I. Solar Bond Prepayments, Part Deux

A. Introduction

I wrote recently about SolarCity’s prepayment of certain Solar Bonds. You can find the article here. At the time, SolarCity had filed only a Form 15 terminating the registration of some Solar Bond issues, but had made no disclosures about either bond payments or prepayments.

I speculated SolarCity’s prepayments were made to avoid a non-monetary default under its important $373 million secured credit loan line, and discussed how the prepayments were consistent with the idea that SolarCity’s merger with Tesla (NASDAQ:TSLA) was in reality a bailout of a failing company to serve the interests of their controlling shareholders.

A few days after my article, Bill Cunningham picked up the thread with a valuable dive into the intricacies of SolarCity’s debt stack (Tesla Admits SolarCity Is Undergoing A ‘Financial Restructuring’).

Bill wrote without the benefit of Tesla’s Proxy for its June 6 annual shareholders meeting. That Proxy adds further detail and clears up a few more mysteries.

Let’s summarize where things stand with the Solar Bonds and then discuss the implications. First, though, let’s pose this question:

B. Why did SpaceX buy SolarCity bonds in the first place?

SpaceX is privately owned and has a business entirely unrelated to that of SolarCity. So, why did SpaceX purchase some $165 million of Solar Bonds?

Elon Musk’s explanation to The Wall Street Journal last April (shortly before the Tesla merger with SolarCity was announced) was that the bonds were an “excellent investment.”

Really? SpaceX had no better place to park its money than in the unsecured bonds of a struggling enterprise?

C. SolarCity just repaid $90 million in Solar Bonds to SpaceX.

In my earlier article, I noted SolarCity had terminated the registration of $100 million in Series 2016 Solar Bonds, and that SpaceX held $90 million of those bonds which were due this past March.

I wondered whether SpaceX demanded payment in March, or instead agreed to extend the maturity of the bonds, as it did for SolarCity the first time they came due.

We have our answer from the Proxy:

In March 2017, the 4.40% Solar Bonds due March 2017 held by SpaceX were repaid in full…

D. Will SolarCity in June repay the $75 million of Solar Bonds still held by SpaceX?

SpaceX holds $75 million of 4.4% Solar Bonds due on June 10.

Will SolarCity repay those bonds when they come due in June or, instead, as it has done in the past, will SpaceX extend the maturity for a year so that Tesla would be able to make use of the badly needed cash for its capital projects?

The Proxy offers no answer. However, based on SolarCity’s payment to SpaceX of the $90 million in Solar Bonds due in March, it’s a safe bet SolarCity will also pay SpaceX for the $75 million of Solar Bonds maturing in June.

E. What has become of the $100 million in Solar Bonds owed to Musk and the Rive brothers?

SolarCity’s Form 15 terminated the registration of the Series 2016 6.5% bonds maturing in February 2018. Elon Musk owned $65 million of those bonds, and Lyndon and Peter Rive owned another $17.5 million each.

There were various news reports about these bonds, including an article on the Bloomberg site based on information from a “person familiar with the matter”:

Elon Musk, Lyndon Rive and Peter Rive saw their approximately $100 million of bonds converted to private SolarCity debt, according to the person, who wasn’t authorized to speak publicly.

The Proxy offers this disclosure:

In August 2016, SolarCity issued $65 million in aggregate principal amount of 6.50% Solar Bonds due February 2018 to Elon Musk, upon the same terms and conditions offered to the public. In April 2017, Mr. Musk agreed to exchange the 6.50% Solar Bonds for a $65 million promissory note bearing interest at 6.5% issued by SolarCity on substantially identical terms, including the remaining maturity.

The Proxy offers no information about the bonds held by the Rive brothers, but I think it’s likely that the Rive brothers, too, have accepted promissory notes in lieu of the Solar Bonds.

The Bloomberg article also offered this:

“Musk’s policy has been to not take money out of the business, and a conversion instead of liquidation would be viewed as more shareholder friendly from a governance perspective,” Michael Morosi, a renewable energy consultant and former analyst at Avondale Partners LLC, said in an email.

Did I miss something? Elon Musk has a “policy” of “not taking money out of the business?”

That certainly was not his policy last year when he sold $600 million of his Tesla stock, and trousered approximately $125 million in after-tax cash.

Contrary to Morosi’s spin, exchanging bonds for promissory notes with the exact same terms tells us nothing about whether Musk and his cousins will or will not take money out of the business. And why is taking $165 million “out of the business” for SpaceX any different, from a Tesla shareholder point of view, from Musk taking money out of the business?

Either way, it’s an insider tapping Tesla cash to pay obligations SolarCity was unable itself to pay.

Given that the promissory notes accepted by Musk and the Rive brothers have exactly the same terms as the Solar Bonds they surrendered, it means their notes are payable next February.

Will the noteholders demand (and, given Musk’s control of Tesla) receive payment in full? We’ll have to wait until next February to see. However, if that’s not what Musk intends, then he just passed up an opportunity to make a favorable public relations splash by announcing that he and his cousins had extended the maturity of the debt.

F. What was the point of the Solar Bond prepayments?

So, why did SolarCity prepay some Solar Bonds?

I think my original thesis holds up: SolarCity’s secured credit facility requires it to maintain a minimum amount of “unencumbered liquidity.” SolarCity was in danger of violating the covenant. Debt represented by “Solar Bonds” counts against the threshold, but the debt represented by a mere promissory note does not. So, the Solar Bonds needed to be paid.

Tesla devised a solution, with these elements:

  • Repay the $75 million in Solar Bonds due to SpaceX in March;
  • Prepay $20 million or so of Solar Bonds held by retail buyers (Bill Cunningham did yeoman’s work in establishing that amount, and determining that the face amount of Solar Bonds sold was smaller than the issuance amounts in the registration statements);
  • Exchange the Solar Bonds held by Musk and the Rive brothers for promissory notes (truly form over substance, as both obligations are unsecured); and
  • Repay the $90 million in Solar Bonds due to SpaceX in June.

With $265 million of the Solar Bonds retired by reason of the payments to SpaceX and restructuring by Musk and the Rive brothers, was it really necessary to prepay the $20 million? Probably not, but prepaying a few retail holders gives the transactions less ugly cosmetics.

My guess is that at least some of the cash needed for the payments and prepayments was down-streamed to SolarCity from Tesla. Regardless, it’s cash no longer available to the parent company, with all its immense capital needs of Model 3 development, Superchargers, Service Centers, and more.

G. Implications

As I have long maintained, one of the principal motivations of Tesla’s “merger” (more accurately, a business combination) with SolarCity was to make sure SolarCity could repay its $165 million of Solar Bond obligations to SpaceX.

After SolarCity’s offer of the Solar Bonds failed to attract significant retail investor interest, SpaceX decided to buy the bonds itself.

Ask yourself: Who made that decision for SpaceX? There’s only one correct answer. Like those of Tesla and SolarCity, SpaceX’s directors are supine and deferential, allowing Musk to make all key decisions.

As 2015 proceeded, it became increasingly clear SolarCity was an ineptly managed enterprise with a failing business model and endless cash burn. SolarCity lacked Tesla’s sex appeal to equity investors and could not issue more stock. SolarCity was on the cusp of insolvency.

SolarCity was unable to repay the Solar Bonds held by SpaceX when they first came due. The solution was for SpaceX to “pretend and extend” in hopes the bailout merger would happen.

Now that the merger has closed, Tesla is able to funnel money to SolarCity which, in turn, is able to funnel it to SpaceX.

I’ve written before that we would know a good deal about the character of Elon Musk, and the true purpose of the SolarCity merger, by whether (1) SpaceX’s Solar Bonds that came due in March were paid, (2) SpaceX’s Solar Bonds coming due in June are paid, and (3) SolarCity’s $100 million debt to Elon Musk and the Rive brothers is paid next year.

We have our answer on question (1). I’m confident that the answer to question (2) will be along the same lines.

As to question (3), much depends on Tesla’s share price when the maturity date is reached next February. If it’s above $200, I believe SolarCity will repay Musk and the Rives. If it’s below $200, Musk may decide he can’t afford to do so, as the consequence would be a further share price decline.

II. Other Proxy Disclosures

In no particular order, a few other disclosures in the Tesla Proxy:

SolarCity’s Zero-Coupon Convertible Bonds

As Bill Cunningham detailed, SolarCity has three issues of convertible bonds, each of which is now convertible to Tesla stock.

Two of those issues are interest-bearing and have conversion prices far above Tesla’s current share price. The third is a zero coupon (non-interest bearing) issue due December 2020, with a strike price of $300 per share.

The Proxy indicates such bonds are convertible to 33,333 shares of Tesla stock, but does not indicate any such conversion right has been exercised.

A revocable trust formed by Elon Musk holds $10 million principal amount of the zero-coupon bonds. Another $103 million of those convertible bonds are held by third parties or other insiders.

It’s worth noting that, at current Tesla share prices, some holders may have decided to exercise the conversion option.

Kauai Island Details

The Proxy also discloses that Tesla recognized $18 million in revenue from its sale of Powerpack products to SolarCity for installation at the Kauai Island Utility Cooperative project in Hawaii. The Proxy does not disclose the cost of goods or net revenue.

Validation of a Model 3 Beta Prototype

The Proxy notes that the “Beta Prototype of Model 3 was validated in Q1 as a performance milestone for Musk options vesting.”

III. Thanks for the help…

I’m a long way from fully understanding SolarCity’s capital stack. Any progress I have made is thanks in large part to the work of Seeking Alpha contributors Bill Cunningham, EnerTuition, and robiniv, with a big assist also from Seeking Alpha member notasmidgeon.

I haven’t yet penetrated to the heart of the labyrinth, where dwells the fearsome Minotaur of SolarCity debt: Variable Interest Entities (VIEs). It is through the wicked alchemy of VIEs that Tesla is able to make SolarCity’s massive operating losses appear much smaller than they actually are.

I have a capable tour guide through this maze, Seeking Alpha member paperstreet, and hope one of these days to scratch out an explanatory piece soon. A sort of Idiot’s Guide to VIEs.

Disclosure: I am/we are short VIA OPTIONS.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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