In Parts I, II, and III, we took a deeper look at their recent CFO change, their loss of four Directors, and the loss of the confidence of some of their biggest institutional investors. In each of these indicators there is a possible inference that insiders at the company know about something rotten in Tesla that is obscured from the ordinary shareholders. In this post we will take a deep dive into the SolarCity acquisition and look at the reliability of Musk and Tesla’s statements surrounding the acquisition.
A company’s commitment to transparency is important for the long-term health of any company, but it is particularly important during an acquisition because of the complexity of the accounting and the need for judgement calls from management concerning the value of control and synergies. It is no surprise that 17% of the Critical Audit Matters (CAMs) disclosed by auditors so far have concerned business combinations.
The SolarCity Acquisition: Vertical Integration or a Bailout?
Tesla announced that it had made an all-stock offer to acquire SolarCity on June 20, 2016. SolarCity was one of the leading solar panel installation companies in the country. Everyone expects a merger to be announced with certain ritualized glowing rhetoric and grand promises and Tesla’s announcement was no exception:
We would be the world’s only vertically integrated energy company offering end-to-end clean energy products to our customers…
We would be able to maximize and build on the core competencies of each company…
Culturally, this is a great fit. Both companies are driven by a mission of sustainability, innovation, and overcoming any challenges that stand in the way of progress.
One thing to note, right from the start, is that Musk was the Chairman of the Board of both companies. At the beginning of 2016, he owned 26.5% of Tesla and 21.9% of SolarCity. There were other connections, as board members of both companies are partners in other ventures together and both the CEO and CTO of SolarCity were close relatives of Musk. In short, there were far too many connections between SolarCity and Tesla for this transaction to occur at arm’s length.
Whenever there is a potential conflict of interest in a merger like this, there is a greater need for transparency because the courts may look skeptically at the transaction if it goes badly. Tesla made its case on its blog, and the story they told their investors was that 1) this merger would create the world’s only vertically integrated sustainable energy company, and 2) that a merger with SolarCity would benefit Tesla financially in the short term and long term.
Let’s examine the first claim. The vertical integration was announced repeatedly and with much pomp, but the claim is really a stretch. Solar panels are rationally related to electric cars, but did the merger help Tesla make cars that were cheaper or better? No, this integration came from selling a potential source of energy for their vehicles. Would Ford vertically integrate, using the same logic, if they bought Exxon?\ After the merger, Tesla separated out its new residential energy storage product and paired it with SolarCity to create a new business segment. So, in truth, Tesla diversified its business and their claim of vertical integration was mere puffery.
A Look Back at SolarCity Prior to the Merger
Putting aside the puffery, let’s look at the claim that the purchase of SolarCity would benefit Tesla. At first glance, this claim seemed plausible at the time, since SolarCity had almost $2 billion in equity on their balance sheet, stemming mostly from the $5.8 billion in lease and to be leased solar system assets.
But a closer look at SolarCity’s income and cash flow statements from 2016, provides some crucial context:
SolarCity was able to dramatically increase its revenues in the two years before the merger, but only at great expense. Not only were installation costs high, but the company also had teams selling the product door-to-door. Sales and marketing accounted for nearly half of the companies operating expenses. Considering that gross profits need to exceed operating expenses and interest expenses to keep a company in the black, SolarCity had no prospects of short-term profits.
Because SolarCity operated at a perpetual net loss, it relied on debt and government subsidies to keep afloat. To boost sales, SolarCity offered a no money down installation of solar panels to potential customers, but it would retain ownership of the panels and lease them to the customers. This also allowed them to take advantage of something called the Investor Tax Credit (ITC). SolarCity’s description of how it used the ITC is as follows:
[R]egulations enable the ITCs to be separated from the ownership of the property and allow the transfer of these ITCs. Under the lease pass-through fund arrangements, the Company can make a tax election to pass through the ITCs to the fund investor, who is the legal lessee of the property. The Company is therefore able to monetize the ITCs to investors who can utilize them in return for cash payments.
So, SolarCity’s business model was to purchase and install solar systems at great expense and recoup the costs over time with a combination of income from leases and cash payments for the accompanying tax credits. But this strategy was failing SolarCity. The cash flow statements show that SolarCity spent over $1.6 billion in 2015 and 2016 on purchasing solar systems that were leased and to be leased, but that those cash outflows did not generate much revenue, with only $293 million in 2015 and $422 million in 2016.
At the time of the merger in 2016, SolarCity had $5.8 billion in assets attributable to leased solar systems, more than half of their total assets. Those leases only produced $422 million in revenue. After the acquisition Tesla discontinued offering to lease solar panels with no money down. By doing so, it essentially put an end to SolarCity’s business model, and it’s not hard to see why.
Finally, there were real concerns about the long-term viability of SolarCity because the ITC tax credit that spawned the solar business has been set to start phasing out for residential homes this year. This tax credit has little hope of extension.
Other Warning Signs at the Time of the Merger
In addition to these issues, there have also been reports that SolarCity was having trouble raising debt and that Musk’s other company Space X had purchased $167 million in bonds to keep the company afloat.
There were also serious concerns raised about the valuations provided by the banks involved. A number of concerns were raised, but there were two that stood out. First, Tesla’s bank Lazard used Goldman Sachs to estimate their cash flows, but SolarCity’s bank Evercore used SolarCity’s estimates for cash flows. The second point was that Evercore used 6-8% percent perpetual growth for Tesla and 3-5% perpetual growth for SolarCity in its terminal value, which is problematic because it assumed growth that was higher than that of the economy forever.
There was also some suspicious behavior by Tesla. In 2016, just a few weeks before shareholders voted on the merger with SolarCity, Musk announced that Tesla would begin installing complete solar roofs, where the individual tiles would act as solar panels. The tiles used in this announcement were fake. Tesla was not ready to bring the product to market, and in the three years since the unveiling, only a handful have been installed. In context, the unveiling of the solar tiles seems like misdirection.
It is hard to have confidence in Musk and his management team’s commitment to transparency when they use fake props to unveil an idea for a flashy new product right at the time when shareholders ought to be doing their due diligence for a vote on a merger that raises serious conflict of interest concerns.
Musk and his Friends Won at the Expense of Other Tesla Holders
So, it seems SolarCity was a dog and Tesla paid $2.6 billion dollars for it. We would argue that SolarCity was worth far less than $2.6 billion, perhaps nothing, perhaps it was only a liability. Since Musk and his friends owned stock in both companies, they were better off than Tesla owners who did not own SolarCity prior to the merger.
Per the terms of the merger, each share of SolarCity stock was exchanged for shares of Tesla stock. If SolarCity was worth nothing, then most Tesla owners had their ownership diluted by the acquisition, except for Musk and his friends. Take Musk for example, before the deal Musk had approximately 37 million shares representing 19% of the ownership of Tesla (his shares had been diluted by an offer earlier that year). When the deal was completed, when Tesla registered approximately 2 million additional shares, of which Musk received approximately 400,000, or twenty percent, representing his 20 percent stake in SolarCity.
Predictably, the merger has led to securities litigation. And this suit may have legs, as discovery is well underway, and trial is set for March 2020. Musk has already been deposed for the case, and has admitted that he was involved in the discussions surrounding the merger, and that he was well aware of a liquidity crisis facing SolarCity at the time. His recusal from the actual vote may not matter, as the suit alleges that 6 out of the 7 members of the board benefited from the merger.
It is likely that the case will resolve before trial, but the fact that this litigation has progressed so far lends further credence to the idea that this merger was a raw deal for Tesla shareholders. As a corporate Watchdog, what concerns us about this merger is the possibility that Musk, along with his friends and relations, were not transparent about why they wanted to merge the companies, and that they benefited while Tesla’s shareholders were left with a smaller slice of the pie.
In the Aftermath of the Merger SolarCity has Proven It Was a Dog
With the benefit of hindsight, even the most skeptical assessments of SolarCity were understated. After the merger Tesla broke into two segments, automotive and energy generation and storage. Energy generation and storage includes sales associated with Tesla’s Powerwall system, (a battery that will power your home in case of an outage), as well the solar panel systems that were originally sold by SolarCity. Overall revenues for the segment have increased every year, but that has mostly been due to the popularity of the Powerwall system.
Less than two years after the merger, Tesla began cutting positions at SolarCity. It ended door to door sales, only offering the product online, and ended a deal with Home Depot that accounted for half of its solar panel sales. There have been other hiccups with the solar panel technology, with Walmart suing Tesla for no fewer than seven fires started by defectively manufactured solar panels.
Without a presence in stores, and with installations declining steadily every year, it seems that SolarCity is truly dead just three years after the merger, along with the dream of a “vertically integrated” all-electric experience for the consumer. Musk and his friends promised the shareholders a dream and delivered a flop, at least so far.
But Tesla’s supporters have had their patience rewarded, Musk announced earlier this year that 2019 would be the year of the solar roof. He has offered the third iteration of the solar roof tiles to rekindle their zeal, at $21 per square foot for the experimental technology, when a conventional roof ranges from $3.5 to $5.5 per square foot. True believers need to act now and install this monstrously expensive roof before the $8,500 Investor Tax Credit for solar installation beings to phase out next year.
Since the first announcement of the solar tile seems to have been made to sell the merger with SolarCity and not the tile, we wonder if this announcement is more misdirection for some other issue at Tesla.
**SolarCity’s Enduring Legacy, A Boondoggle in Buffalo **
Before SolarCity was acquired, Musk struck a deal with Governor Cuomo to have the State pay $750 million to SUNY, who would build and furnish a factory according to SolarCity’s specifications, and SolarCity would pay any additional amount required. This was a part of a scandal ridden government attempt to revitalize the city of Buffalo. Tesla had promised that this factory would lead the industry in manufacturing solar tiles.
Tesla’s accounting for this gift from the State of New York has undergone some changes. Initially, when SolarCity was the original lessor, it put the factory on the books as if they owned it because of their potential exposure to cost overruns if SUNY were to waste money and leave SolarCity on the hook. This project was valued on the books at over $800 million accounting for almost half of the equity on the books at the time of acquisition. That changed in the first quarter of this year:
Following the adoption of ASC 842, we no longer recognize the build-to-suit asset and related depreciation expense or the corresponding financing liability and related amortization for Gigafactory 2 in our consolidated financial statements.
Tesla now recognizes the property on the balance sheet as a right-of-use asset. The accounting for this gift is opaque, but that is nothing compared their lack of transparency about the status of the solar tiles that the factory is supposed to be churning out.
10k 2016: We currently expect to commence production in the summer of 2017 at our Gigafactory 2 in Buffalo, New York, and begin customer installations of the solar roof later in 2017
Q3 2017: We … plan to produce Solar Roof tiles at Gigafactory 2.
10k 2017: We recently commenced Solar Roof production at our Gigafactory 2 in Buffalo, New York, and are beginning to install them in customers’ homes
Q2 2018: We are also continuing to iterate on our Solar Roof product design and production and installation processes before ramping production…
10k 2019: We have been installing this product at a slow pace to gather learnings about our design and installation processes, and plan to ramp the production of Solar Roof with significantly improved manufacturing capabilities during 2019.
Q3 2019: … we are planning to scale over the remainder of 2019 and into 2020
Reuters reported in May of 2019 that only 21 homes in California with solar tiles were hooked up to the grid. Musk owns four homes in California. Perhaps with the launch of its third iteration of the Solar Roof, Tesla will have more success, perhaps not.
There are more problems with the factory than just the fact that the main product it is supposed to produce has been a flop. Part of its deal with New York was that Tesla would employ 1450 employees there by April of 2020, and there currently are only 800 employees working there. Tesla will need to pay $41.2 million to SUNY every year that if fails to meet this benchmark. Tesla has partnered with Panasonic and considered moving the production of other products to the factory to boost employment there, but that cost more than paying the fine.
Workers there have reported that production is virtually non-existent and that employees sit around on their phones unless the press is scheduled to visit, in which case they block off unused parts of the factory and try to look busy.
It appears that Tesla has kept SolarCity’s Buffalo factory open largely for show. This has saved face for Musk and his management team but has probably cost Tesla an enormous amount of money.
At the time of the merger, there was plenty evidence that SolarCity was not worth the trouble. It bled cash, it had no hope of running an operating profit, and the tax credits it depended on were set to phase out in a few short years.
In the aftermath of the merger, even more evidence has come out supporting the idea that SolarCity was a dog, and that Tesla was aware of this fact when it went through with the deal. In fact, the “launch” of the solar tile weeks before the shareholder vote seems to be deliberate misdirection. The simplest explanation for all this evidence is that Musk and his friends had a serious conflict of interest.
Transparency is critical to the long-term health of a company, because the accountability it brings helps management make good decisions, even when they are hard and humiliating. The ongoing boondoggle in Buffalo is emblematic of the legacy wrought by Tesla’s lack of transparency surrounding the merger. The question arises, if Musk and his friends aren’t committed to transparency, then what else might they be hiding?
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