With this week's announcement of a definitive agreement between Tesla (NASDAQ: TSLA) and Solar City (NASDAQ: SCTY) for a merger, Tesla is now hurtling forward driven by its own corporate version of Autopilot towards its vision of a hopefully more sustainable future. There were unfortunately some hurt-lings among the Solar City holders, however, as Tesla's original announcement on June 28 of a proposed share exchange of 0.122 to 0.131 Tesla shares for each Solar City share has now been reduced to a ratio of 0.110 Tesla shares. With such a change in the share exchange ratio in just one month, Tesla should just wait another 12 months and then acquire Solar City for nothing!
The unfortunate surprise for SCTY holders of a lower exchange ratio is actually just Elon Musk's way of saying hello and welcome to the party. Party goers at Tesla are already well accustomed to other surprises such as lower than expected vehicle deliveries, late vehicle introductions (Model X being 18 months late and then another nine months before achieving consistent volume production), and projections about earlier vehicle introductions that are supposed to provide positive cash flow for later vehicle development that are then never achieved.
Myth of shares being recalled from stock lending programs for a shareholder vote
There is another Tesla party that has been going for quite a while which is the active interchange of comments on investor message boards between Tesla bulls and bears. There are now an ever increasing number of comments that the shareholder vote (which will probably occur in October or early-November) will trigger a "short squeeze" based on a vague urban legend that shareholders cannot vote shares that have been borrowed by short sellers. As such, so the story goes, the TSLA and SCTY shareholders will withdraw all their shares from securities lending programs so that they can vote for the Master's vision of a sustainable and green future.
Short sellers, who are continuing to project a red future for both of the companies, know that such an urban legend isn't correct and that is also part of the reason why they are so happy having borrowed such a large number of TSLA and SCTY shares to sell short. If such a procedure was required, there would be massive disruptions every year during proxy voting season as shareholders temporarily recalled borrowed shares to vote them each year.
What can occasionally happen during a period of uncertainty as to the outcome of a merger is that risk managers responsible for margin programs at individual brokerage firms will adjust both margin requirements for long purchases and borrowing rates for short sales depending on those managers' views of the potential customer risks during an uncertain period. With the currently proposed transaction, such risk managers would probably view the possibility of a merger that does not get approved by shareholders as a risk for TSLA short sellers. Aside from the recent increase in TSLA short interest that has increased borrowing rates for TSLA shares, I do believe that the current rates are somewhat higher based on what I just described about individual brokerage firm risk manager activities along with some risk managers also deciding that no shares are available for short sales.
Other "short squeeze" myths and fantasies…
Another speculative rumor floating around is that Elon Musk has withdrawn all his shares from securities lending programs. Elon and I are not on the best of terms at the moment and so he hasn't shared with me where his shares are held but since Musk appears to live in a virtual world, he doesn't seem to be the share certificates in a shoe box under the bed type - especially given that would be sort of lumpy under his sleeping bag. Musk has also borrowed against his TSLA shares (please see page 48 of the Q1 10-Q filing in the "Risk Factors" section) and so those shares would be in a margin account.
Margin account shares cannot be withdrawn from securities lending programs at the discretion of a client which means that all of Musk's shares are probably borrowable by short sellers. The firms holding Musk's shares would also be highly unlikely to agree to not lend them out given the current borrowing rates for the shares. What is also silly about all of this, however, is that only in very rare cases does the availability of shares to be borrowed have any effect in the short-term (over a one to three month period) on stock prices given overall market liquidity.
There is a theoretical grain of truth that a "short squeeze" can be produced by over a three to six month period by large institutional holders withdrawing shares from securities lending programs but that is unlikely to happen for various reasons which I will describe below.
Institutional impediments to withdrawing shares from securities lending programs
The main reason that large institutional holders such as Fidelity are really happy to have their TSLA and SCTY shares in securities lending programs is the current borrowing rate. Most portfolio managers are also blissfully unconcerned about shares they hold being shorted from a sort of Alfred E. Neuman perspective of "what, me worry?" as such brilliant portfolio managers would never think that any shares they currently hold would go down in price!
There are also a LOT of structural and institutional impediments to withdrawing shares from stock lending programs at all of the large external custodians such as State Street, Bank of New York Mellon, and Northern Trust. There are extensive legal contracts in place governing the custodian relationships between investment advisors and their external custodians and "one off" requests to withdraw individual stocks from a custodian's very lucrative stock lending programs are not received favorably or processed quickly. There are also internal investment advisor impediments to such requests even being communicated as securities lending program decisions are made by Administration related management at investment advisors. Most firms also have an internal structure where portfolio management personnel do not interfere with overall firm business practices.
I also have an interesting story about a stock where I did request that the shares be withdrawn from the custodian's securities lending program to illustrate both the impediments and how long it can take. The situation was a small-cap stock that only traded around 100,000 shares a day (not like Tesla which averages over 5 million shares a day) and where my fund owned three million of the company's 20 million shares outstanding. Short interest at the time was also about four million shares and so I thought it would be fun to amuse myself by withdrawing all the shares held in my fund from being lent out.
The first impediment was with the management of my firm which seemed appalled that I didn't know my place and would even communicate such a request. The CEO of the firm was especially being a stick in the mud which I suspect was influenced by the fact that the external custodian would usually invite him to be a "speaker" at two or three conferences a year held at high end resorts (with great golf courses!). Doggedly persistent that I am, however, I pushed on and brought up the topic at the next quarterly trustee's meeting of the mutual fund I managed.
The mutual fund trustees, who had previously been bamboozled by being told that the firm's funds were receiving EIGHT BASIS POINTS A YEAR for participating in securities lending were initially hesitant at upsetting such a lucrative apple cart but some of them were a bit intrigued by my idea. It then took another month before a special vote by the trustees was held to then allow me to go forward with my request to have the thinly traded small-cap stock's shares withdrawn from the custodian's lending program.
After that, however, I began to fear that I would wake up some morning to find a horse's head at the foot of my bed. The head of custodial operations at the custodian called to tell me what an "unwise move" I was making. At the same time I, ummm, already had a hedge fund planned to be opened within the next year and my prime broker contacts at Goldman and Bear Stearns who were going to be joint prime brokers at my new hedge fund called to tell me that I was "going to make a very bad name for myself" around the street.
Against such pressure, onward I plunged and what subsequently happened was amazing. Five day settlement was in place at that point and so simple me thought that I'd get all the shares back within a few weeks to test my theory and see what would happen. But, only three to five percent of the three million shares that my fund held which had been lent out were being returned each week on average. About every two weeks, I would usually get more nasty phone calls from the CEO of my firm, the head of the custodian, various operations managers at the custodian, my prime broker contacts, and…even from some hedge funds who had shorted the shares. The end result was that it took FOUR MONTHS to get all the shares back (but the day to day trading action was hilarious to watch as the stock did triple by the end of the four months!)
I haven't now become senile to not realize that the final comment I just made above would seem to negate my perspective that short squeezes are urban legends and that they can't happen at all. The difference in this case was that what I described was a thinly traded small-cap stock where the short position was around 40-days of trading volume versus TSLA where the currently inflated short position is only around seven days of trading volume. So, in conclusion about all this, short squeezes are theoretically possible but very unlikely with a stock having very high liquidity such as TSLA.
Myth of the "Desperate Bear"
There are also lots of comments about "desperate bears" trying to bail out their short positions by spreading the dreaded FUD about Tesla and attempting to drive the stock down a few points. With TSLA's all-time high two years ago being over 20 percent higher than current price, I don't think there are any desperate bears currently but I will also explain bear characteristics a bit later.
First, however, I will address possible margin calls that have been speculated about for short positions. Margin calls are very unlikely as margin calls are not on individual positions but only on the value of an overall account given possible debit balances. Most short positions would be part of an overall portfolio of short positions and so one short position "going up 25 percent" would not trigger a margin call for the overall account.
Most hedge funds with short positions in Tesla are also effectively not subject to margin calls as a little oversight in Dodd-Frank results in Brokerage Firm Prime Broker divisions still being able to offer essentially unlimited leverage to their prime brokerage clients. Given my experience managing a long/short hedge fund for nine years which used two prime brokers, I definitely know how all this stuff works.
As for "bear" characteristics, successful short sellers have three attributes: 1) very strong fundamental and financial analysis skills which enable a deep understanding of all fundamental factors affecting a company; 2) an expert chess player's skills at anticipating future moves by a company; and 3) a psychoanalyst's insights at gauging investor sentiment on the wide manic-depressive spectrum of human emotions.
The first two characteristics are essential and required but the third characteristic is actually the most important. Most short selling opportunities are seen in enthusiastic manic periods where the enthusiasm of other investors, which at that point are usually no longer even driven by their view of company fundamentals but rather by excitement over the apparent momentum of the large price gains that have already occurred, reach a peak (usually shown by one last upward spike on a stock chart). At such a peak, there is then usually no additional "net new money" available to drive the stock higher as many holders of the stock will also usually start selling on such spikes.
Anyone with a reasonable amount of short selling experience also knows that there is a consistent statistical distribution to the results of their short sales. My own experience is that around 70 percent of my short positions have profits and 30 percent have losses. As such, some losses are actually expected and don't result in my feeling "desperate." Of the 70 percent of my short positions which have profits, 50 percent of those positions have profits between ten and 20 percent, 30 percent have profits between 20 and 30 percent, ten percent have profits between 30 and 50 percent, and ten percent have profits between 50 and 80 percent (almost none ever go to zero). Of the 30 percent of my short positions that have losses, there is an even split between positions with losses of zero to ten percent and those with losses of between ten and 20 percent.
Risks of a TSLA short
The main risk of a TSLA short is that most short sellers will scurry to cover when there is any short-term price momentum that moves against them. It is also a crowded trade and so that risk is somewhat accentuated. TSLA also has an interesting additional unquantifiable risk in the numbers of supporters who have bought into the "sustainability" and "alternative to ICE vehicle" story and who aren't influenced by ongoing fundamentals (minutiae such as large operating losses requiring dilutive capital raises) but such holders probably don't have a lot of buying power to drive the stock higher.
I think those risks are somewhat mitigated by anticipated events over the next three to six months which I believe will begin to be a catalyst for some of the large institutional holders of TSLA to start reevaluating their holdings. I believe that Q3 deliveries will probably be only around 21,000 vehicles which would be perceived as below expectations given the projections of 50,000 vehicles delivered in the second half of 2016.
I also think the proposed Solar City deal will have some interesting side effects. I managed small-cap mutual funds for 20 years and an unfortunate reality of being a small-cap manager is that positions are concentrated and with limited relative liquidity. TSLA is not a small-cap stock and the large holders probably could all exit their positions within a few weeks but SCTY, which also has a lot of the same holders, is a lot more volatile and less liquid. Some "less liquid" positions are essentially held by default by portfolio managers as selling a large position could have significant price effects.
With such characteristics, I would guess a lot of the joint holders of both stocks when they saw the proposed merger announcement suddenly went "whew" as they realized that if the merger is approved that they will now have a much more liquid holding of their SCTY shares. I would also guess that the proposed merger would not have been regarded positively by large institutional holders given that corporate governance issues are a prominent area of concern in the current environment. From such factors, I think that once the merger is complete, there will be a reasonable number of institutional holders who will then be tired of the Elon Musk medicine show and will pull the plug on their TSLA holdings.
Other risks of a TSLA short are that there begin to be tangible milestones concerning the Model 3 launch that the company announces periodically over the next 15 months. I think TSLA is in a "show me" mode at this point, however, with any future new vehicles given that the Model X launch was essentially 27 months late including the additional nine months it took to get the vehicle into volume production.
There is unlikely to be any significant short covering of borrowed Tesla shares unless the company can begin to display tangible milestones of its progress which could include better than expected deliveries and more positive financial results - particularly with gross margins. Short sellers will not be "forced" to cover their positions due to imaginary factors such as share recalls or margin calls. Based on most short sellers' future price targets for TSLA, the current elevated borrowing rate is also not a factor that would promote very much short covering, if any at all.
Disclosure: I am/we are short TSLA.
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.
Additional disclosure: This article expresses the author’s opinions and perspectives about various investment related topics. Since all statements in the article are represented as opinions, rather than facts, such opinions are not a recommendation to buy or sell a security. My own investment position described in the disclosures is not intended to provide investment advice or a recommendation of a specific investment strategy but is a required disclosure item by Seeking Alpha. My own investment position may have been initiated at very different price levels than current prices levels and so that is also why my disclosed position is definitely not intended as an investment recommendation. All investors should also do their own research before making any investment decision.