you are a Tesla bull or bear, it's worth a close read.

And what if Devonshire is right? Might they be mistaken, those who so endlessly proclaim that Tesla cars herald the dawn of a new and glorious environmentally green era? Would they be open to considering that possibility and adjusting their policy prescriptions?

I invite those who see flaws in Devonshire research to share their view in the comments.

Noisy promises and hushed retreats

Exuberant celebration of battery-swapping capabilities. Which is quietly walked back.

Excited hoopla over the growing Model X reservation number. Which silently disappears.

Boisterous buzz about free (and then $100) for unlimited ranger service. Which disappears with hardly a whisper.

Off-the-hook demand for the 10kWh Powerwall. Which steals away in the night.

Great fanfare for high-performance loaner cars. Which ends with a muted policy change.

Endless hype about the staggering size of, and cost savings resulting from, the Gigafactory. Which is delayed for three years with a back-handed mention.

Does anyone notice a pattern here?

A Note About My Contributors

I have dispensed with the evidently annoying habit of using the first person plural (thank you, phexac), but have not stopped relying on - and borrowing shamelessly from - the great insights from thoughtful commenters here and at the Yahoo Tesla board.

In this article, I have relied heavily on posts by xonkd at Seeking Alpha, and bulbtrader, n0m0renancy, temagami, freestyledesign2015 and donroband at the Tesla Yahoo board.

As always, none of them necessarily joins in all points of my analysis, and I alone am responsible for my errors.

Disclosure: I am/we are short TSLA VIA LONG-DATED PUTS.

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.