For anyone curious as to why Tesla's credit ratings may be relevant...
Likelihood And Consequences Of A Tesla Credit Downgrade
- Tesla will probably be downgraded by one or both of the main credit rating agencies in the near future.
- A downgrade will take its unsecured debt into the "C" rating range.
- The company's access to new debt from the public bond markets will likely be insufficient to cover a significant proportion of its capital needs.
When Tesla issued $1.8 billion of junk bonds in August, it sought and received ratings on the bonds from both Moody's and Standard & Poor's, the two largest credit rating agencies. The ratings of the bonds were:
- B3, with a stable outlook by Moody's (a newly assigned rating); and
- B-, with a negative outlook, by Standard & Poor's (a reaffirmation of a previously assigned rating).
For those unfamiliar with credit ratings, here is a simple summary:
In addition, Moody's gave the company a rating with regard to its liquidity - speculative grade 3 or SGL-3, which Moody's defines as:
While most of the comments in this article are applicable to both agencies, I will concentrate on Moody's, which are more open and makes more information available to the public than S&P, which restrict much information to subscribers. In particular, Moody's provided an informative press release when rating the bonds, on which this article will draw extensively. Note that Moody's gave a B2 rating to the Tesla "corporate family", while assigning a lower rating of B3 to the bonds, because the bonds, while technically senior obligations of Tesla, effectively rank junior to the $1.9 billion secured debt because of the extensive security interests given to the secured lenders. Since this article is looking at Tesla's ability to issue more junk bonds, the B3 rating is more relevant here.
Likelihood And Consequences Of A Tesla Credit Downgrade
Will Tesla be downgraded?
Moody's helpfully summarized the primary factors which might lead to a downgrade (or an upgrade). Those factors are:
Has the Model 3 had any major production or quality problems? If any readers have not been keeping up with current events, I recommend Montana Skeptic's excellent commentaries. As for EBIT/Interest, Moody's hope that Tesla would earn enough before interest and taxes to pay half its interest bill looks very optimistic in the light of the recent 10-Q:
The ratio, which had been improving, has fallen dramatically, and that is despite the fact that only about six weeks of interest accrued on the junk bonds during the third quarter.
How about other factors supporting Moody's rating? It based the rating for Tesla on the expectation that:
- "the launch, production ramp up, and market acceptance of the Model 3 will be successful enough to achieve approximately 300,000 unit sales during 2018 (a full-year sales rate averaging about 5,500 per week) with a gross margin approximating 25%"; and
- "Tesla's brand name, production facilities, and product lineup would have considerable value to another automotive OEM or technology firm targeting the electric vehicle and mobility markets".
There seems little possibility that 300,000 units will be produced in 2018. Musk said on the Q3 conference call that he expects "to achieve a production rate of 5,000 Model 3 vehicles per week by late Q1 2018". Montana Skeptic's convincing argument suggests that even if everything starts to function perfectly from now, Tesla only has capacity for 5,000 cars per week. As for the gross margin, even if we use the company's controversial definition of gross margin, it is now claiming only 18%, far from Moody's target. Finally, while I think all agree that there is value to an acquirer in the brand and in the product line-up, few acquirers are likely to assign much value to production facilities that have been so publicly shown not to work.
Likelihood And Consequences Of A Tesla Credit Downgrade
S&P is less forthcoming, simply stating that, "Negative outlook reflects Tesla's increased execution challenges over next 12 months, raising risks related to sustainability of capital structure". As discussed, above, the challenges have turned out to be show stoppers.
Based all of the above, I believe that a downgrade in the near future is highly likely. It seems the market agrees. Tesla's junk bonds now trade at a yield of 6.32%, a full percentage point above the August issue yield. A move of this magnitude generally presages a significant credit event, such as a down grade or a default. This move was not due to a general rise in junk bond yields. The price of the high-yield SPYDR, the SPDR Bloomberg Barclays High Yield Bond ETF, which is a useful proxy for the high yield market as a whole, was 36.77 at the close on 8/17/17, the day when Tesla's bonds were issued, and closed at 36.68 on 11/10/17. Despite the support from the company's retail fan base, the bond trades worse than the average B rated bond.
So, what if Tesla does get downgraded?
From Moody's B3, the next step down is to Caa1 (the S&P equivalent is from B- to CCC+). This move from the B range to the C range is significant.
Firstly, the debt is much more expensive. A recent (September) 8-year bond issue by a Caa1/CCC+ corporation (Golden Nugget, Inc.) priced at 8.75%, more than 3% higher than Tesla's August issue.
Secondly, there is much less capital. Most high yield indices and institutional high yield investors allocate much less capital to C range investments than to B range investments. According to peritusasset, the high yield bond market in the US has total issuance of approximately $1.6 trillion. Again according to Peritus, high yield issuance is running at about $29 billion monthly. While it is difficult to establish how much went to each rating level, an approximate amount may be found by looking at two of the largest high yield aggregators - JNK, which tracks the Bloomberg Barclays High Yield Very Liquid Index, and the iShares iBoxx $ High Yield Corporate Bond ETF, which tracks the Markit iBoxx USD Liquid High Yield Index.
Likelihood And Consequences Of A Tesla Credit Downgrade
In the case of JNK, the allocation is...:
... while in the case of HYG, it is:
This suggests that the monthly pool of available capital for Caa/CCC issuance is around 12-15% of the $29 billion, thus around $3.5-4.4 billion, while the pool for B/B is $11.6-12.2 billion - almost 3 times larger. If Tesla, subsequent to a downgrade, sought to issue the same amount of bonds as it did in August, it would be soaking up approximately half the monthly available funds for the entire country - not a realistic prospect. And it seems likely, after the August experience, that the retail fan base will have discovered the unpleasant truth about low-rated junk bonds - you get much of the downside of the equity and none of the upside - so they will not be there to provide additional funds.
Persons more expert than I, notably Andreas Hopf, EnerTuition, Montana Skeptic and Bill Cunningham, have suggested that the company will need very large cash infusions within the next few months. Elon Musk better hope that investors are feeling generous, because the bond market is unlikely to be sympathetic.
So, in summary, equity investors who agree with the above experts that Tesla will need a lot more cash soon should consider that the cash will likely not be available from the debt markets. The best case is, therefore, that there will be another dilutive equity raise. The worst case is that equity is also unavailable, leading to a rapid collapse into default and bankruptcy. Debt investors should consider the likelihood that the junk bonds will trade down toward Caa1/CCC+ yields, which would probably require another 10% fall in the bonds' trading price.
Link: http://seekingalpha.com/article/4124487-likelihood-consequences-tesla-credit-downgrade