Feb 26 2014, 7:26pm CST | by Forbes
Just after 3pm today I suggested that Tesla Motors, which issued a $600 million convertible just under a year ago, could and probably should do a bigger one now, with its stock up over 150% from the time of the first deal.
Well, what do you know. As soon as the market closed, Tesla announced a $1.6 billion, two- part (five-year and seven-year, $800 million each) convertible deal. I’d love to put myself in Elon Musk’s league with a “great minds think alike” comment, but let’s be real. Still, Branch Rickey said that luck was the residue of design. The design is simple: companies with high-flying stocks, particularly those like Tesla with grand ambitions, should take advantage of a market that appreciates their volatility and growth potential and is willing to lend them money to participate in that potential. Did I say money? I meant, cheap money. As in zero coupons, as with Yahoo and Akamai, or very low coupons, as with the new Tesla deals.
The key to the Tesla convertibles is volatility, far more than with either Yahoo or Akamai. Both of those companies are now established Internet moneymakers. Tesla is still on the come. But Tesla trades like a pony named Wildfire, and it looks more and more like the company will be around far longer than many people predicted.
You can use that volatility two different ways. If you don’t want to hedge, you can buy a piece of paper with reasonable confidence you will at least get your money back, along with some pretty meager coupons. But your upside can be substantial—anyone watching Tesla knows that. If you do want to hedge, by shorting the stock or using options, you can give yourself ways of making money as long as the stock makes big moves in any direction. Of course, you have to make sure that you can borrow the stock, and that the company stays in business. Otherwise, the premise of the favorable risk/reward collapses.
Since Tesla is still not quite at the point where people are ready to concede the company is thoroughly credit-worthy, investors need to apply a discount to the pure bond portion of the convertible. This is what the convertible would be worth if investors decided there would be no chance of getting any equity upside. Let’s stick with round numbers—it’s around 80 cents on the dollar for the five-year bond and 70 cents (maybe a little less) for the seven-year. So the option component has to be worth 20 cents on the dollar for the shorter bond and a bit over 30 cents for the longer one. When Yahoo did its zero-coupon convertible bond in November, by contrast, the bond was probably worth around 92 cents on the dollar even without any convertibility value.
Is Tesla volatile enough to justify the convertible pricing? Probably. Right now, it’s more than volatile enough. Implied volatility in near-term Tesla options has been in the mid-50’s, according to an article yesterday. To justify the new convertibles’ pricing, you need to assume “only” that the stock has 45% annual volatility over the life of the bonds. For those new to the game, this means, more or less, than you can expect roughly two-thirds of the time that Tesla stock will be somewhere between up 45% and down 45% in a year. Of course, it’s that other one-third of the time where things get really interesting.
In general, convertible investors don’t like to assume that stock volatilities will exceed 40% annually, even with companies that have exhibited much higher levels. This is because volatility tends to decline as companies mature, and because the nature of convertible models can lead to fairly horrific pricing errors when you overestimate volatility. (That’s a story for another day).
I expect this deal to go well—the convertible market needs new deals and Tesla has become a benchmark name. The pricing (likely around 0.5% coupon and 40% conversion premium for the five-year deal, and 1.5% coupon with a similar premium for the seven-year), is less attractive than the 1.5% coupon and 35% premium on last year’s five-year issue. But that was to be expected, given how well Tesla has done in the meantime, even though interest rates have risen significantly from a year ago. The stock will probably become somewhat more expensive to borrow, which could be a bit of a problem, but I think (see below) that most buyers will not be looking to hedge—though those buyers would surely prefer slightly more generous terms.
Ordinarily, you’d expect a stock to trade down when it makes the kind of move Tesla has made, then announces a big capital raise linked to the stock. But Tesla is up in the aftermarket. Does this make sense? Well, it could make as much sense as anything else involving this stock. First of all, the company is using some of the proceeds—it is unclear how much—to offset some of the convertible’s dilution by repurchasing shares. Perhaps more importantly, the convertible market is now dominated by unhedged investors, many of whom will be thrilled that they can put big chunks of money to work in a name they have come to know. Plus, the “gigafactory” story has a nice spin to it. Tesla is not my kind of stock, but people have made a lot of money in it, and I’m not ready to predict that the convertible issue means the game is over. It just means the company is being smart.
One other thing—don’t worry too much about the filing Tesla made yesterday saying that it could experience a “material adverse effect” from early conversions of the bonds it issued last year. Those bonds were trading today at about a 3-4% premium to their stock value. If you convert early, you throw away this 3-4%. Admittedly, this isn’t a lot of money relative to the kind of numbers Tesla has been putting on the scoreboard. But since there’s no good reason to convert early (holders of the old bonds still will participate in the shares’ upside, collect coupons that shareholders won’t get, and have more downside protection than shareholders against a massive drop in Tesla stock), it looks like the filing was just something the lawyers said Tesla had to do.
It says here this Tesla deal will exceed $2 billion when all is said and done.
Source: Forbes Business
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