A lot of news stories this year have centered on Tesla’s (TSLA Quick QuoteTSLA - Free Report) need to raise additional capital sometime in 2018. Many analysts point to the fact that Tesla is spending cash at a rate of approximately $700M per quarter and that the company’s remaining reserves -as of the end of Q1 2018 – were only $2.7B, suggesting less than a year of operations before additional cash is needed.

Goldman Sachs recently predicted that the company might need as much as $10B by 2020 to refinance existing expiring debt and fund normal operations.

CEO Elon Musk has fanned the flames of the debate by proudly announcing that the company will soon be producing 5,000 Model 3 autos per week by Q3 and that the company will be generating enough free cash flow to make raising additional cash unnecessary.

Who’s right? That remains to be seen, but let’s look at some scenarios in light of the recent 25% rally in Tesla shares.

Bond Ratings and Conventional Debt

The discussion about Tesla’s need to raise capital in 2018 really began in earnest in March when the company’s debt was downgraded by Moody’s. The official ratings announcement lowered Tesla’s Cumulative Family Rating from B2 to B3 and its Unsecured Note rating from B3 to Caa1. Each of these moves put Tesla one step lower into the non-investment grade – or “junk” – category.

Moody’s also noted that Tesla has approximately $1.2B in existing debt coming due in late 2018 and early 2019 and the fact that future unsecured debt would be subordinate to the company’s existing $1.9B credit facility.

The ratings downgrades are significant because many institutional investors have internal rules requiring them to hold bonds only above a certain ratings level. At lower levels, they may be forced to sell their holdings and/or precluded from investing in future issues.

Yields on Tesla’s unsecured bonds maturing in 2025 rose to nearly 8%.

Because of the high rates demanded by the market, conventional debt is probably the least likely scenario if Tesla goes to the markets to raise cash.

Convertible Debt

A convertible bond is essentially the same as a typical corporate debt issue except that it includes a provision for the owner to choose – at its discretion – to be repaid in common shares instead of cash. The specified conversion rate (quoted in shares per $1 of debt) generally implies a strike price above what the stock price is when the bonds are initially issued. The net result performs like a combination of a bond and an out-of-the-money call option. Because the bondholder gets riskless participation as an equity investor if shares rise, convertible debt pays a considerably lower interest rate than conventional debt.

Tesla’s most recent 5-year convertible bonds, issued in March of 2017, paid a coupon rate of just 2.375% and offered a conversion ratio of 3.05 shares for every $1000 in debt which implies a strike price of $327.50/share – 25% above the $262 market price of the stock at the time of issuance.

Obviously, if the holders of a convertible bond choose to exercise their conversion rights, the number of shares outstanding increases and current shareholders are diluted. In most circumstances, because the exercise price is above the market price - and thus the share price has to have risen for exercise to occur - the total value of the holdings of existing shareholders is higher even after accounting for the dilution.

This is why the recent rise in Tesla’s stock price is important to their liquidity position. When offering a convertible issue, the greater the exercise price, the lower the amount of dilution if it’s exercised.
In round numbers, if the conversion price is $400, 33% fewer new shares would be issued than if the price is $300. The effect is linear – the higher the stock price rises, the higher the conversion price will go and fewer shares will be issued to retire the debt.

The recent 30% rally in share price makes a convertible debt issue considerably more likely.

Secondary Equity Offering

The main difference between a convertible debt issue and a secondary offering of shares is that when new shares are offered, dilution of existing shareholders is guaranteed, but the company gets cash to fund operations or retire debt without paying a coupon for it.

This makes an equity offering advantageous for a company with a high share price, but also a low credit rating.

Secondary offerings sometimes have a depressive effect on share price both because of the dilutive effect and because they often occur during hard times when the shares have already been trading lower. With a stock like Tesla - which is growing quickly – a rising share price can be an important tool for a company to finance growth. With the apparent trajectory Tesla is on, it’s likely that shareholders would gladly accept a marginal dilution in their ownership interest if it means the company can continue its march to profitability.

The Prospect of No Capital Raise

As mentioned earlier, Elon Musk has stated that he believes that Tesla will not have to tap the equity or debt markets for funds in 2018. We previously examined how increased production of the Model 3 might prove him right. (Read that article here>>)

You’ll note that this describes what might be described as either a virtuous or vicious circle. The more Model 3s Tesla sells, the more cash they make. If the situation causes the shares to rise, it will be easier to raise cash in the debt and/or equity markets exactly when they need it least.

If production, margins and cash flow are disappointing, the company will have a more immediate need for cash, but if the shares are also lower, those funds will come at a greater cost.

We’re only a few weeks away from Q2 production numbers, at which point the situation should become much clearer.