Does RSE can merge/buyout FVC?

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Executive Summary

Tesla’s CEO, Elon Musk, has declared the intention to acquire SolarCity. SolarCity is a solar company that was founded by Peter and Lyndon Rive in 2006. During times where, fossil fuel prices are spiraling and the desire for clean energy is increasing, the company became the number-one solar panel installer in the United States. Its long-term financing agreements with customers also provides recurring revenue for this company. SolarCity had a five-year compounded annual growth rate of 62.25 percent. Despite these facts, the company has never had a profitable year. It is important to note that the firm has become dependent on large amounts of debt to finance its large capital expenditures.

On the other hand, analysts believe that SolarCity will finally become profitable in 2017. With the acquisition of SolarCity, both Tesla and SolarCity would increase their profits significantly and experience significant cost synergies. At present, Tesla specializes in designing, manufacturing, and selling electric cars. The acquisition of SolarCity could provide Tesla with a realistic opportunity to expand its market share, increase operational efficiency, and access cheaper financing.

Tesla’s CEO, Elon Musk believes that he can increase SolarCity’s operating margin to make it valuable, even though he is unsure about the fair purchase price. However, Tesla’s investors may not agree with the acquisition of SolarCity. SolarCity is unstable and unprofitable. Tesla is also experiencing cash and profitability issues and may not be able to sustain another risky company. The first step in determining if this acquisition would be beneficial is to conduct a valuation on SolarCity and determine what a fair purchase price would be.

Analysis

The markets for solar power and automotive industries are characterized by high level of competition, as the large-scale companies must sustain their market size. This explain the reason why SolarCity has required lots of financial supports to gain and maintain competitiveness. Tesla’s CEO, Elon Musk, has noticed the long-term growth opportunities for SolarCity, especially, because of the expected growth in demand for the Tesla model 3 and the proposed partnership with SolarCity to launch Gigafactory. Acquiring with SolarCity can play a significant role in helping to reduce Tesla’s operating costs and increase the revenue.

On the other hand, this acquisition would also influence economies of scale. It will provide a suitable stage for SolarCity products and enable Tesla to upsurge its production capacity. This merger and acquisition aims to eliminate the overhead expenses and improve efficiency, service delivery, and customers’ satisfaction. It will allow Tesla to downsize and focus on the key business activities. This deal could enable SolarCity to reduce the level of debt comparing to the other competitors in the industry.

SolarCity’s recent poor financial performance could significantly persuade SolarCity stockholders to accept Tesla’s acquisition offer. As previously mentioned, the company has already recorded losses for several consecutive years. Elon Musk is adept in analyzing the market and applying to the corresponding business strategies. He determines to restructure SolarCity and help to change its bad financial status. To control the overhead expenses will create a realistic means for Tesla to increase its operating margin over time.

In the realistic world, the uncertainty should be taken into consideration. These uncertainties will affect the income and/or costs after the merger of Tesla and SolarCity. First, the volatility of crude oil price. Electricity is produced by burning crude oil. As a result, crude oil price has tremendous influence on the production cost of electricity. If the crude oil price keeps increasing, the price for electricity will increase proportionally. Residents will look for alternative to supersede electricity. Solar Power will be the major alternative and the income for Tesla – SolarCity will be increased. Another one is environmental issues. Society is becoming more aware of all the environmental issues we are experiencing. The desire for clean energy resources is increasing. Electric vehicles have become a popular solution. And for end users, the way for them to save cost will be solar power. In this case, end users can get the automobile and the charger from one company. It will also save end users time for shopping around for the solar panels provider.

Until now, we assumed that the merger is good for both companies. But there are uncertainties that will affect them negatively. First is the entry of new electric car builders and solar panel providers. Tesla is a well-known manufacturer for fully electric cars. But some other car manufacturers have already built fully electric cars, for example, BMW i3, Nissan Leaf and Chevrolet Bolt. For people that do not purchase Tesla, they will have more selections for solar panel providers. New comers will probably cause Tesla’s and SolarCity’s revenue and production to decrease by having lower manufacturer's suggested retail price (MSRP) for the vehicle and a lower cost for solar panels. For the cost perspective, to keep the technology up-to-date, additional costs will be invested to the research and development department. In addition, higher welfare will be needed to prevent top technicians and engineers from jumping ship.

To determine the value of SolarCity to Tesla we have used the discounted cash flow analysis and the comparable valuation approach.

The Discounted Cash Flow Analysis

To determine SolarCity’s value, we are required to calculate the weighted average cost of capital (WACC) for the sake of all the future cash flows.

After evaluating the balance sheet of SolarCity, we can easily get the Debt, it should be current liabilities plus the long-term debt, which is 4,070.85. After that, CAPM formula can be used to calculate cost of equity (Re). The risk-free rate is the 30-year U.S. treasury rate is 2.5%. Moreover, the market risk premium is 5%. For beta we use the average range between 1.95-2.40 which is 2.175 due to different source. In addition, the cost of debt is 6.8%. Accordingly, to all the figures we got, we can use the CAPM formula to calculate the cost of equity and then the WACC. As the following matrix shown, the cost of equity is 13.38% and the WACC is 8.28%.

Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. The essence of the free cash flow valuation is that the value of a firm can be obtained by the present value of all future cash flows. To value the firm today we are required to discount all the future free cash flows with the WACC. First and foremost, we should apply to all the figures we got to calculate the cash flow of SolarCity. Among this, the most important is we need to add the synergy to EBIT to get the new result.

All the data we can reach in the case, such as capital expenditure, depreciation and amortization and net working capital, as 23%, 3.5% and 10% of the revenue respectively. Based on the information we can calculate them one by one. Once we get the EBIT, the synergy of 20% of expenditures should be applied to generate the new EBIT with synergy. Synergy is the concept that the value and performance of two companies which combined will be greater than the sum of the separate individual parts. The same way to count Operating Cash Flow (OCF) with synergy. So, the free cash flow (FCF) is equal to new OCF minus the change of net working capital and minus capital of expenditures (CAPEX). The Terminal Value can be obtained by including all cash flow after the explicit forecast period during 2017-2021. Using Vn= (1+g/(rwacc-g))*FCFn, we can get the Vn then Enterprise Value EV (PV Cash Flow + Terminal Value) can also be calculated, which is 6,048.82. At last, the market value of equity (MVE) is received by EV minus debt 4,070.85, is 1,977.97. Given the current number of total shares is 97.59, we can get the share price, which is $20.27 per share.

When making a comparison between SolarCity without synergy and with synergy, it is not difficult to see that synergy would help SolarCity to improve its financial status, because it has shown the negative data of FCF with no synergy. The acquisition could definitely benefit the SolarCity. However, it may not be a wise decision for Tesla to acquire SolarCity. The actual SolarCity price per share is $20.27 instead of the asking price of $29.35. To further confirm our results, we can also use the comparable valuation approach.

Based on our data we have concluded that Tesla should not acquire SolarCity. We came to this conclusion by using WACC, discounted cash flow analysis, free cash flow analysis, and the comparable valuation approach. Our findings all point to the same conclusion, that SolarCity’s share price of $29.35 is overpriced and does not correctly correlate with the value of the company. It is our recommendation that Tesla not acquire SolarCity unless SolarCity shareholders are willing to accept a share price of at most $20.27.