Earlier this week I was alerted to a story about everyone’s favourite electric car company Tesla and their ‘interesting’ approach to the on-going financial black hole that represents their balance sheet.
Despite declared a loss every quarter since they were founded in 2008 (yes, that’s right, ten years ago), this is a stock that has risen from less than $20 in 2010 to more than $300 as of February 2019. That’s a 1400% ROI for someone that bought the shares at listing price and yet this is a company that was cash flow negative until 2018!
The company raised more than $800m of debt in December having raised nearly $500m in February 2018. Now, issuing the debt doesn’t necessarily mean that it’s added to the pile outstanding. Sometimes, company issue debt and use it to pay off existing obligations at a lower rate (a bit like rolling over your credit card).
At some point of course, the original debt does actually have to be paid back. Companies rarely pay these debts off in one fell swoop and usually chip away at it over decades as growing earnings reduce the impact of the repayments on their overall income. I ask you, however, what happens when that income is funded by more debt?
Tesla’s aren’t exactly cheap and many, many of their customers take out financing plans to spread the significant (some are over $100,000) costs of the purchase. What do you think will happen as interest rates rise and customer’s income is squeezed? When they have a mortgage, and a credit card, and a store card, and a phone contract, and a home equity line of credit, AND a financing package for their car? They’ll cut back spending to repay debt, and cut back further, and then they’ll start defaulting.
Not on their mortgages (everyone needs somewhere to live) but on their incredibly expensive car payments. After all, you can always use a bus or get a cheaper car, but when the equivalent on a home is going from a four-bedroom house to a tent in the park, what would you do? You’d get rid of the car of course.
So what happens to Tesla? The income that’s required to maintain the huge debt pile they’ve acquired starts to dry up. If they’re lucky, it won’t fall far enough to impact repayments, or maybe they’ll be able to renegotiate terms with the bondholders to restructure their liabilities. More than likely, however, the bondholders will see the collapsing revenues and pile out of the bonds, and the company’s credit rating will collapse as debt repayments start to eat up more and more of their income. What’s worse, all those customers that default on their payments will have their cars seized – great, right, now the company can sell them to new customers and recover the money?
Erm, probably not actually – those $100,000 cars sure aren’t going to sell for the same price second hand, and in a market where incomes are drying up, it’s going to be harder than ever to sell them at that value. So now the company has a stack of ‘assets’ that it can sell for less than they were originally booked at – if they can sell them at all – collapsing demand for their debt (which is essential to running the company) – and a public reputation that looks only marginally less attractive than Philip Green’s.
Does that sound safe to you? Does that sound secure? Does it sound like a sensible investment? No, of course it doesn’t. It sounds like an overleveraged house of cards (which is exactly what it is). It’s still called a bond and it’s still held by bond funds around the world but if your IFA is telling you that bonds are safer than shares or that they’re lower risk, maybe take a look at situations like Tesla and consider whether you should agree with them or not.