SolarCity Corp (SCTY) Merger Will Continue To Drag Tesla Motors Inc (TSLA) Stock

• Tesla Motors stock tumbled after Goldman Sachs cut the Price Target to $185 even as it raised the EPS forecast.
• In a surprise, Tesla won’t be raising money this quarter.
• Tesla has announced an unexpected product launch on October 17th.

Tesla stock has remained extremely volatile in last few months and the last week was no different. On 2nd October Tesla came out with its Q3 delivery numbers which surprised the market on the upside with Tesla stock jumping more than 4%. But it was not able to sustain the momentum and was back to around $200 level.

And then on October 6th Goldman Sachs came out with its report downgrading Tesla stock to neutral and cutting its price target by 23% from $240 to $185. Unsurprisingly Tesla stock tumbled around 5%, below the psychologically important $200 level before bouncing back after a tweet from Elon Musk saying Tesla won’t be raising money in the coming quarter.

Goldman Raises Revenue Forecast But Cuts Price Target

The Goldman Sachs report contains a curious dichotomy. On the one hand, the report cuts Tesla’s stock price target by 23% but on the other hand, the report raised the revenue and earnings estimates for the company till 2020. For instances, Goldman raised Tesla’s 2017 revenue target by 14% to $11.8 billion. Incidentally, Goldman had forecasted $10.8 billion revenues in July and then later slashed it to $10.1 billion before raising it to current forecast of $11.8 billion. This clearly shows the difficulty in forecasting, even for short term, the revenues of companies like Tesla.

The Risk From SolarCity Deal

Goldman also raised forecasted 2018 earnings for Tesla by 33%. It expects Tesla to be profitable next year, instead of a loss in the previous forecast. So what explains the apparent dichotomy between the price target cut and improved revenue and earnings outlook? We will have to take a look at the discounted cash flow valuation equation to answer that question.

As shown in the equation, cash flows are one part of the equation, the other part is the discount rate or cost of equity.  The higher the discount rate, lower the value of equity. The cost of equity is generally calculated using CAPM and can be adjusted for additional risk. As the report pointed out, SolarCity (NSDQ:SCTY) merger increases the risk associated with Tesla stock, pushing up the cost of equity and reducing the value of equity. So in spite of better outlook in terms of revenue and earnings, Tesla shares are worth less because of the high risk associated with SolarCity merger.

As we had pointed out in our earlier article, SolarCity merger will put Tesla’s balance sheet under heavy stress. Both the companies are cash guzzlers burning million of cash in operations and both require cash for heavy investments. Also, none of the companies are profitable. The merger of two cash burning unprofitable companies definitely raises the risk. The Altman Z score (used for predicting the possibility of bankruptcy) indicates that a merger will push the companies nearer to bankruptcy. Tesla stock is down more than 10% since the announcement.

Also Read: California Contract A Big Win For Tesla Motors Inc Stock

Tesla Will Not Approach Market For Funding

In a surprising move, a couple of days after the downgrade, Mr. Elon Musk tweeted that Tesla will not be raising money from the market in Q4. When asked whether it will happen in Q1 2017, he said it was unlikely. As we have pointed out Tesla is in great need of cash for its planned investment. Even Tesla in an August filing with SEC had said that the company is planning to approach the market to raise money through debt or equity. Musk in an had asked his employees to produce every car possible and cut every unnecessary cost as it would help them convince the investors when Tesla approaches them for raising money.

So what changed between then and now? There are many speculations. The downgrade would have pulled down the price at which Tesla could have raised money from investors. Also, Goldman was one of the biggest cheerleaders of Tesla. Goldman was Tesla’s lead manager along with Morgan Stanley when the company had raised $750 million in May this year. Curiously, Goldman had upgraded Tesla on the same day on which Tesla launched the secondary offering. With Goldman no longer playing along Tesla may find it difficult raise money. Tesla had also reported record delivery in the third quarter. This might have helped it in improving its cash position. The delay in the capital raise will remove some pressure from Tesla stock from now, but there are still many headwinds.

Also Read: Should Tesla Motors Inc (TSLA) Worry As Apple Inc (AAPL) Beefs Up Project Titan?

What Next?

Tesla has three major events coming up this month. Tesla will be doing an unexpected product launch on October 17th followed by Q3 2016 earnings announcement on 26th October. Then on 28th there will be a Tesla/SolarCity product announcements. Tesla is likely to post strong revenues, but its profits and cash flows will need watching. A good profit and cash flow number will act as a tailwind for the stock. But the headwinds from SolarCity deal will remain. Currently, there are seven litigations in the courts against the deal. A delay in the deal due to the litigations will increase uncertainty around the stock. Tesla stock is likely to remain volatile in the coming days. In spite of an improved outlook, Tesla stock remains a risky bet.