Tesla raises $2.4 billion in capital; Is Tesla desperate?; Taking a closer look at the deal

Monday, May 6, 2019
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***I just got back from Omaha from the Berkshire Hathaway annual meeting and am at the Ira Sohn Investment Conference today. Look for my thoughts on both later this week in Empire Financial Daily.

In the meantime, I'm sharing an interesting note my longtime friend and former business partner Glenn Tongue sent me about Tesla's (TSLA) recent $2.35 billion stock and bond sale. Glenn spent two decades as an investment banker on Wall Street, so he's an expert in the various ways companies can raise money. He has some unique and important insights on Tesla's complex financing that aren't being fully appreciated by analysts or investors, which he's allowing me to share with you today. Read on for the details.***

I (Glenn) love going to the movies. And even though I know it's not good for me, nothing is better than getting a big bucket of popcorn and a medium Diet Coke. But the prices never seem to stop going up – it's now $8 for the popcorn and $6 for the medium soda – a total of $14!

Yesterday, while waiting in line for the Avengers movie, I noticed the theater was offering a combo pack – $12 for a large bucket of popcorn and a large soda. An idea sprung into my head: What if I bought the combo pack and sold half of the large Diet Coke to the next person in line? I would be left with half of the large soda, which is the same size as the medium that I wanted in the first place. To make it worth his while, I could sell it to him for the discounted price of $3.

This would be a good deal for both of us. I would be left with my bucket of popcorn (worth $8) and a medium soda (worth $6) and would pay just $9 for it after my side transaction. And the guy behind me would get a medium soda for half the price. Only the theater would lose out... It should have received $14 from me and $6 from my new friend but would ultimately get just $12.

Why am I telling you this story?

Because a similar set of transactions played out with Tesla last week when the company sold $1.6 billion of convertible bonds and $750 million in stock.

A convertible bond pays an interest rate (in this case, 2%) and can be exchanged for a fixed number of shares if the stock rises (in this case, if the stock rises to $309.83 from the issuance price of $243). Convertible bond buyers appear to get a good deal – in the downside scenario, they're senior to shareholders and receive interest and principal upon maturity (albeit at a lower interest rate than traditional debt). And if the stock soars, they can convert their bonds to shares and benefit from the gains above the conversion price.

But as with seemingly everything associated with Tesla, things are not what they seem. While bulls cheered what seemed to be a successful offering, I actually think this financing revealed what a desperate situation Tesla is in. Let me explain...

Using the analogy above, Tesla is the movie theater. It sold the combo pack (convertible bonds and stock) to underwriters (me), who sold all of the popcorn (the convertible bonds) and some of the soda (stock) to the guy behind me in line (investors).

But here's the kicker: The underwriters sold half of the soda (stock) back to Tesla for more than Tesla originally sold it. The convertible bond buyers did well. The stock buyers did, too. Only the movie theater (Tesla) lost out on the deal.

In reality, it's more complicated than that, and the math is tricky... But the bottom line is simple: The underwriters and investors made money at Tesla's expense.

So why did Tesla do it? Because it desperately needed the cash and had no other way to raise it – other than issuing super-expensive capital.

Let's take a closer look at the transaction using the numbers from the prospectus. The company issued $750 million in stock (approximately 3 million shares at a price per share of $243). It also issued $1.6 billion of convertible notes with a 2% interest rate. The note holders can convert the notes into stock at a share price of $309.83, ultimately representing 5.2 million shares.

But here's the key: Along with the offering, Tesla paid $413.8 million to purchase a call option. The stated purpose was to offset the dilution the company would incur if the convertible notes convert into stock.

Think of a convertible note as debt with an option to buy the stock. We can segregate these components of value in the convertible bond. In this case, if the value of the option is the $413.8 million, then the bond is worth about $1.2 billion ($1.6 billion less the $413.8 million). With these numbers, Tesla's effective interest rate on the bond component is 8.5%. In other words, Tesla in effect just issued an 8.5% bond.

Why would Tesla go through so much trouble (and pay the banks such high fees) instead of just issuing an 8.5% bond? Simple: Few investors want to buy huge amounts of debt in a risky, money-losing company like Tesla.

The convertible bondholders have no such risk because they have (or will soon have) shorted the stock against their convertible bond. If the company sinks, they'll make money on the short position. And if it succeeds, they'll make money on their convertible bond. It's close to a risk-free 8.5% return for them.

But Tesla bought the $413.8 million hedge from the underwriters – the people who repackaged the stock that was purchased in the offering. Yes, the same stock that Tesla sold in its equity deal was repackaged as a call option that Tesla bought... in effect, a round trip for that stock.

For dealers to create the hedge for Tesla to buy, they need approximately one-third of the shares (1.73 million) underlying the convertible bond. Let that sink in... 1.73 million shares out of the 3 million issued – more than half of the entire stock offering – were required to repackage a security to sell back to Tesla! This underscores what a difficult time Tesla had finding investors.

The rest of the transaction falls into place from there. There wasn't much stock left to sell, so the underwriters went to existing shareholders and convinced them that this transaction would give the company some breathing room. That's good for the stock, and existing shareholders are already believers.

As for the convertible, that's easy to place as long as it's possible to short the underlying stock. And of course, the underwriters are happy... they make $30 million in underwriting fees and only they know how much Tesla overpaid for the hedging transactions. While I don't know the exact amount the company overpaid, keep in mind the negotiations were between a first-deal, novice 34-year-old CFO and veteran dealmakers at Goldman Sachs (GS).

In addition to the structure of the deal, one important element of this issuance really troubles me: In the prospectus, the company calls itself a manufacturer of cars and solar-energy systems.

However, if you listened to the single sales call for the deal, which was only open to large, well-connected funds, Musk stated that the manufacturing of cars and solar-energy systems is simply a "backstop to value," and that Tesla's path to a $500 billion market cap is via autonomous driving and robotaxis. This concept is nowhere to be found in Tesla's publicly filed selling document. This is a blatant violation of U.S. Securities and Exchange Commission ("SEC") rules to selectively share highly material information.

In light of this, why isn't the SEC blocking the sale of these securities? Because Tesla did a transaction that the SEC doesn't review...

In my many decades on Wall Street, I have never once seen a company present one business plan in their regulatory filings while privately pitching an entirely different one to select investors. This behavior is outrageous, and we'll see if Tesla's acquisition of Maxwell Technologies gets new scrutiny in light of this brazen sidestepping of regulations.

Once you understand the details of this financing, it becomes clear that Tesla was truly desperate. While the structure was clever and allowed the company to raise much-needed cash, it paid a very high price.

The cash gives the company a few more quarters to try to turn things around, but given the abysmal first quarter and downward trends, I wouldn't want to own this stock. Despite the ever-changing narratives, Tesla has never had a profitable year. I'm willing to bet they never will.

Thanks for your contribution, Glenn!

Best regards,

Whitney

Whitney Tilson

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About Whitney Tilson

Prior to creating Empire Financial Research, Whitney Tilson founded and ran Kase Capital Management, which managed three value-oriented hedge funds and two mutual funds. Starting out of his bedroom with only $1 million, Tilson grew assets under management to nearly $200 million.

Tilson graduated magna cum laude from Harvard College with a bachelor's degree in government in 1989. After college, he helped Wendy Kopp launch Teach for America and then spent two years as a consultant at the Boston Consulting Group. He earned his MBA from Harvard Business School in 1994, where he graduated in the top 5% of his class and was named a Baker Scholar.

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