What would you do if you had enormous amounts of cash available right now? Yes, maybe, hey maybe (😉), you would consider buying Tesla shares at $222. Especially if you have confidence in the executive capabilities of the company to achieve its targets in the coming months and years. Share buybacks are an ideal way to return wealth to the shareholders of a company.
We have just finished celebrating the long overdue credit rating upgrade of Tesla to investment grade by S&P (Moody’s didn’t even have the time to catch up, no surprise here), and we are already talking about the next hot subject: potential share buybacks by Tesla. Let me address why this all intertwines, the ideal timing, the typical way of execution and show how other mega cap companies have implemented similar strategies before.
Follow the breadcrumbs:
An increasing number of market participants has been advocating for share buybacks since late spring 2022, notably Leo KoGuan, the third largest individual shareholder of Tesla, and Gary Black, Managing Partner of The Future Fund LLC, whose $FFND ETF has Tesla as its largest holding, increasing its allocation most recently to up to 13.4%.
When asked at the annual shareholder meeting in Austin in August 2022 how Tesla plans to use its capital in coming years, Elon Musk said that “a sort of share buyback is possible,” depending on what Tesla’s future cash flow looks like. (Look out for these words in what follows.)
Whilst the upgrade to investment grade of Tesla by S&P was long overdue, the timing of the release on October 6th 2022 was more than surprising. Nothing obliged the rating agency to take action on this particular day, especially since prior delays of rating actions have always been explained by the need to see sustained business and financial performance going forward and usually happen after earnings calls. So why would S&P act a fortnight prior to the earnings release of Q3 2022, and base it on production numbers only?
In their (I can’t stress this enough) enthusiastic press release, S&P views Tesla “more favorably because it continues to demonstrate market leadership in electric vehicles, with solid manufacturing efficiency that supports strong EBITDA margins and sustained positive free operating cash flow … The improved view of Tesla's business supports its prospects for solid and sustainable free cash flow over the next few years.In 2022 and 2023, we expect Tesla to sustain FOCF to sales of over 10%, … backed by industry-leading EBITDA margins of roughly 20%, compared with our upside trigger of 18% and well above our 10% threshold for above average margins for automakers.” They continue to praise Tesla, its engineering prowess, and even acknowledge that Tesla’s “autopilot and full self-driving (FSD) technologies could sustain and improve its competitive advantages as it continues to make progress developing its FSD capabilities and remotely updatable artificial intelligence software.”
Haven’t heard enough yet? Let’s continue: “With over $18.3 billion in cash and cash equivalents at June 30, 2022, and our expectation of solid cash flow at least through 2023, we believe Tesla will maintain its strong liquidity … Tesla appears likely to sustain its recent track record of free cash flow beyond 2024.” S&P goes on to describe “Tesla's annualized EV production and delivery run rate supports over 50% volume growth in 2022 and exceeds 2 million units of deliveries over the next 12-18 months. EBITDA margins are 18% - 21% over the next two years, which we consider well above average relative to peers. Capital expenditures are around 10% of sales. Zero net debt; and Annual FOCF to sales of over 10% in 2022 and 2023.” And continues “We expect the company will proactively refinance or repay its minimal upcoming unsecured debt maturities given its strong credit standing and available cash and cash equivalents, which totaled over $18 billion as of June 30, 2022.”
The wording and detail of this report strongly suggest that there is now communication between Tesla’s management and the rating agency S&P. Add to this Elon’s tweet, five weeks ago, which shows his respect (or lack thereof) with regards to S&P’s principal competitor, Moody’s.
It is uncommon that a company would favor one rating agency over a second one. Usually issuers who need debt “accommodate” all three major agencies (please note that Fitch has never rated Tesla). And S&P and Tesla had some important past beef to digest: the inclusion in the S&P 500 index in Dec 2020 was long overdue, and the ejection in May 2022 of Tesla from the S&P 500 ESG index is an obvious embarrassment for S&P (here is my detailed video on that scam).
So Elon and team may have just decided to apply the old Latin rule of “divide et impera” (divide and conquer), not a surprise when one knows Elon’s appetite for history. We can only speculate on whether communication is happening (S&P’s press release does hint to it) and whether information has been exchanged which allowed S&P to better understand the company. And prepare for more.
Other mega cap companies did this before
Tesla may consider a strategy similar to the one Apple has been using successfully for the past nine years: Issuing debt to finance share buybacks.
Apple got upgraded to investment grade on April 23, 2013. S&P rated Apple’s debt AA+, Moody’s Aa1 and Fitch followed suit a couple of days later with an A+ rating. All three rating agencies were solicited by Apple to rate the company, so that Apple could simultaneously issue a major bond to help finance an increased share buyback, which was initially announced to be $45bn, and then amounted to $100bn in the two year span up to 2015. Warren Buffet had long advocated this strategy.
Apple’s main reason for issuing debt for share buybacks in 2013 was to avoid the 35% repatriation tax of overseas profits if they were to use parts of their then $145bn cash cushion. The Tax Cuts and Jobs Act in 2017 largely reduced this tax and Apple announced its plan to pay $38 billion in repatriation taxes when bringing $252.3bn in overseas cash back to the USA. And yet, Apple continued more recently its strategy to issue debt for share buybacks.
Here Apple’s stock buybacks over time. And right below the debt issuance chart over the same time horizon.
Apple is not the only mega cap company to issue debt to finance share buybacks. Microsoft has done so from 2008 to 2017:
Here are the corresponding charts for Tesla, showing share issuances (i.e. no share buybacks) and debt issuances, which have now nearly disappeared.
Going back to Apple, below is an interesting chart which shows how Apple reduced the number of outstanding shares from over 26bn to now 16bn. This corresponds to a reduction of 38.5% of outstanding Apple shares in the past nine years.
You certainly have no difficulty pointing to the moment in time (in April 2013) when the Apple investment grade rating was granted and bond issuance started.
(Please note the lower graph is not quarterly growth of the company, but growth of outstanding shares, measured on a quarterly basis.)
Will Share Buybacks limit other projects?
It is important to note that share buybacks are initiated after all other operating projects are funded. They are not a replacement of investments (new giga factories) or research & development. A company will consider share buybacks when the internal rate of return of purchasing back and retiring stock is larger than other financing options. It also sends the right signal to investors that excess cash is utilized in the best possible manner. Gary addressed it in this tweet, taking into account that a possible refinancing might cost today 5%, which is still significantly lower than the 23% return projected in 2030.
What are the advantages of share buybacks coupled with debt issuance?
Share buybacks coupled with debt issuance show that management is confident in the company's long-term prospects, and believes the stock is currently cheap while financing conditions are acceptable. This exact same strategy was announced by Apple at the Q1-2013 earnings call when they reported their first year-over-year earnings decline in a decade and provided fairly bleak guidance, yet CEO Tim Cook sounded optimistic about the company's financial prospects. For Microsoft the simultaneous issuance of debt for stock buybacks coincided with the beginning of the GFC.
It's understandable for investors to become frustrated when a stock's price drops significantly. However, if Tesla were to plan a large share buyback, there is a silver lining. The cheaper the stock is, the more shares Tesla will be able to repurchase and retire, thereby boosting future EPS whilst not decreasing the cash position.
How does it technically work?
A company can execute stock buybacks at any given moment in time, with the exceptions that firms are restricted from repurchasing their shares for two weeks before the end of a quarter and for 48 hours after releasing earnings.
No shareholder consent is necessary, the Board of Directors has this authority alone.
A stock buyback occurs when a company buys back its shares from the marketplace, usually by missioning one or multiple broker(s) to execute the share repurchases (can also be by tender to corporate stock holders, much more rare).
The effect of a buyback is to reduce the number of outstanding shares on the market, which increases the relative ownership stake of the stakeholders. As stocks trade in part based on supply and demand, a reduction in the number of outstanding shares often precipitates a price increase. Therefore, a company can increase its stock value by creating a supply decrease shock via a share repurchase.
Share buybacks can help companies reduce the dilution caused by employee stock option plans.
Gary Black summed it up well here (price was pre-split, now $233)
Why now?
First and foremost, the current stock price represents an excellent opportunity to buy an undervalued stock.
Second, the SEC is actively working on changing the reporting rules for share buybacks. Up to now, issuers typically disclose repurchase plans or programs at the time that the share repurchases are authorized by the board of directors. This announcement typically just announces the maximum amount desired, without giving precise details of timeline. Most share repurchases are then executed over time through open market purchases. Issuers are not required to, and typically do not, disclose the specific dates on which they will execute trades pursuant to an announced repurchase plan or program. Investors and other market participants normally do not become aware of an issuer's actual share repurchase-related trading activity until they are reported in an issuer's periodic reports, long after the trades have been executed. The SEC wants to change this to daily reporting.
Third, doing a share buyback before the year 2022 ends would not have any tax consequence for Tesla. This will change next year, as on August 16, 2022, President Biden signed the Inflation Reduction Act of 2022 into law and one of the provisions included an excise tax of 1% on share buybacks. The new rule goes into effect for repurchases after Dec. 31, 2022, that are valued at over $1 million.
And doing a share buyback would immediately increase the value of stock for investors, including Elon (!) and employees.
How much?
In mid-May 2022 (the stock was then hovering around $235 split adjusted), Leo KoGuan has called the numbers of $5bn of share buybacks in 2022, followed by a second tranche in 2023 of $10bn.
He confirmed this week, when the stock had fallen to similar levels:
My assessment is that the amount of the share buyback in 2022 should be much higher. We may never see TSLA in the $222 range again and should take advantage of the current favorable market and regulatory conditions.
Let’s continue to follow the breadcrumbs …
