Executive summary

Tesla CEO Elon Musk has an extremely high stock option package that rewards him handsomely if he succeeds in building one of the biggest companies in the world. Another view one could take on the bonus is that it protects the private holdings of Mr Musk towards a dilutive share issuance that Tesla might do to inorganically grow into a big car manufacturer.

The truth is probably somewhere in between.

In any case, the option rewards open the path for Mr. Musk to acquire a large automobile since scaling up to the production capacity of Tesla will not be easy. Musk is smart enough to know that production doesn’t scale like software and that something extra is needed here.

In addition, Tesla is seen as the best producer of software for cars but is struggling immensely with the supply chain and assembly.

Of the possible candidates for such a merger, FCA stands out as having a price that Tesla is able to afford, is being valued extremely cheap, located in the US/EU, having a luxury brand in Maserati that would be a great addition to Tesla, being actively looking for a merger partner for the last 2 years and having a CEO that is friends with Musk.

Contrary to this thesis, FCA has announced a partnership with Waymo, and the CEO has communicated his disdain for EV on various occasions, although the FCA investor communications contains allocated budgets for electrification. In addition FCA owns the

The play here is not to buy Tesla (yet), but to buy FCA and hoping I’m more or less right. The downside is owning FCA at 2.6x EBITDA.

Before we start

What follows is just a thought experiment on how Tesla can get itself out of it’s current predicament with a ‘big bang’ solution. They can probably survive on their own as well.

I do not think it is highly likely this scenario will materialise, but when making some back of the enveloppe calculation, it seemed more or less to work for every stakeholder involved.

Elon’s bonus

Tesla CEO Elon Musk has an impressive option package. The option package involves realizing 12 of the 16 operational milestones, and all of the market capitalization milestones. Note that there is not a ‘per share’ milestone, leaving the path open to dilutive actions that would allow Elon Musk to reach the milestones.

Source: tesla website

Musk’s big problem

Being entrepreneurial and visionary and all that might be great, but the car industry is enormously complex. Producing/assembling the cars is not even the hardest part of the job, but it is the logistical complexity of getting all the supplier to deliver the right stuff in the right order in the right time that is incredibly hard. There is a reason why the Germans/Japanese are so good at this stuff.

If I were Musk, I would look deep into myself and realize bringing this expertise in the Tesla group would be a good idea. Musk is great in coming up with products, and great in executing them. But there is a very large difference in assembling rockets or software (which is more a piece-by-piece thing) compared to car assembly (which is a chain thing).

Musk at some point has to come back to reality and see he is not really an alien send to push the human race into space, but that he is an extremely talented human being, with 4 kids and 4 companies (or more if you count to yet to be founded candy company) to take care off … at some point something will break without outside help.

Tesla is one of the most shorted companies, and has an enormous cash drain that does not look like it will be resolved in the next quarters because of constantly failing to meet production targets.

https://www.bloomberg.com/graphics/2018-tesla-burns-cash/

Other car companies

One of the big reasons people like to short Tesla is because of the seemingly semi-idiotic valuation of the company. Mr Musk has also commented that the valuation is quite rich, but at the same time takes a couple of hours off to bash shorters on twitters.

Source: compnay websites … should be more or less correct

Looking at other car companies, the Tesla valuation is not that out-of-whack, although very high. BUT Tesla has an insane amount of growth compared to other manufactures and has more than 500.000 cars in pre-buy. That is 25b USD in revenue in prebuy! That is an unseen amount for any car manufacturer.

The profit margins corrected for the huge Tesla R&D expenses, show that Tesla makes a more or less decent profit (EBITDARD) that is slightly below, but inline with, the other manufacturers except for Ferrari. Ferrari is probably a bit different in this case. Also note the premium BMW and Daimler can extract. The Tesla buyers I know in my personal life are former BMW/Mercedes/Audi drivers, not former Nissan or Renault drivers.

An EV/EBITDARD of 50x is a still a bit special, but hey, you are talking about an upstart disruptive thing here with 40% + growth in an otherwise stagnant industry, give them a break. This high valuation is what allows Musk to pull this trick.

Suppose Mr. Musk really wants to do an acquisition, it would probably be < 100b enterprise value to be able to be manageable. Considering the difficulties Tesla has with their bonds, a low debt acquisition would be preferable. This leaves Mr. Musk in the ball park of Peugeot, FCA, Renault, Ferrari, … or he can try to work with the owners of Jaguar, Volvo or a car brand I’m forgetting here…

Best candidates

Of these car brands FCA seems the most likely. Renault is EU only and Ferrari does not have the production capacity to help Musk (although the brand would fit). The EU would probably shower Musk with subsidies.

FCA has a number of brands that would fit: Maserati could be an uber premium Tesla, and Fiat is one of the best-in-class car producers in terms of CO2 and CNG engines. The fiat 500 is available at a < 10.000 EUR price point, and is great for urban traffic.

FCA also has the RAM truck brand, which would not be the best fit for “green” Tesla, but which could be sold to a Chinese player. FCA is in the process of spinning off it’s component business, which mainly makes power trains and exhausts but also telematic systems and instrument clusters.

FCA makes most of its profit in the US, but has a strong presence in the EU, mainly through its small and efficient Fiat 500. The Jeep brand is the most profitable of the group. FCA has a lot of cash reserves, which would come in handy.

Exor, the holding above FCA also included a nice story with regards to the electrification of the car industry in their annual report. I can’t remember who the main competitor of Edison was …

exor shareholder letter

Another candidate would be PSA. PSA has less car brands and no US presence. On the other hand, PSA is owner of Faurecia, which is a big supplier to Tesla. PSA recently bought the Opel/Vauxhall brand from GM, so it might have other things on its managerial mind.

Ford/GM would be too large, as Tesla will never be able to refinance the USD 100b in bonds of those companies…

FCA actively looking for merger partner

As reported by the FT (and numerous other news sources) FCA CEO Marchionne has been looking for a buyer for the last 2 years. In the meantime, Ferrari has been spun off, and FCA is currently looking to spin of part of its component production companies.

https://www.ft.com/content/83d8336c-867b-11e7-bf50-e1c239b45787

Marchionne/FCA and Musk relationship

Marchionne said, “As much as I like Elon Musk, and he’s a good friend and actually he’s done a phenomenal job of marketing Tesla, I remain unconvinced of… [the] economic viability of the model that he’s pitching.”

The only thing that doesn’t fit with this investment thesis is the fact that Marchionne doesn’t believe in electric cars. The Exor management is more strongly committed to this.

exor shareholder letter

In 2015 however, there were talks between FCA and Tesla. https://www.benzinga.com/media/cnbc/15/06/5558006/heres-what-elon-musk-said-about-fiat-chrysler

Musk commented: “There was no, I don’t want to characterize it as anything more than we had a pleasant meeting and there is a slight chance of something that may come up in the future.”

Again the shareholder letter, yes I also hear voices in my head

Contrary to Tesla , FCA actually can build cars

FCA has an EBIT margin of 6.4%, comparable to VW/Peugeot and in the range of GM, but almost double of that of Ford. Daimler/BMW are higher up with 7.9% and 9.9%.

EBIT% is growing very fast at FCA in the last years.

FCA produces 4.6m cars every year, compared to 30.000 cars produced by Tesla this year… just saying

What would happen in a FCA/Tesla merger?

FCA revenue 133b USD

Tesla revenue 11.7b USD

TOTAL = 144.7b USD (7 out of 8 in the bonus plan)

FCA EBITDA 8.4b

Tesla EBITDA 0.b

Total = 8.5b (5 out of 8)

Total operational score = 12 out of 16. BOOM! Headshot !

FCA net debt= 5b, but FCA has much more operational cash. The number above comes from CapIQ, and do not reflect the operational liquidity of EUR 20.4b of FCA

Tesla Cash 0

Total = More than enough not to go bankrupt any time soon.

Source: FCA website

FCA market cap = 31.5b USD

Tesla market cap = 60.9b USD

Total = 90.4b

Presumably this will be done with a premium to convince FCA shareholders (and mainly the family shareholders behind FCA) to agree to a high risk plan.

Okay, now it gets complicated

Suppose Mr. Musk does a merger with FCA at a premium. What would be the effect?

Let’s go all out and assume a 75% premium. The following calculations work for smaller premiums, as well as for slightly larger ones.

source: my excel sheet

An offer of 75% above the current market cap of 30.4b of FCA would result in an acquired market cap of 53.2b. That is still an EV/EBITDA for FCA of 4.23, which is still ridiculously low.

One would need 153.3m new shares for this this deal (which would be swapped with the FCA shares). Presumably the Italian owners of FCA could call Goldman Sachs and arrange some futures to lock in (part of) the value they receive, reducing their risk. Musk would come ahead in this story with +/- 500m. But he would gain an army of engineers, 159 plants, 26b in equipment and some laptops.

An action like this would trigger the first tranche of the warrants (or more if the market reacts favorable to this deal). The EV/EBITDA of 9.27x of the combined entity would be high but in the normal range.

Tesla shareholders would not benefit greatly from this deal, apart from the (possibly) favorable market reaction. It is possible that the news of this acquisition would lead to a short squeeze, once the market realizes that cash and production issues can be solved by buying your way out of this misery.

The future

Now that Musk has acquired sufficient plants to actual build the things he sells, he would be able to produce (let’s say) USD 45b worth in cars by 2020. That is 25% of Mercedes, bringing Trump’s dream of a Mercedes free US a little bit closer to reality.

Let’s say FCA grows with inflation, and capex is kept at around 7b (which is probably an estimate on the low side). A large part of the R&D budget of FCA can be used by Musk, so the R&D of Tesla would “only” grow with 15%, FCA remains constant.

If we assume an EV/EBITDA of 9.5 by 2020 (inline with Mercedes) that would increase the value of Tesla shares to 688 USD/share making Musk around double as rich as he is now, and this would solve a lot of problems for him.

This would allow Musk to use the time between 2020–2031 to go to Mars, with a company that generates 20b a year in free cash flow.

Additional bonus points to support the thesis

FCA is moving up

The bonus plan was approved at the end of January (!)

Musk is communication something is up

Also, it is possible he is just referencing the Q2 results, but hey, you can dream no ?

Tesla is delaying its VIN registration

Tesla is delaying its Vin numbers, which might point to production problems. https://teslamotorsclub.com/tmc/threads/no-recent-vin-assignments.107124/

The VIN number also contains a code for where the car is manufactured (11th digit), so this might also point to an imminent move/split of the production location. Both are possible.

Musk has been spending time in Europe

Musk has been in and around Europe a lot lately, mainly to look for a location for the new gigafactory, but some Italian espresso is always nice.

Musk is tweeting the Tesla will start building a truck

Conclusion and what you should do if this makes sense

Buy FCA obviously, worst case you own a company at 2.6x EBITDA. Alternatively you can buy Tesla, but the downside is much bigger.

You can also take an additional mortage and buy out-of-the money call options (not real invesment advice). After all, you missed bitcoin, and all your friends got rich quick.

Keep the faith in Tesla. Or not! You are free to do whatever you want, even if it is going to Mars.

Things that do not fit with this: FCA doesn’t really like EV, the family shareholders of FCA are probably not completly insane, Trump.

Cognitive dissonance (to see both sides of the picture): https://hiddenvaluestocks.com/wp-content/uploads/2018/04/Stanphyl-Capital-Letter-April-2018.pdf

Again: the main short thesis points are (a) high valuation (b) production problems ( c) management issues (d) other car companies are getting into the EV field. Tell me what problem is not solved? FCA has a very low valuation, has ‘old school’ brands, has no EV and is looking for merger …

It’s probably a figment of my imagination.

DISCLOSURE

I’m long FCA (and Ferrari thanks to the spin-off) since 2014. Not selling. No shares in Tesla, but if this happens, I would probably keep them.