Analyses and investment views

Bond excesses, part I. - Tesla

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Bond excesses, part I. - Tesla

Tesla, the manufacturer of cars by the same name, has issued its first classic bonds. With a volume of USD 1.8 billion, the bonds are due in 2025, have a 5.3% coupon, and are rated B-, which is deep in speculative territory. Are these bonds a good investment or is it better to avoid them?

Almost all companies work with debt. A common feature of companies with sustainable competitive advantage is that they do not need much debt for their activities. At times of crises, great debt is undoubtedly the most common cause of mortality among companies and of permanent losses for investors. We should determine what level of debt is acceptable based on fulfilment of the following conditions:

1. Is the value of assets greater than the value of liabilities? The balance sheet test.

2. Does the company have sufficiently high operating cash flow or a possibility to sell assets to satisfy the demands for servicing the debt plus its repayment? The cash flow test.

3. Does the company have the possibility to acquire capital in the markets should its cash on hand not be sufficient? The liquidity test.

In theory, it is enough if a company fulfils at least one of these conditions. That leaves it vulnerable, though, and it may end up being insufficient. In 2008, we witnessed a number of companies losing their access to capital through the market and, because this was the only option the managements were relying upon, they found themselves in unresolvable financial situations. Their choices were bankruptcy, forced sale of undervalued assets, sell-off of entire companies at low prices, or large share issues at miniscule prices. All these actions constituted permanent losses for their shareholders.

So how is Tesla doing with a view to these three conditions?

On its balance sheet, we see that it has equity of USD 5 billion. Because, however, more than USD 6 billion of its assets are assets of Solarcity, a company bought just before its bankruptcy (and managed by Musk’s cousin), the value of its own net assets theoretically convertible to cash will be much lower, maybe even negative.

Concerning cash flow, Tesla is in a much worse situation. Tesla is no young start-up. It is a company 15 years old that has consumed almost USD 9 billion for its activities. This has been acquired through issuing shares and convertible bonds along with billions more in loans taken on. The current amount of debt even before the issue of the new bonds is almost USD 8 billion. Most of this money is gone. Tesla currently has negative cash flow of more than USD 2 billion per year and there is no hope for a quick improvement. Therefore, Tesla also does not pass the cash flow test. We have great doubts about the very sustainability of its business model.

Tesla has based its entire existence on successfully convincing its backers to pour in more and more money. These speculators are mesmerized by Elon Musk and tenaciously keep Tesla alive by repeatedly buying up new share issues. If this situation comes to an end, it will be a big problem for Tesla. The new bond issue will bring Tesla cash for some 9 months of its continuing existence, but at the same time it increases interest costs by USD 95 million per year and substantially worsens the company’s balance sheet.

It is a mystery to us why Tesla is issuing debt and not shares. Because the shares are at least 100% overpriced, it would be logical to exploit this situation by issuing as many new shares as possible. The high price of Tesla shares is the only thing the company has going for itself so far. It is probable that this advantage is only temporary and that disillusionment will set in sooner or later. Even under an optimistic scenario for Tesla’s future development with the company selling 1 million cars annually within the next 7 years, it will need at least another USD 15 billion of new cash.

But manufacturing a million cars per year is no small matter. Today, Tesla has immense problems manufacturing just one-tenth that number. In addition, even selling a million cars is no guarantee of Tesla’s profitability. Its technological head start vis-à-vis its competition is rapidly diminishing, and most other automotive manufacturers have incomparably greater resources and possibilities for further research.

Tesla’s newly issued bonds make no sense to us. A 5.3% coupon is terribly low in comparison to the risk they carry. It also puts Tesla’s shareholders into a worse position because the pressure on the balance sheet and cash will increase substantially. From the company’s perspective, it is a rather incomprehensible step. Instead of Tesla’s exploiting the high share price and doing a massive share issue, it is taking on debt, thereby unavoidably weakening its share price and the only real possibility available for its financing. The only ones really liking this bonds issue must undoubtedly be the investment banks that will receive an estimated USD 30 million in fees for executing it. Invest with care!

Daniel Gladiš, 15 August 2017


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