In What May Go Down As The Worst Deal Of The Decade, Tesla Wants To Buy SolarCity

| About: Tesla Motors (TSLA)

Summary

There is very little in the form of sales synergies of the combined companies – the much-touted element of the acquisition.

The combined company will be humongous, cash hungry, financially untenable, and will take management's attention at a critical time ahead of the Model 3 launch.

This deal provides a unique opportunity for shorts to take low risk short positions in both stocks as long as they protect themselves from any downside from deal termination.

In a pre-market conference call to support the deal, the Company's counsel claimed that this deal was presented as an offer and not as a definitive agreement because of Elon Musk's holding in the target company.

Per the conference call, the key strategic rationale for the deal is the benefits of combined sales process for generation, storage, and EV. Benefits were also claimed in terms of combined cost structure.

We believe the stated rationale makes very little sense as these products have very different characteristics and sales cycles. A car sale is also much more of an emotional sale compared to the economical nature solar/battery sale.

Mr. Musk, like Mr. Rive, also claims that only 1% of the US is penetrated with solar, we find this claim to be highly misleading. The argument here is that there is somehow unbound growth ahead and there is synergy in the sales cycles. We completely disagree. Solar, BEV, and batteries are at a very different place in terms of their economic feasibility and customer penetration.

SolarCity is already hitting a plateau in terms of residential solar sales whereas BEVs certainly appear to be at the knee of the s-curve. On the other hand, battery technology is several years from reaching meaningful penetration in the US market in terms of residential PV deployment.

As a solution provider, it makes a big difference that the auto industry is a high barrier to entry industry whereas solar panel installation is a low barrier to entry business. Having combined sales efforts in this context makes very little sense.

More damningly, Mr. Musk's comments about Silevo/SolarCity superiority and manufacturing prowess indicates that he vastly overestimates SolarCity's differentiation and underestimates the competition in the solar space. One of the particularly egregious claims during the conference call was Mr. Musk's statement about the combined company's manufacturing prowess: "I'm highly confident we'll be the world's best manufacturer by a margin people don't even think is possible."

We find this claim hard to fathom in the context of SolarCity, which has no meaningful manufacturing experience and has executed poorly on the Buffalo fab. It is especially galling since public disclosures so far indicate that the fab will have an uncompetitive cost structure. Our research suggests that, at the onset of production at the Buffalo fab, SolarCity will have a cost structure north of $0.55 cent a watt whereas other vertically integrated players will have a cost of sub-$0.40 per watt. This cost discrepancy will make it extremely difficult for SolarCity's manufacturing to survive, let alone thrive.

Mr. Musk also claimed, without any supporting thought process, that integration of SolarCity would make Tesla's execution easier and not harder. However, this flies in the face of logic as, at least in the beginning, the acquisition and integration process will at best be distracting. Post-acquisition, it will take considerable amount of management attention to gain whatever imaginary synergies that Tesla sees.

Bottom line is that there is very little in the form of sales synergies - the much-touted element of the pre market call. In fact, we suspect that actual synergies will be negative given the difference between solar panels, batteries and BEVs we have identified above. We expect the cost of sales to go up and not down as management claims.

By almost any measure, the proposed deal from Tesla Motors (NASDAQ:TSLA) to buy SolarCity (NASDAQ:SCTY) stinks. Much has been written about this in other forums. Readers can see some articles from Wall Street Journal and Bloomberg for some perspective.

This proposed deal is in many ways worse than the disastrous SunEdison (OTCPK:SUNEQ) deal to acquire Vivint Solar (NYSE:VSLR). We expect the outcome for Tesla and SolarCity to be somewhat similar. Suffice it to say, we believe this is by far the worst deal investors are likely to see this decade.

SolarCity, as a company, is in a difficult situation. It should be abundantly clear to investors that SolarCity's installation business generates no value and has been destroying shareholder value for the past several years.

SolarCity's prospects are grim and the Company currently does not have enough cash to meet its guidance. The Company is desperately in need of capital in a deteriorating residential solar lease/PPA industry. SolarCity may need to raise a couple of billion of capital in the next 12 to 18 months. As recently as yesterday, Goldman Sachs put out a note showing how poor a situation SolarCity is compared to its peer group. With traditional channels like ABS closing and the market ascribing higher discount rates to assets, the Company's options are limited. If this acquisition were to go through, these capital raise problems would now become Tesla's problems.

SolarCity has had a bad practice of financing long-term needs with short-term debt. It does not help that SolarCity operates with negative working capital and is in a serious cash crunch. The Company also has convertible debt, whose resolution could create up to a billion in additional cash burn for Tesla if and when the time comes to close the deal.

There are certainly no meaningful synergies between Tesla and SolarCity. If anything, SolarCity considerably reduces the attractiveness of Tesla Energy's business. Synergies or not, Tesla Energy's battery business is too tiny today to make much of a meaningful impact today. In the future, buying SolarCity would make Tesla's energy storage solutions less attractive to SolarCity's competitors. Competitors are likely to seek out energy storage solutions from Panasonic, Samsung, LG Chem, BYD, GCL and other players thus dramatically reducing the Total Available Market, or TAM, for Tesla Energy.

One could potentially argue that Tesla can use the high efficiency solar cells that will get built in the Buffalo factory to adorn Tesla's future cars and Tesla Superchargers. However, it should be noted that SolarCity has no proven manufacturing competence and the execution on the Silevo/Buffalo factory has been subpar, behind schedule, and the Company has a demonstrable cost disadvantage compared to its peers. This factory is also likely to require significant cash investments before ramping fully.

Adding insult to injury, SolarCity is not even a growth story. Its growth now largely appears dead. We also believe SolarCity is on track to miss its Q2 as well as full year guidance.

The deal is also being made at an especially sensitive time for Tesla. Tesla has a make-or-break ramp-up of Model 3 ahead of it. Given the unrealistic and aggressive nature of the ramp, Tesla's operations demand undivided attention from the management. A failure here could permanently cripple the Company or worse, drive it into a bankruptcy. It would make little sense at a time like this for the management to be distracted with an ill-thought-out acquisition.

So, the question becomes why does Mr. Musk want to buy SolarCity and why does he want to do it now.

Seeing no meaningful positives and seeing no reasonable logic, we are of the opinion that the purpose of the deal is primarily to preserve Mr. Musk's brand equity.

Tesla is a story stock that relies on the credibility of Elon Musk, and his other venture, SolarCity is about to fail spectacularly. Musk's larger than life image cannot be tarnished by failure. That would be not just a black eye for Musk but a valuation hit for Tesla as fans start questioning Musk's aura of inevitability. Buying SolarCity, for a fraction of Tesla's market cap, would conveniently remove that possibility and reduce the negative impact to the Elon Musk brand name.

Or, so seems to be the thinking. But, we believe, as with a lot of cockamamie schemes from the Musk Empire, this one may end up being a stunningly bad plan.

The acquisition dramatically increases the cash burn and capital needs of the combined company, and in context, the size of the risks that are being taken by Mr. Musk. This dramatically increases the chance of distress at Tesla. With misadventures like this, markets will also bring into question the safety of Tesla car reservation holder deposits. It is not inconceivable that, post this news, we will start seeing an actual decline in Model 3 reservations.

As such, it is clear that few sane investors will buy into Mr. Musk's narrative that this deal is blindingly obvious. The questions that investors were recently asking of SolarCity such as "What is SolarCity?" "What is the purpose of the Company?" "What is the Company's business plan?" will now become questions to Tesla. "What is Tesla?" "What is the purpose of the Company" "What is Tesla's business plan?" "Is Tesla not an auto manufacturer?" If there are no compelling answers, investors will start lining up for the exits.

In fact, the exodus may have begun immediately after the announcement and this exodus will likely gain strength over time. We can easily see Tesla stock sinking into double digits and thus depressing the deal value. Such a stock price compression may lead Tesla's board to terminate the acquisition.

There is very little doubt in many savvy investor's minds that both Tesla and SolarCity are overvalued companies. Combining the companies only makes this overvaluation a bigger issue.

While we have long believed Tesla was overvalued, we have never seen the stock as a short as there was no clear catalyst to overcome the Company's cult status. We believe this deal changes that narrative. We now advocate a short in Tesla as well.

From SolarCity's front, the uncertainty of the deal closure could impact necessary capital raises and further distress the stock similar to what we have seen with Vivint Solar. If the deal does close, it is likely to be at a significantly lower valuation than what is being currently contemplated. SolarCity stock is unlikely to do well whether the deal closes or does not close. In other words, SolarCity will go down by itself or take Tesla with it. We, therefore, continue advocating a short on this name.

This deal provides a unique opportunity for shorts to take low risk short positions in both stocks as long as they protect themselves from any downside from deal termination. Protection is mandatory since the chances of a bad deal like this unraveling are considerable. More so in this particular case given that Mr. Musk has recused himself from voting due to conflict of interest.

Epilog:

To gain synergies, there have to be two strong operations with strategic overlap.

What we have with Tesla is a company that is burning cash profusely and is in a make-it or a break-it situation with its Model 3 ramp. In SolarCity, what we have is a financially troubled company with a broken business model that is in distress.

There are no real sales synergies between solar panels, batteries and BEVs as they have different characteristics, different supply chain dynamics, and are likely to have different customer penetration levels.

It is not difficult to see that two people with 150+ IQ can come together to get to a 160 or 170 combined IQ. However, if two people with sub-100 IQ get together the combined IQ could drop to an 80 or a 90. It is this latter category that this Tesla/SolarCity merger fits into - two weak companies that become weaker when together.

Beyond Mr. Musk's vanity, we see nothing here for investors.

Our View: Short Tesla and SolarCity.

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.