Tesla’s Model 3 Woes Mean Another Equity Raise Soon
Tesla (NASDAQ:TSLA) is on pace to have operating losses of more than a billion in H2 2017, plus immense capital expenditures. Result: Tesla will be raising capital again soon.
The only question is whether the capital raise will happen early next year or instead will need to be accelerated to later this year.
This time will feel different.
For the past several years, the capital raises have come with the promise of brilliant things to come: the Gigafactory, Tesla Energy, the Model X, and most especially the Model 3.
Now, the Model 3 is here. And yet, it’s not here, and there are several key developments that are likely to give institutional investors pause about loading on more Tesla shares.
Most obviously, there is the elevated share price. You might explain it as driven by irrational exuberance, or perhaps by resort to the George Soros theory of reflexivity. But you can no longer pretend to explain it using any discounted cash flow model or other conventional valuation method.
With a share price in the $300s, it becomes far more difficult for any institutional investor to justify adding more TSLA. If anything, the tendency will be to continue to lighten up.
Stormy Weather In Longville
But there also are other motes to trouble the mind’s eye.
- Tesla's “full self-driving” story has proven to be hollow. The hardware claimed to be FSD capable likely is not. The Autopilot software continues to lag. In consequence of the broken promises, Tesla faces a class-action lawsuit.
- Tesla has recalled 11,000 Model X cars for defective seats. The danger is not so much the specific recall as the hubris and corner-cutting illuminated by the recall. Let’s remember back to when, dissatisfied with its seat vendor, Tesla took the Model X seat manufacture in house (let’s also recall that perennial Tesla cheerleader Dana Hull at Bloomberg told us that was a good thing).
- The Model 3 rollout troubles continue. Tesla likely will not come close to its promised production rate of 5,000 per week by the end of this year. The risks of skipping rigorous beta testing continue to become evident.
- Tesla confirmed it recently fired a number of employees. Was that number several hundred, as the account in The Mercury News stated? While Tesla undoubtedly had some sub-standard employees, large-scale firings would be an odd step to take at the moment you’re promising to roll out your mass-market car in great volume. As CoverDrive asked, “If these firings are a result of a normal annual appraisal process, how many employees were culled last year?”
A Change In Sentiment?
In short, we may be about to see a change in investor sentiment. For evidence, take a look at GM’s (NYSE:GM) share price over the past month...
... and compare it to Tesla’s:
Investors with whom I’ve spoken believe that behind the rise in GM’s share price is market enthusiasm for its great strides in developing EVs and its now-evident lead in developing autonomous driving technology. They see an interesting trade developing by pairing these two charts.
Tesla fans here hate to read it, but the ineluctable fact is that three months after the Model 3's introduction, the Chevy Bolt continues to outsell the Model 3. That trend will continue for several months to come, and every Bolt sale made is a potential Model 3 sale lost.
So, to return to the original point, Tesla soon will need more cash. Lots more cash.
Tesla Already Paid $535 Million Of SolarCity Debt…
And my question is: How much longer will capital markets tolerate Tesla continuing to downstream cash to pay SolarCity’s debts?
How much longer will investment banks be willing to ask their largest investor clients to pour more money into Tesla with the knowledge that much of the cash will be down-streamed for no good purpose whatsoever?
Because, already, Tesla has done just that: downstream an immense amount of cash to pay debts that do not advance the Model 3 or Model Y or solar roof tiles or Tesla semi one iota:
- Earlier this year, Tesla used $200 million of cash to pay off SolarCity Solar Bonds (including $165 million paid to related party SpaceX).
- More recently, from the $1.8 billion it collected in its junk bond offering, Tesla used $325 million to pay off SolarCity’s revolving line of credit.
That’s $525 million of SolarCity recourse obligations, extinguished this year with Tesla cash.
… And There’s Another $1.4 Billion Yet To Go
Even worse, there’s more to come. Ignoring SolarCity’s non-recourse debt, and focusing just on the recourse debt, here’s what remains:
- $100 million of 6.5% SolarCity notes due to Elon Musk, Lyndon Rive, and Peter Rive, due in February 2018.
- $230 million of 2.75% SolarCity convertible notes due November 1, 2018.
- $566 million of 1.625% SolarCity convertible notes due November 1, 2019.
- $103 million of SolarCity zero coupon convertible notes due December 1, 2020.
- $32 million of Solar Bonds at various interest rates (ranging from 2.5% to 6.5%) and maturities, held by third parties and Peter Rive.
Add it all up, and it’s $1.03 billion of debt, plus some $29 million in interest to service that debt each year.
On top of this, SolarCity has other contingent obligations including, most significantly, payments off $41.2 million per year for 10 years if SolarCity fails to meet its employment promises at Riverbend, which seems likely. So, that’s another $412 million.
From a strictly financial viewpoint, and with the aim of maximizing the capital available to pay for the Model 3 production equipment and invest in the forthcoming solar roof tiles and Model Y and Tesla semi, what would make most sense to do?
For the Good of Tesla, It's Time To Default
That’s easy. What makes most sense is to allow SolarCity to default on all this debt. Every last dollar of it.
Should Tesla allow SolarCity to default? An argument sometimes made near the time of the merger (by those savvy enough not to be gulled by the phony “synergies” story) was that Musk could not afford the reputational risk of a SolarCity failure.
My personal view was that the real motivations for the merger were:
- to assure that SpaceX would be repaid its $165 million in Solar Bonds;
- to assure the SolarCity insiders would have their worthless SCTY stock options converted to valuable TSLA stock options, and
- (less importantly in view of the dollars at stake) to assure that Musk and the Rive brothers would receive payment for their Solar Bonds.
As to items (1) and (2), mission accomplished. As to (3), TBD, but highly likely.
Regardless, we are now long past the point where Tesla or Musk would suffer much reputational harm from a SolarCity default. The Rive brothers have exited SolarCity. SpaceX is spared by having recovered its $165 million. Tesla has begun laying off SolarCity employees and scaling back its operations.
The SolarCity story is over. Everyone knows it.
Tesla Has No Legal Obligation For SolarCity’s Debt
Can Tesla allow SolarCity to default on its obligations with impunity? With one important footnote, yes, it can. By reason of the way Tesla structured its merger, Tesla has no liability whatsoever for all the debt and contingent obligations I’ve listed.
Let’s review: Tesla employed a so-called reverse triangular merger when it acquired SolarCity. Consequently:
- Tesla designed the transaction to isolate SolarCity as a wholly-owned subsidiary.
- SolarCity retained all its existing subsidiaries. In addition to the subsidiaries, all the other assets that were owned by SolarCity before the merger continued to be owned by SolarCity after it was completed.
- And, most significantly, all the liabilities that, before the merger, belonged to SolarCity, will after the merger continue to belong to SolarCity, and SolarCity alone. Tesla assumed none of them.
- Indeed, Tesla’s bankers under its hugely important asset-based secured revolving credit agreement – the so-called ABL Agreement – expressly prohibited Tesla from assuming any SolarCity debts.
The merger changed only one thing: the shareholder arrangement. All former SolarCity shareholders became Tesla shareholders, and Tesla became the sole SolarCity shareholder.
Since the merger closed, Tesla has not assumed one cent of SolarCity’s recourse debt. It has not done so because it cannot do so; the ABL prohibits it. And, if you are a Tesla shareholder, that seems quite wise. You don’t want Tesla, already knee deep in debt, to wade in even further.
What About Riverbend?
What about the contingent Riverbend penalty obligations of $41.2 million per year for 10 years for failure to meet what now seem to be impossibly high employment obligations? New York State politicians and newspaper writers like to speak of the employment obligations as belonging to Tesla.
Those obligations don’t belong to Tesla. In fact, they don’t even belong to SolarCity. They belong to a completely insolvent SolarCity subsidiary called Silevo LLC.
At August’s conference call, Musk affirmed Tesla’s “commitment” to the Riverbend facility:
Yes. Just on the Buffalo front – I really want to emphasize, we expect the Buffalo Gigafactory to be a powerhouse of solar panel and solar glass tile output. It is going be a kick-ass facility. We have made that commitment to the State of New York. We are going to keep that commitment.
And then, we're also thinking hard about, where do we put Gigafactories three, four, five, and six? We expect to keep the majority of our production in the U.S., but it's, obviously, going to make sense to establish a Gigafactory in China and Europe to serve the markets there, because it's not (efficient) to build cars in California and truck them halfway around the world, particularly when you're trying to make things as affordable as possible – that really hurts.
Is that a legally binding promise, that Riverbend will be "kick-ass?" Of course not. To begin with, who is “we?” Is “we” more than Silevo? Musk does not say.
And, in classic Musk fashion, after offering nothing of substance to Buffalo, he immediately begins discussing other projects for which Tesla manifestly lacks funds to pay.
Dear Andrew Cuomo: It’s Time To Ask Tesla To Sign On The Dotted Line
You know what would be fun? Seeing whether New York State Governor Andrew Cuomo, who is made out to be a latter-day Marcus Aurelius in the recitals to the Riverbend agreement, will demand that Elon Musk cause Tesla to guarantee those Silevo obligations.
But for that to happen, politicians would first have to become more honest with their constituents. I won’t hold my breath.
Failing that, the press would need to become more alert and alive to the very shaky nature of the underlying Riverbend deal, including the highly suspicious ways in which it has been amended. Will that happen? TBD.
If I were a Tesla shareholder, or an investment banker getting ready to beat the bushes for another Tesla equity raise, or a Tesla bondholder, or vendor, or other creditor, then the very last thing I would want is for Tesla to be paying any more SolarCity obligations.
(The next-to-very-last thing would be for Tesla to assume any SolarCity obligations, but the ABL lenders have my back there.)
Elon Musk’s Confusion
Let’s review a bit of history. During a conference call in advance of the merger vote, Barclays' Brian Johnson asked how SolarCity was going to pay its $900 million or so of convertible bonds. Was Tesla intending to raise cash and "downstream" it to SolarCity for the convertible bond repayments?
In response, a baffled Elon Musk - evidently unaware either of the structure of the merger transaction or the requirement of the ABL amendment - answered:
It's just one - It's going to be one company.
Which, of course, was not true. It was not true under the structure described in the merger agreement and explained in the amended Registration Statement. And it was not true under the ABL.
That Q&A led to an important twitter exchange between David Tayar and Elon Musk:
Musk's astonishing Twitter dialogue promises both that Tesla will pay SolarCity debts and that Musk himself will pay them if Tesla does not. 290 people, some of them no doubt SolarCity shareholders who were thereby persuaded to vote in favor of the merger, liked Musk's tweet.
Has the tweet plus the evident reliance created some legal obligation on the part of Tesla? On the part of Musk personally?
Probably not, but those are certainly open questions. No prudent and capable general counsel would ever have permitted a CEO to dig such a hole by making such a public and unequivocal statement.
Musk Has A Huge Conflict Of Interest
And so, gentle readers, we have an interesting problem.
Assume you agree with me that, at this moment, the last thing Tesla needs to be doing is down-streaming cash to pay SolarCity debts. And that what Tesla should instead be doing is conserving all the cash it has for vitally needed capital expenditures necessary for the success of the Model 3, the Model Y, and the Tesla semi.
If that's the case, then for the Tesla directors to fulfill their fiduciary obligations, they would direct Tesla management (starting with CEO Elon Musk) to stop down-streaming cash to SolarCity.
Ah, but there’s the rub. Elon Musk (who is the most important Tesla director) promised that if Tesla did not pay SolarCity’s “debt,” then he would personally do so.
Consider this: it may very well be in Tesla’s best interests to stop paying SolarCity obligations for which it has no legal obligation.
But it is not in Elon Musk’s interests, because he has personally promised to pay the debts if SolarCity fails to pay them.
We have a classic conflict of interest. The CEO and director of Tesla is hugely conflicted as regards SolarCity debt. It is in his company's best interest to allow a subsidiary to default on some massive debt obligations. But it is in his personal best interest for his company to satisfy those obligations, even if his company's prospects are thereby crippled.
An immense amount of damage already has been done with the payment of $200 million in Solar Bonds (most to SpaceX) and the $325 million SolarCity revolving credit line.
Much more SolarCity recourse debt remains. I will be most interested to watch how this plays out, starting with the $100 million due to that very same CEO and his cousins next February.
In the meantime, Governor Andrew Cuomo, where do you stand on all this? Are you going to ask Tesla to put in writing that it will perform Silevo LLC’s obligations at Riverbend if and when Silevo fails to do so? Just asking.
A Note about My Assumptions
My calculations of the amount of SolarCity debt Tesla will need to service and pay off are based on the assumption that there will be no net excess cash flow from the assets securing SolarCity's vast non-recourse debt or, if there is excess cash flow, it will be "restricted" and hence unavailable for some time period.
In that regard, I note that the SolarCity acquisition added about $130 million of restricted cash to Tesla's balance sheet. And, it is quite apparent from Tesla's SEC filing that Tesla used 100% of Tesla dollars to pay off SolarCity's $325 million of revolving debt.
Even if some net SolarCity cash yet emerges from the maw of its non-recourse debt, the essential point still stands: there will be hundreds of millions of dollars of SolarCity debt that can be serviced and satisfied only from Tesla's resources if SolarCity is to be saved from a default.
And it is contrary to Tesla's corporate best interests, but in line with Musk's personal best interests, to service and pay that debt.
So, Is It Finally Safe To Short Tesla?
No, I don't think so. Not yet. Certainly, not for any smaller investor who cannot happily part with his or her wager at the casino.
But these factors make me believe the time to short Tesla may be getting closer.
- $1.8 billion more in debt, with its concomitant $96 million in annual interest.
- Potential legal liability for Tesla's over-promising on Autopilot and Full Self-Driving.
- Signs that Tesla made a grievous error in rushing the Model 3 to market without extensive beta testing.
- SolarCity continuing to say "feed me!" while it becomes increasingly apparent that doing so is not in Tesla's best interests.
- A possible change in sentiment.
If I may borrow from Churchill, I might say, now, this is not the end. It is not even the beginning of the end. But, it is, perhaps, the end of the beginning.
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: I am short TSLA via long-dated options