In the Wake of Model 3 Demand, Will Tesla Motors Raise Some Fresh Capital?

By Markets Fool.com

Model 3 prototypes. Image source: Tesla.

Continue Reading Below

There's been a lot of chatter on Wall Street on whether or not Tesla Motors will raise some external capital. Generally speaking, secondary offerings are a negative event for shareholders due to the dilutive effects, but Tesla raised nearly $650 million last year and shares jumped instead of the usual selling pressure.

Model 3 reservations are now approaching 400,000, and it's going to be quite a challenge to meet that demand from a production standpoint. It's a very real possibility that Tesla may choose to tap the public markets for some more cash. But will it?

The case for tapping public markets
As usual, Tesla CEO Elon Musk has dropped some cryptic hints on social media. Not even Musk expected this type of response from the Model 3 unveiling. Musk openly admitted that the blockbuster reservation numbers will require a change of plans:

A week after the unveiling, Barclays analyst Brian Johnson speculated that Tesla might raise $3 billion due to Model 3 demand, so that the company could ramp even faster than initially planned.

Continue Reading Below

Model S production. Image source: Tesla.

There is also the issue of the federal tax credit of $7,500, which begins to phase out after Tesla reaches 200,000 units sold in the U.S. Tesla has to approach this threshold very strategically, and Musk suggests that it is. After hitting 200,000, there are several quarters where customers can still get full or partial credit.

It appears that Musk is willing to sacrifice near-term deliveries in order to postpone hitting 200,000:

But then wants to be able to maximize the number of deliveries before the credit expires, since there is no volume limit during the phase out period.

Increasing output in order to maximize deliveries within this window would be costly, but it would also make an external capital raise worthwhile because it would dramatically grow Tesla's customer base (who often become brand ambassadors) while strengthening their loyalty, knowing that the company went to extra effort to help them get the tax credit.

If Tesla is willing to take a hit on near-term Model S and Model X deliveries for the tax credit strategy, then some of the money for Model 3 manufacturing and tooling will have to come from somewhere else since S and X sales are intended to fund infrastructure investment.

At the same time, conducting a secondary offering at current prices of around $250 would have minimal dilutive effects on existing shareholders, specifically because Tesla shares are sporting sky-high valuations. For example, here is the dilutive effect for varying amounts of capital, assuming the offer priced at $250:

Capital Raised

Shares Issued

Dilutive Effect

$1 billion

4 million

3%

$2 billion

8 million

6%

$3 billion

12 million

9%

Data source: Author's calculations based on 132 million shares outstanding.

As an existing shareholder, I wouldn't mind taking a 3% to 6% dilutive hit if it meant that Tesla could ramp Model 3 faster. The 9% might be a little much, though.

And the case against
In the fourth-quarter shareholder letter, Tesla said it expected 2016 to have positive net cash flow without turning to external capital. That includes funding $1.5 billion in capital expenditures (down slightly from the $1.6 billion spent on capex last year). Guidance also calls for non-GAAP profitability. So Tesla doesn't think it needs external capital, although that was also before it knew how many people were going to want a Model 3.

Another general risk with the Model 3 production ramp is that Tesla doesn't want to overshoot its target. While there is a surge of initial demand, if Tesla ramps too aggressively and then demand wanes to more modest sustained levels, it might be left with excess capacity (which contributes to higher fixed costs).

Brace yourselves?
The more I think about it, the more an external capital raise makes sense for a number of reasons. But most important, I wouldn't view a secondary offering as a negative event. Much like last year, I think the benefits of adding to Tesla's cash position (currently $1.2 billion) in terms of production planning and customer satisfaction is meaningful while the cost in terms of dilution is very modest.

If Tesla pulls the trigger, don't be surprised if shares jump (again).

The article In the Wake of Model 3 Demand, Will Tesla Motors Raise Some Fresh Capital? originally appeared on Fool.com.

Evan Niu, CFA owns shares of Tesla Motors, andhas the following options: long January 2018 $180 calls on Tesla Motors. The Motley Fool owns shares of and recommends Tesla Motors. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.