the Tesla (TSLA)/SolarCity (SCTY) merger

Yesterday, TSLA and SCTY announced the two firms had reached agreement for TSLA to acquire SCTY in an all stock deal.  TSLA will exchange .11 shares of its stock for each share of SCTY, with closing sometime before yearend.  SCTY has 45 days to shop for a better offer.

Most commentaries I’ve read seem to miss two things:

–the original TSLA proposal said it anticipated an exchange ratio of between .122 and .131 to one, subject to closer examination of SCTY’s books.  The purpose of the range, as I see it, was to put a ceiling on what TSLA would pay for SCTY, no matter what good things it found on closer inspection.

Well, the opposite has happened.  The actual offer falls 10% below the lower bound, suggesting that SCTY looks considerably less great on the inside than its public financials would suggest.

–the combined entity, despite anticipated administrative/marketing savings of $150 million a year, assumes it will need to make an equity financing next year.

 

Overall, however, I think this is a good deal for SCTY.  Although I have traded the stock from time to time, the one thing that has always bothered me about SCTY is its stepchild status in the Elon Musk empire.  I say stepchild because TSLA, not SCTY, owns the Gigafactory, which will supply state-of-the-art batteries to SCTY.  To me, this signaled that TSLA was in the heart of the Elon Musk empire and that SCTY was on the periphery.  The merger changes that.

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.

 

rent vs. buy: financing and Solarcity (SCTY)

My California son, Brendan, got me interested in SCTY a while ago.  SCTY rents solar panels that generate electricity to individuals and to companies.

From an analytic point of view, it’s a complex and interesting firm.  It may also eventually turn out to be an important component of the nation’s power generation.  But it’s by at least a mile the riskiest stock I own (both Brendan and I hold small positions).  For instance, SCTY is a JOBS Act company , so the financials it has published to date aren’t ready for prime time.  Its business is heavily dependent on government subsidies of one type or another–and they’re shrinking.  It’s part of–but not at the heart of–the Elon Musk empire.  So holding it runs counter to the time-honored rule that you have your money as close as possible to where the entrepreneur has his–in this case, that would be Tesla, I think.

In this post, I want to use SCTY to  illustrate that in the rental model, a company can have an immense call for capital in advance of the business generating much revenue.  This can pose a significant risk.

Here goes:

First, note that I’m making the numbers simple (read:  pretty much making them up) and that there are many, many more moving parts to what SCTY does than I’m going to write about here.  But I think what I do say gets to the essence of the matter.

the business basics

1.  Look at a typical rooftop solar panel array that SCTY installs on a single family house.

–the panels cost $10,000 to build and install

–they have a 30-year life

–the homeowner signs a 20-year contract to pay $50 a month to rent them.

2.  In this industry, there’s some urgency to get panels installed on rooftops, at the very least because once someone has signed a 20-year contract, he’s not going to switch to another provider.  So the first mover has a key advantage.

financing new customers

Suppose SCTY installed panel arrays on 50,000 rooftops last year and wants to install another 100,000 this year.  What do the money flows look like?

Well, $30 million is coming in in rental income from last year’s installs.  But this year’s installation program will require $1 billion!! in capital to complete.  Where is this money going to come from?

In many senses, SCTY is a startup.  It doesn’t have deep pockets or an existing cash-generating business to use to fund the panels.  So raising $1 billion, and presumably more than that next year, is a formidable obstacle.

my point

That’s the point of this post–that the upfront capital committment in a rental business–especially involving physical stuff–can be very large.  From a financial point of view, some rental/service companies aren’t that much different from owning, say, an oil tanker, a steel blast furnace or a cement plant.  Not so glamorous if you look at them this way.

what SCTY does

The SCTY solution?  …the installed solar arrays are each sort of like a bond, that is, they pay a fixed amount of money each month for twenty years.  At the end of that period, the array still has ten years of useful life and therefore hopefully a substantial residual value.  If you package up a big bunch of them, the result doesn’t look that different from a collection of car loans or home mortgages.  In other words, the bundle is a security that you can sell to institutional investors who are looking for fixed income investments.  That’s a bare-bones version of what SCTY does.  Of course, it doesn’t hurt that SCTY is run by a financial entrepreneur.  Not every solar panel company is going to have the size or credibility to do this.