28 October 2016 Tesla & SolarCity: As easy as pie?

INDUSTRY BACKGROUND difficult for anyone to know, as financial insiders and analysts, On 29th August, every Tesla of this moment, whether or not the business press, and the SUMMARY employee received an email the presumably accretive public alike. We certainly know The merger of Tesla and SolarCity from CEO Elon Musk to let them cultural and philosophical fit the outcome desired by Elon could be a game-changer for Elon know, directly, that “the third between Tesla and SolarCity will Musk – as he himself wrote to Musk – and his shareholders. quarter will be our last chance indeed play out in such a way Tesla employees in the August that their mutually addressable email, “it would be awesome to While consensus sentiment to show investors that Tesla can surrounding the acquisition has be at least slightly positive cash market grows, synergies are throw a pie in the face of all the been negative, investors and flow and profitable before the realised, and performance naysayers on Wall Street who commentators might focus more on Model 3 reaches production.” improvements are keep insisting that Tesla will the synergistic opportunities of the operationalised.” always be a money-loser!” transaction as there are significant Just two months prior, Tesla, on gains to be realized. the heels of ramping production In the three months since, Here, FTI Intelligence presents capacity for its not yet delivered precisely because these its view on the transaction, one FTI Intelligence has analysed the questions remain, the markets that is informed by our technical potential synergies that could be Model 3 sedan and still generated from the transaction and completing construction of the have on balance grown expertise in merger integration, identifies these as the catalyst that Nevada Gigafactory, had increasingly pessimistic about identifying and implementing will generate the economies of scale proposed to acquire the cash the transaction, expressed via operational efficiencies, a deep required to be successful in their flow negative SolarCity. the stark quantum of the two understanding of both corresponding verticals – and companies’ stock prices. Tesla, residential and commercial deliver value to all stakeholders. At the time, FTI Intelligence since the 20th June solar markets, and finally, our published a Spark – Energy announcement has seen over 7 familiarity with the capital Insight called Let the sparks fly: percent of its market cap erode, markets, as we seek to the (net) meter is running on while SolarCity has fallen 16 determine whether Elon Musk Tesla’s bid for SolarCity, percent – substantial proof the can have his pie, and throw it, seeking to identify and analyse market questions the likelihood too. the multiple factors weighing of the transaction itself. upon the ultimate success – or FTI SPARK VIEW failure – of this proposed The basic question of “can this Understanding the ingredients EXPERTS combination. transaction work” continues to From the day of its Robbie Goffin be the subject of generally announcement, multiple Managing Director As we observed then, “it is negative (if at times melo- audiences sought to make +1 415 293 4460 dramatic) scrutiny from sense of the announced [email protected] Stock Price Chart merger, quantify its economic drivers and rationale, and have Carl Jenkins 30% clearly had difficulty in doing so. Managing Director As the largest shareholder of +1 303 689 8877 20% both companies, Elon Musk [email protected] was and is, fairly or not, in an 10% enormously delicate position Chris Hollern with regard to potential Consultant 0% conflicts. Certainly, it did not +1 303 689 8883 -10% help assuage concerns about [email protected] process when subsequent -20% regulatory filings showed one of Aris Karcanias the investment banks retained Managing Director -30% by SolarCity to advise on the +44 20 3727 1282 merger inadvertently [email protected] discounted the value of the company by $400 million. ‪@FTIConsulting‪‪‪‪‪‪‪‪‪‪‪ S&P 500 Index Tesla Motors, Inc. SolarCity Corporation www.fticonsulting.com Source: Bloomberg, 2016

While FTI has significant market) is a straightforward and revenue problem per se. “In our view, the commercial expertise when it low cost marketing program to Rather, the issue confronting comes to properly valuing execute. The reverse, equally, both companies is profitability. success or failure of energy assets, what we would is true – there are roughly Thus, when looking to quantify the transaction is, first, say here is this: in our view, the 140,000 Tesla vehicles on the the impact of the merger on the a far greater function success or failure of the road in the United States, and combined entity, a key question transaction, at current certainly many of these owners is to identify whether or not of whether or not the proposed prices, is, first, a far will be receptive to an there are opportunities to combined company greater function of whether or integrated, clean energy reduce expenses, and the can realise the not the combined company can solution. magnitude of those reductions. realise the potential synergies potential synergies available to it, and second, Increased product awareness, a Due to the distinct nature of available to it, and whether the capital markets will strong brand, providing a fully each of the business segments, second, whether the reward these synergies with integrated solution – while the simple truth is that ongoing access. pundits may aggressively meaningful cost economies of capital markets will debate the degree to which scale are not going to be an reward these synergies Further, FTI Intelligence would these customer bases will impactful source of cost with ongoing access.” also observe that while revenue overlap and spur additional savings. While FTI typically synergies are likely available, sales, FTI Intelligence believes it looks for cost structure when it comes to the core value is disingenuous to imagine improvements from improved driver of the acquisition, we there will be no revenue benefit supply chain management, end believe the proper rational- at all. Further, an integrated to end workflow optimisation, isation and management of offering, marketed by an and focusing on multichannel expenses – in particular, integrated salesforce, should at manufacturing efficiencies, we Selling, General & some point provide an ultimate see consolidated Administrative (SG&A) expenses opportunity to reduce not just improvements in the Cost of – will be crucial. the overall cost of sales, but Goods Sold ranging from 0.5 – improve competitiveness 1 percent. Revenue thanks to bundled pricing. From a revenue standpoint, the With a consolidated COGS of merger of the two companies As far as the numbers are just under $7.5 billion, we’re has been held as an opportunity concerned, that translates to looking at potential savings to deliver a philosophically the following: with combined FY ranging from $38.5 million to EXPERTS consistent product line across a 2017 revenues expected to be $80.6 million. Robbie Goffin broader customer base, under a $9.3 billion (based on con- Managing Director brand that is immediately sensus growth estimates of Kicking SG&A +1 415 293 4460 recognisable and identified not 32.9 percent for Tesla and 67.9 Far and away, the largest [email protected] simply with happy consumers, percent for SolarCity) projected impact of the merger will be but passionate ones. revenue synergies are expected realised through the reduction Carl Jenkins to range from a low of 3 percent in costs associated with selling, Managing Director Further, renewable energy to a high of 8 percent (based on marketing and general +1 303 689 8877 presents adopters with two FTI’s experience). overhead. As it stands, SolarCity [email protected] interrelated issues: generation, in particular has been and storage – put simply, In turn, we can expect the effectively managing a broad Chris Hollern generating energy during the combined company to realise reduction in its installation Consultant day only solves half of your between $279.2 million and costs, by far its biggest +1 303 689 8883 problems, assuming you would $744.7 million in additional expense, driving them steadily [email protected] like to be able to turn on your revenues – which is to say, down from $2.40 per installed lights at night. even at the low end, a Watt in Q1 2014 to &1.98 per Aris Karcanias consequential amount. Watt in Q1 2016. SolarCity’s Managing Director Integrating and selling Tesla’s stated goal is to ultimately +44 20 3727 1282 home battery storage solution Expenses reduce its installation costs by a [email protected] to SolarCity’s existing installed Revenue increases are one further 50 percent thanks to customer base (currently, over thing, but as many have and will lower hardware pricing and ‪@FTIConsulting‪‪‪‪‪‪‪‪‪‪‪ 300,000 households, or continue to point out, neither initiatives to reduce other soft www.fticonsulting.com approximately one-third of the Tesla, nor SolarCity, have a costs.

At the same time, however, and mortar stores will equally reported by other, established “In other words, without sales costs have been benefit SolarCity’s offering. auto manufacturers (Ford and making hyperbolic challenging, and quite nearly GM are on either side of 10 doubled from Q4 2015 to Q1 General and administrative percent). assumptions one way or 2016, rising from $0.54 to FTI’s long experience in merger the other, there is a $0.97 / Watt as fixed costs integration is that, properly So, if the estimated synergy scenario where the were amortised over lower executed, our clients typically value improvements on the volumes. Sales costs clearly benefit from streamlining expense side range from 20 to combined company is have significant room for organisational structures and 30 percent, this in turn EBITDA positive at the reduction, not just from recent consolidating administrative suggests available synergies end of 2017 to the tune levels but even further below functions. Back office ranging from $491.5 million to historical norms as productivity departments can be $773.1 million. of almost $95 million. improvements are implemented consolidated and deployed And $95 million buys a – the goal, as stated by the across multiple channels – IT, If we further include the savings lot of pie…” company, is $0.40 / Watt. maintenance, installation, we expect from improved COGS, accounting, etc. – and result in there is implied potential value As we think about the meaningful savings. creation from these synergies possibilities of combining the alone of between $530 million two companies, we see real Further, we believe the to $854 million, and again, this opportunities for continuing to consolidation of the battery and does not include the effect of drive sales and marketing costs solar businesses in particular, any of the previously discussed lower and identify three main given the clearly complimentary revenue synergies. drivers: nature of the products, not only represents a clear opportunity Most interestingly, we note 1. Reduced customer to realise cost synergies, but what happens as we flow all the acquisition costs for both can only help with continuing to synergies through a simple companies. In consolidating, integrate and refine the product model of the consolidated costs related to offering. company, using FY 2017 independently selling consensus estimates. products to each other’s By the numbers customers is eliminated, and So practically speaking, what In other words, without making an immediately available does all this suggest in terms of hyperbolic assumptions one referral network is created. actual value? way or the other, there is a EXPERTS This will only drive SolarCity’s scenario where the combined Robbie Goffin customer acquisition costs For 2017, estimated combined company is EBITDA positive at Managing Director lower. SG&A for the companies is the end of 2017 to the tune of +1 415 293 4460 $2.386 billion. Elon Musk almost $95 million. [email protected] 2. Reductions in sales force himself has called for cost headcount by combining the reductions of between 20 and And $95 million buys a lot of Carl Jenkins battery and solar array sales 30 percent for the combined pie. Managing Director departments. These company, and while he’s clearly +1 303 689 8877 products are naturally got a vested interest in those A capital idea [email protected] complimentary, and selling numbers being as high as Moving on from our synergy them as a package is possible the simple fact is that, analysis, we’ll turn to an Chris Hollern sensible on its face. in FTI’s experience, this range is observation we made when we Consultant not unreasonable. first wrote about the merger: +1 303 689 8883 3. Joint branding and marketing “If the combination of Tesla and [email protected] for all products going FTI Intelligence notes that SolarCity represents a forward. Using Tesla’s Musk’s proposed SG&A philosophically consistent Aris Karcanias established and highly synergies, if implemented at the marriage, then the one issue Managing Director credible brand name to combined entity, would reduce that represents the greatest +44 20 3727 1282 consolidate marketing for the consolidated company’s practical disparagement is one [email protected] arrays, batteries, and cars. SG&A margin between 18 to 21 that has historically corroded The presence of Tesla’s percent (high and low ranges) thousands of otherwise happy ‪@FTIConsulting‪‪‪‪‪‪‪‪‪‪‪ growing network of bricks and would move the company unions: money.” www.fticonsulting.com squarely toward SG&A margins

Consolidated Company – EBITDA Waterfall

Sources: Tesla and SolarCity 10-Ks and 10-Qs; Analyst Estimates from Oppenheimer, Baird and Roth Capital, 2016

Should the two companies completed in Nevada – these operating losses of 1.1 billion. combine, while they will have are significant costs, and are While a thorough analysis of the cash on hand of roughly $3.4 being amortised over what is pro forma capital structure of billion (as of 30 June 2016), currently a very number of units the combined structure is after Tesla’s equity raise, which sold. Operating losses at Tesla beyond the scope of this by most measures is significant. have been, and will continue to document, FTI here will make However, these two particular be, steep – the company several observations that have companies are simultaneously recorded losses of $889 million interesting implications with EXPERTS ambitious, and growing – cash, in 2015 alone. regard to the cost of capital. Robbie Goffin and plenty of it, will be a critical Managing Director a raw material for both over the SolarCity, which at its core is a At the outset, we’ll avoid the +1 415 293 4460 next several years. consumer lending business – distraction of discussing equity [email protected] revenues from leasing and issuance. The combination of In the case of Tesla, while the lending to finance solar array price and opinion volatility Carl Jenkins company just reported record installations outstrip direct surrounding the merger make Managing Director deliveries of 24,500 vehicles array sales revenues at a ratio an analysis of the cost of equity +1 303 689 8877 for Q3, the company still of roughly a 4:1 – requires capital too subjective for [email protected] produces a fraction of the ongoing access to capital in comfort. However, the debt vehicles that its established, order to finance these cash- markets lend some useful Chris Hollern legacy competitors do (for a hungry activities. insights here. Consultant sense of scale, GM sold roughly +1 303 689 8883 ten million vehicles last year). Further, the ongoing Of the two companies, SolarCity [email protected] development of its own is perceived by the capital At the same time, new models production facilities in upstate markets to represent the Aris Karcanias are being developed, which New York and its dependence greatest risk. This is evident in Managing Director means factories must be tooled on scaling and deploying new the pricing of the company’s +44 20 3727 1282 at the same time that the technology acquired in the debt, with the 2.75 percent [email protected] Gigafactory is still being purchase of Silevo. On a trailing convertible bonds due in 2018 twelve month basis, SolarCity trading at roughly $80. The ‪@FTIConsulting‪‪‪‪‪‪‪‪‪‪‪ has recorded strike price on the embedded www.fticonsulting.com

equity option is at roughly most similarly rated peers CONCLUSION “It would be awesome $61.66 – which is to say, the accessing the marketplace – The overwhelming combination to throw a pie in the company’s stock price would the Bloomberg fair value yield of both surprise and skepticism have to roughly triple for this curve for B3 rated industrial that has greeted the proposed face of all the option to be in the money. bonds, at five years, is 6.76 merger of SolarCity and Tesla naysayers on Wall percent. since it was announced in late Street who keep With the equity option June strikes us, frankly, as effectively worthless, the Over the last 30 days, 53 somewhat misplaced when insisting that Tesla will convertible debt is a nearly pure corporate high yield issues have measured against the very real always be a money- expression of credit risk. At been placed in the US high yield value it has the potential to $80, the yield on the bonds is market for amounts of at least create. loser!” – Elon Musk roughly 14.25 percent, more $200 million, at coupons than 1300 basis points above ranging from 4.25 percent FTI is well aware of the gap that the interpolated treasury curve (Ba3/BB- Crown American) to exists between identifying and a clear signal that the 9.625 percent (Caa1/B- Kinetic opportunities for operational market has significant concerns Concepts) – but with just over improvements and synergies, about the company. 80 percent of the issuers vs. realising them. At the same pricing below 8 percent and an time, the potential for However, the credit markets average coupon for the entire improvements has, in our view, have a far more constructive group of 6.48 percent. been perhaps too deeply view on Tesla. Looking at the discounted. outstanding Tesla 1.25 percent While we are well aware that convertible bonds due in 2021, current trading levels in the Arguing about the value of Solar we observe recent trades at primary and secondary market City as an isolated asset, while $86.75 – or a yield of 4.54 for debt hardly guarantee a potentially entertaining percent. While the option access and pricing, they are pastime (one fueled, certainly, embedded in these particular certainly a reasonable proxy. by revelations that the exercise bonds is not worthless, it does We would therefore suggest, in was mishandled by one of the have low value (the strike price candid opposition to the firms originally hired to do it) is over $359, so Tesla stock majority of increasingly will not lead to a useful would have to trade up at least pessimistic financial conclusion about the value of 75 percent from current levels commentary, that access to the merger – there are, as we to be in the money). debt capital at reasonable rates have documented here, may be contemplated. multiple, meaningful, At 4.54 percent or roughly 335 opportunities to surface basis points over comparable Thus, setting aside any operational synergies. treasuries, what we can do is predictions that would be put at begin to quantify just how risk by equity market volatility, Again, FTI fully acknowledges impactful the merger would be SolarCity’s stated assumption that identifying synergies is not with regard to SolarCity’s cost of that its pre-tax Weighted equivalent to realising them, capital. Even if borrowing Average Cost of Capital will be but we can also say that a spreads for the combined entity 7.4 percent may be reasonable review of the doubled from Tesla’s current characterised as defensible in underlying and complementary levels, it still suggests the context of a merger. business segments makes clear unsecured term financing that there is a path – a should be available in the 8-9 And, while Tesla’s short-term Disclaimer: Our thought leadership relatively straightforward one - content does not necessarily reflect percent area – which is to say, cost of capital seems likely to where the combined entity has the views of FTI Consulting but are the roughly 500 basis points below increase given the upfront risks the potential to be EBITDA observations of our individual experts, current spreads. that the transaction represents positive by the end of 2017. who we encourage to publish their to the enterprise, there is every personal perspectives on important Further, a review of current opportunity for the combined And, if this turns out to be the and timely business issues. market conditions for U.S. high company – should it execute on case, then Elon musk is going to yield debt suggests that implied synergies – to be in a position keep a lot of bakeries busy: he’ll ‪@FTIConsulting‪‪‪‪‪‪‪‪‪‪‪ coupons of 8 or 9 percent to drive those costs lower. be ornamenting a lot of faces www.fticonsulting.com would frankly be high relative with a lot of pie.