Government Pressure Mounts On Tesla's Struggling Solar Unit

Summary

• Tesla's solar business has been deteriorating for years. The company forecasts further declines in installations in Q1 2019.
• Tesla builds its solar products at Gigafactory 2 in Buffalo, NY. The state provided $750 million in funding in exchange for promises of jobs and billions of dollars in future investment.
• If Tesla fails to meet its first employment milestone obligation in April 2020, it will face steep financial clawbacks.
• State government officials have turned a blind eye to the situation for the most part. Investigations by a number of legislators have brought the issue back into the spotlight.
• Tesla could find itself with significant financial obligations from its Buffalo mess. It also risks losing the goodwill of state governments that have lavished subsidies on it in the past.

Tesla (NASDAQ:TSLA) claims the somewhat grandiose mission of “accelerating the world’s transition to sustainable energy.” That is an awfully lofty goal for a niche electric car company, yet it has won over countless supporters in the financial world, media, and general public.

To support the idea that it is a sustainable energy company, and not just a carmaker, Tesla has branched into other ventures, most notably residential solar. Despite its lofty ambitions, however, Tesla’s solar business has been contracting markedly:

• Installations fell to a five-year low in Q4 2018 and are expected to fall further in Q1 2019.
• SolarCity installation centers are closing all over the country. Investment in solar leasing has fallen dramatically.
• The Solar Roof, a product meant to enter mass production in 2017, has not left the design stage.
• Gigafactory 2 in the RiverBend area of Buffalo, NY, where Tesla’s solar systems are built, has failed to create the jobs it promised in exchange for $750 million in state subsidies.

The list goes on.

Taken together, these developments lead to the inescapable conclusion that Tesla’s solar business is falling apart, as we discussed in a research note published Feb. 7. Yet, Tesla has largely managed to avoid open criticism, especially where its Buffalo factory is concerned.

Unfortunately, for the upstart electric car company, the period of salutary neglect appears to be at an end as state politicians become increasingly vocal in their criticism, sniffing around in ways the government has avoided to date.

As New York wakes up to the problems in Buffalo, Tesla looks set to face stiff financial penalties. Worse still, as its “energy company” mirage dissipates, markets will be forced to come to terms with what Tesla really is: A radically overvalued carmaker in need of a steep downward price correction.

Salutary Neglect (and a nod to Montana Skeptic)

Montana Skeptic, Seeking Alpha’s erstwhile doyen of Tesla criticism on Seeking Alpha, wrote a number of penetrating articles on the subject of Gigafactory 2. All are still well worth reading for anyone not familiar with the truly wild bends and turns of the story:

• “SolarCity's Buffalo Deal Has Lots of Crooked Bends in the River”
• “More Dark Corners of SolarCity's Buffalo Deal”
• “Tesla Has Stiffed New York State On The Riverbend Factory”

Montana Skeptic meticulously (and hilariously) detailed the many bizarre decisions on the part of the government of New York state and Gov. Andrew Cuomo. In the third entry listed above, he offers this cutting takedown of the whole project:

"New York's $750 million investment in the Riverbend factory, measured by any objective standard, is a complete catastrophe. (Not unlike every other New York State spending boondoggle that's supposed to increase employment). The essential purposes of the deal have failed. New York has repeatedly watered down the employment obligations. Neither the employment nor the spending obligations begin to run until the factory is fully operational, which is now said to be at least several years away."

Rather than confront Tesla or admit that the $750 million had been frittered away for virtually no gain, the politicians in Albany preferred to revise commitments downward and act as if everything was going well.

Fast forward to 2019, and little seems to have changed on the surface. Tesla is still nowhere close to achieving its employment promises, despite their having already been seriously watered down from the original agreement. The company reported a headcount of just 800 workers at the plant at the end of 2018, far from the 1,460 it is still obligated to employ by April 2020.

Why would the government of New York sit idly by and offer no public criticism for years on end? Alas, the answer is all too simple. It's not in Cuomo’s interest, or that of his allies in Albany, to bring public attention to such an obvious failure. They are the ones who signed off on it in the first place, so taking a stand now - while in the interest of voters and taxpayers - is not in their own narrow political interests.

Legislators Dig In

Tesla has enjoyed years of salutary neglect thanks to state political leaders’ preference for avoiding a confrontation that would only serve to harm themselves. At long last, however, that time appears to have come to an end.

The pressure began to build the first week of February when local Buffalo reporters published statements from ex-Gigafactory 2 workers who called into question the reported 800-employee headcount. Tim Kennedy, a state senator representing Buffalo, claimed to be “infuriated” upon learning that Tesla had fired 50 workers from the plant during its latest sweeping firing spree, and began to dig deeper into the company’s employment claims. In an article published Feb. 6, Kennedy declared that he was investigating the situation with vigor:

"We immediately contacted Tesla, we let them know that if these allegations were in fact true, certainly they were disturbing and raised eyebrows. We wanted to know the answers...We are yet to get a formal written response from Tesla on these questions."

Kennedy’s outrage is quite understandable given the apparent lack of value for money his constituents have received. Yet, one might think the effort of one local politician would be insufficient to move the needle in Albany, especially as he's a member of the Republican minority. However, he's far from alone. During a budget hearing on Feb. 12, legislators from both parties, including some of the state government’s heavy hitters, went on the offensive. State Senate Finance Committee Chair Liz Krueger, a Democrat representing a district in Manhattan, was particularly scathing:

"So, we spent $1 million per job?...The return doesn’t seem to be translating for the people who live in the city of Buffalo."

Howard Zemsky, New York’s economic development chief, responded to the barrage of criticism by pitching an optimistic outlook:

"I think the RiverBend project has got a better future than it has had a past. I think there’s a path forward for more production there."

However, Zemsky offered little in the way of concrete plans, instead relying on a hope that Tesla would find a way to “diversify the product base” by undertaking new clean energy ventures at the facility, while equivocating that New York would not be investing any further into the facility. That is hardly a recipe for success.

Clearly, the pressure is mounting on Tesla and its backers. Looking the other way is no longer an option. That means Tesla has to either deliver on its promises or start paying serious financial penalties.

Investor’s Eye View

The strange saga of Gigafactory 2 has clearly entered a new phase. Investors may ask why this matters so much. It matters for two key reasons.

The first is the impact on Tesla’s immediate bottom line. Should the company fail to achieve its first employment milestone in April 2020, it will face a financial penalty of $41.2 million. That may not sound like much to a company valued at $55 billion, but it represents 10% of the automaker’s net earnings in Q3 2018, arguably the best results it will ever show. And it is not a one-off charge, but an annual penalty that will be inflicted each year Tesla fails to meet its obligations. The company will also be held to account if it fails to keep up with its pledge to invest $5 billion in New York over the next decade.

Tesla has managed to show profits the past two quarters by cutting capital expenditures to the bone. It will have to spend billions over the next couple years on its proposed China facility, as well as production capacity for forthcoming vehicles lines such as the Model Y and Tesla Truck. The company is trapped between a rock and a hard place: It can neither afford to pay those recurring penalties, nor invest in New York at the level promised.

The second reason the Buffalo story matters from an investment perspective is how it's shifting politicians’ perspective of Tesla. The company has enjoyed billions of dollars in government subsidies, both from direct grants and indirect subsidies such as tax credits. Tesla has received such generosity because it has made big promises with regard to jobs, investment, and transformative technology. If politicians lose confidence in Musk’s ability to deliver on his big promises, those valuable subsidies - which have been absolutely critical in keeping the lights on at Tesla - could dry up, or at the very least come with far more strings attached.

This is especially true in light of the growing dissatisfaction among local governments in terms of value for money obtained from these sorts of big investments. The case of Amazon's (AMZN) withdrawal from its planned New York HQ2 project in the face of local government pushback should be seen as an ominous sign for Tesla's future ability to rely on public largesse.

Tesla’s growth narrative is built on promises of monumental growth across a host of business segments. The slow collapse of its solar business will not destroy the company, but it will compromise its ability to survive on subsidies, as well as put significant downward pressure on its share price.

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.