Summary

We have previously written about the proposed acquisition of SolarCity by Tesla and shared why we believe it is a bad deal for Tesla shareholders.

In this deconstruction, where feasible, we quote entire paragraphs of text so that there is no question about quoting something outside of context. The quoted text is from Elon Musk and the paragraph that follows it is our view on what was said.

The quotes have been taken in chronological order so that readers will not have a problem looking at the questions that led to these quotes and context they have been taken from. If anything is deemed out of context, we look forward to discussing that in the comment section.

One of the major themes of the call was the synergistic sales process. Early in the call Mr. Musk said:

1. “And then, in terms of the sales process itself, when we’re selling somebody the Powerwall, very often if not almost always, they’re curious about solar and want to do the same things. So then, not being able to sell them solar directly at SolarCity — sorry, at Tesla through our stores is pretty inefficient. But I think as you look ahead to say Model 3, a $35,000 car, well that same person at the same moment, we could sell them roughly an equivalent amount value of solar panels and Powerwall effectively doubling, or almost doubling the sale at that time and then putting all in at the same time.”

Several questions arise:

- How big is this customer base? Tesla likely would have sold less than 100,000 cars by the time this acquisition closes (if it does). Given many Tesla owners are repeat customers with multiple Teslas, the unique customer count is probably in the 50k to 75k range. Most of these are affluent, “green”, and either already have solar systems or will have no interest in getting a leased system from SolarCity. We would be surprised if the potential client base here is less than 10k. As we move toward Model 3 customers in 2017 (more likely 2018), this phenomenon is going to repeat. Very few of these customers will be good targets for solar systems.

- With net metering, which effectively is equivalent to a free battery in the grid, the market for residential battery system in most parts of the US is close to “0”.

- Customers coming to buy a $35K product can be upsold another $35K? Really? SolarCity has been exceptionally capable at targeting the gullible but what percent of customers could fall into this bucket? This would not be a difficult task to experiment. Wouldn’t it behoove management to do a trial to see the effectiveness before making concrete plans?

- What is the penetration of Tesla stores in the US? How big will this channel be in 2017? 2018?

- Will the same salesmen be trained to sell cars, solar panels, batteries, car leases, solar leases and battery leases? And, be good at all of them? If anyone thinks this can be done on scale effectively, we have a bridge to sell.

- With solar companies bombarding customers with solicitations, what percent of the customers are likely to use this particular channel for buying solar systems?

Given the above factors, we would surmise that less than 10% SolarCity business is likely to come from this channel. Probably far less than 10%.

2. “So, we’re headed to cash flow positive situation for the next three to six months at the [indiscernible], and that’s where the company has been steering itself, reducing their growth rate to some degree to achieve that cash flow positive position, but they are very clearly on their way to getting there in short order. So, it’s actually — we expect it to be a net cash generator, not a user of cash, particularly when taking into account the dramatic reduction in the cost of sales of solar systems sold through our stores. The biggest factor in SolarCity’s increasing cost per watt in Q1, was their sales costs. So, some of you — quite a big increase in sales cost. That will go radically in other direction with sales through Tesla.”

First of all, investors should realize that when SolarCity, or a Musk enterprise, says “cash-flow positive” it means something completely different from what that phrase is supposed to mean. For SolarCity, if capital raises plus FCF is greater than zero, then the company is cash flow positive (for example, see recent conference call transcript and the Q&A on the subject with Gordon Johnson). One should also consider that Mr. Musk’s past promises that Tesla will turn cash flow positive have been worthless.

Even with these caveats, can SolarCity turn cash flow positive? Note in the last sentence the Mr. Musk is counting on “sales through Tesla”, the same sales we discussed in the previous question, to turn SolarCity cash flow positive. Such commentary makes one question the credibility of these claims.

3. “I think the way to think about this is, not to kind of look in the rearview mirror but to look through the windshield. I think only about 1% of U.S. homes have solar. So, you have a massive addressable market that’s unserved. And there is at least 40 to 60 million households that where solar - where they could do solar if they wanted to. So, if the economics were right and they liked the aesthetics and was easy to do, then they would do it. So, the future market there is really gigantic.”

The “1% of US homes have solar” is the most abused marketing pitch to investors in the solar industry. While that statistic looks good on paper, residential solar is facing severe headwinds and when adjusted for the number of geographic areas where solar makes sense, the available market is much smaller. As we have discussed in an earlier note, California, which makes up for about 50% SolarCity’s business is much more saturated than most investors realize. For any investor inclined to believe otherwise, the question to ask is “Why are SolarCity sales stagnating?”

4. “We really need to have an integrated product. The Powerwall and the Powerpack need to be designed together with the solar system. So, it’s a one piece thing. And we really can’t do that if we are two separate companies. We’ve got to treat SolarCity like they are any other company, which is extremely unwieldy. So from my standpoint, this makes the execution easier and not harder.

SolarCity, at the root of it, is an installer and finance company. It has little expertise in battery technology or productization. Even if one were to assume that SolarCity has the proper expertise, that competency may be limited to less than 5% of the Company. Would it make sense to buy SolarCity for total EV of about $6B when all you need is a few tens of engineers to productize Powerpack and Powerwall? It is like buying McDonalds because you are looking for a burger chef. The whole thought process is incredulous.

Let’s say SolarCity is the only place in the world where this expertise resides, couldn’t Tesla do a joint venture of some kind?

5. “And I think SolarCity has got a great future independent of Tesla and also Tesla does. But, being able to integrate things at the product level, at the consumer experience level, the utility level, the commercial level, it actually makes it easier, not harder. And that’s why we are doing this. It’s like why should companies exist at all, what the point of having companies. The point is that a given company is going to create a more compelling better service for the end customer. And then, should the companies be two separate containers or one container, and if they’re one container, we can make a more compelling product and work together easier. So that’s the reason for it. So, I think that speaks to sort fundamental economic goodness of the transaction. And it will be harder if we remain two different companies.”

Once again, the thought process expresses here, except in rare cases, should not lead to an acquisition. As an auto dealer, Tesla may find it can give customers a good experience by providing Starbucks (NASDAQ:SBUX) coffee. Would Mr. Musk achieve that by buying Starbucks?

6. “But looking ahead, particularly to next year, selling Model 3 something in the order of $35,000 car, if we are selling Powerwalls and solar systems of comparable value and doing so in the same sales footprint with the same person, the first order approximation, our cost of sales should drop in half as would SolarCity’s correspondingly; maybe it’s not entirely in half, maybe it’s 30% to 40%. It’s a pretty — I think a very substantial drop on SolarCity side and also a material drop on Tesla side. So, you’re basically selling let’s say almost twice as much in a single transaction as you otherwise would.

And then, on the installation and setup side, it’s one crew instead of — and one visit instead of two to three visits. The ongoing maintenance is kind of one point of contact and not sort of two or three points of contact. And the cost of the system itself is lower because we’re not duplicating hardware, the hardware level. So, I think that all makes a lot of sense. And yes, the final costs of our companies would go down materially. I think it’s — one could argue about like is it sort of 20% reduction, 30% reduction, 40% reduction, but it’s pretty significant and for sure better than if the companies were separate.”

This is, more or less, a repeat of what we see in the first bullet above. Given the lack of any synergy and given the likely training problems and expertise, we predict that the outcome is going to be exactly opposite of what Mr. Musk suggests. In other words, cost of sales post acquisition will likely increase by 30% to 40%.

7. “We are going to be the world’s best manufacturer, not by a small margin but by a margin that people don’t even think is possible. And I believe in taking a first principles physics based approach to analysis. And my analysis of the situation is that dramatic improvements are possible on the automotive side and on the photovoltaic side.”

This statement, more than anything, shows the hubris that is Elon Musk. As such, in spite of participating subsidy hungry businesses, Musk enterprises do not post a profit. The Company’s marquee product Model S commands a below average rating for reliability. The Company’s Model X is an unmitigated disaster in terms of design and reliability. The Company bleeds money like there is no tomorrow.

We do agree “improvements are possible on the automotive side and on the photovoltaic side”. There is no doubt that there is a whole lot of room for improvement at Tesla and SolarCity. In this case, Mr. Musk has a lot to prove.

We view Mr. Musk’s statement that Tesla is going to be the world’s best manufacturer with a sense of sheer incredulity. There is a clear line between confidence and arrogance and Mr. Musk crosses the line with nary a realization that the king is naked.

To claim that one can dramatically improve the manufacturing processes in a mature and cost sensitive industry is highly questionable. Even in the unlikely scenario that such a leap can be achieved, it is illogical to suggest that others will not make similar improvements.

8. “An important advantage of the Silevo technology is that it has significant higher efficiency than the very low cost Chinese panels. So, on the same surface area of roof, you can get as much as a third more power. And then aesthetically speaking, the Silevo panels look better, they look a lot better. And if it’s done right, we can make your roof look better with solar panels than without. This is a night and day difference.”

While it is true that Silevo modules have higher theoretical efficiencies than most other modules in the market, this has only been achieved on a prototype and pilot manufacturing line to date. What would be much fairer to compare is what the competition is likely to be when SolarCity is in high volume manufacturing. Currently, SolarCity expects the volume ramp to occur by mid-2017. Given current industry efficiency trends, we submit that, by the time Buffalo fab fully ramps, Silevo modules will be within 10% of the leading edge products that many Chinese manufacturers would be shipping at that time.

In terms of Silevo panels looking better, we suspect that Mr. Musk is referring to the semi-transparent nature of the bifacial technology used by Silevo. If so, that is not unique to SolarCity and any company that sells bifacial solar products may have a similar look. If the semi-transparent look is not what Mr. Musk is referring to, and there are other physical changes, we submit that there is very little in terms of physical appearance that cannot be easily replicated by other players.

9. “And if you’ve got a — if somebody’s got a $400,000 house, if you make roof look ugly, then arguably you have made that house worth 5% less or some non-zero percent less valuable. On the other hand, if you make the roof look beautiful, you have made the house more valuable, and maybe that’s plus 5% or some non-zero percent plus percent in the value of a house. If it is something on the order of 5%, then the value delta there is call it $40,000 or maybe something like 2% or 3% and it’s 20,000, just like there is — you have a quite a big value delta. So, being able to have higher power that looks great and I think it costs better, at least as good as if not better, then what’s coming from anywhere else in the world, that’s obviously a wining outcome, and that’s the outcome that we will pursue. And I think we will be comfortable to get there.”

While the incremental value of better looking panels on a house is debatable, we agree with Mr. Musk’s argument that panels will look increasingly better over time. In fact, we have argued that this is one of the many reasons why current technology will be obsolete before the end of the initial 20 year lease term that SolarCity uses. This is precisely the thing that makes the whole SolarCity model such a money loser and non-starter.

10. “I do want to emphasize that I think the Silevo technology is going to make quite a big difference. And I don’t think it’s been a fundamental cost issue that prevented from being at or lower cost per watt than any other panel in the world.”

We disagree with the assessment and we see this as lack of understanding of the business aspects on Mr. Musk’s part to make such a claim. Contrary to what Mr. Musk may think there are at least two fundamental reasons there is a cost issue for SolarCity.

1. Scale: If and when fully ramped by mid-2017, SolarCity will be around 1 GW production. This compares poorly with the market leaders who are likely to have 5x or more capacity at that time. The R&D and SG&A overhead at these companies is effectively 1/5 or less per watt compared to SolarCity.

2. SolarCity is operating with key employees in super expensive San Francisco Bay Area and expensive New York Buffalo area. The labor costs in these areas are far in excess of what it costs to do similar work in China and Southeast Asia. SolarCity will save some money in transportation but those savings pale in comparison to labor force costs.

11. “I spent time in the SolarCity Silevo power plant in the Bay Area. And so, I am familiar with this. And my observation is there are dramatic improvements, like there’s not some physical thing that’s preventing it from being super competitive. It’s actually relatively straightforward manufacturing process.”

This ironic view contradicts heavily with the statement that “We are going to be the world’s best manufacturer, not by a small margin but by a margin that people don’t even think is possible”. If the process is “relatively straightforward” as Mr. Musk suggests, how can Tesla beat other players by miles? Is the competition so incompetent that they cannot even excel at “straightforward” process? Once again, there is no end to the hubris being displayed here.

12. “And although some utilities would exaggerate the impact of solar on the grid, ultimately the impact of solar on the grid beyond a certain localized percentage does have an impact and you do need to buffer the power. So, they have valid argument. It’s just exaggerated.”

While there is no doubt that everyone exaggerates in pressing their case (as can be seen by Mr. Musk’s own claims about the benefits of this merger), we believe Mr. Musk is missing the major challenge faced by residential solar and why it is not economical to a large extent. We believe that the reality is opposite of what Mr. Musk claims. The key challenge to the residential solar industry is that the benefits of rooftop solar to the grid are vastly exaggerated. That is the reason why SolarCity depends so deeply on subsidies.

13. “….we don’t have a good basis for doing some special deal with SolarCity, because that’s effectively a conflict of interest. Ironically conflict of interest goes away for one company, but it doesn’t go away for two separate companies. So, like I say, it’s not really a good rationale for just offering a special deal and only working with one company that I also happen to own. It just — I don’t think we have a good moral or legal basis for behaving special way to SolarCity unless we’re — it’s actually one company.”

Balderdash! There is nothing illegal or unethical about giving preferential treatment to other companies. It is done all the time in the form of special agreements and JVs. There is nothing moral or ethical about it. The real problem here is that giving special status to SolarCity can alienate other solar customers who could potentially use Tesla’s batteries. However, this particular problem only gets exacerbated by acquiring SolarCity.

14. “And it’s seamlessly integrated product that all just works together, that’s better. You don’t want to have heterogeneous systems integration problem. That’s just basically where the interfaces break down and then people — there is some pointing fingers like this didn’t work, now yours thing didn’t work, like this is just one integrated system, there is no finger pointing, you can iron out all the bugs and it just works. And you’re not wondering whether should I blame the solar company or the battery company or the — who knows and this is sort of like pain in the butt to try to figure that out, if you’re the end customer.”

While at a high level this sounds like a fine argument, this type of thinking fails real life tests routinely as companies try to vertically or horizontally integrate and provide all pieces of a solution. It is not that vertical/horizontal integration never works. It does. There has to be compelling economic rationale for it. Such a thing goes not exist in the current proposal.

15. “And I mentioned this whole thing about manufacturing a machine that builds a machine. I’ll tell like its order of magnitude improvements are what I think can be achieved. We won’t get there right away but by version three of the machine that builds a machine order of magnitude.”

This sounds appealing at an esoteric level. In practice, unless Tesla is getting into the business of developing production tooling, we fail to see much weight behind this argument. As long as the company uses standard production tooling, as it does today, there will be no meaningful differentiation at the production level. In a half a decade or a decade, if Tesla gets to a stage where they are developing most of their own tooling, we can revisit this argument. Until then, the Company has nice goals but no discernible competitive advantage.

16. “Well, I think once the deal is done the cash burn is likely reduce because of reduced cost of sales and general operational efficiencies like a lot of things are duplicated, got duplicated. So, we expect cost to decrease, and to increase the positive cash flow from the SolarCity acquisition. Yes, I mean it might take a few months for those to come into effect, but pretty short order, let’s six months after the acquisition is complete. I would expect those efficiencies to become — to be very significant.”

As discussed earlier, it is unlikely that SolarCity’s cost of sales under Tesla will decrease. It is far more likely to increase, especially considering the high end operations of Tesla and the associated cost structure.

17. “But I think, morally and legally we would find it very difficult to defend a unique relationship that just favored SolarCity, if we’re separate companies. For one company, then obviously that’s fine. The separate companies, we can’t do that.”

Again, the same flawed argument we saw in item 13 above repeats.

18. “Yes. Since SolarCity is constrained in the short-term from just going out and raising equity itself, Tesla would provide bridge loan if needed. I actually don’t think it’s going to be needed to be clear, because that’s something that’s only fair and perfect to do. So, we’ll be there if needed, but I don’t think will be needed.”

If and when a deal with Tesla is reached, it is unlikely that SolarCity can raise much capital - either debt or equity. The uncertainty of the merger would effectively seal the liquidity path for SolarCity. Can Tesla, with its disastrous model X launch, and a high burn ahead of Model 3 introduction afford to shore up SolarCity? Would this be wise? Would Tesla need to raise capital again soon?

19. “We’re not limited in stores in terms of selling solar and efficient stationary. We could do that and then potentially offer to sell the car there in a gallery format something like that. So, it does open up additional options on the retail front potentially that you mentioned.”

Firstly, it is very unclear if there is much of a synergy between high end car dealership and being able to sell solar panels. SolarCity has had a partnership with BMW for selling solar systems along with BMWs. There is no indication that this program was successful. Even if it was successful, doesn’t BMW now have a reason to pick a different service provider than SolarCity post Tesla acquisition? Wouldn’t other car companies, that go this route, also choose someone other than SolarCity?

The situation is similar when it comes to other product areas. Mr. Musk has stated in the past that about 90% of Tesla Energy business will come from Powerpack and not the Powerwall. Given this is not a traditional area of strength for SolarCity and given that this is a highly fragmented market with several major players such as FirstSolar, Canadian Solar, how does this acquisition help? Isn’t Tesla effectively making its potential customers seek out competitive battery solutions?

When it comes to residential markets, it is a pipe dream that there will be any significant battery uptake in the in the US for the foreseeable future. At the root of it, the interests of solar industry (SolarCity) and storage industry (Tesla) collide when it comes to batteries. Solar industry wants unimpeded net metering as that serves the solar installation industry. Whereas net metering makes it nearly impossible for battery economics work. The strong lobbying done by SolarCity and rest of solar industry ensures that there will not be much of a market for residential batteries in the US in the near future.

EpilogIn this deconstruction, we aimed to show the false assumptions, false narrative, and inconsistent logic that make up for this ruinous proposal. While we have considerable respect for Mr. Musk and his achievements, the amount of drivel in the call from a man who his fans consider a genius is astonishing.

There is a deep conflict of interest between solar installers and battery manufacturers. Battery manufactures should do everything in their power to oppose net metering and all the rate structures pushed by solar companies that allow solar customers use grid as a free or low cost battery. It is net metering and poor rate structures that are impeding battery adoption at the residential level. SolarCity has also not made many friends in the utility space - a customer base where much of Tesla Energy’s future customer base resides. A CEO committed to Tesla’s shareholders, a CEO who would like to see a good ROI on the battery division, would do everything in his power to work against SolarCity and not acquire it.

Frankly, the misguided ramp of Model 3 and the patently terrible deal with SolarCity make us question Mr. Musk’s suitability to be the CEO of Tesla. He may have been a great startup guy but that phase is over now. A public company deserve a CEO who is a good steward of public investments. What we see with Mr. Musk is recklessness and braggadocio.

Let’s look at the announcement itself. It was originally made through a blog post. Is that an appropriate channel for releasing such major and material information? There was also a conference call on Tuesday afternoon to select audience. Average investors had no access to this and as of the writing of this article, this presentation has not been made available to investors in the form of audio or a phone replay. Isn’t this a violation of SEC disclosure laws?

What Tesla needs today is someone who can guide the company to a successful Model 3 execution and beyond. Mr. Musk can move on to working on Hyperloops, Rocket ships, and any many number of fancy ideas that are in the realm of private markets.

At the minimum, Mr. Musk must choose between Tesla and SolarCity and decide which Company’s interests he wants to champion.

As far as the proposed acquisition goes, we expect the boards to ratify the deal. However, as investor awareness of the topic increases, we expect shareholders to sour on the deal. We believe it is likely that this deal will not be consummated.