Tesla: Shorts Are Now In Charge

Despite finally dipping my toe into Tesla (TSLA) on the short side earlier this year, I’ve largely stayed out of the debate on Seeking Alpha. Actually, making this bet is a change of pace for me. I’ve often fielded questions, as a long/short investor focused on cash flows, on why I did not short this company from 2014-2017. The problem with shorting Tesla – and something numbers-focused short sellers have repeatedly glossed over – has been Elon Musk. Savvy investors realize that. Cash burn just did not matter so as long as Elon Musk could continue to convince institutional investors to cough up billions of dollars to fund his vision.

This is changing. The situation in 2018, particularly in recent months, has called his ability to do that into question. With significant pressure on his company, recent well-publicized news items (“Funding Secured”, senior management turnover, Joe Rogan interview) have begun to weigh on many investors, large and small. While many have wondered why the Board of Directors has not taken action, I think the answer to that is obvious. They simply cannot kick Elon Musk to the curb; the Board knows that without Musk there is no Tesla and the debt-funded growth story folds in on itself. Longs have to think long and hard on whether raising capital will be as easy as it has been in recent years, especially as the 2018 and 2019 Convertible Senior notes now look like they will have to be rolled over with cash instead of stock. The short side, years early on betting against the firm, finally will have its time in the sun. While calls for bankruptcy are way too early, in my opinion, there is still money to be made betting on lower equity pricing.

Laying Out The Framework, Broad Short Case Review

Tesla has had absolutely no problem raising nearly $3,000mm from secondary stock offerings since 2015. The company raised billions more in hybrid debt alongside that on very attractive terms. However, perhaps nothing is more indicative of Tesla’s access to capital than their recent pure bond offering. In my opinion, the $1,800mm raised by the 5.3% Senior Notes due 2025 was a watershed moment that highlighted Elon Musk’s continued ability to sell the future. Any impartial bond analyst that looked at the financials and lack of bond protections took a very cautious outlook. This pessimism was something that could be seen in Moody’s initial bond rating of B3, well into junk territory. These analysts took a very bleak outlook on Tesla’s future, its execution risk, and its cash needs.

As a result of the rapid ramp up in Model 3 production and the significant increase in capital expenditures required under the production plan, we expect that Tesla will remain free cash flow negative into 2019. Given this negative free cash flow outlook, the uncertainties associated with the launch of the Model 3, and the potential cash requirements necessary to cover the maturities of its convertible debt, Tesla will face large cash requirements through 2018.

This does not even factor in the usual protections built into debt rated this far into junk. As a reminder, the sole guarantor on these notes is Solar City. The Gigafactory, a core component of the Tesla story, is not collateral and can be levered up itself. There are none of the usual covenant restrictions on further debt issuance, selling assets, or on capital spending. Nonetheless, Goldman managed to find buyers at a 5.3% coupon – a rate 200bps below where typical bonds of this credit quality would be priced. After the recent downgrade to Caa1, it is easy to forget that Tesla is in the company of distressed stories like Windstream (WIN) and Revlon Consumer Products. These issuers are seeing double-digit yields to maturity on their debt. Even after the recent collapse in the Tesla 2025 bonds (now worth 84 cents on the dollar), the yield to maturity is still 8.3%. That is lofty, all things considered.

However, can Tesla roll over the debt at attractive terms going forward? Remember what is coming due shortly:

  • $920mm in 0.25% Convertible Senior Notes (March 2019)
  • $230mm in 2.75% Convertible Senior Notes Due 2018 (November 2018)
  • $185mm on the Term Loan (December 2018)

With shares now down meaningfully from the $420.00/share Privatization Rally, rolling over into fresh Converts becomes more and more dilutive to shareholders with every passing day. The downturn in the 2025 Senior Notes shows that demanded interest rates will be in the high single digits. I think it is clear that this time next year, Tesla will, at the minimum, be dealing with $100mm+ in additional annual interest expense or shareholders will be facing significantly more dilution down the line.

*Did he inhale or not inhale? “420” per share indeed.

All of this will weigh heavily on the mind of Elon Musk and Tesla management heading into Q3 and Q4. Cash burn, which in the past did not matter, now does. Big institutional investors and lenders, which Tesla has relied on to finance its capital structure, are going to focus heavily on reported results. Tesla is going to have to borrow more capital to boost production at some point; investors will want to see a somewhat sustainable business model while operating under that 5k/week Model 3 run rate. While there have been many “make or break” calls on Tesla over the past several years, I believe that the second half of 2018 is where this will finally be true. Remember this statement from the most recent conference call:

I feel comfortable achieving a GAAP income positive and cash flow positive quarter every quarter from here on out.

There is little margin for error. Despite the share price collapse, analyst estimates for Q3 and Q4 have come up meaningfully over the past weeks and months. If Tesla reports continued cash burn heading into this major refinancing activity, there is substantial downside potential for the common equity. This will be pivotal. Fasten your seatbelts.

Disclosure: I am/we are short TSLA.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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