Tesla Motors Inc: Junk Quality or Not?

Earlier this week, Standard & Poor's Ratings Services gave Tesla Motors (NASDAQ: TSLA  ) a non-investment rating of B- on the company's corporate debt. That puts the company on par with countries like Congo and Pakistan. Are Tesla shareholders risking too much?

Model S. Image source: Tesla Motors

The rating
What does a B- rating really mean? According to the rating agency's website, debt that falls under this rating is "[m]ore vulnerable to adverse business, financial and economic conditions but currently has the capacity to meet financial conditions."

Standard & Poor's makes some good points.

First and foremost, Tesla's $2.9 billion in convertible bonds is a substantial sum for a company with about $700 million in revenue last quarter. Even worse, the company still isn't consistently reporting positive GAAP net income yet.

But the biggest risk, according to Standard & Poor's, is Tesla's lack of resources to withstand industry shifts. 

Our "vulnerable" business risk profile assessment incorporates Tesla's narrow product focus, concentrated production footprint, small scale relative to its larger automotive peers, limited visibility on the long-term demand for its products, and limited track record in handling execution risks that could arise in managing high volume parallel production.

In other words, Tesla doesn't have the research and development capacity to respond to rapid change. For instance, say, hydrogen fuel cell technology for vehicles suddenly becomes feasible, compelling, and marketable -- so much so that battery vehicles can't keep up. If something like this happened, bigger auto peers would have the capital needed to make rapid changes, and Tesla wouldn't.

A necessary risk
On the other side of the coin, it's Tesla's pure play on electric vehicles that gives it an advantage over its peers.

Photo: The Motley Fool

If the company hedged its bets with other technologies, Tesla wouldn't have the capacity to make big bets on the future of its fully electric cars, like it is by building the Gigafactory, or the world's largest factory for producing lithium-ion batteries. In fact, investors would likely flee in droves if Tesla CEO Elon Musk suddenly expressed a new plan to hedge its bets with lithium-ion technology by testing new hydrogen fuel cell vehicles. It's Tesla's focus that gives investors confidence. Without it, Tesla wouldn't be able to execute with such ambition and timeliness.

But even though that "narrow product focus" the rating agency is worried about may be one of the key drivers behind the market's optimism for Tesla, it doesn't make Standard and Poor's objections unmerited. If Tesla's limited visibility of the demand trajectory for electric vehicles turns out to be too bullish, the company would, indeed, have a very rough road ahead -- Tesla has no plan B.

This is why a bet on Tesla, in many ways, is a bet on electric vehicles. Further, this is also why a bet on Tesla stock partly boils down to a test drive in a Model S. Investors have to ask themselves once they experience the technology, "Does Tesla's approach to electric vehicles undoubtedly have a big place in the future?"

Someone has to take a big risk to give electric vehicles a chance, and Tesla is the company has chosen to do it. As a focused niche player, the risk is certainly there, but so is the upside potential over the long haul.

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Read/Post Comments (6) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 31, 2014, at 1:33 PM, StanO6 wrote:

    I'm not concerned.

    Among all of the accolades Model S received to date, Car and Driver magazine just gave it another: Model S has the best aerodynamics.

    Consider, all of the talent at all of the automobile manufacturers, yet Tesla Motors continues to do it better.

  • Report this Comment On May 31, 2014, at 2:31 PM, deeageaux wrote:

    If what we currently understand to be some basic scientific truths radically changes and hydrogen fuel cell vehicles become a better option than lithium ion battery electric vehicles then Tesla is in trouble.

    That is a "gamble" I am willing to bet on.

  • Report this Comment On May 31, 2014, at 3:50 PM, LikeTesla wrote:

    Not seeing Fuel Cells as a viable threat!

    There is simple physics and then also the infrastructure build out cost! Why would you want to develop something that is only carbon neutral if you have four times excess power capacity and that all generated by renewable "green" energy. You have to have four times excess ..., waste three to make one. Not seeing the "common" sense logic there!

    http://phys.org/news85074285.html

  • Report this Comment On May 31, 2014, at 4:46 PM, PaulsMax wrote:

    I generally think that the ratings agencies (especially after 2008) like S&P have a done a better job on analyzing debt instruments. Two points on this: S&P's concerns for Bondholders, should translate into a message to equity shareholders. Is S&P always correct? Obviously the answer is "no," but , at a minimum, they do a very good job of laying out the risks of an investment opportunity.

    In the case of Tesla, I think S&P raises very legitimate points about the industry dynamics and landscape. My primary concern is that Tesla's chances of out-spending and out-pacing the likes of Toyota for full electric technology are low. Toyota management is not stupid. The Prius is a very profitable vehicle due to the economies of scale Toyota has enjoyed on hybrid technology. If fully electric cars are the profit center of the future you can bet Toyota will be a big player. Toyota has $36 billion in operating cash flow, versus just $250 million at Tesla. I think there is some chance that Tesla will be a niche player with a focus on the premium/luxury vehicle segment.

    I currently own a Honda hybrid. The Tesla as is an amazing vehicle, that is definitely on my short list for my next car. The biggest concern for me is that Tesla will be the next Fisker and may not be around in 5-10 years. My friends who bought Fiskers for over $100,000, now have lawn ornaments.

    While TSLA may end up being a successful company long-term, S&P's rating, which is not just "junk," but is 6 notches into junk territory, argues that the probability of bankruptcy is greater than long-term success. Statistically, S&P ratings have been very good at predicting probable bankruptcy. In bankruptcy, equity shareholders get wiped out.

  • Report this Comment On May 31, 2014, at 5:13 PM, PaulsMax wrote:

    I should also add, loving a product, does not necessarily equate to a good investment opportunity. I am extremely impressed by the Model S after test-driving a friend's. That said, i loved the Fisker even more, which IMHO has much better styling than the comparably bland Model S. I am glad I never bought a Fisker given what happened to their customers after the company went into bankruptcy.

    While Tesla has great promise, I think that S&P is just putting a realistic probability of their succeeding as an ongoing concern with their B- rating. The barriers to entry for Toyota are relatively low - especially when you consider the massive cas flow and balance sheet that Toyota commands.

  • Report this Comment On June 01, 2014, at 12:49 PM, dlwatib wrote:

    S&P rating on Tesla debt may not matter very much. They have already sold what they need to build their first gigafactory. And the main value of the bonds was the attached stock warrants anyway.

    Of course Tesla is a high risk stock. But when the CEO is Elon Musk that reduces the risk an awful lot. The guy does what he sets out to do, and he not only does it, he does it with style and excellence. I actually have no doubts whatsoever that he will repay those bonds on time.

    The real question for Tesla is: How long is it going to take to grow the company to the same size as one of the major automakers like Toyota? To achieve that goal it needs to be about 20x as big as it is now. I'm guessing about 15 years.

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