Tesla, Inc. is one of the most celebrated firms on Wall Street, but the company’s latest deal is ruffling some feathers. Aswath Damodaran, an NYU finance professor, reckons that the firm’s decision to sell bonds doesn’t make much sense. It’s based, he says, on the idea that those buying the bonds don’t understand the value of them.
That’s a pretty harsh criticism of what looks to be a pretty normal debt deal. Tesla bonds are rated at “junk” levels by both Moody’s and Standard and Poors. The firm’s 5.3 percent interest rate on the $1.8 billion in debt is certainly low for that rating, but Damodaran’s criticism’s are much more cutting.
Debt doesn’t make sense for Tesla
There’s one big reason why large firms like debt. They’re able to pay less taxes the more debt they take on. This is called the tax advantage of debt, and it’s a controversial feature of the US tax code. It’s better for firms to issue debt than stock because they can write off interest payments as a cost of doing business.
Because firms only pay taxes on profits, this ensures they pay less tax than if they issued dividends from stocks. The problem for Tesla, Inc. , as mentioned by the Stern school of business professor, is that it loses money. Tesla pays nothing in corporate taxes, and so issuing debt isn’t better than selling shares in terms of taxes.
On top of that, Tesla is still carrying forward losses from previous years. That means that not only will the firm not pay tax in 2017, it’s not likely to pay tax for several years to come. Damodaran says “Tesla is singularly unsuited to using debt.”
He adds that while “the benefits from debt are low to non-existent, the costs are immense.”
Those costs include: adding cash burn on an annual basis (through interest rates); and taking power away from shareholders.
Why is Tesla stock burdened with debt
The professor concludes by offering two reasons why Tesla, Inc. is taking on debt despite how unwise it seems. The first idea is that the firm is trying to avoid share dilution. The second is that Elon Musk wants to follow the financing path of established car makers.
Neither of these, says Damodaran, make much sense. Tesla has always prided itself on not being a traditional automaker, and “dilution” can be overcome by selling convertible bonds.
There has to be some reason that Elon Musk and the investment bankers advising him decided to go this direction, however.
Tesla, Inc. sells bonds on a story
Though Damodaran’s image of Tesla is purely based on the idea that it’s a story stock, as outlined in his wonderful blog on the firm from 2016, he denies the idea that that can work for debt. There are, however a couple of key considerations that could strengthen the Tesla debt story.
The first is that it wants to enter and get the trust of the bond markets by building up a history. There’s a strong likelihood that the firm is going to keep loaning money over the next decade in order to build out its massive proposed empire.
Things like self-driving trucks and solar tiles aren’t going to build themselves, after all, and Tesla, Inc. is very unlikely to generate enough cash to be able to make its own investments in the coming years.
On top of that, it may not be dilution that Tesla is scared of. Instead the firm could be frightened that a dilution counter-story could take hold. Wall Street, fully aware that Elon Musk and Deepak Ahuja are likely to dip back into financial markets multiple times, likely doesn’t want to see the firm issue stock each time it needs more cash.
The $1.8 billion that the firm got this time may not have diluted the stock much. But how much expected dilution is already priced in? This is an important, and overlooked, part of the Tesla, Inc. story.
Even if the firm does soon become cash neutral, it’s not likely to return money to its shareholders for years because of investments. It’s also likely to periodically go to the debt and equity markets for funding. If not, its expansion is going to be very slow indeed.
Tesla stock still volatile
Wall Street is still, understandably, quite volatile in its assessment of Tesla stock. The EV maker is planning to massively multiply both unit and dollar sales over the coming twelve months. The risks involved are great, and there really aren’t great models out there to predict the firm’s chances of successful execution.
That means that those betting on the firm are taking a big risk by buying in right now, and the addition of debt makes their position worth less, though the effect is small depending on your forecast for the firm’s future.
One thing is clear. Those betting on Tesla stock will capture all of the upside from the firm’s future. Those buying bonds will never get more than the 5 percent or so they’ve already been promised.
Morgan Stanley weighs in
On Monday Morgan Stanley increased its price target on Tesla, Inc. to $317. In the report that accompanied the price target hike Adam Jonas put a lot of focus on the Supercharger network as a driver of value.
“Although other auto companies have launched and will continue to launch electric vehicles, we are not aware of any other auto company that is building out the necessary after-sales infrastructure to support a significant volume of electric vehicles,” he wrote.
Mr. Jonas thinks that this infrastructure will be key for all EV makers in the coming years. Its importance is one of the reasons he reckons Tesla will dominate, and that the firm’s real competition will come from Silicon Valley rather than Detroit.
Despite that, his price target is lower than the expected opening price for Tesla on Tuesday. Even that kind of bullishness can’t be twisted into an opportunity for capital gains every time. The median price target on Tesla remains below its current trading value. With dilution still a worry for analysts, it may stay there for quite a while.