Tesla: A Case Study

Apr 2, 2018 | Case Studies

Tesla’s financial position is weak due to ongoing and cumulative losses from operations. Because Tesla continues to lose money, it is reliant upon new capital to support its continued operations. The weakened financial position and growing capital needs put the company in a precarious position, with the very survival of the company left to the whims of the capital markets (the providers of capital).

With its lack of earnings and large cash burn, Tesla has relied on raising new capital at regular intervals to continue with ramping production. To date, the capital markets have obliged with fresh capital. In our assessment, capital markets have done so with very cheap credit, especially considering the company’s up-until-now single-B credit rating (this is very weak). With such a high equity market capitalization and no earnings, the company cannot consider (though we think it should) raising equity without driving share prices off a cliff. Successive investors would demand a more favorable entry price, and existing investors would seek to avoid dilution so that the stock price would respond adversely.

 

Without reasonable access to equity capital, Tesla is left to just borrow more. Except, creditors seem to have finally awoken from their slumber. Negative cash flow, limited value assets (again, negative cash flow), senior management departures (we counted three in March alone), quality control issues, ongoing failure to meet production targets, et cetera are causing creditors to rethink Tesla’s risk premium. Helping wake creditors, Moody’s downgraded Tesla’s senior unsecured credit rating deeper into junk territory from single-B to triple-CCC (B3 to Caa1), citing production shortfalls of the Model 3 and pending maturities of convertible bonds. We don’t think Moody’s is wrong in doing so because Tesla is precariously close to bankruptcy. The bond price collapsed, and yields spiked higher as a result.

Recent market activity – namely, bonds repricing for much greater risk – seems to have shuttered another door for much needed capital. As its cash burn continues, Tesla has a tall order ahead for replenishing liquidity. While we suspect Tesla has another trick or two up its sleeve to raise capital, each successive round will require ever more pounds of flesh, which comes at the expense of existing capital providers – both equity and creditor. Creditors assuredly woke up, and now, equity investors may be waking up too…

In the latest SEC 10-K filing (annual report covering the year ended 12/31/17), Tesla reported a net loss of -$1.96 billion attributable to common stockholders (its biggest ever loss) and cash flow from operations of -$60 million. The latter number seems almost refreshing when framed against the $4.97 billion accumulated deficit reported in the shareholders’ equity section of the balance sheet. This is because it implies Tesla is $60 small-million away from breakeven operations – from a cash flow standpoint anyways. But this figure comes before considering cash needed for investing activities. Even mature companies spend large sums refurbishing fixed assets just to maintain operations. During 2017, Tesla spent $3.41 billion on capital expenditures (how else would Tesla manufacture cars, if not with equipment?) and $660 million on other equipment purchases related to long-term sales financing of solar panels. (We won’t delve into solar financing, which is under the Solar City brand, here because the explanation is too wordy for purpose of this writing.) The combined automobile manufacturing and solar equipment expenditures totaled more than $4 billion. Because cash flow from operations has been negative in each year (with exception of 2013) going back to 2009, Tesla has relied on new capital to finance capital expenditures. Economic law dictates that (in the long-run) cash flow from operations must exceed capital expenditures if capital providers are ever to get their hard-earned money back. With ever increasing losses and continued cash burn, investors must make value judgments of when, if ever, and by how much cash flow from operations will exceed capital expenditures. Without such rational assessment, an investor is speculating – and likely to face – permanent loss on their investment.

 

Tesla’s current equity market capitalization is $42.5 billion, but it reached a high of $60 billion in January and February this year. As noted above, Tesla lacks earnings and positive cash flow, does not pay a dividend, and carries a credit rating of triple-C. For context, here are profiles of Tesla’s American competitors:

 

  • General Motors (GM): net income of $10.6 billion, cash flow from operations of $17.3 billion, which exceeds $8.4 billion of capital expenditures for $8.8bn free cash flow. General Motors pays a dividend, currently yielding 4.25% at $35.70 share price. The credit ratings are triple-B (investment-grade). Market capitalization is approximately $49 billion.
  • Ford Motors (F): net income of $6.4 billion, cash flow from operations of $18.0 billion, which exceeds $7.0 billion of capital expenditures for $11.0 billion free cash flow. Ford pays a dividend, currently yielding 5.55% at $10.80 share price. The credit ratings are triple-B (investment-grade). Market capitalization is approximately $43 billion.

 

We ask rhetorically, why should investors be willing to pay more for Tesla than General Motors and Ford?

 

In the old days, growth capital came from equity financing. Once an asset was proven to generate reliable cash flow, credit could be applied to the asset to create leverage and increase returns to equity. Nowadays, in the era of central bank monetary easing, credit has flowed easily and depressed risk premiums in both credit (low interest rates) and equity (high multiples) markets. Investors seemingly couldn’t find business ideas they didn’t like. In the case of Tesla, credit was applied to assets not yet producing reliable cash flows – more than $5.4 billion has been borrowed in the name of Tesla. Without cash flow, the creditors cannot be paid unless more capital is raised. In the old days, without payment to creditors, companies would go bankrupt, and assets transferred from common stock owners to creditor owners.

 

With Tesla’s current operating profile and capital needs combined with the company’s market price, we think of the situation as akin to running with a noose around your neck. Maybe you won’t trip and fall, but running is quite careless. In Tesla’s case, a stock priced for perfect operational execution (as we think recent price indicates) seems careless. Any operational tumble could result in that noose tightening and an air pocket like drop in stock (and bond price). We wonder if recent drops in price of Tesla’s stocks and bonds may be foretelling.

Producing the Model 3 (Tesla’s mass-market car) profitably and on (the new revised) schedule is, more than ever, critical to Tesla’s ability to raise more capital and continue as a going concern. Even if Tesla can deliver on said requirements, we are not convinced the equity is priced right for the ongoing risks of an immature company competing with established and mature titans – who have decades of manufacturing experience and greater financial fire-power.

 

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07/2017 – Market Commentary

Aug 15, 2017 | Market Commentary

Oil Market
Energy Private Equity
Amazon Retail | Financial Services
China
Greece
AstraZeneca

Combining our experience and daily focus, we aim to process, distill, and comment on various activities in the market place here in the Market Commentary section. Our purpose is to get you thinking about things in order to avoid just re-presenting otherwise meaningless statistics like unemployment level, S&P 500 closing price, etc. Ballast will provide you this commentary on an ongoing basis with the intent of delivering insight and color that is not readily available through public outlets. We assume that you are familiar with common sources for latest readings of Dow or S&P closing prices and that you see the major headlines like the Federal Reserve Bank having increased or decreased the Fed Funds rate.

In our opinion, a great deal of time and energy from sell-side economists is spent addressing unemployment, ISM Index, payrolls and all the other monthly economic releases, speaking to facts without necessarily instilling wisdom. To us, this is an outcome of the age of Google – anyone now has the ability to quickly search the internet for facts and information (and now disinformation). But knowing facts and information is different than having knowledge and wisdom.

Here are some insights from July events to highlight some of the things we have worked on and thought about on behalf of our clients:

Oil Market

With oil prices in decline for most of the month of July, high-yield debt markets began to reflect trouble in energy-related credit again. The Ballast team began re-examining some of the companies/bonds from 2015-2016 to reacquaint ourselves with the energy sector. It’s still early, but we think the opportunity could re-open if WTI oil trades back below $40/barrel, a price not seen since early 2016 when the energy sector “recovered”.

 

There remains a variety of reasons that oil could trade lower.  First, U.S. shale oil producers continue to grow output through increased drilling and well completions (a large number of wells were drilled but uncompleted from before and during the “crisis” of 2015-2016), which are relatively cheap to turn on in the current price environment. Operations are booming again so much so that there is said to be equipment scarcity. What!? Further, OPEC (Organization of the Petroleum Exporting Countries) is struggling to maintain its output reduction quotas due to turmoil across much of the middle east, select members being exempt from the cuts (Nigeria, Iran, Libya, et al), and suspected cheating. Oil demand continues to fall short of projections, which has kept supply in excess of or matched demand, leaving oil storage facilities around the world highly utilized much more so than in recent history. Storage levels have fluctuated regionally and traders have reacted in a number of different ways, with the result being price volatility. We think these points highlight the sensitivity and vulnerability of oil at present and therefore, positively reflect the opportunities that may arise over the next year.

Energy Private Equity

EnerVest, a large energy-focused private equity group based in Houston, Texas, splashed investment headlines during July. They had the distinguished honor of having the first private equity fund of initial size greater than $1.0 billion to go bankrupt – that’s right, their investors are likely to get zero ($0.00) of their capital back. One of EnerVest’s other funds has a NAV (Net Asset Value) described as “pennies on the dollar” and yet another one of their funds is at a material discount to initial contributed capital. We are not surprised to see such news for the industry and would not be surprised to hear of more of these instances in coming years.

Amazon Retail | Financial Services

Amazon never ceases to amaze and bewilder investors. Sears announced it had reached an agreement to sell its Kenmore appliances on the online retailer. The news boosted Sears while competitors in the space – Lowe’s, Home Depot, et al – saw their stock prices fall by 4% or more. This goes back to our thoughts on Amazon from June Market Commentary. While we think the agreement may help Sears at the margin, we remain unconvinced of the near-term implications for Lowe’s, Home Depot, et al.

 

Amazon hasn’t stopped making headlines there, though. In fact, there is nothing this company seemingly cannot disrupt. The latest news here is that Visa, Mastercard, Paypal, et al face long-term disruption from Amazon. Although the news did not seem to move stock prices adversely, we think the article commentary was another example of analyst over-reaction. Otherwise, we hope Amazon does not start an investment advisory business. On that note, robo-advising is on the rise and is likely to be a topic of a future Ballast piece. Stay tuned.

China

Under pressure from both Chinese and U.S. governments, there has been more news of Chinese companies slowing acquisitiveness. We think a significant portion of today’s market valuations reflect takeover premiums – that is that the potential for company to be acquired is reflected in its price. Since Chinese companies have been a large participant in acquisitions in recent years, we think the absence of Chinese buyers will slow acquisitions and cause the equity markets to move sideways until another catalyst emerges for an up or down movement.

Greece

Greece has been in financial trouble for a number of years. The EU, rightly or wrongly, has held Greece financial prisoner. The country has been forced to implement strict measures to shore-up large and long-running deficits in order to stabilize outstanding debts of the country. Further, Greece has been in and out of recession for at least half a decade, and needless to say, the bond issuance from the country has been both infrequent and high-yield. The country is at a level comparable to emerging market countries.

 

Greece was able to issue €3.0 billion five-year bonds to the market at 4.625% yield with the deal two-times oversubscribed, which means there was twice as much interest in the deal than bonds available. While it’s not a century bond like Argentina issued in June, we think the Greek issuance echoes our thoughts on the Argentina bond we commented on in the June Market Commentary piece. Investors appear to be yield-hungry regardless of risk.

AstraZeneca

AstraZeneca (AZN), a global pharmaceutical company, reported  disappointing research of a key trial drug in the company’s pipeline. The drug is an immunotherapy for treating lung cancer, and it was expected to be a blockbuster (high revenue and earnings potential) and a primary treatment for lung cancer patients. On the news, AZN stock promptly traded 16% lower. This made sense to us given the significance the drug represented to future earnings.

 

Thinking this would be an opportunity for the credit side, we looked to the bonds for more attractive value. What we found did not make sense – bond spreads remained at recent tights (low spread means high price) and so the bonds remain richly valued. Having followed the company for a few years, we think the announcement means more than has been reflected in the credit spreads. Front in our mind is that Pfizer (PFE) made an offer to acquire AZN three years ago for £55/share and AZN “successfully” resisted the takeover, causing PFE to walk away. As of this writing AZN shares trade at £42. We’ve seen this type of thing several times in the last five years and cannot understand the governance at some of these pharmaceutical companies.

 

Underscoring our caution with AZN valuation, the CEO was rumored to be a top candidate to take the vacant seat at Teva, another pharmaceutical company – and a story we have followed. The AZN news may be just the thing for its CEO to make the switch. This would open AZN to strategic uncertainty, and it confirms the execution of strategy at AZN is not what was otherwise anticipated, as well as the fact that the Pfizer deal was a good deal. The only thing we can think of is that creditors believe a takeover is now back in play (which would come at the cost of shareholders’ lost opportunity three years prior), and so credit spreads may be reflecting this. A takeover is uncertain and the acquirer could be of weaker credit quality, so tight spreads are of little interest to us here.

 

We think this was a rare instance where the equity analysts and market reacted correctly and the credit analysts and market did not. We passed on AZN for now as the opportunity has not materialized as we expected.

The Ballast investment team continuously monitors events like those outlined above, as well as the opportunities that arise from them.

 

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