It will never make money, they said.
Demand has plateaued, they said.
Model 3 will never be profitable, they said.
Then Wall Street lined up to lend Tesla (TSLA) billions of dollars.
What is happening?
For the first time ever, Tesla is raising straight debt without the option to exchange the bond for shares in the company. As I explained in my article, Bye Bye Dilution, this is a very positive development for long-term shareholders. Earlier in the week, articles from Bloomberg and Reuters had estimated the likely interest rate of the unsecured bond at ~5.5%, which was already favorable to the company and represented a significant improvement over diluting shareholders with convertible bonds, but the estimated rate has declined even further throughout the week. The number whispered now is below 5% and the issue was oversubscribed three times by Wednesday.
Why is this surprising?
The lower-than-expected interest rate was surprising (to some), because Moody’s and S&P had rated the unsecured bond at B3 and B-, respectively, or several notches below investment grade. With those “junk” ratings, Tesla’s unsecured notes should be priced above 5.5%, even after the recent significant improvement in high yield debt markets:
Instead, Tesla’s unsecured notes will likely price closer to BB rating, which is several notches above where the bonds were rated and a lot closer to investment grade:
This is very positive for the company and its shareholders, as I discuss below.
Why is Tesla able to raise so much at so little cost?
Seriously? Read my two dozen articles. Next question.
Why is this important?
Aside from disproving the key parts of the bear argument, Tesla’s improved access to inexpensive non-dilutive debt capital means one crucial thing: Lower discount rate.
Lost? Read on.
As I explained in my recent article, the vast majority of Tesla’s revenues and nearly all of its profits are in 2019 and following years, as is the case with many hyper-growth companies. For companies with such cash flow characteristics, the discount rate (more specifically, the weighted average cost of capital) plays a major role in calculating the intrinsic value of the company.
In general, the weighted average cost of capital (“WACC”) can be calculated with the following formula:
where D is the total debt, E is the total shareholder’s equity, Ke is the cost of equity, and Kd is the cost of debt.
The lower the WACC, the higher the estimated intrinsic value of a company, all else equal. Further, the above equation means the lower the cost of equity and cost of debt, the lower the WACC, and the higher the estimated intrinsic value of the company. Finally, since cost of debt is almost always lower than cost of equity, the higher leverage a company uses (to a reasonable extent), the lower the WACC, and you guessed it, the higher the estimated intrinsic value of the company.
Read the above paragraph as many times as you need to before moving on.
In light of the above, Tesla’s ability to issue non-dilutive debt at a low cost benefits the company and its shareholders in three ways:
- Lower-than-expected cost of debt lowers the company’s discount rate;
- The fact that Tesla can now finance its growth with debt, instead of through equity secondaries, allows the company to lever its balance sheet, which lowers the company’s discount rate; and
- Since the company can now issue non-dilutive debt, the company no longer needs to dilute its existing shareholders by 7-10% each year, as has been the case in the past.
These are all very positive developments for Tesla’s long-term shareholders.
Tesla reached a very important milestone this week: the ability to issue non-dilutive debt, and it did so at rates more favorable than most expected.
As I concluded in my recent article, Tesla Is Making A Strategic Mistake, the company is facing an unusual strategic problem of too much demand. Despite its continued efforts to anti-sell the Model 3, net reservations have continued to increase at a rapid rate, and competitors are not in a position to help satisfy the surging demand for all-electric and increasingly autonomous cars. In light of its stated mission, the company needs to accelerate its production ramp quicker than the already unprecedented level.
And this week’s bond market debut allows the company to do just that.
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Disclosure: I am/we are long TSLA.
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