While many of those comments were insightful, the ones that really arrested our attention were those surmising that Tesla may be engaged in a "Shrink & Stall" strategy at the Gigafactory. In other words, Tesla may have no present intention of proceeding forward with further construction, and, possibly, might have decided to source its Model 3 cells, at least initially, from Asia.
We were so struck by the comments because Shrink & Stall seems so exactly to fit what we're seeing. That strategy would explain CEO Elon Musk's recent comment on Tesla's Q4 2015 earnings conference call, that the Gigafactory "does not appear to be anywhere near the critical path for the Model 3."
It would dovetail nicely into CFO Jason Wheeler's mandate from CEO Elon Musk that "cash is king" and Wheeler's pledge that he will be searching for every way possible to generate more of it, and spend less of it. Tesla appears to have determined it can no longer afford to pour treasure into the Nevada desert.
If Shrink & Stall is why Tesla has so badly missed its Gigafactory targets, then Nevada's massive incentive program is indeed in desperate trouble. And, who could have seen that coming?
Well, actually, critics on both the right and the left saw it coming. But pointing fingers now does no good. Much more useful for Nevada taxpayers would be devising a plan to minimize the damage.
This article explores whether, in light of Tesla's broken promises, Nevada has any meaningful remedies under the October 17, 2014 Incentive Agreement.
While the contract gives Nevada no silver bullet, neither does it leave Nevada defenseless. Assuming Nevada acts quickly, there are several quite useful steps it can take to mitigate past damage and protect from future harm.
However, much depends on the attitude of Nevada state officials. If they want to pretend (as at least one appears to be doing right now) that all will be well, then Tesla will continue to miss forecasts while Nevada continues to hand out benefits. The damage will grow rapidly and be far more difficult to undo.
If, instead, Nevada officials are willing to recognize they have a problem, roll up their sleeves and make a determined effort to take corrective steps, then Montana Skeptic may have some helpful ideas.
II. 'We promise that all this is true...'
Let's quickly review where things stand. To secure the $1.3 billion package of tax abatements, tax credits, free land, free highway construction and discounted electricity, Tesla had to submit a detailed application to the Nevada Governor's Office of Economic Development (the "OED").
The application contained several important components:
- a "Construction Employment Schedule" (Attachment E) in which Tesla projected the number of construction employees to be engaged in building the Gigafactory,
- an "Operations Employment Schedule" (Attachment D) in which Tesla projected how many full-time employees would be at the Gigafactory "by the end of the allowable 10-year period" (we will return to that phrase later),
- a "Participant letter requesting incentives" which was required to describe, among other things, "[h]ow the project will promote the economic development of the State," and
- a "Capital Investment form" (Attachment F) listing the structures Tesla intended to build and the equipment it intended to install.
The application eventually became Exhibit A to the Incentive Agreement, where (in Article 1) it was defined as the "Application" and was, as the lawyers like to say, "incorporated" into the Agreement. In other words, the Application became part of the binding contract.
In fact, the State of Nevada did not simply incorporate the Application into the agreement. It took matters one step further, and required Tesla to represent that the information it had furnished the State was true. Incentive Agreement Article 2 reads as follows:
The Lead Participant [Tesla] submitted the Application which contains information the Lead Participant represents to be true, and which satisfies the requirements of SB No. 1 and other applicable statutory requirements for qualification for and grant of tax abatements and incentives pursuant to SB No. 1, AB No. 1 and Chapters 231, 360, 361, 363A, 363B, 372, 374 and 377 of the NRS;
As the emphasized text makes clear, Tesla has represented - promised in a formal, legal manner - that all the information in its Application is true. Tesla made the representation fully aware that the special legislation (SB No. 1, etc.) that would authorize Nevada's grant of the $1.3 billion in benefits depended on the veracity of the information Tesla had furnished.
What, exactly did Tesla 'represent to be true'?
So, what has Tesla represented to be true? It has sworn the truth of the information it furnished about (1) how many construction workers it would employ, (2) how many Gigafactory workers it would employ, and (3) how much it would spend building and equipping the Gigafactory.
1. Tesla promised to employ 1,700 full-time Gigafactory workers during 2016.
Tesla's "Operations Employment Schedule" has the following projections for Full-Time Employment:
Tesla made projections for only these years because they are the only years requested on Nevada's application.
The projections present an obvious question: When does each year begin and end? As we explain in the note near the end of this article, the text and structure of the agreement show that Year 1 is a partial year. It ended on June 30, 2015. The successive measuring years each begin on July 1 and end on June 30.
So, we know we are (in February 2016) in the 8th month of Year 2. Less clear is how many full-time Gigafactory employees Tesla promised to have in Year 2.
We see two reasonable ways to determine that number. First, one might perform a simple linear interpolation using the numbers on the Construction Employment Schedule for Year 1 (300) and Year 3 (2,000). The midpoint of those numbers works out to 1,150 jobs in Year 2.
Alternately, one might refer to the "Participant letter" which is part of the Application, and as such represented by Tesla to be "true." Nevada required that the Participant letter discuss (among other things) "[h]ow the project will promote the economic development of the State..."
Tesla engaged its Nevada legal counsel, the Reno law firm of Bradley Arant Boult and Cummings, to write its Participant letter. That letter states:
The Project is expected to have a profound impact on the economic development and the economic diversity of the State of Nevada as described in the 44 page report prepared by Applied Economics for the [Governor's] Office [of Economic Development], dated September 2014.
So, take your pick. If one interpolates from the Construction Employment Schedule, then Tesla promised 1,150 full-time Gigafactory jobs in Year 2. Or, if one relies on the Participant letter, then Tesla promised 1,700 full-time jobs in Year 2. Tesla has promised the truth of either number.
No matter which number one chooses, it is evident that Tesla's actual Year 2 hiring, most recently reported to be 272 jobs, falls far short.
2. Tesla promised to employ 1,932 construction workers during February of 2016.
Tesla's Construction Employment Schedule is based on a 5-Phase construction process. The schedule shows that both Phases 1 and 2 would be complete by the end of 2015
The schedule's manpower chart breaks down the number of construction workers promised to be engaged in each construction phase during each month. In February 2016, for instance, the chart shows that 898 full-time workers would be building Phase 3 while another 1,034 full-time workers would be building Phase 4.
As is clear, Tesla promised that it would have 1,932 full-time construction workers employed during the very month that this article is being published.
3. Tesla promised to build the entire Gigafactory structure by the end of 2017.
The Construction Employment Schedule also shows completion of all 5 Phases by December 2017.
Let us restate that to make sure it sinks in. Tesla promised Nevada that it would build the entire Gigafactory by the end of 2017.
That date, of course, makes sense in view of Tesla's announced promise to begin producing the Model 3 by late 2017, and its oft-repeated assurance that the batteries for the Model 3 will be manufactured at the Gigafactory.
This date is confirmed by Section 5 of the Application, which asks Tesla to state its "Estimated completion date."
Ah, you protest, perhaps Tesla had in mind completion of something much smaller than the sprawling Gigafactory shown in its gorgeous renderings (which it also shared with Nevada officials during the negotiations). Alas, the Construction Employment Schedule refers to Phases 1 through 5. It lists no further phases.
If you still have lingering doubts, you might examine the Application's next question and answer:
Q: How much space (sq.ft)?
An area of 5.8 million square feet works out to about 540,000 square meters. That is more than three and one-half times larger than the approximately 150,000 square meters in the existing "pilot" structure. In other words, less than 28% of what it promised Nevada.
So, yes, Virginia, Tesla really did promise Nevada taxpayers that, in exchange for the $1.3 billion basket of gifts, it would complete the entire Gigafactory by October 2017. Or, at the latest, December 2017, which is the date used in Exhibit K to the Incentive Agreement:
Peak construction employment of approximately 3,000 construction and installation workers; construction duration Sept 2014 through December 2017...
We know of no reasonable way to interpret these provisions, taken separately or together, other than as promises by Tesla that, by the end of 2017, Tesla would have completed a Gigafactory structure with no fewer than 540,000 square meters of area.
Perhaps Tesla can still do so? Perhaps it can more than triple the size of the existing structure in the next 22 months? That's highly improbable. Even if the world's largest construction companies could mobilize on site tomorrow, it's highly doubtful they could build another 290,000 square meters of structure in only 22 months.
But even if the construction could occur so miraculously, the construction companies would still need to be paid. Which calls to mind the question of how much Tesla promised Nevada it would spend.
Under the Incentive Agreement, Tesla promised to spend $1.1 billion on just the "Building Site and Infrastructure" (see "Capital Investment" attachment). That doesn't include another $2.4 billion of promised spending on equipment and installation.
Given that Tesla has spent only about $335 million on Gigafactory construction to date, Tesla would need to spend another $800 million or so. Tesla, which is a promiscuous burner of cash, simply does not have that kind of money.
III. Summary of Tesla's Broken Promises
Let's summarize where things stand.
Tesla promised that it and its co-Participants would employ at least 1,150 full-time Gigafactory workers this year. At last report, only 272 are on the payroll.
Additionally, Tesla promised it would have 1,932 construction workers on site right now. It appears there are nowhere near that number, as there is no evidence of any new construction activity.
(Some of our critics have taken us to task, pointing out that, not being on site at the Gigafactory, we cannot be certain about how many construction workers are on site. If our critics are correct, and right now there actually are 1,932 construction workers - or anything close to that number - then we promise to publish a full-throated apology for this article. We note, however, that pinning down our claim with absolute certainty might be perilous.)
Tesla also promised 540,000 square meters of Gigafactory structure, costing $1.1 billion, by October 2017. To date, it has built only 150,000 square meters, and spent only about $335 million.
IV. Memo to Nevada: Tesla doesn't have money to finish the Gigafactory.
How's this for a circular dilemma:
However, to achieve that volume, Tesla needs a functioning Gigafactory, which Tesla always has defined as a factory that starts with raw materials, manufactures the materials into cells, assembles the cells into modules, and assembles the modules into battery packs.
Elon Musk himself underlined this only five months ago when he tweeted that production of the Model 3 depends upon a "fully operational" Gigafactory.
But Tesla most certainly does not have the money to build more Gigafactory.
So, things are rather wrapped around the axle, aren't they? Tesla needs money to finish the Gigafactory, and it hopes the Model 3 will generate that money, but it can't build the Model 3 without the Gigafactory.
Meanwhile, even more urgent than finishing the Gigafactory is developing the Model 3. And if you think the Gigafactory is expensive, then reflect for a moment on what finishing the Model 3 will cost.
The Model 3 will share few if any parts with Tesla's existing vehicles, and instead will have new battery architecture, new motor technology, and new vehicle structure. It also will need an entirely new production line. Those costs could easily run north of $1 billion (far north) not counting a penny more on the Gigafactory.
On top of that, with a growing maintenance backlog and need for retail locations to spur sales, Tesla has a pressing need for more Service Centers. And, with 55,000 more Tesla cars on the road than a year ago, it also needs more Superchargers.
With these more urgent priorities, it's no surprise that the Gigafactory appears to have fallen to the bottom of the capital expenditure list.
V. What can Nevada do?
There is ample evidence that, as regards the Gigafactory, Tesla is indeed in "Shrink & Stall" mode. Tesla clearly has broken the promises it made in its Application and, by extension, in the Incentive Agreement.
So, what can Nevada do about this?
We might suggest a three step program:
1. Admit there is a problem.
The first step to solving any problem is admitting to oneself that there is a problem. Denial of the problem is never a useful strategy, nor is making excuses.
As we discuss later in this article, it appears that at least one high-placed state official is eager to minimize the problem and pretend all is well. If that is to be the official Nevada attitude, then any state official reading along up until this point should simply close out of this article and tend to other tasks.
2. Consider two possible contractual claims against Tesla.
In our earlier articles, we have detailed how the Incentive Agreement is heavily lopsided in favor of Tesla. For instance, the agreement has no "milestones" that would have required Tesla to meet certain capital expenditure or employment milestones by specified dates. Instead, Nevada has to wait until July of 2024 to take action.
We have also detailed how, even in 2024, Nevada has no ability to enforce Tesla's hiring promises. And how Nevada has no legal right whatsoever to claw back either the free land that Tesla received ($43 million) or the highway construction Nevada has agreed to perform ($70 million).
But while heavily lopsided in favor of Tesla, the Incentive Agreement also contains some provisions that can be very useful to Nevada.
A. Nevada can claim misrepresentations under Article 2.
We have shown that under the agreement's Article 2, Tesla made an unqualified representation about the truthfulness of the information it furnished to encourage Nevada elected officials to vote for the extensive tax abatements and other subsidies.
Relying on that representation, and noting that only 16 months later, Tesla is breaking every material promise, Nevada could assert that Tesla knew all along it could not perform, but went ahead and made the promises to induce Nevada to grant the munificent benefits, and hence has committed intentional misrepresentations.
Such a claim would require proof that Tesla knew from the outset that it was unlikely to keep the promises. That is no simple matter. But, as the lawyers like to say, there already appears to be enough evidence to get the case to a jury, and pre-trial "discovery" would likely develop more evidence.
Indeed, simply the prospect of having Elon Musk testify under oath might be enough to get Tesla's attention.
B. Nevada can demand proof that Tesla can perform under Section 3.08.
We believe Nevada may have an even easier route than a misrepresentation claim. Under Section 3.08 of the Incentive Agreement, Tesla acknowledged that it:
understands and agrees that its continuing eligibility for the tax abatements and incentives granted herein is expressly conditioned upon its compliance with the following requirements:
A. Capital Investment Requirement
Provide documentation satisfactory to the [OED] that the Participants in the Project collectively will make the Minimum Capital Investment in the State during the Construction Period.
The "Minimum Capital Investment" is $3.5 billion (Article 1(m).) The "Construction Period" ends on June 30, 2024 (Article 1(h)).
The State of Nevada could reasonably point to the following facts to contend that Tesla will not be able to make the Minimum Capital Investment by 2024, or ever:
- Tesla incurred $889 million of operating losses and $1.6 billion of cash burn during 2015,
- Tesla's sales are shrinking: it almost certainly will deliver significantly fewer cars in the first quarter of 2016 than it did in the last quarter of 2015,
- Tesla's revenues also are shrinking: its revenues in the first quarter of 2016 almost certainly will be significantly lower than those in the final quarter of 2015,
- Tesla's bonds coming due in 2019 and 2021 are trading at significant discounts, suggesting that bondholders are pricing in a significant possibility of default,
- Tesla has repeatedly stated that the Gigafactory is essential to building the Model 3, yet it lacks the funds to complete the structure,
- Tesla's own timeline showed it would conclude arrangements with the dozen or so necessary Gigafactory sub-suppliers by the end of 2014, but it appears than none has been concluded, and
- Panasonic (OTCPK:PCRFY) has the right to back out of its Gigafactory obligations if the sub-suppliers cannot be committed.
It is certainly a serious matter to file a lawsuit. It might well be in both Tesla's and Nevada's interests to avoid litigation.
But, threatening a lawsuit on the basis of the legal claims outlined above might well force Tesla to the negotiating table and compel Tesla to (at last) be candid with state officials.
Making such claims would give Nevada two big sticks. First, under Section 3.01 of the Incentive Agreement, which requires "ongoing compliance" by Tesla to qualify for abatements and incentives, Nevada could announce that it will immediately withhold further abatements and incentives.
Second, under Section 5.01(b), Nevada could assert that Tesla has submitted a "false statement, representation, or certification" in obtaining transferable tax credits, and could demand that Tesla repay the $9.6 million in transferable tax credits received to date.
And let's pause for a moment to consider who would be calling balls and strikes if this dispute were to escalate to a lawsuit. One of the provisions in the Incentive Agreement that is undoubtedly favorable to Nevada is Section 6.01, which requires that any lawsuit be decided by courts in Carson City, Nevada.
Tesla will no doubt be mindful of Nevada's home field advantage, and that could be an important dynamic in the negotiations.
3. Summon Tesla management, ask questions, and demand collateral.
We've now outlined what Nevada officials might do to get the attention of Tesla management. We suggest that Nevada officials invite Tesla management to meet with them in Carson City. Tesla officials were certainly eager enough to travel there when seeking the benefits package, and no doubt they will appreciate how appropriate it is that they return.
State officials should ask Tesla to come to that meeting prepared to answer the following questions:
- What yield did you experience on the 21,282 U.S. Model X reservations that you had recorded at the time of the September 29, 2015 "reveal" of the Model X? (Our own internal calculations suggest that the yield may be less than 25%, which would be well below expectations. This information is important to assessing whether Tesla can achieve break-even in 2016.)
- In view of the fact that your debt is rated as junk by Standard & Poor's Ratings Services, do you still believe you can issue more debt to finance the remaining Gigafactory construction?
- If you cannot or will not issue more debt this year, will you instead raise capital by issuing more stock?
- How many sub-suppliers are needed for the Gigafactory to be "fully operational" (that is, manufacturing cells and batteries for Model 3 cars) and, of that number, how many have committed to locate there? (We believe the answers are, respectively, approximately 14 and zero, but at least one of our critics is convinced otherwise.)
- In any bankruptcy proceeding, what priority would Nevada's contractual claims to claw-back tax abatements and tax credits have relative to the claims of (1) Tesla bondholders and (2) those making deposits on the Model 3?
- Tesla has committed $1.1 billion to the Gigafactory construction. Panasonic has stated it will contribute "up to" $1.6 billion. So, where will the remaining $800 million come from?
The fact that Tesla's mostly supine and sycophantic analysts have never asked such difficult questions should not deter Nevada officials from doing so. Nor should the fact that a sizeable chunk of the media prefers hagiography, stenography, and hyperbole to research and reporting.
Unlike many of the analysts and much of the media, who have much to gain from Tesla, Nevada has a lot to lose. So it can hardly afford not to ask the questions.
Let's suppose that Tesla's answers to Nevada's questions won't be altogether comforting. Short of a lawsuit, is there any step Nevada can take to improve its position?
It appears to us that there are at least two useful actions Nevada can take.
Quit Digging the Hole.
Mindful of the injunction that when one finds oneself in a hole, the first thing one should do is quit digging, Nevada could suspend any further tax credits and abatements unless and until Tesla proves it can perform. Nevada also could revoke Tesla's discounted electrical rate and require the firm to pay market prices.
Demand Some Collateral.
Also, while most of Tesla's assets are pledged under its June 10, 2015 ABL (Asset-Based Lending) Credit Agreement (since amended) with a consortium of banks, Tesla has some valuable Nevada real estate that appears to be unencumbered by any mortgage.
The real estate includes (1) the 980-acre Gigafactory tract it received for free in a Nevada-sponsored land swap, plus (2) several additional tracts of land totaling some 1,973 acres that Tesla later purchased.
Nevada should demand that Tesla grant the state a mortgage on this land to secure Tesla's obligations. That way, if Tesla were to default, the State would be a secured creditor with meaningful collateral.
It is possible that Tesla would need to get permission from the banks under its ABL Credit Agreement. That agreement is complex, but it appears that a mortgage of the land would be a "Permitted Lien" under Section 10.01 because it would secure "Indebtedness permitted by Section 10.04(r)." (We caution that Tesla has disclosed that it recently amended the ABL Credit Agreement; Tesla has not yet disclosed the revisions, and it's possible that these provisions may have changed.)
If the banks have hesitations, we suggest that Nevada invite them to the negotiating table as well. We suspect the banks would cooperate. All their debt comes due four years before the important June 30, 2024 deadline date under the Incentive Agreement.
Besides, it would seem in the banks' interests to make certain that the State of Nevada remains Tesla's friend. And in the unlikely event that bank resistance actually were to become an issue, Montana Skeptic would stand ready to offer some specific and intriguing ideas about how that resistance might be overcome.
VI. A few words about the Nevada OEG Director
Several commenters have pointed us to an article in The Verge discussing the munificent benefits package bestowed upon Tesla by the State of Nevada.
The article reports that the Executive Director of the Governor's Office of Economic Development, asked about Tesla's apparent failure to keep its capital expenditure and employment promises, had the following explanation:
[The OED] failed to account for the time between when it published the report and when Tesla started work on the factory. He says the report is months 'out in front' of where Tesla is, as it was pegged to a January timeline while the project did not get underway until October 2014. The state, he says, 'just didn't think of that time lag.'
We find this account unpersuasive. The OED report is dated September 2014, which is a month before the date of the Incentive Agreement. Tesla's Construction Employment Schedule shows construction workers on site in September 2014. And press reports indicate that site preparation work actually began on May 19, 2014.
While it hardly needs saying, the Executive Director of a state agency has no right or authority to unilaterally amend an agreement that was approved by the legislature and signed by the Governor of the State of Nevada.
The important point is not that the Executive Director's explanation is nonsensical and transparently defensive.
The important point, rather, is that if the State of Nevada is to make any headway in protecting the rights of its taxpayers under the Incentive Agreement, it will need an altogether different attitude from the cringing and defensive crouch adopted by the OED.
We can assure Nevada state officials that Elon Musk will be neither cringing nor defensive. In the history of the crony capitalism, there are few businessmen who have extracted more government benefits and subsidies than Elon Musk. Nevada officials should fully expect him to be continuing to look for ways to pick their pockets (and, by extension, the pockets of Nevada taxpayers).
In dealing with Tesla and Musk, Nevada would do well to adopt the Latin motto of the high school of one of our friends, Facta non verba.
VII. How to measure time under the Incentive Agreement:
This section of the article explains why Year 1 under the Incentive Agreement ended on June 30, 2015. You can skip this section if you already agree that is so.
Recall that phrase we quoted near the beginning of this article, "the allowable 10-year period." That phrase appears in the State of Nevada's application instructions:
Please complete columns through (NYSE:D)...with information on all qualified employees [minimum 30 hours per week] that are projected to be hired and employed by the Participants by the end of the allowable 10-year period. (emphasis added)
Obviously, the Year 1 though 10 projections tie to the "allowable 10-year period," but when does that period begin and end?
The Incentive Agreement text answers that question, indicating in several places that the 10-year period ends on June 30, 2024, and hence began on July 1, 2014. (Yes, that is before the Incentive Agreement was signed, but Tesla actually began work at the Gigafactory site in May 2014.)
Here are some tell-tale references:
- Article 1(h): definition of "Construction Period" (ending on the later of the date on which Participants expend $3.5 billion of capital on the Gigafactory or "June 30, 2024."
- Section 3.03: abatement of Modified Business Tax ends on "June 30, 2024."
- Section 3.04: abatement of Personal Property Tax ends on "June 30, 2024."
- Section 3.05: abatement of Real Property Tax ends on "June 30, 2024."
- Section 3.08(h): "[Tesla] will maintain Continuous Business Operations in the State until at least June 30, 2024..."
Thus, there can be no reasonable doubt: Year 1 is a partial year, and must end on June 2015 if Year 10 is to end (as it does) on June 30, 2024.
Even if one believes, though, that Year 2 began only on January 1, 2016, it is evident that Tesla has not come close to keeping its promises.
VII. A further note about some loose ends.
Writing this article caused us to come across two ambiguities that we have been unable to resolve.
1. How many Phases to the Gigafactory?
How many phases does the Gigafactory have? The Panasonic president, in a recent interview, spoke of 8 phases.
The Construction Employment Schedule in the Incentive Agreement breaks the construction of the factory into 5 phases.
Perhaps there are 3 more phases that don't involve construction, or perhaps the different actors use different phasing in their planning. Parts of the Incentive Agreement are redacted, so possibly the answer lies in the agreement itself but is invisible to us.
For now, we are unable to solve the mystery, so we note that it exists and creates the potential for some confusion.
2. How much did Tesla promise would be spent on the Gigafactory?
Similarly, what is the minimum amount that Tesla promised Nevada that Tesla and its co-Participants would spend on building and equipping the Gigafactory?
The text of the Incentive Agreement says $3.5 billion (Article 1(m)) while the "Capital Investment form" (Attachment F to the Application) says $5 billion.
We assume that the text of the Incentive Agreement would supersede the exhibit, and that $3.5 billion is the number to which Tesla is contractually committed. However, the agreement is ambiguous.
IX. A Note about the other Contributors
Those familiar with our work know that Montana Skeptic relies on a brain trust of thoughtful commenters, some at Seeking Alpha and others at the Yahoo message board for TSLA.
It is for that reason, and not simply because we realize we are the king who is wearing no clothes, that we use the first person plural - "we," "us," and "our."
Those whose research and analysis has contributed to this piece include temagami, investor.gator, metalapocalyptica, freestyledesign2015, dynamicviolence, and n0m0renancy. As always, none is them is responsible for my errors, and none of them necessarily agrees with all points in the article.
Disclosure: I am/we are short TSLA VIA PUT OPTIONS.
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.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.