Is The Proposed Tesla Solar City Deal A Big Mistake?

  • Tesla has proposed to buy SolarCity in an all-stock deal worth $2.7B.
  • Many Tesla investors are opposed to this due to SolarCity's high cash burn and mounting debts.
  • Does it make any sense for Tesla to proceed with the proposed merger?.

It's about a month since electric car maker Tesla Motors Inc. (NSDQ:TSLA) made an offer to buy America's leading full-solar provider SolarCity (NSDQ:SCTY) for ~$2.7B. Tesla proposed an exchange ratio of 0.122x-0.131x shares of Tesla common stock for each SolarCity share. That works out to $26.50-$28.50/share, or about a 21% premium to the SolarCity stock price just before the deal was announced. As expected, SolarCity shares rallied sharply after details of the merger hit news feeds--up 20% since then. Meanwhile, Tesla sold off sharply, tanking more than 13% due to sharp criticism of the deal. Thankfully, investors seem to have finally given Tesla a free pass and the shares have managed to fully recover and even tuck on a small gain of 2.5% since then.

Tesla has said that the proposal builds on an ongoing partnership between the two companies that involves SolarCity using Tesla's battery packs in its solar projects. The deal had Wall Street and TSLA investors sharply divided over its merits, or lack thereof, with some labeling it:

 "A shameful example of corporate governance at its worst,"

Perma-bull Morgan Stanley's Adam Jonas:

"While there may be any number of lucid arguments supporting the strategic rationale of a combination, we believe many of the benefits could have been achieved through arm's length/strategic partnership and without the risks inherent in exposing Tesla shareholders to the financial and capital markets risk faced by SolarCity,''

''Does SolarCity help Tesla make better cars, he asks. "No ... the success of the Model 3 will be due to factors not related to the ownership of a solar company." Benefits from owning SCTY are "theoretical and very long term."

CEO Elon Musk has since then held two separate conference calls to try and shed more light onto the deal. Musk explained that a consumer with a PowerWall, car charging infrastructure, and solar panels will be able to make a bundled purchase and perform a single install. Musk said that if Tesla did not merge with SolarCity it would make Tesla's execution ''harder and worse.''

Although there was not a whole lot of granular detail regarding Tesla's debt load on the deal, Musk said that the company's cash flow was enough to cover what's required with the recourse debt. Musk insisted that the deal must go on if both Tesla and SolarCity are to truly scale up. But the initial price action on SolarCity suggested that the market was placing a very high probability that the deal would be turned down by Tesla shareholders. Indeed, Credit Suisse has estimated there is only a 20%-40% chance that the SolarCity deal will close.

SolarCity to Increase Tesla's Cash Burn

It's not hard to see why Tesla shareholders are opposed to the proposed tie-up. Other than the lack of clear synergies that SolarCity will bring to Tesla's table, Tesla investors have been mostly concerned that the deal will accelerate Tesla's already high cash burn rate. Not only is SolarCity not profitable, but its losses have been widening. The company's losses swelled from -$191M in 2012 to -$1.2B over the past 12  months. Meanwhile, the company's debts have ballooned from $342M in 2012 to $4B over the past 12 months. SolarCity's free cash flow has declined dramatically since 2013 and is now deeply in the red.

 SolarCity Revenue vs FCF Trends

TSLA-2

Source: Forbes

Then there is the nagging worry that Tesla could be grossly overpaying for SolarCity. Once the merger is consummated, Tesla will take on SolarCity's current debt load of $5B. So in effect it means that Tesla will be paying a massive $7.7B for SolarCity. SolarCity has a TTM after-tax profit of -$685M.

The deal appears to be highly favorable to SolarCity shareholders but could end up destroying value for Tesla shareholders. Tesla investors are likely to see the deal as a way for SolarCity executives to bail out the ailing company (many SolarCity executives also sit on Tesla's board with Elon Musk being each company's largest shareholder).

From a purely empirical and analytical viewpoint, the deal does not make much sense for Tesla shareholders.

But CEO Musk has other ideas. Musk said today that he expects the SolarCity deal to pass with at least a two-thirds majority saying:

"The most informed investors are highly supportive of the transaction... most just didn't understand how bringing together a car and a solar company made sense from a product standpoint."

Maybe Tesla investors should wait for Musk to reveal the full roadmap of how the company intends to integrate SolarCity into its operations before making up their minds regarding whether the merger will create any meaningful value for Tesla.

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