Tesla, SolarCity And The Race To The Bottom

| About: Tesla Motors (TSLA)

Wall Street has always been captivated by controversial companies, controversial leaders, and controversial mergers. Tesla's shocking offer to buy SolarCity on Tuesday featured all three, so it was no surprise that the deal instantly seemed like a bigger story than the presidential race, gun control, ISIS, and Brexit. It even managed to make the last controversial company that dominated headlines, Valeant Pharmaceuticals (NYSE:VRX), seem like an afterthought.

A few people have written in asking my opinion of the deal. The short answer is, I believe investors are well advised to avoid both stocks like the plague. As separate entities, these companies are wildly overvalued story stocks with a good chance of going broke. Together, they will form one wildly overvalued story stock with a good chance of going broke.

SolarCity is run by two of Elon Musk's cousins and has consistently lost money providing loans to folks to buy solar panels. I can't see how an acquisition by Tesla would help this dodgy business model succeed. If anything, it could make things worse. A flurry of lawsuits will inevitably follow the deal, as ambulance-chasing lawyers will almost certainly accuse Musk of bailing out his potentially catastrophic investment in SolarCity with Tesla's balance sheet.

I recently dined with the CEO of a solar installer. We had a fascinating discussion about the industry. The executive said that SolarCity could (and possibly should) go bankrupt and that it has a negative 25 percent margin on cash (not lease) sales that hurts other operators in the space. He also bemoaned the fact Wall Street, which loves fee-generating clients like SolarCity, fails to emphasize this glaring flaw in its reports on the company. Most intriguingly, he claimed that the recent extension of the investment tax credit for solar, which SolarCity supported, would harm, not help the industry. Why? Because it will unfairly keep struggling operators like SolarCity alive and allow them to continue to cut prices so that all companies in the sector lose money.

Speaking of losing money, Tesla might be an even bigger mess than SolarCity. It sold a paltry 50,000 cars last year and lost almost a billion dollars in the process. It also has a mountain of debt. Most analysts, including Musk himself, believe Tesla needs to sell 300-400,000 cars annually to be a survivor in the brutal auto industry. To accomplish that massive leap in production, Tesla is counting on its recently announced Model 3, which the company is working to ship in late 2017 and will reportedly sell for about half of the current Model S's $75-85k sticker price.

Setting aside Tesla's enormously ambitious plans for the Model 3 rollout and its troubling history of issuing (and failing to live up to) overly optimistic guidance, two further issues may come to haunt the company. First, I'm not sure the cars it produce are as wonderful as everyone thinks they are. The Model X SUV has been an unmitigated disaster. And while the flagship Model S has a sleek design, one review said comparing its interior to an Audi A8 is like comparing a Burger King to Buckingham Palace. Second, the environmental benefits of an all-electric car may be less, perhaps much less, robust than the company claims.

Sure, some Tesla enthusiasts may be able to afford to clad their homes in enough solar panels to go completely "off the grid," but the vast majority of car buyers still receive their electricity from traditional utilities, which means power comes into their homes largely from generation plants that rely on fossil fuels like coal, oil, and natural gas. Furthermore, the sizeable battery packs in electric cars lose capacity over time (estimates are 10 percent degradation annually), and eventually need to be discarded. While less polluting than nuclear fuel rods, those battery packs aren't exactly green waste. They're toxic. And yet, this issue is rarely discussed by the company or understood by Tesla buyers, many of whom reside in affluent, politically correct enclaves like Marin County, California. Despite the impressive number of pre-orders touted by Tesla for its Model 3, I remain doubtful that consumers outside of liberal bastions on either coast will buy the all-electric concept in big numbers.

Anyone considering buying Tesla stock in the wake of its announcement to acquire SolarCity would be wise to remember the other controversial, debt-laden company I mentioned in the opening paragraph. Not long ago, like Tesla, Valeant's stock was soaring well above $200 a share as it made one acquisition after another. It only took a few months to crash to earth, though, after investors discovered that much of its business model was dependent on a scheme to overcharge payors, including Medicare and Medicaid. Valeant still has its defenders, most notably Bill Ackman, but the company's once crowded bandwagon is getting emptier by the day.

I have no idea if Tesla and/or Valeant will someday go all the way to zero, but there is no denying that one or both very easily could. That fact should rightfully scare commonsense investors away. There are hundreds of better, safer options out there to be had-well-managed, dividend-paying company stocks with little or no debt and zero risk of going bankrupt. Real investment success is much more the product of minimizing losses than it is hitting "home runs," which is what an investment in Tesla or Valeant would be if either stock rallies from current levels.

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