Image source: SolarCity.
The following piece is the author's opinion and does not reflect an official position of The Motley Fool or any of its premium newsletters.
At The Motley Fool, our mantra has always been "to educate, amuse, and enrich." We've long been the independent voice of reason, arming individual investors with information for them to make better decisions in the crazy world that we call the stock market.
With that framework in mind: Tesla Motors (TSLA +0.63%) made an offer yesterday to acquire SolarCity (SCTY +0.00%) in an all-stock deal that values the company between $26.50 and $28.50 per SolarCity share. This represents a premium of 25% to 35% compared to Tuesday's closing price of $21.19.
That premium might look impressive at first glance. But some Foolish fundamental analysis tells us that the offer on the table is actually far too low.
The merits
Let's start with some background about SolarCity and an explanation of why Tesla wants to acquire it.
Many of us at The Motley Fool are big fans of SolarCity, and we have it as an official recommendation in several of our premium services. It is a great company with a strong mission statement and visionary management. And it has a massive growth runway ahead of it, with still less than a 0.2% share of the multitrillion-dollar U.S. electricity-generation market.
Elon Musk is both chairman of SolarCity and CEO of Tesla. He makes a compelling case for why combining the two companies would make business sense:
We would be the world's only vertically integrated energy company offering end-to-end clean energy products to our customers. This would start with the car that you drive and the energy that you use to charge it, and would extend to how everything else in your home or business is powered....
We would be able to expand our addressable market further than either company could do separately. Because of the shared ideals of the companies and our customers, those who are interested in buying Tesla vehicles or Powerwalls are naturally interested in going solar, and the reverse is true as well....
We would be able to maximize and build on the core competencies of each company. Tesla's experience in design, engineering, and manufacturing should help continue to advance solar panel technology, including by making solar panels add to the look of your home....
Culturally, this is a great fit. Both companies are driven by a mission of sustainability, innovation, and overcoming any challenges that stand in the way of progress.
The deal is undoubtedly transformative for Tesla. The company can use its shares (which are arguably valued at a premium) as currency to buy up SolarCity's bright future. It wouldn't be a stretch to see Tesla sell cars and Powerwall battery packs to SolarCity's existing customer base.
The deal also makes a lot of sense for multibillionaire Elon Musk, who can transfer his corporate ownership like poker chips from a smaller to a larger empire. Due to SolarCity's ailing stock price, Musk would be selling low shares of the company he owns $478 million of (due to his 22% stake in SolarCity) in exchange for incorporating its benefits into the company he owns $6.8 billion of (his 21% stake in Tesla). It's indeed a "no-brainer" decision for him, since he financially has 14 times larger an interest in Tesla than he does in SolarCity.
But it's not as clearly a good deal for SolarCity shareholders. Non-billionaire individual investors, whose personal net worth isn't heavily leveraged to Tesla, would be seeing their investment swooped out from under them at a valuation significantly lower than what SolarCity is actually worth.
Why the valuation is too low
A significant portion of SolarCity's current valuation is due to existing contracts already in place. The "premium" offered today simply does not give the company enough credit for the future growth this business is capable of.
To demonstrate, let's look at the value of those existing contracts. The following chart is adapted from a piece we published in our Motley Fool Million Dollar Portfolio service last month.
| Metric | Q1 2016 | Q1 2015 | Q1 2014 |
|---|---|---|---|
| Pre-tax unlevered NPV (in billions) | $3.62 | $2.03 | $1.03 |
| Non-recourse debt (in billions) | ($1.63) | ($0.62) | ($0.21) |
| Pre-tax unlevered NPV to equity holders (in billions) | $1.99 | $1.42 | $0.82 |
| Weighted shares outstanding (in millions) | 98.1 | 96.7 | 91.4 |
| Pre-tax unlevered NPV to equity holders (per share) | $20.33 | $14.63 | $9.02 |
Data source: Author's notes/earnings presentations. NPV = net present value.
SolarCity already has more than two gigawatts of solar panel capacity installed on rooftops across America. Those systems are continually generating power, which residents and businesses pay for on a monthly basis (just like a utility). Terms specifying the price and minimum output are written into contracts, which run for a period of at least two decades.
If we take all of those future payments, subtract all maintenance and financing costs, and discount the result to the present, we come up with a metric called pre-tax unlevered NPV, which is the present value of all of the company's future cash flows. The company often sells off those future cash flows to other investors in order to raise cash up front, so we can further deduct non-recourse debt to get a present value of what is owed to us as common shareholders. In the most recent quarter, that value was $1.99 billion -- or roughly $20.33 per outstanding share.
Let's stop and think about that for a second. This $20.33 per share is the value of SolarCity to shareholders if the company achieves absolutely zero growth going forward. The contracts are already in place and the systems are already generating power. It essentially assumes that SolarCity just continues serving its existing customers and collecting their monthly checks.
But the thing is, SolarCity is actually adding more value for shareholders every year. The present value of its existing business (pre-tax unlevered NPV to equity holders) has increased from $9.02 per share two years ago to $14.63 per share last year to $20.33 per share today.
The high end of Tesla's offer ($28.50 per share) values all of SolarCity's future growth to be worth about $800 million, or roughly $8.17 per share. That's the value that Tesla believes all of SolarCity's future commercial installations, international expansion, and in-house production efficiencies are worth for shareholders.
I think that assumption vastly underestimates SolarCity's true potential. SolarCity has become a vertically integrated fine-tuned machine. The company plans to install more than one gigawatt of new capacity in 2016, which would be a 50% increase to the two gigawatts of cumulative capacity it has deployed up to now in the decade it's been operating. Due to the combination of maturing financial markets and its in-house operational improvements, SolarCity is now capturing a spread of nearly $0.50 of value per watt deployed. Considering that gigawatt of new capacity coming on line, that could easily add up to $500 million of added value in this year alone.
Several Wall Street analysts are able to decipher this financial mumbo-jumbo and recognize the true potential of this business. The median price target of the 15 firms who cover the company is $31. The high price target among consensus estimates is $50.
Elon Musk seems to understand the value of SolarCity as well, personally having bought more than $28 million worth of shares on the open market during the past year:
| Date | Shares Transacted | Avg. Price per Share | Total Amount |
|---|---|---|---|
| Aug. 24, 2015 | 123,510 | $40.49 | $5,000,364 |
| Nov. 12-13, 2015 | 307,152 | $25.35 | $7,786,062 |
| Nov. 16, 2015 | 198,615 | $26.45 | $5,253,109 |
| Feb. 12, 2016 | 569,680 | $17.56 | $10,001,245 |
| Total | 1,198,957 | $23.39 | $28,040,780 |
Source: SEC Form 4 filings.
Short-sellers and dark-cloud headlines
Complicating matters even more, fear is at its apex for SolarCity right now.
Earlier this year, Nevada made retroactive decisions to reduce net metering rates and impose fees on solar customers who connect to the utility grid. Those were not solar-friendly moves, and they essentially slashed all of the state's renewable energy progress it had made during the past decade (not to mention also inciting a public backlash). Investors have sold off the stock, fearing other states might follow Nevada's lead and impose their own solar-unfriendly regulations. The fear of future uncertainty isn't all that different from what we've seen at Chipotle (another company we also love for the long term) during the past six months.
Short-sellers, well aware of the negative publicity, have taken advantage of the opportunity of the market's hesitation and pushed the stock down even further. As of May 31, nearly 50% of SolarCity's publicly traded shares were sold short.
Having half of a company's public float sold short is incredibly high. But businesses that can survive the negative sentiment eventually see the pendulum swing the other way. Short-sellers' window of opportunity (i.e., profiting when negative sentiment is high and a company's future looks bleak) closes when a business demonstrates strengthening performance. This often results in a phenomenon commonly known as a short squeeze. When a large number of short-sellers simultaneously look to cover their positions, the stock price can very quickly vault higher.
Musk is already well aware of the short squeeze phenomenon, which Tesla itself experienced in May 2013. Investors who were dubious about Tesla's future were proven wrong when the company reported its first profit and received accolades from Consumer Reports. The short squeeze took full effect, and Tesla's stock price rallied 57% in just one month.
The Foolish bottom line
There is one final twist to this story that makes it even more relevant to individual investors. Musk, fellow board member Antonio Gracias, and Musk's cousins, Lyndon and Peter Rive, have declared that they are too heavily invested in SolarCity and Tesla and so have recused themselves from voting on the proposal. They are leaving the fate of SolarCity's future in the hands of all other investors -- so if you are a shareholder, you should consider this offer carefully.
That might be the loudest call to action yet, giving individual investors a chance to make a difference. I believe Tesla's offer is too low, and significantly undervalues the true potential of SolarCity's business.
