- Tesla's high-yield debt is losing value and putting pressure on positive sentiment about the company.
- Tesla is also struggling to ramp up production of its Model 3.
- The stock has been getting hammered ahead of first-quarter delivery announcements and earnings.
There's a famous passage from Ernest Hemingway's novel "The Sun Also Rises," in which two characters discuss financial ruin.
"How did you go bankrupt?" one asks.
"Two ways," the other replies. "Gradually, then suddenly."
To a certain extent, this is what's happening now with Tesla. No, I don't think the company is lurching toward a sudden bankruptcy, though that risk has been present for several years as the carmaker has pushed the envelope on CEO Elon Musk's vision, burned through billions in cash, and returned again and again to the debt and equity markets to finance a surge in production.
The balance sheet doesn't look great, and the stock has gotten hammered over the past month — it's down nearly 30%, and dreams of its hitting $400 a share are fading fast. Tesla will report first-quarter earnings and first-quarter vehicle deliveries in April and May, and nobody expects the news to be particularly stirring. Production of the Model 3 mass-market vehicle is well behind schedule, and while Tesla spent less cash in the fourth quarter of 2017 than predicted, the eye-watering burn rate has most likely returned this year.
The biggest problem for the company now is the bond market. Last year, Tesla issued junk debt, and Moody's just downgraded the firm's rating. This move has greatly intensified negative sentiment and has added to downward pressure on the stock.
Bondholders aren't cheerleaders
When Tesla made its junk offering, I wrote that the major risk was the unflinching, long-term realism of bond investors. On the equity side, buyers tend to be optimists, willing to overlook sketchy fundamentals to capture growth. But on the debt side, a calculation about catastrophes is always being made, particularly when the debt is high-yield and thus quite risky.
The bond markets have begun to complain about the company. On Wednesday, "Tesla's notes plunged to a low of 86 cents on the dollar, the clearest sign yet creditors aren't totally sure the company will be money good," Bloomberg's Molly Smith reported.
The dynamics here are textbook: Tesla hasn't made any money since its 2010 initial public offering and has used equity raises, customer deposits, and more recently high-yield debt to fund operations. This has been going on for years as bulls and bears, longs and shorts, have jousted over the company's future. Call it the "gradual" part. Now the "sudden" part has kicked in, and it's look-out-below time for shareholders.
This isn't Tesla's first crisis, and Musk has options. He sold a 5% stake in the company to China's Tencent last year, and in the past both Daimler and Toyota have bought up and later sold equity. And if shares stabilize at about $250, Tesla should still be able to return to the markets to raise money — in fact, investor enthusiasm could run higher than in the past, as the stock could look discounted to some bulls. The Morgan Stanley analyst Adam Jonas, with a $379 target price, recommended buying the stock last week, given the dip.
Even if shares fall below $250 — the level at which I've generally felt Musk believes is a capital-raise sweetspot — Tesla has a ways to go before the situation gets dire. A full-on panic would require a collapse to deep bear territory, say $150 to $200, and even then Tesla could be bolstered by waves of bargain-hunting buying. Seasoned Tesla investors are also used to this kind of volatility.
Sudden collapse is nothing new in the auto industry
Still, the warning klaxons blaring in the bond markets shouldn't be ignored. Automaking is a capital-intensive business, and Tesla spent over $3 billion last year; it will run out of money at some point this year without additional funding. Traditional car companies typically use periods such as the past three years, when sales have boomed and profits have been steady, to lay in war chests in the multibillions.
But those companies are able to execute that game plan because they've largely been running off legacy capital investments. General Motors doesn't have to create capacity in the same way Tesla now does. If GM had 400,000 advance orders for a vehicle, as Tesla does for the Model 3, GM would fire up or shift around capacity to build the cars. Tesla has been ramping from scratch and is spending huge amounts of cash to overcome "production hell," as Musk calls it.
Tesla has, in a sense, been living on credit, which is nothing new in the car business, but it is a habit that can turn lethal faster than anyone expects. I watched GM, Chrysler, and Ford struggle for years prior to the 2008-2009 financial crisis and the Detroit meltdown. And then inside 12 months, GM and Chrysler were bankrupt and Ford had mortgaged literally everything to stave off that fate.
If you look out across today's auto industry, you see some trouble spots: Nissan-Renault may be the biggest carmaker in the world, but it has been spending heavily to acquire and hold market share; Volkswagen is only just getting its act together in North America; Ford is restructuring its management.
But for the most part — with low unemployment, a strong US economy, a corporate tax cut, and easy credit — the business looks great. Balance sheets are solid and ready for the cyclical downturn that hasn't yet arrived, but that will eventually.
Tesla has been losing money while everyone else is making it
Tesla is the odd man out. Yes, the company attracts mega-buzz. But nobody else has seen a 30% stock crash in a short period of time, on the heels of a massive run-up. And nobody else is sitting on a junk-debt powder keg.
In essence, Tesla's fundamentals are out of alignment with the sales boom in the US that has enhanced the traditional auto industry's fortunes. While Tesla has been reliably losing money since 2010, GM has made $70 billion since its own postbankruptcy IPO in 2010.
For much of 2017, nobody cared, and Tesla's stock hit new highs. That masked the manufacturing crisis that Tesla was up against. That crisis now looks to be more severe than anyone expected, though in fairness to Tesla, the Model 3 production plan is supposed to hold up for a decade, and the company has never enjoyed a peaceful rollout for a new car.
But you can't just ignore this bondholder freak-out. In fact, you can never ignore a bondholder freak-out in the auto industry. This is because automaker stocks tend be pretty boring. GM and Ford won't rise or fall on their stock because they don't use equity to finance operations. They have profits to do that. And if they have shortfalls, they issue debt. So when things go south, it's the debt that imposes the biggest risk.
The bottom line is that for a long time, we haven't had Tesla debt to worry about (what debt it did issue was convertible to equity), and we were able to fixate on the stock price. But now we do have some debt to look at — quite a lot, in fact, after the SolarCity merger in 2016 — and that debt is doing what it's supposed to do. It's telling a true long-term story and shaking out all the financial fantasy.
If Tesla emerges from the crisis with a market cap that accurately represents what the company is worth now, and what it could realistically expect it to be worth in the future, we'll have the debt to thank for it.