While we previously pegged the odds of Tesla’s proposed merger of SolarCity at a 50/50 probability yes/no, we now peg those same odds at 70/30. However, with an 0.11x exchange of Tesla stock for each share of SolarCity, if the deal were to close today, SolarCity would be valued at $20.21/share, or 2.0% upside. However, were the deal not to close, we believe SolarCity’s stock would trade down to $6/share (we believe SolarCity is still creating negative value for each system sold on an unlevered basis. Thus, on valuation, applying 70% to $20.21 + 30% to $6, on arrives at a probability adjusted year-end 2016 price target of $16, or 20% downside.
So, despite advisory firm Institutional Shareholder Services’s (“ISS”) approval last week, why do we still see a 30% chance some shareholders “walk” on this deal when the date for approval (i.e., Thursday of this week) is so close, and the merger-arb spread has come in so much? In short, we assume investors aren’t willfully ignorant. What do we mean? Well, in SolarCity’s C3Q16 10-Q, which was released last week, we gleaned two key takeaways, including:
§ SolarCity sold roughly 25% of their panels to the Commercial and Industrial (“C&I”) segment during the quarter; and, despite the company reporting C&I prices for their systems sold at roughly $3.00/W, based on checks we did months ago, we know that C&I prices in the US are 35%-50% below what SolarCity has reported; thus, if one were to spread the SG&A across proportionally to the average selling price (“ASP”), SolarCity’s creation cost would be significantly higher than the reported $2.89/W level, which would also mean a huge miss on megawatts (“MW”) deployed in C3Q16, not the beat reported; and
§ SolarCity changed the useful lives of their systems from 30 years to 35 years in the quarter, artificially (we believe) reducing depreciation expense, allowing the company to inorganically beat on EBIT and thus EPS.
We believe these actions are HIGHLY questionable, and assume Tesla investors either: (a) lack a very basic understanding of the solar market, or (b) lack a very basic understanding of accounting. But it doesn’t end there. In addition to these forms of what we see as accounting chicanery, SolarCity claimed that it generated cash in the quarter. However, when adjusting for the debt the company issued in the quarter (i.e., excluding it), its cash balance fell from $146mn in C2Q16 to just $67mn in C3Q16. Thus, again, assuming the portfolio managers at Fidelity, Baillie Gifford, T. Rowe Price, Vanguard, Black Rock, Morgan Stanley, etc. are aware of this, and not under Mr. Musk’s “spell”, we still see a 30% probability this deal does not close. As such, we would be short the stock ahead of Thursday’s vote.