Tesla: Shanghai Surprise
One Month After Tesla Breaks Ground In Shanghai & Still No Clue About How Much The Plant Cost Or How It Will Be Funded
Tesla (TSLA) stock is in a tailspin, again.
Closing at $297 today, the stock is down 11% ytd, well off its high last August at $379 and trailing even 2018's comparatively tepid average of $316.
Tesla bondholders have remained wary, with the benchmark 5.3% senior notes still hovering near 86 where they've traded since last September after plunging more than 10 points versus the beginning of 2018.
Investors are spooked as more Wall Street analysts have slashed their formerly ambitious estimates for Tesla's fourth-quarter and 2019 revenue, profit, and cash flow primarily due to what they now identify as lower than expected demand and profitability for Model 3.
The thing is, Tesla has been signaling escalating troubles for months as I have warned in "Great Magic Trick Tesla; Now Do It Again" which digested Tesla's "miracle" third quarter and "Tesla: Down to the Wire" which reviewed the frantic close of the fourth quarter).
So while it's interesting that market estimates are collapsing toward my previously below-consensus estimates—and even I lowered my already cautious 2019 numbers—I'm concerned about other potentially quake-worthy news affecting performance for 2019 and beyond which we are not getting from Tesla.
With little more notice than a tweet
CEO Elon Musk popped into Shanghai, China, in early January for a showy groundbreaking ceremony to launch Tesla's new multi-billion dollar Gigafactory 3 which reportedly will be capable of doubling Tesla's current production capacity.
Even more surprising, Musk projected Model 3 production will begin there before the end of this year—less than eleven months from now.
Yet three weeks later we still have no idea how much this mega-plant will cost, or counterparty terms, or whether Tesla even has "funding secured" to pay for it—and these may not even be most troubling facts investors don't have.
What are Musk, and Tesla, and Tesla's banks, and Musk's China-based financiers not telling us about Shanghai Giga 3?
I have a theory—and it raises troubling questions and potentially nasty surprises for investors.
Welcome to the Show
I found it interesting that Tesla held its seemingly impromptu groundbreaking for Shanghai Giga on the same day trade talks resumed between the US and China.
Indeed, Chinese Premier Li Keqiang later told Musk, “We hope you can get a firm foothold and expand the market,” and “we hope your company can become an in-depth participant of China’s opening and a promoter of the stability of China-U. S. relations.”
Bingo.
While it's debatable how convinced China is that it must strike significant trade concessions with the US under the Trump Administration, it's easy to see how Tesla's Shanghai plant can be mutually beneficial for China and global EV-market leader Tesla.
China comprises the largest car market in the world, and it has become particularly committed to curating electric car dominance. But its decelerating economic growth also threatens China's already substantial investment in its heavily subsidized domestic electric car industry, including some $5 billion reported in direct government subsidies in the past five years and another $50 billion planned. Moreover, few of its unwieldy stable of 487 fledgling electric car makers germinated so far are likely to succeed.
That's a problem for China, already glutted with the world's largest car-making production capacity with enough factories to churn out 43 million per year in mostly conventionally powered cars versus "new-energy" vehicles (plug-in hybrids, pure-battery electrics, and fuel-cell powered).
Much of this capacity was added recently, with most already underutilized. Estimates project just 29 million cars, about 67% of capacity, were produced in 2018. Global demand for conventionally powered vehicles is faltering even as electric car sales are booming.
China has been moving the goal posts to favor electric car production, with new rules now requiring all car-makers manufacturing in China to substantially boost pro-rata production of electric vehicles made in China by 2019, with required levels to escalate every year after.
It has also relaxed rules requiring foreign companies operating in China to share ownership and profits with a Chinese partner—because attracting and retaining dominant market share expedites its goals. This explains why China has welcomed Tesla to open Shanghai Gigafactory 3 as the first plant wholly owned by a foreign-based automaker. Premier Li Keqiang even offered Musk permanent residency to sweeten the deal.
Shanghai Giga's initial annual production is targeted at 250,000 cars, with full capacity at 500,000 expected by the end of the first decade. This is reported as the largest foreign investment ever for Shanghai's manufacturing district, the Lingagng Industrial Zone—so far.
The Wall Street Journal reported that "Volkswagen AG (VOW GR) is building a 300,000-capacity EV factory in Shanghai, having opened three new Chinese plants for both EVs and gasoline cars in 2018 alone.
Ford Motor Co (F US) also plans to open an eighth China factory, with new JV partner Zotye Auto, that will be able to produce 100,000 electric cars a year."
That's just the tip of the iceberg. China has a massive pipeline of 32 new car plants planning to open, bringing additional capacity of 7.5 billion mostly electric cars.
This signals increasing risk of impending overcapacity as well as impaired profitability potentially threatening electric car producers over the near term as the surge of new factories come online.
So, No Time to Waste
After talking about Shanghai Giga for four years, Musk announced ambitious plans for it in 2019:
He said the plant will produce the elusive "affordable" versions of Model 3, a feat Tesla has yet to manage, plus the still unseen Model Y, which may or may not finally be unveiled in March as promised. Higher-priced Models 3, S, and X will continue to be produced in Tesla's flagship plant in California.
He also is "aiming to finish initial construction this summer, start Model 3 production [by] end of year & reach high volume production next year."
According to Tesla's third quarter 10-Q, this means "producing approximately 3,000 Model 3 vehicles per week in Shanghai, China in the initial phase." Tesla took nearly 15 months to accomplish this is an existing US factory. According to Musk, Shanghai Giga will build the factory and ramp up production in less than eleven months.
That's a tall order considering Tesla has a long track record of missing critical targets. None of Tesla's current factories are even close to completion and all have cost significantly more than estimated.
This makes me skeptical Musk can pull this off in less than 18-24 months.
Musk even joked with Lesley Stahl during his 60-Minutes interview in early December that his projections shouldn't be trusted:
People should not ascribe to malice that which can easily be explained by stupidity." (LAUGHTER) So— so it's, like, just because I'm, like, dumb at…at predicting dates does not mean I am untruthful.
Elon Musk to 60-Minutes, 12/9/18
Tesla said on October 2nd "we are accelerating construction of our Shanghai factory, which we expect to be a capital efficient and rapid buildout, using many lessons learned from the Model 3 ramp in North America."
A 210-acre site for the plant was purchased shortly after, but as of December only one contractor had started buying construction materials.
Whatever has been accelerated is unclear, since the site looks much the same months later:
No Bucks, No Buck Rogers
My first reaction to Tesla's surprise groundbreaking ceremony for Shanghai Giga, especially given its ambitious construction and production schedule, was where is the funding?
As I noted when the news broke, a massive project of this size typically has primary financing in place long before construction starts.
Yet all we have is the company's statement back in July, which Musk has since affirmed, that "initial investment will not start in any significant way until 2019, with much of it expected to be funded through local debt."
Given the ocean of cash China has availed to fund such ventures, I have no doubt Musk can attract lenders and investors for Shanghai Giga.
But it's been three weeks now since the big reveal and Tesla still hasn't provided investors with any vital details.
Here's what we do know:
Don't Look at Me. Tesla admits it can't afford to fund costs to build the factory which have been estimated to range from $2 billion to $5 billion (before cost overruns kick in). Even at the low end, this could boost 2019 consolidated capex by at least $2 billion to at least $4.5 billion, by my estimate, versus 2018 when Tesla slashed capex to an unusually low $2.5 billion due to its worsening liquidity pressure.
This could push 2019 cash consumed to nearly $2 billion—not including $1.9 billion in debt due—versus approximately $2-3 billion in available cash (excluding customer deposits) I estimate at the end of 2018.
The trouble is Tesla's operations still do not generate unvarnished free cash flow, much less sustainable cash flow sufficient to cover capex plus hefty near-term debt maturities(see my reports "Great Magic Trick Tesla; Now Do It Again" and "Tesla: Down to the Wire").
The perilously expensive ramp-up last summer of the Model 3 nearly bankrupted the company, according to Musk, and recent trends suggest that Model 3 demand may already be slowing before it has even become sustainably profitable just as sales of higher margin Models S and X are falling.
Tesla's liquidity pressure worsened just as it also has been falling seriously behind with capex to fund such critical projects as refreshing its aging Models S and X and introducing the long overdue Model Y, the Roadster, the Semi, and the Pickup.
Adding to this are vital expansions required with its Supercharger network, customer service stores, and obligated development at existing factories—Tesla says even its first factory is only 30% complete. Tesla's starvation diet imperils not just its growth, but also its path to stability.
Borrowing more in the US is a problem. Tesla already has amassed an unwieldy debt load which it struggles to support. I estimate total debt and leases at yearend 2018 at $12.2 billion, which indicates leverage still uncomfortably high at nearly 6x with potentially little if any improvement in 2019—little comfort to investors in its "triple-C" rated bonds.
Tesla also has little maneuverability with its banks given its struggling operations and because virtually all of its US assets already are encumbered to back its sizable credit facility loans which impose tight restrictions on additional borrowing—such as a fresh new $2 billion loan for an overseas asset in a country with tense relations, at best, with the US.
Renegotiating covenant terms to make room likely means more restrictions and/or higher fees to reflect increased risk, and there's no guarantee the banks will play ball.
Yet borrowing in China presents other complications. We can see that most everything Tesla owns already is backing $3.9 billion in senior secured debt, on top of roughly $6.3 billion unsecured subordinated debt.
Given Tesla's poor credit quality, there's a good chance Chinese lenders also may want protective terms and secured claims to the factory assets.
This, however, may potentially create conflicts with agreements Tesla has in its US debt agreements, which have covenants that restrict its ability to borrow, make guarantees, buy and sell assets, and move cash around—which may prove even more problematic between entities across borders.
Building and operating a massive factory in China requires all of those actions, and we know how much Musk hates to be restrained.
All this has happened before, and all this will happen again.
Battlestar Galactica
What if Musk Finds Another Way?
For Musk, 2018 was "excruciating" as his struggles to save Tesla made it "the most difficult and painful year of my career." The company was "bleeding money like crazy" and came "within single-digit weeks" of "death" during the torrid ramp-up of the Model 3—a previously undisclosed surprise to investors.
He doesn't mention the extreme pressure was self-inflicted—the result of years of his zealously ambitious production guidance for the overdue launch of the new Model 3 which also has triggered a criminal securities fraud investigation by the Department of Justice. Musk is long known for dramatic, outrageous, and even reckless behavior, and this wasn't his first run-in with federal authorities.
We've also seen how much Musk despises the scrutiny, the accountability, and the criticism that comes with running Tesla as a publicly traded company, and what he'll do when he's desperate. As he explained back in August after tweeting out of the blue, "Am considering taking Tesla private at $420. Funding secured:"
As a public company, we are subject to wild swings in our stock price that can be a major distraction for everyone working at Tesla, all of whom are shareholders.
Being public also subjects us to the quarterly earnings cycle that puts enormous pressure on Tesla to make decisions that may be right for a given quarter, but not necessarily right for the long-term.
Finally, as the most shorted stock in the history of the stock market, being public means that there are large numbers of people who have the incentive to attack the company.
I fundamentally believe that we are at our best when everyone is focused on executing, when we can remain focused on our long-term mission, and when there are not perverse incentives for people to try to harm what we’re all trying to achieve.
This is especially true for a company like Tesla that has a long-term, forward-looking mission. SpaceX is a perfect example: it is far more operationally efficient, and that is largely due to the fact that it is privately held.
This is not to say that it will make sense for Tesla to be private over the long-term. In the future, once Tesla enters a phase of slower, more predictable growth, it will likely make sense to return to the public markets.
The pressure of Tesla's apparent near-bankruptcy during the Model 3 launch, unreported at the time, inspired Musk to announce his bogus "take-private" plan, which he had pursued on his own for months without any input or discussion with Tesla's feckless board.
The stunt cost Musk his Chairman's seat and landed him convicted by the SEC of securities fraud, albeit subject to a comparatively modest $20 million fine. His response, "I do not respect the SEC. I do not respect them."
Ah, the Glorious Simplicity of Complete Control
Musk is much happier running his privately held companies, including Space Exploration Technologies Corp. (SpaceX), Neuralink, and The Boring Co. He particularly enjoys his flexibility to embrace his "controversial practice of spreading overlapping assets across his disparate technology firms."
In other words, Musk likes to shuffle cash and resources between his companies. As he told The Wall Street Journal, “There were a few cases where one company was doing considerably better than another, and I borrowed money.” Typically, this also means Musk borrows heavily against credit lines secured by stock in his companies to fund cash infusions into other of his companies.
Indeed, Musk borrowed $20 million from SpaceX, where he also is Chairman, CEO, and the largest shareholder, to help fund his purchase of Tesla in 2008.
He also directed SpaceX in 2014 to buy a significant chunk of bonds in struggling SolarCity, where Musk was also was Chairman and the largest shareholder. Musk directed Tesla to buy SolarCity when it seemed likely to fail in 2016, a move vehemently criticized by Tesla's investors as self-dealing as well as detrimental to Tesla's financial health. SolarCity's foundering assets and operations, and especially its bloated debt load, continue to impair Tesla's struggle to improve profitability and financial stability.
Musk said The Boring Co. was started in January 2017 as a joke, albeit the kind of game only billionaires can afford. Spun off from SpaceX, Boring managed to raise $112 million in funding in April 2017, but a few months ago in late 2018 investors in SpaceX were surprised to learn that SpaceX cash, equipment, and employees had been diverted to Musk's pet company.
Obviously, what makes Musk happy has typically not been the most effective way to run a company, as Tesla's investors have learned after ten years of continuous losses with Musk at the helm. In just the past few weeks Tesla has reported disappointing sales trends, additional price cuts, and a 7% layoff which follows a 9% headcount reduction in June. SpaceX announced a 10% layoff two weeks ago.
Let's start with the $140 million Tesla spent in October to purchase the Shanghai site. The news was reported by Shanghai authorities, not Tesla, after Musk had signed the deal. Interestingly, WSJ noted at the time:
The 210-acre site in Shanghai’s eastern Lingang district cost $140 million, according to a Shanghai government website tracking major land purchases in the city. Though it didn’t mention Tesla by name, its description of a large land sale concluded on Wednesday in Lingang almost certainly refers to the Tesla deal.
Now say, for example, that Tesla funded the purchase of the land as a "permitted investment," which falls within limits allowed in the company's credit facility agreements. This investment then could be structured as an unrestricted subsidiary, legally separate and apart from Tesla's existing assets and their related obligations. Tesla Shanghai can later be spun out as an independent entity, likely controlled and mostly owned by Musk; The Boring Co. Strategy 2.0.
From this seed, Musk's Tesla Shanghai can pursue local funding and strategic partnerships and remain free from Tesla's balance sheet obligations as well as US scrutiny and related restrictions while the factory gets built and placed into production.
Musk can also direct Tesla, which likely remains a minority investor, to continue making "permitted investments" and contribute resources and expertise as needed, similar to SpaceX diverting cash and resources and Tesla selling attractively priced "parts" to The Boring Co. Such cash and asset contributions will probably flow one way only for the foreseeable future—from Tesla to Tesla Shanghai.
When ready, most likely in 2020, Tesla Shanghai can begin to produce and sell increasingly more attractively priced Model 3 and the new Model Y, tariff-free, directly into the hottest electric car market in the world.
Tesla Shanghai has the potential to be more profitable versus legacy Tesla given its comparatively higher margins thanks to locally sourced, lower-cost labor and resources at brand-new, experiment-free production facilities—profits that stay in Shanghai. Clean slate.
Back in the US, Tesla may struggle indefinitely to profitably sell its price-disadvantaged, aging product offering versus increasingly more competitive rivals (including Tesla Shanghai) while sinking under its above-average cost structure, a cumbersome debt load, and prohibitive capex it can't afford but which is necessary to pursue tragically starved R&D which determines its future.
Meanwhile, Musk Tesla Shanghai begins to repeat the strategy with Musk Tesla Europe Co. to locally and more profitably serve a market with a population twice that of the US in a region that already has begun to mandate the end of combustion engine car production in 5-15 years.
This strategy theoretically allows Musk to cordon off ownership, profits, cash flow, and assets from claims by Tesla's US lenders and investors. What's made in China mostly stays in China—a scenario no doubt also preferred by China, which is facilitating his plans.
Another critical and likely risk of such a venture to Tesla—and Tesla investors—aside from not reaping significant proportional benefit from Tesla Shanghai, is that Unrestrained Musk tends to take even greater risks.
This increases odds that he stumbles with Tesla Shanghai as he did with Tesla, making costly mistakes that delay progress, increase expenses, and extend indefinitely its potential reliance on cash and resources from Tesla—and no one can or will stop him.
This is a just spooky fairy tale, right? Right?
It's at least worth considering that Musk may covet the opportunity to create and completely control a new, high-growth and pre-tested venture with the potential to preserve his wealth and privacy and possibly become a streamlined Tesla empire—while exploiting Tesla's resources as a backstop.
Of course, my speculation may be debunked as soon as tomorrow when Tesla reports fourth-quarter results. Maybe.
Either way, we know enough to remain concerned:
We are not likely to know what is happening with Tesla Shanghai until long after it's done. Tesla and especially Musk have a long track record of deliberately poor if not altogether deficient disclosure, even more so when risks to investors are highest.
Musk loves complete control and creative funding strategies, and he refuses to be restrained.
Tesla's board has rubber-stamped every move he's made for years, and I see nothing to change that. Tesla's "refreshed" board includes Musk's hand-picked Chairman (and former Tesla board member) Robyn Denholm and the addition of Musk-fan Larry Ellison, himself convicted by the SEC of insider trading which netted him a $100 million fine after he cheated his own shareholders as CEO of Oracle by selling Oracle stock just before the announcement of a disappointing quarter.
Musk seems to have suffered few if any troubling consequences for even his most serious misdeeds, and so has acted more or less with impunity. Why stop now?
So while we don't know whether or not Musk wants to go rogue with Tesla Shanghai, we can't rule it out.
Maintain “Underperform” on TSLA 5.3% Senior Notes due 2025, down just over a point over the past month at 85.8 (8.1% ytw; 559 bps). That’s a meager 93 bps per turn of leverage—hardly adequate compensation for such a volatile issuer. Given Tesla's persistent uncertainty and potentially escalating risks we could see 3-5 points additional downside from here.
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