God (or whatever spiritual being or belief system in which you believe) has a wonderful sense of theater. Elon Musk’s Tesla proposed to acquire Solar City on June 21, 2016 – the Summer Solstice. The market’s reaction was swift and severe. Telsa’s stock dropped 13.6% and Solar City’s gained 20.3%. The prevailing view is that Tesla’s acquisition of Solar City is a de facto bailout of Solar City by Tesla’s shareholders. Given the commonality of board members and shareholders of both companies (notably, Mr. Musk himself, with 20% stakes in both companies) has drawn unfavorable comparisons of the culture corporate governance in those companies with Ukraine. Ukraine is that big country on the Risk board that is practically impossible to defend, and is a punching bag of corruption indices, coming in as more crooked than Russia, Kazakhstan, and Kyrgyzstan. (Ukraine did come out two spots higher than Nigeria – the inventor of the gold scam.) Not good. Analysts are hammering Tesla and Elon Musk. Board members are recusing themselves from voting on both sides of the transaction, and it seems impossible that this deal doesn’t land in court somehow, if it closes.
Musk’s position is that this is a logical, vertical integration. People who drive Teslas care about the Earth and saving polar bears, and thus also want solar panels via one-stop shopping. Okaay… The funny thing is, neither company is profitable – so this doesn’t appear to be a profitability story. Tesla is certainly sexier – I’m not sure that people who buy Teslas are so much tree huggers as they simply like cool cars and the awesome driving experience that is electric vehicles. Solar panels aren’t sexy. They are kinda cool, but you’re just as likely to buy one because you want to save the Earth as because you are convinced society is doomed and you want to make sure your power is off the grid so that when the dollar finally collapses, you can still power your doomsday bunker. So why the hate for Tesla?
As of the date of the announcement, Tesla’s market cap was $32.3 billion and owed $3.41 billion in debt – well above water. Solar City, however, had market cap of $2.07 billion with debt of $3.25 billion – so far underwater that Aquaman was rumored to be up for the CEO job (ironic for a solar company). Tesla lost roughly $3.9 billion in market value. How does this add up? It’s too simplistic to simply say that the market doesn’t like deals right now, as indicated in a Wall Street Journal article.
Tesla, in effect, is to take on net $1.18 billion of additional debt ($3.25B-$2.07B). $1.18 billion of equity was wiped out.
Tesla also was being discounted due to what is called the portfolio effect. The portfolio effect is the observed discount the market applies when a company is involved in multiple, unrelated business. The market doesn’t like conglomerates. Empirical data on the portfolio discount for public companies indicates a discount of 5%, or $1.65 billion (5% x pre-announcement market capitalization of $32.3 billion).
$530 million was accounted for by the premium that Tesla is to pay Solar City to acquire it (pre-announcement market cap of $2.07 billion vs. post-announcement of $2.6 billion).
Adding up $1.18 billion, $1.65 billion and $530 million accounts for $3.36 billion of Tesla’s loss in value. What about the remaining $0.54 billion? Most likely, the remaining value loss of $540 million is attributable to a key person discount in connection with Elon Musk’s power over Tesla, or 1.7% of Tesla’s pre-announcement market capitalization. The market has, for the moment, lost a bit of confidence that Elon Musk is out to build shareholder value, rather than protecting his own investments. This seems plausible, and data indicate that key person discounts in publicly-held companies in the U.S. may be as high as 10%, so 1.7% is well within the range indicated by empirical data. And, there are calls for greater board independence to dilute Mr. Musk’s influence. Indeed, it may be that Tesla shares have already priced in some sort of key person discount, and the proposed Solar City acquisition simply tacked on an additional 1.7%.
Tesla’s share price has recovered a bit but clearly has settled in at a structurally lower level. When a large deal like this is proposed, typically the seller needs to commission a fairness opinion study, to communicate to the selling shareholders whether the deal is consistent with fair value for the shareholders. Oddly, Tesla, as the buyer, may need to produce a fairness opinion of its own. Musk must be quite careful here. He is taking a big risk with this deal and may be spending a lot less time designing electric cars and building gigafactories, and a lot more time with his lawyers and the Securities Exchange Commission.