Tesla: My Evaluation Of The SolarCity Deal

| About: Tesla Motors (TSLA)

Summary

SolarCity doesn't seem to be a good business at the moment despite its future potential.

Although fundamentally it is a very small stake Tesla can certainly afford, it creates more uncertainty in its future cash flow and capital structure.

In terms of market interpretation, the most significant impact is on the quantitative metrics such as FCF and debt ratio.

Is SolarCity (NASDAQ:SCTY) a Good Business?

As the potential deal to buy SolarCity at $25-28 just announced, the price of Tesla (NASDAQ:TSLA) dropped 10% in the after-hours market. Apparently, the market was negative on the deal. This brings a fundamental question: Is this a good decision? And is SolarCity a good business?

Frankly, I don't know enough about the solar installation industry to tell for sure. However, it seems that both equity investors and debt investors didn't feel SolarCity was in a good business.

First, its share price has dropped significantly from $80 in peak to $21, which is back to the same level three years ago (after its revenue almost tripled in the last three years). Second, or more importantly, if its solar installations are good deals, there should be enough banks or financial partners willing to invest along with SolarCity. However, what we have seen is that the financing of these installs are largely using SolarCity's own credit.

Based on its 2015 annual report, SolarCity's asset-backed security is only about $400 million (which is the funding from the third parties without using SCTY's own credits), but its own long-term debt is $2.1 billion ($1.2 billion long-term debt, plus $0.9 billion convertible senior notes).

If SolarCity really acted as a good "platform", I would expect it to have funded its operations more through securitization instead of its own credit borrowing.

Its long-term borrowings are also mostly in short-durations (mostly due in 1-3 years), which seems to be a mismatch with its long-term commitment on the solar systems (usually 10-25 years).

This kind of capital structure brings a question about the attractiveness of the business model to the capital markets, especially considering that we are in a market that is hungry for yield and flows with cheap credits.

The Negative Cash Flow

Tesla is already in a capital-intensive business and already had a negative free cash flow for many years, and had to raise capital many times. Now, after the acquisition of SolarCity, the question is how SCTY, as a subsidiary of TSLA now, can fund its future operations (with or without growth).

In the last year, SolarCity seems to have over $2 billion negative cash flows. Given the lack of interests from capital markets, if SolarCity continues to fund its operation by debts, the cost will be quite high. If it uses credit guaranty from Tesla, the debt cost may be reduced, but in that way, it simply transfers the risk to TSLA.

Even if it doesn't use any guaranty from Tesla, the negative cash flow and debt ratio will both deteriorate very much on TSLA's consolidated balance sheet, and in turn it will affect Tesla's valuation.

Conclusion

In my opinion, the acquisition of SolarCity adds a lot of uncertainty on Tesla's future cash flow deployment. To sustain the existing scale of SolarCity, Tesla has to come up with a plan on how to fund its operations without adding too much risk to its own business.

That said, there might be a time that SolarCity's installation business can become very attractive, especially if Tesla can find a way to get cheap solar systems (including the battery back-up systems). This outlook has a lot of uncertainty though since the demand and pricing of home/commercial battery storage is still not there yet. Also, the cost of solar system installation is also largely on installation service and advertising at the moment.

Overall, Tesla is still one of the high-quality companies that could see huge growth potential later on. Therefore, at least for individual investors, shorting it at the current price, or even at some level much higher, doesn't seem to be a wise choice. In other words, in my opinion, the new uncertainty added by the SolarCity deal should bring more caution instead of an overly bearish view.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within 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.