Looking into the Tesla opportunity // Part3
The impact of part 1 and 2 on cash burn and capital issuance.
Note: This publication has been split in three parts. In part 1, we’ll examine Tesla’s latest convertible notes issuance and the associated risk. In part 2, we’ll explore Tesla’s main investment theses and assess how likely they’re to materialize. In part 3, we’ll evaluate the impact of the conclusions drawn in part 1 and 2 on cash burn and capital issuance. Finally we shall go full circle and decide if the convertible notes make for an attractive investment.
PART 3
Capital intensity and consequently future cash burn is hard to assess. Chrysler was the last successful automaker to be founded. That was 8 decades ago. Ford was the last successful automaker to IPO. That was 5 decades ago. For market incumbents, manufacturing is in place, investing in tooling and equipment has been made. Their book value has a long-standing history built into them. There are no comparable out there. With little to nothing to extrapolate from, we shall limit ourselves to forecasting 2017 in order to avoid falling in too speculative territory.
- Cash needs for investments:
If one thing is for sure, it’s that scaling production will be expensive. Management guidance for 2017 puts capital expenditure at ~$4bn for production line 1 and 2. It’s more then x3 what Tesla spent in 2016.
It’s important to point out that management projections are stated as being highly hypothetical. Tesla has not yet finished building its first assembly line for the Model 3. In Elon’s words “We don’t know exactly where the trouble points are going to be”.
- Cash needs for operations
In 2016 Tesla operational cash burn came in at $124m. Barclays’ Equity research team anticipates operating expenditures to reach ($312m) by 2017.
The 10-K states purchase obligations for 2017 at $2.76bn. Some of them such as purchase of batteries have already been accounted for in operating expenditures. Equity research consensus places total car sales at ~90,000 units. At 85kWh batteries per car and ~$165/kWh we get $1.26bn of purchase obligations that have already been accounted for. That leaves $2.76-$1.26 = $1.5bn most of which are probably part of the $2.5bn planned capital expenditures. With limited information, we shall leave it at that.
That brings Tesla total cash burn for 2017 at $4bn + $312m = $4.3bn.
As of 2016, Tesla was sitting on $3.5bn of cash. The firm is likely to burn $4.3bn in 2017. How does Elon intend to bridge that gap?
- Cash needs from financing
After issuing shares and notes, Tesla raised an estimated $1.37bn —that’s assuming its underwriters have exercised the full extent of their over-allotment option. On top of which Tesla entered into $131.5m hedges and incurred $9m fees. The total net amount raised was consequently ~$1.23bn.
The amount raised should also be netted against other obligations in order to get a full picture. In 2017 there are $508m of SolarCity debt that are coming due. That’s assuming that Musk Inc. kicks its SpaceX loan down the road — which would make sense, given its strategic implications. Hence, Tesla is left with $722m available from financing.
- Additional issuance
That’s $3.5bn + $722m = $4.22bn on hands to meet its projected $4.3bn needs. With the ABL being almost entirely tapped out, there is just enough to see through the year.
Operating cash flows being in negative territory, the company is not going to be able to meet its 2018 cash requirements.
It’s highly likely that Tesla will be raising additional capital before the end of 2017 to face its 2018 cash requirements. To do so the auto firm might find that it has few options left.
There is a cap on how much debt Tesla can raise. A closer look at its ABL indenture shows that, barring a waiver; Tesla’s remaining runway for more debt is, at most, $150m.
The company will have to issue more stocks.
The firm has successfully issued additional shares without diluting its current shareholders in the past. However, this could very well be the end of it. If anything, the 2.375% convertible notes hidden cost suggests limited market appetite for new equity.
- Price floor
Tesla shares are likely to take a hit after an additional issuance.
Convertible notes
As of June 2017, the 2.375% convertibles are trading at 1.21 on the dollar. This premium added to the notes conversion price is equal to $21+$327.50 = $348.50. Which is ~ equal to today’s Tesla’s opening price of $346.
There could be an advantage of buying these notes instead of regular share though. We’ve seen that implicitly SpaceX’s credit rating is that of the US government and so is Tesla. Consequently, convertibles are unlikely to trade below par. Buying the convertible instead of regular shares could get us some downside protection.
At 1.21 on the dollar the convertible yield to maturity is -1.71%. That’s the cost of protection.
Stock
Going back to our Musk Inc. graph.
We mentioned that it would have implications on Tesla’s minimum stock price.
There are three things that matter to Elon: funding his projects, keeping control over them and maintaining a high valuation. These three objectives will start to conflict in the event of a squeeze. If such was the case, what happened with SolarCity provides us with some insights on which of these 3 elements truly matters to Elon.
By getting Tesla to buy the nearly bankrupted SolarCity, Elon was able to keep it alive and more importantly maintain his control. SolarCity was heavily indebted and merging with Tesla was likely to impact the latter’s valuation. And it did for a short spat of time. With SolarCity, Elon chose control over maintaining a high valuation. Control is what truly matters to Elon.
Now, how does this impact Tesla’s stock price?
Elon personal $490m debt is secured against his Tesla shares. The car firm’s shares would have to fall by more then 2/3 before the loans went underwater. That’s when Elon would loose control over Tesla. If what happened with SolarCity is any indication, that’s a line Elon is not willing to cross. Hence, it’s pretty safe to assume that Elon will do anything in his power to keep Tesla’s share above that threshold. In other words ~$100 is a relatively safe floor for Tesla’s stock.
Conclusion
- There are too many moving parts to make a reasonable assessment of Tesla’s future financial performance.
- However, no matter which investment thesis ends up materializing and to what extent, the outcome is likely to be disappointing: either underperformance or dilution.
- Holding the notes could provide Tesla’s investors with upside exposure while keeping some downside protection — notes are unlikely to trade below par while stocks have an implicit floor at ~$100.
- Overall, 1.71% seems like an expensive hedge for a limited long-term payout.
Thanks for reading — feel free to reach out with any thoughts by replying here or on my twitter 👋
