Tesla Is Unprofitable, But Is It Financially Healthy?

Summary

• Tesla is not in danger of bankruptcy. Despite operating losses, it remains financially healthy.
• Tesla will need further financing to continue its aggressive expansion, leading to further dilution to shareholders.
• Tesla has very cheap debt, its cash interest costs are much lower than it appears on the income statement.
• Best case scenario: Tesla has hedging methods in place and if exercised, there will be no dilution to shareholders related to convertible bonds.

Tesla (NASDAQ:NASDAQ:TSLA) is a company that is trying to revolutionize the automotive industry by creating luxury and mass market all-electric vehicles. Tesla, the first auto manufacturer that went public since Ford (F) in 1956, is unfortunately a highly unprofitable business. Nevertheless, in 5 years TSLA stock had appreciated by 1,190%, primarily on the back of promising the world that it will render gasoline cars obsolete.

As an unprofitable company, Tesla has burned through cash like no one else. In the nine months that ended in Q3 2015, Tesla announced that it plans to have capital expenditures of approximately $1.5 billion for the entire year, excluding losses from operations.

As the title expresses, this article makes an assessment of Tesla's financial health. The main purpose here is to answer a key question:

How will TSLA survive through its cash burning stage?

Furthermore, the article focuses on Tesla's capital structure and what's ahead for current TSLA shareholders.

Shareholders should expect some dilution from convertible bonds, but the dilution is fully hedged and won't be terrible.

Tesla has issued $3 billion of convertible bonds in 2013 and 2014. The conversion prices are $125 per share for the bonds issued in 2013, and $360 per share for the bonds issued in 2014. Tesla shareholders should expect a dilution of approximately 11.7 million shares related to these bonds, or 9% of the total shares outstanding as of Q3. However, Tesla did hedge this dilution through warrants. Therefore the 11.7 million shares dilution represents the worst case scenario, which in my opinion is not bad.

The best case scenario is that Tesla will exercise its warrants and buy back the same amount of shares that will issue with the conversion of the bonds. In this case, there will be no dilution. Since TSLA paid approximately $781 million to hedge the dilution, the most likely scenario is that there will be no dilution from the convertible bonds.

Is Tesla at risk of defaulting on interest payments?

The short answer is no. Tesla is not at risk of defaulting on interest payments. Bankruptcy is pretty much out of the question.

While Tesla has issued substantial debt to support its capital investments, the reality is that the debt is very cheap. TSLA interest rates range from 0.25% to 1.5%, for a weighted average interest rate of 1.15%. This is the reason behind Tesla paying such a small amount of cash interest. And by the way, they're fixed rates. So no need to fear the Fed's interest rate hike.

Once the $660 million bonds are converted into common stock, Tesla's weighted average interest rate will decrease to 0.85%. These bonds can be converted anytime since Tesla stock is currently trading way above the conversion price of $125 per share.

The income statement overstates actual cash paid for interest.

The accounting standards that Tesla must follow due to the issuance of convertible bonds forces the income statement to overstate the amount of interest that Tesla actually pays. In 2014, Tesla paid $20.5 million of cash for interest. The expense shown in the income statement was $101 million. Therefore, the amount shown in the income statement is nearly 5 times larger than the cash Tesla paid for interest. This is simply due to the amortization of bond discounts, which is a non-cash expense. In other words, roughly $80.5 million of interest expense is just accounting and does not affect TSLA liquidity or cash position.

The good thing is that it is not hard for Tesla to generate $20.5 million in cash, particularly given their new agreements with financial institutions to act as intermediaries in car leasing.

It is meaningless to calculate an interest coverage ratio for Tesla because of their operating losses. Nonetheless, Tesla is in good form to make interest payments. Their cash on hand alone covers approximately 70 times the interest payments, excluding restricted cash. This makes TSLA solvent enough to make interest payments far beyond 2020.

In short, defaulting on their bonds is pretty much out of the question.

New agreement with intermediaries allows Tesla to receive cash upfront from vehicle leasing.

Tesla has partnered with different banks and financial institutions (intermediaries) in order to improve its cash position. Tesla accounts for this arrangement as a collateralized car lease.

The impact of this arrangement to Tesla and its financial statements is rather simple. When leasing cars, Tesla receives cash from financial institutions as collateralized loans, which are classified as cash flows from financing activities. The costs of these loans are passed to the customer who is leasing the vehicle. The collateral for these loans are Tesla's cars. Effectively, Tesla is either leasing the car to a customer or selling it to the financial institutions.

This arrangement is expected to help Tesla's cash position. As of the end of Q3, Tesla received approximately $322 million in cash from such transactions.

The impact of this arrangement to Tesla's gross margin and bottom line is very clear, but difficult to quantify. Financial institutions, functioning as intermediaries, will take a little profit from car leasing. But the agreement greatly benefits Tesla's liquidity situation. The arrangement allows Tesla to receive cash upfront from car leasing, which will reduce the need to raise cash in the capital markets. See below for Tesla Model S lease option.

Financial Position for 2016 and beyond - How will TSLA survive?

Tesla is shaping up to have another record year. Tesla will likely have GAAP revenues topping $1 billion in Q4. However, Tesla is not slowing down in its capital investments. The development of the Model X, Model 3, supercharger stations, and "gigafactory" will continue to eat up much of Tesla's capital.

Tesla has approximately $1.4 billion in cash, including the recent issuance of common stock. Considering cash on hand and cash to be received from its lease arrangements, I believe Tesla has enough funds to continue expanding aggressively (without tapping capital markets) for another 1 to 2 years. Despite the losses, Tesla remains financially healthy.

However, new financing rounds are likely to continue. Tesla's goal is to achieve economies of scale in order to make a mass market electric vehicle. Tesla will be able to achieve such a goal only with the support of further financing rounds, whether in the form of convertible bonds or stock offerings.

Shareholders should expect further common stock offerings, further bond offerings (whether convertible or plain bonds), and further warrant issuances. This translates to further dilution. Since Tesla could offset the dilution from convertible bonds, shareholders are only exposed to dilution from further common stock offerings. In that case, shareholders must be willing to either add to their position or accept dilution.

Elon Musk continued to add to his stake in Tesla by purchasing $20 million of common stock in the latest offering.

Analyst’s 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.