On June 21, Tesla Motors (NASDAQ:TSLA) made an all-stock offer to acquire SolarCity (NASDAQ:SCTY.DL). We've discussed the merits and disadvantages, the strategic benefits and added complexities, and the excitement and frustration of this deal frequently across The Motley Fool over the past few months.
Shareholders will ultimately decide whether the deal goes through by means of an upcoming vote. If you are one of those shareholders, we encourage you to vote in whatever way best benefits you.
While we won't be giving any personalized financial advice on what we think you should do, we can give you data to make a more well-informed decision. In this piece, I've compiled a fairly large amount of information from a variety of sources; below, I present it as objectively as possible, arranged around several important topics to consider.
Let's start by looking at why Tesla is making this offer in the first place.
- Create a low-volume car, which would necessarily be expensive.
- Use that money to develop a medium-volume car at a lower price.
- Use that money to create an affordable, high-volume car.
- Provide solar power.
The purpose of Tesla's very existence is to help transition our world away from being reliant on greenhouse gas-emitting hydrocarbons. To accomplish that, the first step is to permanently reduce the world's top source of hydrocarbon demand: gasoline for cars. Tesla's vehicles replace internal-combustion engines with electric-powered motors, which give off no emissions and are significantly more efficient (80% efficiency, compared with 20% for ICEs).
However, electric vehicles still need to be plugged in to recharge, and two-thirds of the electricity generated in the U.S. today still comes from coal and natural gas. To address this, SolarCity's solar power systems generate electricity from homeowners' rooftops; increasingly, this solar power is being used to charge Tesla vehicles parked in those homeowners' garages.
Battery storage will also play a key role in the adoption of solar power. People still need electricity during the night and on cloudy days. Tesla's Gigafactory aims to supply batteries for the company's upcoming Model 3 (which will be mass-market affordable), but also to the Powerwall stationary battery backup systems that can be installed by SolarCity.
In short, Tesla is the vehicle (pun intended) to consolidate all of Musk's hopes and dreams into a single company. Strategically, check, but let's see if the acquisition also makes sense to the underlying businesses.
The Business Models
Tesla always seems to be working on a million different things, but the vast majority of its revenue (92%, to be exact) still comes from the up-front sale of vehicles -- which is a function of how many the company can sell and what price it can charge per car.
It's safe to say that even at premium price points, Tesla has no problem stirring up demand. Less than a month after it began taking pre-orders for its Model 3, the company had received more than 400,000 reservations. At a price tag of $35,000, that equates to nearly $18 billion of future revenue. The Model 3 is expected to begin shipping in late 2017.
To put the magnitude of that number into perspective, Tesla did $4 billion worth of total sales last year. This mass-market affordable vehicle will be the game-changer that would really shift this company into a higher gear.
Of course, that $18 billion of revenue doesn't come free. Tesla still has a ton of bills to pay.
- Tesla likes to design vehicles from the ground up and has worked with vendors to design proprietary parts. The company's cost of goods sold comprises about 80% of revenue today, with R&D costs adding another 16%. Those two expenses alone chew up the majority of Tesla's current top line.
- The Gigafactory is in the middle of construction. Once it's up and running, the facility will be capable of producing more than half a million lithium-ion batteries annually, but the total cost is estimated to be $5 billion.
- Management will need to invest in expanding existing manufacturing capabilities to be able to quickly, flawlessly assemble 400,000 new cars to meet the pre-order demand.
- The company is building out a worldwide charging network to allow Tesla owners to recharge their electric vehicles for free. There are now 705 Supercharging stations deployed globally. When you include the destination charging locations found at hotels and popular locations, there are 4,359.
As we saw with the Roadster and the Model S, Tesla's magnificent new product launches attract a lot of media attention and bring a lot of cash in the door. But management is also playing in an extremely capital-intensive industry, which will require them to continually invest billions of dollars to scale and stay a step ahead of traditional competitors. The electric vehicle market is nascent and fast-growing, but it isn't cheap.
SolarCity, too, is a company with big bills and big potential.
The U.S. energy market is massive, yet solar still comprises less than 1% of the overall electric supply. To take advantage of the opportunity, SolarCity has scaled its business quickly over the past decade. Cumulative deployed capacity has nearly doubled every year since the company's (purposeful, symbolic) inception on Independence Day 2006.
The majority of current business comes from operating leases. SolarCity pays the up-front costs of the systems, which it owns, then sells the power produced to its customers over the 20 years their contracts last. In a vertically integrated industry, this model favors the top dog. And as a larger organization, SolarCity can more quickly drive down overhead and operating costs and secure lower financing rates.
Operating leases are still growing at a nice clip, but customers are increasingly choosing either up-front cash sales or solar loans; together, these comprised 19% of new bookings in the most recent quarter. This shift lessens SolarCity's financial burden a bit, since it means customers pay a larger portion (in some cases all) of the up-front costs. But it also increases competition on the up-front quoted price and gives SolarCity less of an opportunity to capture a spread between its rates and its cost of capital.
Commercial installations are also a growing trend, representing 16% of second-quarter deployments. Commercial customers generally get lower price-per-kilowatt-hour rates than residential customers. But because theirs are larger projects that can better leverage labor costs, their economics are still very favorable.
|Sales||2Q 2016||1Q 2016||4Q 2015||3Q 2015||2Q 2015||1Q 2015||4Q 2014||3Q 2014||2Q 2014|
|Operating Lease Capacity Deployed (MW)||191||219||218||172||146||116||162||136||99|
|MyPower Capacity Deployed (MW)||8||14||26||26||27||22||7||0||0|
|System Sales Capacity Deployed (MW)||12||12||9||7||4||5||6||1||8|
As mentioned, SolarCity's business model pays the up-front costs for the systems; it then sells a large portion of the future cash flows to others to raise money, then uses that money to pay for more systems. This model allows management to deploy capacity aggressively without overburdening the company with excessive long-term debt.
If acquired by Tesla, SolarCity would still need to raise significant financing and continue to monetize its solar investment tax credits (more on those below). But being a part of the larger Tesla organization could potentially help reduce operating costs in two areas:
- SolarCity's sales costs are pretty significant, accounting for more than 20% of the company's all-in costs per new installation (sales costs were $0.71 per watt of the $3.05/W of total costs last quarter). The company sends sales consultants to potential customers' homes, which requires a lot of time driving and, if successful, commissions. However, Tesla already has customers coming to it through showrooms across the U.S. and the world. Musk believes potential Tesla customers will also have an interest in SolarCity's solar power systems, which would significantly increase sales efficiency.
- SolarCity is increasingly going after larger community projects, which would require microgrids and battery storage to balance the load and match supply with demand. Tesla's battery packs would play a large role here. If the two companies merge into a single organization, they would cut out any margin Tesla was making on the battery sales, as well as simplifying the transaction logistics and order processing.
As vertically integrated as SolarCity is, it still relies heavily on third-party financing to pay for its systems, and it has significant sales costs.
The Role of Government
The performance of both of these companies is highly affected by government subsidies, policies, and regulations.
SolarCity captures a 30% investment tax credit (ITC) for each solar system it installs. The company aggregates these and sells them as tax equity to third-party investors -- including Alphabet (NASDAQ:GOOGL) and Goldman Sachs (NYSE:GS) -- who can use them to offset their own tax bills. Just recently, congressional lawmakers began investigating how solar companies have valued the systems these credits are based upon.
The U.S. recently extended the solar ITC in its current form through 2019, after which it will gradually decline to a 10% terminal rate in 2022. This extension was a favorable policy decision for SolarCity, and the company's stock shot up nearly 25% on the day it was announced. Individual states, too, have energy policy that can affect SolarCity's performance. California's Public Utilities Commission recently extended net metering rebates and enacted time-of-use rates, both of which are favorable to SolarCity's economics.
But sometimes policy decisions don't work in SolarCity's favor. Nevada retroactively reduced net metering rates and imposed fixed costs for solar customers this February, effectively terminating the progress the state had made in renewable energy and causing SolarCity and others to cease operations there.
Tesla also benefits from a variety of state-based incentives, which offset the sticker price of its rather expensive electric vehicles and make them more affordable for consumers.
Financing and Valuation
When considering valuation, we should recognize that SolarCity's revenues and costs are out of sync. The costs of buying and installing the panels mean large expenses up front, but the company then collects recurring revenue from its customers over the next 20 years. Given this, management tends to quantify things in present-day terms; they report the net present value of all of their projects, subtract out the all-in costs related to those projects, and then quantify the spread between the present value and the costs.
Those costs are pretty significant. SolarCity's tab for buying and installing solar systems comes to nearly $2 billion annually. To pay for that, the company aggregates and sells off tax credits as mentioned above, as well as the future cash flows of the power generated by the systems; these are known as securitizations.
Source: Company earnings reports
Tesla's acquisition proposal caused a real hiccup in SolarCity's financing strategy this past quarter. Both the tax equity and the securitizations were delayed as third-party lenders were uncertain about whether the combined company would be able to pay back its debts. Knowing that the show must go on with or without the tax equity and securitizations, Musk personally contributed $65 million to buy SolarCity bonds. SolarCity CEO Lyndon Rive and CTO Peter Rive (Musk's cousins) together also contributed another $35 million of financing in the round.
There's also reason to believe that SolarCity's financing costs will increase. Each time the Fed mentions "the improving economy" or "increasing job creation," we seem to move one step closer to a rate hike. To keep the growth machine churning, it will be very important for SolarCity to be able to attract financing from both banks and third-party investors.
Even with the financing risks, the company has done a pretty good job so far in creating value for shareholders. SolarCity's projects last quarter created a net present value of $3.62 per watt deployed, compared to all-in costs of $3.05 per watt deployed. Multiplying the spread between the two ($0.57/W) by the total capacity deployed (199 MW, excluding cash sales) means the company created more than $100 million of value to equity holders from their energy contracts during the quarter.
Source: Company earnings reports.
Furthermore, if we take the present value of all of the contracts SolarCity already has in place ("Pre-Tax Unlevered NPV") and subtract all the cash flow from those that has been committed to others ("non-recourse debt"), we can quantify the value of SolarCity's existing business to shareholders ("Pre-Tax Unlevered NPV to Equityholders"). As of last quarter, that value was $2.2 billion, or roughly $22 per SolarCity share.
SolarCity's current share price is only about $17, which is almost 25% lower than the present value of its existing contracts in a zero-growth scenario. At any price below $22, the market believes the company will not create any future value for shareholders. I tend to think that is overly pessimistic, which is why I've often argued that Tesla's offer isn't a good deal for SolarCity.
Several others have also publicly aired grievances about the inaccuracies of Tesla's recent offer:
- Financial advisory company Lazard, which advised SolarCity about what would be a good price to accept from Tesla, apparently made a $400 million mistake (!) that overly discounted its valuation of what the company was worth. After correcting the mistake, management disclosed that they believe SolarCity's equity value is between $18.75 and $37.75 per share.
- Valuation guru Aswath Damodaran blogged about how "egregiously bad" the investment bankers' valuation estimate of Tesla was. Two things had Damodaran most outraged: the bankers' blind acceptance of the company's future cash flow predictions (rather than building their own models), and their ridiculously high terminal growth rate of 6% to 8% for Tesla. Terminal growth rates are typically 1% to 3% to match GDP, where 6% to 8% creates an artificially high potential value for Tesla's stock.
- A leaked internal Tesla email implied that Elon Musk was urging employees to show improved financials just before he attempted to raise money again. While there's nothing wrong with motivating your employees, whipping everyone into shape just before a funding round doesn't necessarily portray a company in a steady state of operations.
Here is a copy of the preliminary prospectus for the merger proposal.
Also at issue is the disconnect between Tesla's and SolarCity's current stock prices. Tesla is trading at about $200 per share, which should mean that SolarCity should trade at around $22 per share to be equitable to the terms of the deal (i.e. 0.11 shares of TSLA offered per share of SCTY). From this, we can discern that there is some uncertainty in the mind of the market about whether the deal will actually go through.
The Vote's Likely Outcome
Despite all of the valuation-related issues stated above, I still believe this deal is likely to go through.
The FTC has already given its blessing. Antitrust concerns were never really an issue between the automotive manufacturer and the solar power provider, but they've nonetheless received the FTC seal of approval as the first required step.
The largest shareholder in both companies is Elon Musk, who owns approximately 21% of Tesla and 22% of SolarCity. Interestingly, Musk has steadily and quietly been personally acquiring SolarCity shares, spending more than $28 million for 1.2 million shares during the past year. And let's not forget about that $65 million of solar bonds.
Musk personally providing financing to SolarCity sounds a bit like deja vu, like when he put up $35 million of his own money to help Tesla survive the financial crisis. The "Bank of Musk" has proven able and willing to provide much-needed cash liquidity when his companies need it most. And he's got the funds to make an impact: According to Forbes, Musk's personal net worth is now estimated to be more than $11 billion.
Because Musk is on the board of both companies, he has recused himself from the coming shareholder vote. Lyndon and Peter Rive, Antonio Gracias, and JB Straubel will all also sit out on the vote.
This means that institutional investors' votes will be a very large factor. Fidelity is the largest institutional shareholder in each company, owning approximately 11% of Tesla and 15% of SolarCity. Tesla's 20 largely institutional stakes combined own approximately 55% of the company (more like 68% if you exclude Musk and the others sitting this one out). Fourteen of these 20 institutions also have a stake in SolarCity, of which they own a 34% combined share (48% if you take out the recused votes). Reuters also reported that more generally, nearly 45% of Tesla's shareholders also hold a stake in SolarCity.
With the heavy overlap, the vote will likely hinge on whatever is most economically and financially beneficial for the voting shareholders. Tesla is a much larger company that occupies a much larger stake in the funds of the voting institutions. Because of the potential sales-cost synergies and the strategic significance of SolarCity in Musk's Master Plan, I expect the institutional investors will ultimately vote in favor of this deal going through.
Foolish Bottom Line
It's almost impossible not to admire Elon Musk's ambition. He goes big every time, and his "change the world" mentality is nothing short of inspiring. His public charisma and confidence (he recently stated that he has "zero doubt" that Tesla will eventually become a trillion-dollar company) have won over many investors willing to follow his plan for world domination.
Of course, there are still several outstanding questions that deserve answers. These include:
- Was SolarCity's recent financing hiccup a result of deteriorating fundamentals and market demand? Or was it because of added uncertainty, actually caused by the Tesla acquisition offer?
- Will a significant percentage of potential Tesla customers really commit to also purchasing or leasing a SolarCity power system?
- Can Tesla efficiently raise enough money for its Gigafactory, manufacturing expansion, and Supercharging network without significantly diluting shareholder value in the process?
- Is now really the right time for Tesla to acquire SolarCity?
You be the judge on each of these points.
Whatever your position on the offer, we encourage all shareholders to vote in the coming deal. Regardless of the outcome, SolarCity and Tesla are both bigger-picture companies, who every day strive to define our future. Expressing yourself via a shareholder vote is key in defining the paths of these two dynamic organizations.