Tesla Is On Sale!

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Includes: SCTY, TSLA
by: ValueAnalyst

Summary

Tesla-SolarCity deal is looking more likely with every passing day.

Fidelity, the biggest ex-Elon shareholder in both companies, very likely supports the deal.

Let's tune out the noise and focus on the practical key points.

First read my previous article on the topic, Tesla and SolarCity: 3 Interesting Facts, for a discussion of the practical reasons behind why this deal is destined to go through. Not to blow my own horn, but as predicted, signs of institutional investor support for the deal is starting to appear. It is not okay to blow your own horn.

This decision will be made by Tesla's (NASDAQ:TSLA) institutional investors; not by the individual shareholders who buy and sell a few shares in their trading accounts; not the boards of directors, more than half of which seem to be recused from voting; and not the SolarCity (NASDAQ:SCTY) shareholders, who most likely love this deal which comes with a nicely sized control premium and an opportunity to participate in the upside through Tesla. So let's focus on the decision makers: Tesla shareholders.

As I discussed in my previous article, Tesla's ownership is concentrated and has proven to be loyal over the last decade. What I did not mention in my last article, but is also very important, is the cross-pollination between the ownership of the two companies. As the above-linked article points out:

... a lot of Tesla shareholders already own SolarCity shares, which could facilitate the deal. The number is estimated at 45% as Reuters reported after talking about Fidelity, which is a major shareholder of both companies and looks to be in favor of the deal.

45% is a big chunk. Whether you believe this is a bail-out or not, Tesla shareholders that also own SCTY are very likely to vote for the deal. Add them (after excluding Fidelity and Elon Musk who are included in the 45% figure) to the three institutional investors I mentioned in my previous article, and voilà, majority.

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It's also important to remember why Tesla shareholders are invested in the stock in the first place: Elon Musk. The present value of future cash flows depend mostly on what he brings to the table instead of the minute details the SolarCity bears point out. Shareholders see value in his mission: to accelerate the world's transition to sustainable energy. A tie-up between Tesla and SolarCity no doubt would speed this up. Although he will not be voting, he made his position on the deal crystal clear:

I have no doubt about this - zero.

We should have done it sooner.

No brainer.

Tesla's shareholders will likely follow his advice.

Now that I've established why this deal is almost certain to go through, let's see how we can profit.

At $200 per Tesla share, and the midpoint of the exchange ratio, the deal values SolarCity shares at $25 each. Considering Friday's closing price of $22.20, this deal provides a potential return of ~12.6% depending on how TSLA shares behave until the deal closes (six months to a year). I believe this is why SCTY shares went UP on Friday in the midst of the S-storm that is called Brexit.

Another way to look at this: if you agree with me that the deal is almost certain to go through, SCTY shares offer a more than 10% discount on TSLA shares. As a value investor, I love a good deal, especially since I believe TSLA shares are also undervalued (but that's a topic for another article). Focus.

SCTY shorts know all this, which is why they scrambled to get on CNBC right after the deal was announced (here and here). Remember that there's only one reason why most large investors get on TV: to affect price in the direction that benefits them. Considering that they've already pushed the price of SCTY down quite a bit over the last year, I suspect that at least some of them will have covered their shorts by the end of the quarter. Since nearly one-third of non-Musk float was short as of mid-June, that's a lot of demand for SCTY that will rush to buy the stock.

This is why I initiated a long position in SCTY last week as I thought further about the practical dynamics of the deal and realized the deal is almost certain to go through.

Please note that I keep using "almost certain," as only two things in life are certain. The tail-end risk of the deal falling through is there, and if materializes, can bring SCTY down, potentially to zero given SolarCity's dependence on capital markets to securitize its receivables and fuel its growth. This is yet another topic for another article because it doesn't affect the likeliness of the deal closing, but the loud noises from shorts can potentially scare off SCTY's capital providers if the deal falls through. That, in addition to merger arbitrage not being a primary pillar of my investment style, is why I limited my long position to a small portion of my portfolio.

Bottom Line: Wink at the noise before turning a cold shoulder to it and instead focus on the factors that matter most. The deal creates a nice merger arbitrage opportunity.

Disclosure: I am/we are long SCTY.

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.