Writing Sample - Merger Analysis

Pricing factors applicable to the merger of Tesla and Solar City

                        Future Cash Flows

Solar City’s sales figures have shown six years of sustained growth entering 2016, ranging 27% to 106%. However, rising operational costs have created a sustained level of net profit losses in that same time span which creates a negative value for EBITDA and therefore creates a challenge to generating a simplistic projection of future cash flows. The attendant rise in operational costs is attributable to consistent increases in sales, marketing, general and administrational expenses that are to be expected with the growth of a new company -especially one that relies on product revenue growth that is tied directly to expanding throughout a geographic area in the installation of residential and commercial energy collectors- and thus a six-fold increase in employment between 2012 and 2015 shouldn’t present too much of a surprise.

Further, SolarCity has issued a substantial amount of debt obligations that also has a direct impact on profitability analysis though these activities are consistent with the growth of a young firm yet must be accounted for in models projecting future cash flow. For the purposes of analysis, the company’s net debt is assumed to be $3.89 billion. Beyond the over $1 billion in long-term debt, SolarCity has issued $882 million in senior convertible notes and $143 million in total asset-backed bonds related to solar energy production.

SolarCity also reported over $1 billion in deferred revenues as a share of total liabilities on its consolidated balance sheet but has not been factored into the amount of net debt as it is not considered marketable and exits as a line-item befitting generally accepted accounting practices.

It must be noted that SpaceX, the cosmic exploration venture of the former SolarCity chairman and current Tesla CEO Elon Musk, has held over $70 million in solar bonds since 2014 and was joined in bond purchases by his cousins Lyndon and Peter Rive -both of which are in direct leadership roles at SolarCity. Thus, the amount of net debt is assumed to be at a marketable value for the purposes of a future cash flow analysis but may not present an accurate amount of economic value due to the executive linkages between SpaceX and SolarCity.

SolarCity stated an income tax provision in their last annual report which would imply a negative rate of taxation going into the future. Carrying this assumption into perpetuity is presents a potential distortion of cash flows, and thus must be tempered down with the expectation that the company will pay a higher amount into the future.

Given these factors impacting cash flow, here are the projected cash flows which result in a final $20.34 per share value of SolarCity at the conclusion of the merger with Tesla and implies a potential 48.93% premium paid by Tesla to acquire SolarCity:

           

Assumptions which have been projected to influence the final per share value of SolarCity:

1] An annual sales growth rate of 1.2%, which is far below both the arithmetic average growth rate over the last five years (roughly 67%) as well as substantially lower than even the lowest year of year rate of 27.34% from 2012 to 2013.

While impressive, double-digit growth isn’t impossible, projecting such a rate on a continual year-over-year basis is improbable given that growth rates beyond 22% move the implied intrinsic value of SolarCity’s stock past its market-high of $84.96 entering March 2014 and growth rates between historical and the rate used in projecting cash flows would imply that SolarCity shareholders agreed to a staggering discount in exchange for shares of Tesla while lower growth rates ventures past the realm of defensible and modest revenue increases and into pessimism given the company’s last five years of performance.

Thus, the 1.2% growth rate likely represents a minimum positive expectation of future revenues which can be generated by operations attributed to the purchase of SolarCity.

2] A negative EBITDA margin of -5.8% is projected into the future of operations and has been made with consideration to SolarCity’s historical trend of presenting a loss of profits to shareholders as it continues to grow but is assumed to decrease in scale as the company requires fewer amounts of fixed cash flows to fuel growth. 

3] A depreciation & amortization expense of 41.7% and an inverse 41.7% “decrease” in capital expenditures (CAPEX) is meant to keep a balanced projection of variable costs in expanding SolarCity with the large upfront D&A expense representing the economic value of depreciating end-user solar equipment over the duration of customer leases as well as accounting for deployment of advances generated by research and development efforts of the firm. 

4] An initial tax rate of 1% and a long-term rate of 29% applied to the last three years of projected taxes paid into perpetuity is a conservative method to factor in future costs of taxation, though it is reasonable to assume that SolarCity would have the benefit of deferring tax payments just as they had in their full year of independent operations.

      5]  A WACC of 4.83% as has been derived by the research efforts of Aswath Damodaran has been applied as the rate in which SolarCity’s future cash flows have been discounted back to the present and is consistent with WACC’s used by other renewable energy companies.

Market Multiple Comparison

            SolarCity’s negative earnings per share yields a negative price to earnings multipland thus does not allow for a simple comparison to other competitors based on this common-sized metric.

         

          Canadian Solar Inc., (CSIQ) designs, develops, manufactures, and sells solar wafers, cells, and solar power products for both on-and-off grid users, but along with SunPower (SPWR) Corporation, Sunrun (RUN) and Vivint Solar (VSLR) who both manufacture solar equipment as well as engage in leasing operations with customers for solar energy but have positive P/E multiples and are not fair comparisons to SolarCity.

            NRG Energy, Inc., also offers solar energy to consumers, but also is involved in fossil and nuclear energy sources thus isn’t a fair comparison to solar city despite its negative P/E multiple and EPS metrics.

Precedent Transactions

Tesla’s acquisition of SolarCity could have been influenced by deals announced prior to August 1, 2016 with the announced attempt by Bayer to fold-in Monsanto in late May 2016 as well as Dow and DuPont’s “merger of equals” which was publicized in December of 2015.

While the mechanism of the Dow and DuPont merger is the same as Tesla’s buyout of SolarCity in an all-stock transaction, the motive driving the joining of the two industrial giants differs significantly with the intention to spin the resulting company off into three new firms. Thus, it may not be appropriate to assume it had a pronounced effect on Tesla’s purchase price of SolarCity less than a year later.

Similarly, the scope of both Dow and DuPont’s businesses subject it to far more regulatory scrutiny which complicates the transaction and could have influenced the price agreed to conduct the deal. The history and size of both firms also changes the price considerations, and thus can apply to the final purchase price from the DuPont shareholders side, where the details of the merger in December 2015 stipulate that those equity holders were slated to earn 48% of the resulting $130 billion DowDupont company with the questioning remaining of how shares in the resulting three spinoff firms would be allocated.

Bayer’s cash purchase of Monsanto is likely presents reasonable price bounds on the Tesla and SolarCity merger, given that the deal was precipitated by a publicized attempt by Monsanto to acquire Bayer’s crop science division in early 2016, which draws a hypothetical analogue to Tesla and SolarCity consistent with SolarCity’s acquisitions of Zep Solar in 2013 and Silevo in 2014 to create vertical integration where there existed the possibility that SolarCity would acquire Tesla’s Powerpack and Powerwall products.

However, the acquisition of Monsanto by Bayer likely could have led to direct price ramifications, given that the announced purchase price of $53 billion for Monsanto in the weeks prior to the August announcement of SolarCity’s purchase would have implied a 25% premium paid for the market value of Monsanto’s stock and a 44% price premium with the agreed upon $66 billion purchase in September of 2016 based on final value of $128 per share of Monsanto’s stock.

The variance between the lower and upper values of presumed price premiums can be assumed driven by industry-specific conditions and regulatory issues, it nonetheless presents a close-but-imperfect price comparison to Tesla’s purchase of SolarCity given the lack of close leadership linkages and financial relationship between Bayer and Monsanto.

Strategic Motivations for Acquisition

From an outsider standpoint, a driving reason to meld Tesla to SolarCity seems to coincide with the public words of Elon Musk such that he considers the gap between the carmaker and solar-installer companies as an “accident of history” given his and his cousins’ involvement SolarCity with Musk serving as chair of the company Lyndon and Peter Rive founded over ten years ago and it also explains the all-stock method of merging the two companies such that each SolarCity shareholder was entitled to .11 shares of Tesla that placed the value of transaction at $2.6 billion.¹

Taking this statement at face value as the be-all and end-all motivation for the merger is unbridled cynicism at best and insinuating borderline corporate malfeasance on the part of the Musk and Rive clan at worst in cashing in overvalued Tesla equity. In a vacuum and without consideration to the finances, the merger evokes thoughts of Temujin roaming the steppe in uniting the Mongolian tribes prior to dominating large parts of the Asian continent, except in this case Genghis Khan is a significantly less violent figure riding a rocket instead of a stallion, the tribes are technology companies that are potential rich but cash poor, and Asia is now a stand-in for the world at-large.

Publicly, the companies espoused the notion that the joining would create $150 million in cost-reduction synergies within the first year of deal closing. While there isn’t much to go on in specifics, reducing the cost of goods sold through a merger is feasible given SolarCity’s staggering operational profit losses increasing in proportion to increases in employee workforce. Such savings aren’t likely to be realized at such a magnitude in that short of a timeframe so enthusiasm for a positive impact on the bottom line should be tempered.

Beyond cutting back on sales, general and administrative costs (which should be possible and probable in the long run) the greatest synergy created is likely from the standpoint of Tesla shareholders who now have a slight hedge on drastic declines in the value of the company’s equity in that Tesla has somewhat diversified itself into providing renewable energy direct to customer’s through the acquisition of SolarCity.

This diversification will only go as far as business attributable to SolarCity’s core focus in end-user solar energy technology purchasing and leasing goes but this also serves as the source of applying some sort of quantifiable measure of putting a dollar value on that synergy.

Recall in the future cash flow projection of this analysis that the purchase price of $20.34 per share of SolarCity is shaped in large part to an expected 1.2% increase in revenues and is drastically lower than the year-over-year gains and a 66% five-year average from 2012 to 2015.

            Doubling this projected growth rate would still provide a 34% cost premium for the acquisition of SolarCity; a six-fold increase in growth to 7.2% puts the implied intrinsic per share value of the stock back to pre-merger values and more than negates the premium paid. The implication here that the price paid by Tesla could have been made with extremely guarded projections of economic value created by SolarCity’s revenue growth will cover the premium; revenue growths in-line with its historicals present potentially huge upside rewards in the acquisition, such that even a low revenue growth in business attributable to SolarCity could stave off the 5% recession in profit margins associated with acquiring firms and the 24% decline in share value within three years after deal closing.

Cost cutting synergies generated from the merger of the two companies can further dampen the typical value destruction involved in a merger and the potential to cut back on fixed costs as well as maintain high annual revenue growth rate increases explains the potentially high up-front premium of 48% paid by Tesla to SolarCity shareholders.

            Conversely, Tesla could have avoided this deal all together and not risked a decrease in equity value that usually attends a merger deal but likely would not have had the means to diversify into a vertical integrated provider of electric vehicles sparked by solar power without paying a higher cost in equity exchanged or in outright cash paid.

            There doesn’t appear to be any regulatory hurdles to the merger, but this could change depending on the combined firm handles the conditions agreed upon between customers and the company with regard to lease contracts, but the solar industry is susceptible to unfavourability of their product offerings if fossil fuels remain relatively cheap as well as if government subsidies for renewables evaporate in a cheap coal or oil energy economy.

Conclusion

I’m agnostic as to whether or not I would make this deal given the closer than arms-length relationship between the leadership of Tesla and SolarCity. If I were only interested in investing in a firm that creates and provides solar energy to customers, I probably would reject the merger deal given that the premium paid shortchanges the effect high revenue growth rates SolarCity had recorded from 2012 to 2015 by a significant margin on future profitability.

 If I’m someone who bought into Tesla in the time frame when shares were going for more than $100, I’m probably in favor of the deal due to the potential beachhead diversification provides with the purchase of SolarCity along with the fact it vindicates a lot of the “goodwill” Elon Musk’s publicly traded ventures have seen with his dazzling efforts as a non-governmental explorer of space.

Financial data acquired from Google Finance, Yahoo Finance and applicable company annual reports.

1 – “Accident of history” quote attributed to report by Forbes, accessed at:
https://www.forbes.com/sites/joannmuller/2016/08/01/tesla-and-solar-city-agree-on-2-6-billion-deal-to-fix-what-elon-musk-calls-an-accident-of-history/?utm_source=TWITTER&utm_medium=social&utm_content=533508922&utm_campaign=sprinklrForbes#6d2d3d92e3d7