- Tesla needs a huge amount of money to run its operations and make investments. The acquisition of SolarCity will make the liquidity position even worse.
- Tesla's Altman Z score shows a high risk of bankruptcy. The merger will increase the probability even more.
- Tesla stock remains very risky bet.
Since the day Tesla (NSDQ:TSLA) signed the agreement to acquire SolarCity (NSDQ:SCTY) the number of people who are predicting Tesla’s doom has ballooned. Many investors believe that the deal will be ruinous for both the companies, especially for Tesla. And the market agrees with them to a large extent. Tesla stock has slumped 14% while SolarCity has slumped more than 30%. The main issue weighing on the stocks is the cash crunch. The 2008 crisis has taught us well about the importance of liquidity. However great your vision may be, to reach there you need to survive now.
On Tuesday, well-known short investor, Jim Chanos, who had successfully bet against Enron, weighed in. To quote him "The bottom line is that Tesla, which was slightly above the red line, puts itself well under the red line by buying SolarCity,". Earlier in June, he had described the SolarCity deal as the worst example of corporate governance. As we have covered in an earlier post there were many corporate governance issues relating to the merger. Mr. Elon Musk was the largest individual shareholder in both the companies, SolarCity CEO Lyndon Rive is his cousin, and the two boards are so related that only two of the board members of SolarCity were able to go through the deal process.
The Cash Flow Problem
While corporate governance issues are definitely a cause for concern, there are immediate existential issues facing Tesla. The company is a huge cash guzzler and so is SolarCity. The company needs tons of cash to survive and adding another cash guzzler only adds to the risk. In 2015 Tesla burned around $500 million of cash in operations. And in the first two-quarters of 2016 the company has burned $350 million. The free cash flow position is even worse with the latest quarter's free cash flow coming in at -$610 million.
This comes at a time when Tesla needs more cash to expand its gigafactory and Model 3 production. Tesla has planned to spend more than $1.5 billion in the second half. This will put Tesla's liquidity under serious stress. And if you add SolarCity's burden then the risk increases even more. In the latest quarter SolarCity had around $250 million in cash on its books while cash burn from operations was more than $380 million. And the way it is going, SolarCity will still need a huge amount of cash. To quote Chanos:
"The combined SolarCity and Tesla, which we think will have a cash burn of a$1 billion a quarter, will constantly need access to capital markets." "To burden your own balance sheet with the kind of business ... strikes us as the height of folly."
The recent deal by SolarCity to raise $305 million in equity has come as a great relief to the market. While there are some concerns about the conditions associated with the equityt issue, in the end, the deal will give SolarCity more time to live. According to reports SolarCity was so cash-strapped that it was about to collapse during the negotiations.
The Need To Raise Capital
Considering the fact that Tesla needs a huge amount of money for investments and that it is burning millions of dollars in operations, it won't be surprising that Tesla is heavily dependent on the market for money. Tesla had recently, in May, raised $750 million from the market. In fact, Tesla has raised money from the market in every quarter in last two years. And Tesla is planning to approach the market again later this year. But considering the risk associated with the merger, the market is wary. And Mr. Elon Musk knows this. In an email to his staff, he had said:
“We will be in a far better position to convince potential investors to bet on us if the headline is not ‘Tesla Loses Money Again,’ but rather ‘Tesla Defies All Expectations and Achieves Profitability,’” . “That would be amazing!".
Measuring The Risk Of Bankruptcy
With liquidity under stress, the risk of bankruptcy runs high. The most prevalent and professionally acceptable way to measure the bankruptcy risk of a company is by using the Altman Z-score. The score developed by Edward Altman in 1968, is the output of a credit-strength test that gauges a publicly traded manufacturing company's likelihood of bankruptcy. A score below 1.8 means that the company is likely headed for bankruptcy, while a score above 3 means the company is not likely to go bankrupt.
Tesla's score does not inspire confidence. The Altman Z-score for Tesla came around 1.82, which means Tesla is entering the very high-risk zone. And the situation will become even worse when SolarCity is merged. The Altman Z-score for SolarCity is currently in the negative with the current score at -0.12. Hence the combination of both will shoot up Tesla's risk of bankruptcy. The Altman Z-score for combined entity is around 1.02, much below 1.8.
Tesla needs tons of cash to run its operations and make new investments. Its near-term projected liquidity is under severe stress. And an addition of another cash strapped company will only compound the problem. While in the long term, a better than expected demand of Model 3 may ease the cash crunch, the near-term prognosis is not good. And to get to the long-term survival in the short-term is important. The Altman Z-score shows Tesla runs a high risk of bankruptcy and the risk increases considerably. The most important task for Tesla now should be to shore up liquidity. A good Q3 delivery numbers will go a long way in helping Tesla shore up its liquidity. After all, cash is always the king. Tesla stock is currently at best a speculative bet.
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