auto leasing

I’ve been reading an article in the Wall Street Journal this morning reporting Fed data that indicates auto loan defaults are on the rise in the US, particularly in poorer areas in the southern US.  This follows recent comments from automakers that the market for new cars is peaking and from used car dealers that prices declined last year and will dip further in 2017. Part of the downward pricing pressure is due to a larger number of cars coming off lease.

car leases

All this should come as no surprise, since the auto industry is cyclical and we’re closing out year eight since the US economy bottomed in 2009.  If there is still a shoe to drop–and I think there is–it will come in the car leasing market itself.  Here’s why:

Let’s say I want to buy a $30,000 car on a three-year lease.  What determines my lease payment?

The leasing company buys the car I want to lease from the auto company and rents it to me.  Its charges consist of:  interest on the purchase price; recovery of the loss in value of the car over the lease period; and the price at which the leasing firm figures it can sell the car for at the end of the lease.  The key figure here is the lender’s estimate of what the car will be worth when I turn it in.  This is called the residual value.

Examples:

1.  The lender estimates the car will be worth $15,000 in three years.   At 4% interest, that’s a monthly payment of $490.  In total, I’ll pay $2743 in interest charges (an average of $76/month) over the three years and $15,000 in principal.

2.  If the car is estimated to be worth $20,000, that translates into a monthly payment of $360, with a total of $10,000 repayment of principal + $3029 in interest ($17.50/mo).

At rates close to zero, an interest rate change makes little difference.  The difference between $490/month and $360 is the residual value assumption.

(Note:   real world leases can be much more convoluted, but these are the economic basics.)

how leasing companies get into trouble

Historically, lenders–and especially those affiliated with automakers–have made the residual values too high.  Why?  To my mind, it’s because a lower monthly payment (i.e., a higher residual value estimate) makes the car sale easier.  In the moment, the day of reckoning appears to be far in the future.  It can also be that the accounting framework the lender uses permits assumed profits on new loans to offset realized losses on old ones.  If so, as long as lease volumes increase, reported profits probably won’t reveal the damage being done.

Experienced auto stock investors are doubtless already worrying about the potential negative effects of leasing.  I imagine, though, that as/when the issue becomes better known–that is, when writeoffs from leasing operations start to emerge–this will be more bad news for auto stocks.

 

Tencent (700:HK) now owns 5% of Tesla (TSLA)

The Chinese internet conglomerate Tencent filed a 13G form with the SEC yesterday, fulfilling its legal requirement to declare 5% ownership of a publicly traded US firm–in this case, TSLA.

Filing a 13rather than the better-known 13D indicates Tencent intends to remain a passive investor rather than seeking a voice in TSLA operations.

According to the filing, Tencent acquired its 8.2 million shares (at a cost of $1.8 billion) both by participating in TSLA’s public offering on March 17th and through market purchases.  Tencent reached the 5% level on March 24th.

When I first heard of the stake, it struck me as peculiar that Tencent would make open market purchases, in which the money goes to third parties, rather than arranging for a private placement of stock from TSLA, in which case all the money would go to fund TSLA.  Looking at the 13G a little more closely, however, I realized that Tencent’s total cost implies an average acquisition price of $219 a share, meaning Tencent has been patiently accumulating shares at lower prices.  Now I’m thinking that Tencent took part in the recent offering to provide some financial support to TSLA–and then rounded its position up to 5% during the following few days in order to file a 13G that publicly declares its backing.

the TSLA offering

The TSLA offering raised about $1.3 billion, through an issue of $400 million in common stock plus $1 billion minus in 2.375% convertible five-year notes.  The conversion price is $327.50, a 25% premium to the stock price at the time of issue.

The notes are convertible, at the option of the holder, but, practically speaking, only if they are trading at a 30% premium to conversion value.  To my mind, though, they represent a much better deal than fixed income investors have gotten in prior TSLA offerings.  This seems to me to imply that these buyers see much greater credit risk with TSLA today than they have in prior years.

Tesla (TSLA) raising funds

Last week TSLA announced that it is raising $1 billion in new capital, $750 million in convertible notes due in 2022 + $250 million in common stock.

The offering itself isn’t a surprise.  TSLA has been chronically in the situation where analysts can see a point on the near-term future where the company could easily run out of funds.  This is partly the lot of any startup.  In TSLA’s case, it’s also a function of the firms continuingly expanding ambitions.  Elon Musk has been saying for some time that TSLA will will need new capital, too.

What is surprising, to me at least, is that the offering is not bigger   …and, more significantly, that the stock went up on the announcement.

To the first point, why wouldn’t TSLA give itself some breathing room by raising more money?  Of course, it’s possible that the small size is a marketing tactic and that the underwriters will soon announce that, “due to overwhelming demand,” it’s raising the size of the offering to, say, $1.5 billion.  Otherwise, I don’t get it.

To the second, this is just weird.  TSLA shares rose by a tad less than 30% in the first six weeks of 2017 and have been moving more or less sideways since.  So the idea that investors are willing to buy the stock can’t be surprising positive news.  And I don’t see the plus in some commentators’ claims that the market is relieved the offering isn’t larger.  I think the market should be mildly concerned instead.

Something else must be going on.

The only thing I can think of is that Wall Street is beginning to believe that electric vehicles are going to enter the mainstream much sooner than it had previously thought.  At the same time, the Trump administration’s intended moves to make it easier for American car makers to sell gas guzzlers for longer may result in Detroit remaining stuck in the past, paying less attention to electric vehicles.  So market prospects for TSLA may be improving just as competition from the “Big Three” may be weakening.

However, that alone shouldn’t be enough to propel a well-known stock higher in advance of an offering.

 

 

 

Intel (INTC) and Mobileye(MBLY)

A week ago, INTC agreed to buy MBLY, an Israeli company that makes cameras and car safety devices, for $15.3 billion in cash.  Its plan is to merge its existing auto components business with MBLY and have that company spearhead INTC’s entire Internet-of-Things effort to enter the auto market.

Why buy rather than build?

The main issue is time, I think.  Part of this is that the timetable for development of autonomous driving vehicles is accelerating.  More than that, however, and the chief reason for the acquisition, to my mind, is the way marketing to the big auto companies works.

Auto companies plan new models several years in advance.  If you want a component in, say, a 2020 model, you probably need to have already convinced an auto maker of its merits by late last year.  Also, unless a component maker has a unique technology, auto companies tend to move slowly.  They’ll initially buy a single component, or they’ll put a part in one car model, just to see how the part–and the supplier–perform.  If things work smoothly, it will consider expanding that part’s use and/or buying other parts from the supplier.

The result is that convincing a car company to risk of using a new supplier takes a long time.  Without MBLY, which already makes key auto components and has an auto-oriented sales force, I think it could easily be a half-decade before INTC would make any significant inroads into the auto market.  INTC probably doesn’t have that much time.

This is not, of course, to say that INTC will be wildly successful in the auto-related IoT.  Without MBLY, though, its chances for success would be considerably dimmer.

what a good analysis of Tesla (TSLA) would contain

A basic report on TSLA by a competent securities analyst would contain the following:

–an idea of how the market for electric cars will develop and the most important factors that could make progress faster or slower.  My guess is that batteries–costs, power/density increases, driving range, charging speed–would end up being key.  Conclusions would likely not be as firm as one might like.

–TSLA’s position in this market, including competitive strengths/weaknesses.  I suspect one main conclusion will be that combustion engine competitors will be hurt by the internal politics of defending their legacy business vs. advancing their electric car position.  The ways in which things might go wrong for TSLA will be relatively easy to come up with; things that could go right will likely be harder to imagine.

–a detailed income statement projection.  The easy part would be to project (i.e., more or less make up) future unit volume and selling price.  The harder part would be the detail work of breaking down unit costs into variable (meaning costs specific to that unit, like labor and materials, with a breakout of the most important materials (i.e., batteries)) and fixed (meaning each unit’s share of the cost of operating the factory).  An important conclusion will be the extent of operating leverage, that is, the degree to which fixed costs influence that total today + the possibility of very rapid profit growth once the company exceeds breakeven.

There are also the costs of corporate overhead, marketing and interest expense.  But these are relatively straightforward.

The income statement projection is almost always a tedious, trial-and-error endeavor.  Companies almost never reveal enough information, so the analyst has to make initial assumptions about costs and revise them with each quarterly report until the model begins to work.

–a projection of future sources and uses of cash.  Here the two keys will be capital spending requirements and debt service (meaning interest payments + any required repayments of principal).  Of particular interest in the TSLA case will be if/when the company will need to raise new capital.

 

 

Elon Musk’s master plan for Tesla (TSLA)

Last week, Elon Musk issued his second master plan for TSLA as a blog post on the company website.

The plan has four parts:

autonomous driving, with the goal of making self-driving cars 10x as safe as those operated by human drivers.  The main issue here is, according to Musk, compiling enough safety date to convince governments to allow autonomous driving on public roads

expanding the product line, to include pickup trucks and compact SUVs, plus heavy trucks and urban buses.

Although what he writes on this topic is not 100% clear, one goal under this heading seems to be to reinvent the auto manufacturing process in a way that the new/improved factory is 5x – 10x as efficient as current ones.  One ambiguity I see is whether this means 10x the efficiency of, say, a Toyota plant, or 10x the efficiency of the current TSLA operation.  I presume he means the former.

Another is exactly what “efficiency” is.  I’m taking it to mean that Musk intends to create factories that, for the same capital investment, will produce 5x – 10x as many cars in a given time as current factories do.  My cursory inspection of auto 10Ks (other than TSLA, I don’t think I’ve owned an auto stock since the 1980s) tells me this won’t mean a huge jump in unit profits for any auto firm, including TSLA, since most of the costs of making a car are in materials and labor, not capital equipment.  Greater efficiency would boost overall profits, however, as well as allow TSLA to dramatically increase its vehicle output.

sharing.  Musk thinks that in an era of autonomous driving, some people won’t own cars themselves anymore.  They’ll simply call for one from a sharing service when they need it.  Other people will own cars but will allow their vehicles to be used in a sharing service when they don’t need them.  TSLA intends to organize sharing services for its vehicles.

This is a much more revolutionary statement than it seems.

The average car is used only 10% – 15% of the day, according to Musk.  If sharing boosted that usage figure to, say, 30% in highly populated areas, then those regions would need only half the cars they do today   …maybe fewer.  At some point, this would mean an implosion in demand for new autos–and the end of the car manufacturing industry as we know it.

merger of TSLA and SolarCity (SCTY).  In his Master Plan, part deux, Musk says he wants to create a “smoothly integrated and beautiful solar-roof-with-battery product that just works, empowering the individual as their own utility, and then scale that throughout the world. One ordering experience, one installation, one service contact, one phone app.”

He says this can’t happen while TSLA and SCTY are separate companies, something he describes as “an accident of history.”

I’m not sure I buy this.  I do think that Musk created clear economic superiority of TSLA over SCTY when he decided to place the Gigafactory for solar batteries inside TSLA.  To my mind, that makes SCTY radically dependent on TSLA today.  Merging the two companies would put SCTY back on an even footing.  For TSLA shareholders, arguably the main benefit of the combination is obtaining SCTY at a cheap price.

Tesla (TSLA) is bidding for SolarCity (SCTY)

The offer is an all-stock deal, with TSLA willing to exchange 0.122 – 0.131 of its shares for each outstanding share of SCTY.  The exact figure will depend on a closer examination of SCTY’s books.  The proposal was announced after yesterday’s close.

My thoughts:

–in today’s pre-market trading, SCTY shares are up by about 14% and TSLA’s stock is down by around 12%.  This has little to do with the merits of the deal.  It’s all about arbitrage.  To the degree the market regards the acquisition as a done deal, it ceases to look at SCTY as an independent entity.  SCTY becomes instead equivalent to a deferred issue of TSLA stock.  Because the bid is at a premium to the pre-offer price of SCTY, SCTY is a relatively cheap way to own TSLA.  So arbitrageurs sell short the “expensive” form of Tesla, i.e. TSLA, and use the money they receive to buy the “cheap” form of Tesla, i.e., SCTY.  So SCTY goes up and TSLA goes down.

–my guess is that there’s no other bidder.  Elon Musk, who owns 20%- of TSLA also owns 20%+ of SCTY.  As is often the case with family-owned empires, one firm ( TSLA) is the heart of the enterprise.  Other companies are arrayed as satellites around the central hub.  Those tend to be more highly specialized, sometimes riskier–and invariably dependent on the main core for essential goods/services.  In this case, the Gigafactory being built by TSLA is going to the be the source of the batteries that SCTY will be distributing to customers.  Who else needs one of these?

–price is the main motive, I think.  SCTY is less than a tenth of the market cap of TSLA, so acquisition won’t make a radical difference in the latter’s fundamentals.  In most cases I’ve seen, the hub-satellite relation persists for decades, with third-party shareholders content with their stepchild status as an adequate tradeoff for the satellite’s narrower focus and faster earnings growth in specific circumstances.

–arguably, this is a good chance for adventurous to buy TSLA shares toward the lower end of its recent trading range.  I’m going to sit on my hands for a while, though, to try to gauge how severe selling pressure on TSLA may turn out to be.