A Tesla show room.
Photograph by John Leyba Denver Post via Getty Images

Is it a bailout?

By Lucinda Shen
June 22, 2016

Elon Musk might call the merger between his energy company SolarCity and electric car maker, Tesla Motors a “no-brainer,” but most of Wall Street seems to disagree.

On Tuesday, Tesla tsla announced plans to buy SolarCity scty for roughly $2.8 billion. The combined entity would be a vertically-integrated energy company with the power of Tesla’s brand.

On the other end of the spectrum, far, far away from Musk, famed short seller Jim Chanos called the move a “brazen Tesla bailout of SolarCity” and a “shameful example of corporate governance at its worst” on CNBC. Notably, Chanos has had short positions—meaning he is betting the shares of the company will fall—in both Tesla and SolarCity.

And some analysts are noting that the deal seems to have more benefits for SolarCity than Tesla—an opinion reflected in the two companies’ stock price. The former rose more than 4%, while the latter fell nearly 9% on Wednesday.

Oppenheimer analysts led by Colin Rusch downgraded the stock to “perform,” or neutral—which on Wall Street usually means sell—following the news, saying that “investors are likely to view this transaction as a bailout for SolarCity and a distraction to Tesla’s production hurdles.”

We expect a robust shareholder fight over this acquisition centered on corporate governance. We move to the sidelines and remove our $385 price target on Tesla shares as we believe uncertainty around the acquisition and the resulting corporate structure will weigh heavily on the stock.

 

Deutsche Bank analysts led by Rod Lache noted that yes, the two companies may fit together as an energy conglomerate, but its investors weren’t looking to invest in such a company. Deutsche Bank reiterated its “Hold” rating—again typically code word for sell—on the stock.

Tesla shareholders have sought to invest in an innovative and disruptive vehicle/mobility company, whose business offers potential for exponential growth. And Tesla vehicle owners primarily buy the vehicle because it’s one of the best, most advanced vehicles available. They are generally not looking for an end-to-end energy solution.

 

A team of J.P. Morgan Chase analysts covering SolarCity noted that while they are skeptical of any near-term customer, product, or technology synergies since the two companies offer different products, the cost of capital for a merged entity may be lower.

We think the proposal offers reasonable value, which might give capital-hungry SolarCity better access to wholesale capital markets via its acquirer’s balance sheet. Another reason this deal may potentially make sense is that the prior go-it-alone approach suddenly seems unattractive and the incremental cost of capital needed to fund standalone growth would probably increase if this combination does not proceed, in our view. We maintain our $25 price target, below the offer range.

J.P. Morgan’s view that the acquisition had limited synergies was reiterated by a team of UBS analysts led by Colin Langan, which found other problems with the deal as well. Adding SolarCity to Tesla’s already teeming plate (namely the Model 3 rollout) could be an “unneeded distraction” for the company’s management, and prove to be a cash burn.

Although SolarCity would only be about 10% of combined Tesla-SolarCity sales, SolarCity’s GAAP losses could be a significant drag. SolarCity would continue to require at least upfront upfront capital investment to grow its business, likely increasing overall cash burn for Tesla.

The team reiterated their “Sell” rating—which is Wall Street speak for “Sell, Sell Sell”—on the stock.

Barclays also noted that the deal would be a “lean mean cash burning machine for Tesla” and a “life-line for SolarCity.” The combined entity would most certainly need to raise more capital, likely through the capital markets. Though, that’s assuming the market remains receptive to Tesla—and that “is far from certain,” the team led by Brian Johnson wrote. Though there are benefits for SolarCity:

There is nothing in the solar industry with brand awareness even approaching Tesla’s. . .In our view, residential roof-top solar is a fragile business highly dependent on continuous external funding from the tax-equity and asset-backed security markets—the potential to be part of a larger company could reduce this hurdle.

The team also tore down theories that Tesla and SolarCity could collaborate to create a product, saying, “not only do solar panels on cars make little sense (they’d be largely cosmetic), we think powering Tesla recharges with SolarCity panels will be tough given recharges occur at night.”

Piper Jaffray analysts led by Alexander Potter note that buying SolarCity may be a tad too ambitious. But the move could also potentially be a draw to investors by capitalizing on Musk and Tesla’s innovative image.

By attempting to produce a full suite of consumer products that produce, store, and consume energy, Tesla is demonstrating once again how ambitious its long-term strategy really is. Big-thinking investors will probably like this approach, as it shows why Tesla’s market cap could eventually far exceed “plain vanilla” peers in the automotive industry—none of whom have the guts to expand outside their own industry, in our view.

The firm maintains a “Neutral,” or hold, rating on Tesla.

Yet, Credit Suisse analyst Patrick Jobin, who covers the solar industry, says that the announcement will likely force SolarCity shorts to cover. Jobin however also notes that he remains skeptical that such a deal will go through.

While we expect a positive reaction for SolarCity, we put a low 20% to 40% probability of the acquisition occurring and see heightened medium-term risks for SolarCity should the pending acquisition disrupt the company’s access to capital markets over the next 3 months to 9 months.

 

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