Tesla SolarCity Valuation Error

What’s a $400 Million Valuation Error Between Friends?

Tesla SolarCity Valuation Error

The Issue

Lazard, the investment bank that advised SolarCity on its $2.6 billion sale to Tesla Motors, made an error in its analysis that discounted the value of the U.S. solar energy company by $400 million, according to a regulatory filing by Tesla.1

Lazard’s original analysis for SolarCity, presented to the Special Committee appointed by its Board of Directors on July 29th, indicated an equity value of between $14.75 and $34.00 per share, as compared to the stock’s closing price of $26.70 on the same day.

However, on August 18th, Lazard discovered and corrected a “computational error” where it double-counted some of the company’s projected indebtedness, according to Tesla’s filing with the U.S. Securities and Exchange Commission.  This was the result of an error “in certain SolarCity spreadsheets setting forth SolarCity’s financial information that Lazard used in its discounted cash flow valuation analyses,” according to the filing.  Lazard revised the valuation range based on its discounted cash flow model to $18.75 to $37.75 per share, approximately $4.00 per share higher.

Tesla SolarCity Valuation Error

Background

Tesla SolarCity Valuation Error

Tesla and SolarCity had a potential conflict in that Elon Musk is the CEO of Tesla and largest shareholder in both companies.  Also, SolarCity’s CEO, Lyndon Rive, is Musk’s first cousin.  This gave concern to SolarCity’s Board and shareholders that the merger of the two companies could create potential synergies for Tesla shareholders, as opposed to those of SolarCity.

The most obvious potential synergies between the two companies involve their vertical integration along the supply chain.  SolarCity’s solar panels, a source of “green energy,” could provide fuel for Tesla’s battery-powered vehicles.  Alternatively, Tesla’s advanced battery technology could extend the usefulness of solar power, storing the energy produced during the day for use at night and thus helping more buyers of solar panels to “get off the grid”.  This could end their reliance on traditional sources of fossil-fueled electricity and future rate increases, an option very popular with retired customers.

Investment Overlap

Tesla SolarCity Valuation Error

Many institutional investors also had large ownership positions in both companies.

Therefore, SolarCity went out of its way to create processes and structures, including a special board committee at SolarCity, aimed at alleviating concerns that Musk used his influence to force the two companies into a deal.2  Part of this process of exercising appropriate corporate governance was to hire independent and competent outside advisors, in this case, Lazard.  After Lazard disclosed its $400 million mistake, undervaluing SolarCity shares by approximately $4.00 per share, Tesla, who offered about $25 per share, apparently did not care.

Tesla said learning of Lazard’s mistake would not have changed their proposal, as they had not included the error in their own calculations.  However, it could have definitely changed SolarCity’s acceptance of, or counter to, Tesla’s offer.  In our opinion, most SolarCity shareholders would consider $4.00 per share of additional value on a $25 stock to be very material, an approximate 16% premium.  Still, it’s not too late for SolarCity to hold out for a higher offer – it has until September 14 to actively seek other acquisition proposals, at which time the so-called go-shop period stipulated in the merger agreement ends.  Additionally, SolarCity was reportedly considering multiple other offers.3

Impact of Lazard’s $400 Million Error

One impact of the announced error is that the “merger spread” between Tesla and SolarCity has tripled in the last two weeks.  Tesla’s offer was based on an exchange ratio of 0.11 shares of Tesla stock for each share of SolarCity stock.  The merger spread refers to the difference between the daily value of SolarCity’s stock as compared to the price expected based on the announced merger, a function of the value of Tesla’s stock price.

This could indicate that investors might be predicting the merger will fail, but that’s not the only possibility.  The action could also indicate an expected proxy vote against Tesla.  The merger deal has generated criticism against Tesla CEO Elon Musk, with critics saying he is using the high-flying stock of the electric car company to bail out the solar energy company.

Wall Street analysts

Wall Street analysts have said the deal makes little sense, given that both companies need to raise significant amounts of capital to fund their future growth expectations.  SolarCity’s cash requirements will be a drain on the electric car maker, which requires significant additional investment to meet its ambitious Model 3 production plans.

Both Tesla and SolarCity stock began dropping immediately after the $2.6 billion all-stock merger was announced August 1, and the merger spread hovered below 5 percent for several weeks, indicating a substantial likelihood of completion.

Tesla SolarCity Valuation Error

But in the last two weeks, since the announcement of Lazard’s valuation error, the spread has more than tripled to 17.7 percent, as shown in the graph above.4

Both companies’ shareholders are expected to vote in October.  Musk has indicated that he will not vote his Tesla shares on the merger due to his conflict of interest.

The most logical explanation of the spread increase is that arbitrageurs no longer believe the deal will go through.  Perhaps investors are having second thoughts because a recent S-4 filing indicates a possible cash crunch, with holders of $422 million in convertible notes asking for their money back.

ValueScope Best Practices: Preventing These Types of Errors

Tesla SolarCity Valuation Error

Start with the End in Mind

Valuation professionals and their teams must adequately plan and supervise valuation engagements.  Also, regardless of the purpose of an engagement, accepted valuation standards require financial analysts to follow accepted valuation procedures.  The working paper file is a record of the independent advisor having followed appropriate procedures and standards.

The Devil is in the Details

Professional valuation tools may come in the form of purchased software or internally developed spreadsheets and templates.  As noted by Lazard, their errors were discovered weeks after they communicated their results to the Special Committee, in spreadsheets that they relied upon from SolarCity.

It has been our experience that most seasoned practitioners and valuation analysts create their own valuation models.  Internally developed tools allow the practitioner to incorporate advances in financial analysis techniques, build in new sources of data, and to take advantage of industry expertise.

However, it is critical to complete a thorough “math check” of computations by a suitably experienced colleague or peer.

Discounted Cash Flow Dilemmas

The discounted cash flow method estimates value on the basis of future cash flows over an investment horizon using empirical market data, macroeconomic and industry evidence, and the underlying fundamental trends for the subject company.  The DCF method then applies a present value discount rate, known as the required rate of return on investment, to the projected future cash flows, which results in an estimation of the net present value of a series of cash flows.

While simple in basic concept, the application of the discounted economic income method provides virtually limitless opportunities for errors.

The following are a few of the common errors that we have seen in others’ valuations that should have been caught and corrected during a proper review:

Connon Errors

  • Mismatching the Discount Rate with the Economic Income Measure
    • The most common error in the application of the income approach is using a discount rate that is not appropriate for the definition of economic income being discounted or capitalized.
  • Using a “Safe” Rate to Discount a Risky Return to a Present Value
    • While not the most common error, this certainly is one of the most egregious. Some analysts have even erroneously discounted a highly risky series of projected economic cash flows using the Treasury bill rate, or worse, the projected rate of inflation!
  • Proper Consideration of Income Taxes
    • Although many valuations deal with partnerships, S-Corps, and other “pass-through entities”, investors make decisions based on after-tax cash flows.
    • It is implicit that the market return data represents returns after corporate taxes but before personal taxes.
  • Applying a Levered Equity Discount Rate to a Debt-Free Earnings Stream, or Applying a WACC to an Equity Cash Flow Stream.
    • Net cash flows to equity (after interest) should be discounted at the cost of equity.
    • Net cash flow to invested capital (debt-free) should be discounted at WACC.
    • Confusing these two concepts mismatches the cash flows and the discount rates.
  • Actual Debt Rate in the WACC
    • A common error is to use a cost of debt that is incompatible with the capital structure assumed in the WACC.
    • If a company is highly levered, it may have very high borrowing costs.
    • In the valuation, however, the analyst may be using a much lower leverage in the WACC weightings, either because the company is undergoing a reorganization of its balance sheet or because an industry-average degree of leverage is appropriate for the purpose at hand. In such a case, the analyst should use a rate of interest appropriate for the lower leverage assumed in the analysis, rather than the company’s actual “high yield” rate.
    • This is analogous to the reasoning behind “relevering” beta to the assumed capital structure for determining the required return on equity using CAPM.
  • Projecting Growth Beyond What the Future Capital Being Invested Will Support
    • As businesses grow, they typically need additional capital expenditures and working capital to support the increased level of operations.
    • One of the advantages of using net cash flow as the prospective economic income measure is that it forces the analyst to explicitly consider these needs.
  • Projecting That Extrapolation of the Recent Past Represents the Best Estimate of Future Results
    • All economic, financial, and regulatory literature makes it clear that valuation is a function of expected prospective economic income.
    • The past history is relevant only to the extent that it may, in some cases, provide useful guidance in projecting future economic income.
    • Many “projections” are nothing more than a statistical extrapolation of past results, with no analysis of the extent to which the forces generating future economic income will or will not duplicate the recent past.

Avoiding Valuation Myopia

Tesla SolarCity Valuation Error

A key benefit of a robust review process is that “different eyes see different things”.  These benefits are magnified when the reviewers also have different backgrounds and expertise.  For instance, at ValueScope our two Ph.D.’s might see and suggest different points than would one of our four petroleum, mechanical, or electrical engineers on staff.  Likewise, having one of our three certified public accounts review the work may bring to light consideration of recent tax law or financial reporting required changes.  Our Chartered Financial Analysts (CFA’s) provide the analytical expertise for consideration of equities, debt securities, and derivatives.

While any review adds some value, a multi-disciplined review can add additional insights, increasing the accuracy and credibility of a valuation.  Although no one is perfect, math checks and quality reviews help to catch errors like those recently announced by Lazard.

Why ValueScope?

Tesla SolarCity Valuation ErrorValueScope is a leader in the application of financial and economic analysis for measurement of value, litigation support, and aiding growth of shareholder value.  Conveniently located between Dallas and Fort Worth, our firm’s single focus is providing quality business valuation and appraisal services.

ValueScope’s professionals have the experience and credentials to support key valuation positions for:

  • transactions,
  • financial reporting,
  • commercial bankruptcy,
  • litigation support, and
  • income, gift, and estate tax matters.

All of our Principals have given expert testimony in US Tax Courts, Federal, State, and County courts.  In addition to large and middle market companies, we have the experience and insights from working with the Internal Revenue Service and the Department of Justice.  This provides a strong base to develop expert opinions of value and economic damages that are credible and supportable to triers of fact.

Notes:

1 – Tesla Motors, Inc. Form S-4 Registration Statement

2 – CNBC Article, August 31, 2016, Reuters

3 – Fortune.com, 5 Things We Just Learned About the Tesla-SolarCity Deal, Jen Wieczner, August 31, 2016

4 – Seeking Alpha, Why the Tesla-SolarCity Merger Spread is Rising, September 6, 2016


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