On August 1, 2016, Tesla (NASDAQ: TSLA) announced that it had reached a definitive agreement with SolarCity (NASDAQ: SCTY), approved and recommended by the Boards of the two companies. Since the talks between the two companies were made public in June, lots have been said about this unusual situation.
So it’s happening. Elon Musk is buying Elon Musk. Or at least to some extent, since the entrepreneur owns roughly 20% of each company and is CEO of Tesla, Chairman of SolarCity. There has been so much said on this deal over the past couple of months that I will only focus on the points that I think are the most relevant: does it make sense for shareholders, should it go through, and will I put my money in it. The answer to the 2 first questions is yes, the one to the last is no, and here is why.
Strategic sense – it’s tough to argue against the strategic vision and potential synergies that could arise from the combination. With Tesla moving away from being a car company towards an integrated energy technology company, the SolarCity acquisition not only lets it have its own source of energy production, but also allows for a greater integration of the different product lines: the solar panels, the storage, the electric vehicle.
People making the point that SolarCity is not the best target for Tesla because it doesn’t have a low cost advantage over some Chinese producers are missing the point. By doing this deal, Tesla isn’t trying to put the cheapest solar rooftops on American homes, but rather to position itself as the Apple of renewable energy.
Believe it or not, but a big con of solar energy for many people is that their house would not look as good, hence diminishing their value. Musk believes that SolarCity has the technology and knowledge to make solar rooftops looking good, and that the impact to a house’s value and aesthetics will be neutral to marginally positive.
Now, you can agree or disagree with that position, but saying that SolarCity is not a good acquisition for Tesla based on SolarCity’s current competitive positioning on a standalone basis does not tell the full story because once the businesses are combined, the value proposition will be somewhat different (hopefully better).
Fast-forward a year or less, and while visiting Tesla’s stores, you’ll still be able to buy your electric vehicle, but you will also consider going off the grid. Entirely. For your car and the rest of your household. And of course, the financing to do so will be provided in the same package than the one proposed for the vehicle, giving a further incentive to consider the full fledged option. Tesla products will very likely integrate much better if not only together than, say, if you bought your solar panel and energy storage system outside of the firm. Again, very much like what Apple does.
Agreed, not everyone may decide to go all in and many may just stick to buying a car when visiting a Tesla store. But the kind of qualified foot traffic that SolarCity will benefit from under this strategy will anyways be a substantial improvement over the current state of things. At the moment, there are SolarCity salesmen going door to door to try and convince people to lease solar panels from the firm. This business model is now dying as everyone has figured out that the move to solar is only worth it if you purchase the panels instead of leasing them, among other reasons.
So you’re essentially now going from a model where you’re begging for someone to lease your panels, to one where you’re on display next to a Tesla car in a branded store where people came by themselves to buy Tesla products; and you’re being promoted as the best, most economical, greenest way to provide the fuel that your new baby needs to drive you around for hours. Frankly, it’s not hard for me to understand why SolarCity has been faring poorly and why it will fare better under Tesla’s umbrella.
That’s for the revenue side. On the cost side, the savings anticipated by Tesla other than the usual corporate overheads reduction will come from the customers who buy several products and that will require only one visit to their houses for the required installations vs. 2-3 currently, making the two companies more efficient once under the same roof. These operating savings are estimated at $US150 million in the first year after closing.
Should it go through – you’ll notice the use of ‘should’ instead of ‘will’ here. This is not one of the usual deals I look at where the vote is relatively straightforward. For one, Musk is involved in the 2 companies with 20%+ ownership in each so an offer by Tesla is always going to be a concern for many due to the potential conflict of interest.
What’s more, SolarCity hasn’t been doing too great of late, largely because of the business model I’ve been describing earlier; of course, it also does not help that SolarCity’s CEO is Musk’s cousin.. but hey they’re a successful bunch in this family apparently. So, in light of this, some have been calling the acquisition a bail out, especially as SolarCity’s debt load is larger than its equity market capitalization.
I think that all of the above are valid concerns, but that the long term benefits of the combination outweigh the short term pain.
As I said, Tesla has the infrastructure to turn around SolarCity, so acquiring them 60% below where they were trading at a year ago is not an awful deal.
Regarding the concerns around a bailout, I think they are overblown. The market cap of SolarCity before the offer was around US$2.0 billion, and if it was bankrupt, it was a hell of an expensive bankrupt company.
Yes, if SolarCity remained on its own and did not change its strategy, it may have gone belly up at some point, but there are a lot of companies in that situation in the market and they’re not all bad acquisition targets.
I think that Tesla can change the future of SolarCity, while at the same time improving its own chances of re-defining the renewable energy industry, and buying it for US$2.0 billion while Tesla’s market cap. is US$33 billion isn’t really like betting the farm from their perspective. The deal will also double the debt on Tesla’s balance sheet, to US$6 billion. But so what? It’s still only 18% of its equity valuation, and you can expect a capital intensive business like this one to need funds to get where it needs to be. If Tesla doesn’t increase its leverage further and churn out cars while integrating SolarCity swiftly, their risk profile should improve over the next couple of years.
To clarify, I am not suggesting that Tesla is being safe and conservative in doing this deal. All I’m saying is that for what they’re trying to achieve, what they’re doing makes sense and comes at an OK price. It could all blow up in their hands over the next few years if sales don’t pan out and they struggle to pay down debt, but any ambitious plan has its risks of failure unless you’re the government and can just afford to keep going endlessly.
Finally, I find it amusing that some people are concerned around Tesla and SolarCity combining because they’re both owned by Musk, and thus Musk buying Musk is a red flag, even though he will not be voting his shares in both businesses. Tesla and SolarCity already do business together, they’re going to do way more when they integrate their full suite of products, so isn’t the acquisition at least making things clear for everyone involved? Not transacting while dealing exclusively with each other would just mean that the shareholders do not get to see any of the benefits of the synergies, while still having their future tied to both businesses.
Based on the above, I think that there is a low to moderate risk that shareholders of any of the companies won’t vote the deal. For SolarCity, even with a low premium, a future with Tesla is rosier than an independent future in a changing market that’s getting more and more commoditized. For Tesla, acquiring SolarCity is a good way to have Musk follow his vision in a way that’s efficient and moral from an operational and governance perspective, respectively. This point is important because I believe that investors in both companies invest as much in Musk than in the businesses themselves. That’s another reason why I believe the votes should both go through, as there is a number of cross-shareholders in both companies, and those who agree to one side of the deal will also agree to the other.
Why am I not investing – the bears! After doing most of the analysis, I checked the cost of shorting Tesla’s shares, which was the last piece of the puzzle. In most deals I do, that cost is negligible – I rarely see anything above 2% or 3% annually. If I went short Tesla’s shares, I’d have to pay an annual 17% on the short leg of the trade. That alone kills the opportunity because it makes the margin really thin, and I don’t feel comfortable leveraging on this one.
At today’s current share price, the spread is roughly 3%, which I believe is decent since the only real obstacles are the shareholders approvals. Under an aggressive agenda (count on Musk for that), everything could be said and done by October ’16, therefore yielding 15-20% on an annualized basis. My worst case scenario (still assuming that the deal goes through, but with some delay) was an 11% annualized return. Since the exchange ratio is 0.11 Tesla shares for 1 share of SolarCity, an investor wanting to play the deal would go short 11 shares of Tesla for every 100 shares of SolarCity purchased.
Overall, I am cautiously optimistic about this transaction, and staying on the sidelines because of the borrowing cost on Tesla’s shares. If someone came tomorrow and lent me those shares at 3% I’d probably go ahead.
In any event, if the deal goes through I’ll be very interested to see how it pans out and probably will write a follow up article on it later on. The jury is still out on Musk but I really believe that the guy will either literally change the energy industry or go broke trying to. He’s committed and puts his money where his mouth is, so bar the unrealistic targets that he’s bound to miss at some point, he still deserves credit for aiming for the moon if lands in the stars.
Disclosure: No position in any of the stocks mentioned in this article.
This article expresses an opinion and the author does not receive compensation for it and has no business relationship with any company whose stock is mentioned in this article; do your own due diligence before making investment decisions.