2 Reasons To Sell Tesla: $920M And $26,250
A little more than two months from now, Tesla -- in which I have no financial interest -- could have a considerably lower cash balance.
How so? The terms of a $920 million convertible bond make me think that come March 1, Tesla will have to part with at least a third of its remaining cash.
Is Tesla stock overvalued? On January 18, Tesla traded at 22% below its June 2018 all-time high and it lost 13% of its value in the wake of CEO Elon Musk's decision to cut 7% of its employees.
I do not think this drop makes its shares cheap. In response to my request for comment, on January 19, Tesla cited its September 30 quarterly report, which stated that Tesla has plenty of cash. As Tesla's spokesman noted
Our sources of liquidity and cash flows enable us to fund ongoing operations, research and development projects for new products, investments in tooling and manufacturing equipment for the production ramp of Model 3... 2018 capital expenditures [we estimate] to be slightly below $2.5 billion, including the acquisition of land use rights in Shanghai, China to build Gigafactory 3 [which is slated to make battery cells and Model 3 and Model Y cars] and for its initial design and construction expenses.
In a January 18 letter to Tesla employees Musk justified this roughly 3,200 employee cut by citing a goal to "reach more customers who can afford" its vehicles -- a problem exacerbated by the staggered 2019 elimination of government subsidies. As he wrote:
Starting around May, we will need to deliver at least the mid-range Model 3 variant in all markets...The need for lower priced variants of Model 3 becomes even greater on July 1, when the US tax credit again drops in half, making our car $1,875 more expensive, and again at the end of the year when it goes away entirely.
Musk argued that in order to be "a viable company" Tesla must get its costs low enough to make a profit on the $35,000 (220 mile), standard interior Model 3 requiring it to cut staff.
This is not the first Tesla layoff. After all in June 2018, the company ridded itself of 9% of its workers -- about 4,100 people, according to CNBC -- "during a make-or-break period as Tesla tried to increase production of the Model 3 after months of delays," according to the Wall Street Journal. This cost Tesla $34 million in "one-time restructuring charges," according to its Q3 10Q.
Meanwhile, Musk said that Tesla must reengineer its manufacturing operations to boost volume and lower unit costs so it can manufacture the standard Model 3 at $35,000. As he noted, Tesla must
[Increase] the Model 3 production rate and [make] many manufacturing engineering improvements in the coming months. Higher volume and manufacturing design improvements are crucial for Tesla to achieve the economies of scale required to manufacture the standard range [Model 3 at a price of $35,000]
Elon Musk has an uncomfortable relationship with the capital markets. Last year, he responded to what he saw as a war with short sellers by tweeting that funding was secured for a Tesla going-private transaction.
It looks like that was not really the case and Musk settled with the SEC by relinquishing his Chairman title for three years -- while Tesla spent almost $26 million in settlement and legal expenses.
This brings me to two reasons that selling Tesla shares would be wise.
1. Big cash outflows looming with dwindling cash pile.
Tesla has borrowed about $11 billion. $6 billion worth of that debt is recourse and most of it comes due over the next six years, according to its Q3 10Q. It needs to pay off a convertible note in the next five weeks, cover severance for its latest layoffs, and pay for the Gigafactory 3.
At the end of September, Tesla had about $3 billion in cash. This brings us to Tesla's $920 million convertible preferred stock -- which comes due on March 1. If Tesla's "average share price [is at] $359.87 or higher for 20 consecutive trading days," Tesla can pay off the note with common shares, according to the Journal.
But that level is 19% above its current price -- and I think it is much more likely that Tesla will need to fulfill its obligations to investors by forking over $920 million in cash.
According to the prospectus, "If one or more holders elect to convert their notes, we may elect to settle all or a portion of our conversion obligation through the payment of cash in the case of the 2019 notes."
Musk said Tesla expects to pay cash. During Tesla's second quarter earnings call, he said, "This convert that's coming due soon, $900 million or something like that. We expect to pay that off with internally generated cash flow."
Tesla has another convertible note due this November -- with a principal balance of $566 million.
I estimate that the latest layoffs will cost about $27 million in one-time charges -- assuming the same cost/terminated worker as Tesla incurred last June. And on January 6, Musk announced plans to build its Gigafactory 3 which will cost about $5 billion, according to Bloomberg.
In October, Musk offered a much lower estimate. He said the cost for Gigafactory 3 would "probably [be] closer to $2 billion. And unless we be at a higher -- and that would be sort of the 250,000 vehicle per year rate. And so I think we could be a lot more efficient with CapEx," according to Tesla's Q2 earnings call.
By my math, the cumulative effect of these cash outflows should bring Tesla's cash balance to a dangerously low level.
That is unless Tesla borrows more money or sells stock. But in October, Tesla supplied two diametrically opposed answers on whether it would do that.
How so? In Tesla's third quarter earnings call, Musk said, "We do not intend to raise equity or debt."
But in its Q3 10Q, Tesla said it would borrow to build Gigafactory 3. "We expect that much of our investment in Gigafactory 3 will be funded through indebtedness arranged through local financial institutions in China."
Which is it, Tesla? On January 21 a person close to the company offered what strikes me as utter nonsense, noting, "There is no contradiction. If you read other stories, no one else notes there is a contradiction...Local loans aren’t raising capital and aren’t raising debt."
Does this mean that if Tesla borrows $1 billion from a Chinese bank it won't be included on its balance sheet?
2. Huge stretch to meet Musk's 25% gross margin on $35,000 standard Model
This leaves me with a final question: Can Tesla make a profit selling its standard Model 3 for $35,000? I don't know what its cost of goods sold is for the Model 3.
But one analyst, Vertical Group's Gordon Johnson, concluded that at a $54,000 average selling price, Tesla lost $14,000 per Model 3 in the quarter ending March 2018, according to US News and World Report. Granted those numbers were for a more costly version of the Model 3.
In 2017, Musk claimed that Tesla would earn a 25% gross margin on the Model 3 in 2018, according to US News.
To achieve Musk's gross margin target for the Model 3 -- and assuming Johnson is right that the Model 3 costs $68,000 to build -- Tesla would have to reduce its Model 3 cost by a whopping 61% to reach the $26,250 unit cost needed to earn a 25% gross margin on a $35,000 price.
This strikes me as humanly impossible -- especially given the difficulties that Tesla has suffered already with its manufacturing process and the organizational confusion that inevitably follows a big layoff.
Just because it trades 22% off its high, does not make Tesla a buy.
Source: https://www.forbes.com