Analyzing and Mitigating Risks Faced by Tesla

Abstract

Understanding and evaluating different factors of risk a business face can help the business plan and operate strategically in order to be sufficient and avoid any loss to the business, especially for a multinational business like Tesla, where there are numerous risks affecting the business. In this paper, we aim to analyse the different risk factors Tesla is currently facing, evaluate any current strategies they are utilising to tackle those risks and provide business dissertation help and draw out relevant recommendations that the company can further adopt to mitigate and further minimise those risks. Through thorough study and evaluation of the risks and strategies of Tesla, it can be seen that there significant risk both external and internal to the company, however, the company only adopt certain strategies, for example using derivative tools to mitigate some of the risks, where as other risks do not have any hedging strategies against. Our findings and evaluations led us to form recommendations of different hedging tools that the business should consider adopting to minimize their risks, such as forward contracts, forward rate agreement and transfer of invoice.

Introduction

Risk management in multinational corporations has expanded greatly in the past decade and has led us to better understand the benefit of a well-built and structured risk management models and programme, and the reduction in those risk management models (Smith, 1995). Managing risk, especially in a multinational company such as Tesla is crucial for the operation of the business, not only does it help reduce cost and failure for the company, it also helps in adding value to the company (Smith, 1995). Multinational corporations face both external and internal risk factors, and when not handled effectively or successfully, these risks can cause a disruption to the operations of the business. Tesla is one of the leading clean energy automobile companies in the market, competing with fueled automobile companies like Audi, BMW etc, and also other leading clean energy automobile companies.

This essay will investigate the different risk factors Tesla is currently battling with and formulate relevant and appropriate risk management strategies and models they could adopt to reduce those risks.

Tesla

Tesla is an American clean energy motor company supplying electric cars, based in Palo Alto, California. They design and manufacture electric vehicles, also providing energy storage and systems and products. The company operates in two segments, automotive and energy generation and storage. Its energy storage products are provided to homes, commercials and utility sites, selling directly to customers through their websites and retails stores (Editorial, 2020). There are multiple production and assembly plants, located in the United States and Shanghai, China. Tesla also has multiple showrooms and retail stores across the United States, and also in Dubai and South Korea (Tesla Annual Report, 2019). As of 2019, they ranked the world’s best selling plug-in passenger car manufacturer, beating BYD Auto. Their global sales rose 50% in 2019. Its market capitalisation reached $166 billion on February 20 2020.

Risk factors affecting Tesla

Tesla INC is vulnerable to many risks which are mainly associated with their international operations and overseas expansion. Unfavorable regulatory environment, political turmoil, taxation laws, law & Order situation and labor laws in oversea territories put themselves in a susceptible position and that can harm the business activities of the company.

Governance risk

The significant risk regarding Tesla’s corporate governance is that any failure on a higher managerial level can result in negative publicity, and as a consequence harm the business’ reputation and operating results, as well as Tesla’s access to additional funds and capital (Tesla Annual Report, 2019). Furthermore, dependence on the public image of the CEO Elon Musk poses a risk to the firm's stock, making it extremely vulnerable to the actions of one person, who, having a broad public exposure, is subject to numerous public offences and is prone to making questionable statements (CBS, 2018).

The CEO of Tesla made a remark about taking the public company to the private, which misled the investors. Such remarks led towards allegations on Tesla, and significant corporate governance risk occurs in the form of losing trust from the investors.

It can create risks on the leadership positions as well where Musk might need to resign from prominent positions (Mont, 2018). Such events cause four of Tesla’s directors to leave the company, which proves the existing risk of similar events reoccurring in the future (Waters, 2019). Thus, the corporate governance risks revolve around leadership, dissatisfied investors as well as structural risks for Tesla.

The retirement of old board members might create an impact on the corporate governance of Tesla as it could lead towards the shaky situation within the organisation. New investors could come into the organisation, and it could bring instabilities if the interests are not aligned with each other or actual organisational philosophies (Hull, 2019). Thus, the changes in shares should be done painstakingly else it could lead towards interest based conflicts which are one significant corporate governance risk for Tesla. Moreover, such conflicts or risks could affect stock performance as well.

The governance risk of Tesla can also be witnessed during the event of an acquisition. It is analysed through Tesla’s annual report that the board of directors have the rights and power and delay the acquisition process, which itself creates confusion at governance levels. Such changes can cause again operation as well as acquisition risks and if not appropriately controlled then could lead towards the financial risks for Tesla. Further, the issues like cash burning, employee lawsuits, vehicle safety and manipulation in information also give birth to corporate governance risks. Its relationship with its stakeholders, especially government and the authorities, could be hampered negatively (Slane, Makower, & Green, 2018).

Political risk

Political risk for Tesla INC having international operations are due to numerous factors which can negatively affect Tesla’s income, growth, revenues, operations and /or complicate its current business strategy. Political environment includes factors like macro-economic issues in a country for example high or unstable interest rates, social problems like civil unrest. government actions, like seizing the most valuable assets, unstable economic trends, trade deficits, import & export policies etc.

In the case of Tesla INC, following are the external political factors which are significant and have huge impact on its business strategy.

Government encouragements for electric automobiles manufacturers (this is in the favor of Tesla)

G to G trade agreements

Political environment (stability / unstable in the countries in which Tesla is operating or planning to operate

Tesla Inc. has got the opportunity to support its business operations and achieve desired financial performance through the incentives which they have been receiving from various governments (Stobbe, 2019). Due to the minimized carbon emissions of its automobiles and other operations. Various countries have taken these policy decisions and encourage those companies who have low carbon emission products and environment friendly operations and abide by Environmental, social governance framework. Few of them are China and Russia (apart from other European countries). Tesla received favorable responses from these countries. Also, Tesla has ensured that they must enter and expand their business in relatively stable and growing economies.

Liquidity risk

Even though Tesla doesn’t have sufficient liquidity it meets that criteria’s of the industry therefore it can be said that the automotive industry has high liquidity risk, and Tesla’s liquidity is adequate in the industry but company carries a higher risk of bankruptcy compared to other automotive companies for being a new innovative auto company, see Appendix 1. It should be noted that for the company to increase its liquidity it will need to increase its sales, according to an annual report Tesla’s account receivables are negative 367$ million. Tesla relies on new gigafactories in Shanghai and Nevada(Annual Report, 2019) but to do that they need to attract other sources of liquidity and cash flows. Investors have high expectations for Tesla according to ( Forbes,2020) as the share price of Tesla hitted all time high, as a result topping the expectations therefore Tesla can still hope to attract more sources of liquidity. Having a low liquidity makes Tesla to be heavily exposed to liquidity risk.

Credit risk

Credit risk is the possibility of a loss result from borrowers inability to pay the lenders. Tesla’s great potential for future growth and its unpredictability meant that it is a high-risk, high-reward stock. It has a B- rating on S&P. Up till November 2019, the company’s total debt outstanding was 13.3 billion and has a FRISK score of 3. (Creditriskmonitor.com, 2020) This indicates that it is at high risk as is designated in the “red zone”. One of the characteristics of being in the red zone is high financial leverage. By looking at the recent financing, Tesla has a total debt outstanding of $13.3 billion, if debt financing costs trend higher, it would place further pressure on pre-tax profit and free cash flow (Creditriskmonitor.com, 2020)

Tesla has over $9 billion in debt with maturities ranging from 2018 to 2049

Tesla’s August 2017 5.3% debt that is due in August 2025 is trading at a 12% discount, or 88 cents to the dollar (Forbes.com, 2020)

In February 2019, Tesla has $920 million in convertible senior notes set to expire on March 1, at a conversion price of $359.87 per share, but it’s stock hasn’t traded above $359 for weeks and was closed at $297.86 on Tuesday. (Kolodny, 2020) Tesla would not have to pay the debt in cash if the shares were valued at conversion price, because then the bonds could be converted into Tesla stock.

By looking into Thomas Reuters, Tesla’s has an account receivable ratio of 16.9. Compared to industry average of 88.8, we can conclude that they are relatively efficient in collecting receivables. On the other hand, the average account payable ratio for Tesla is 64, and the industry median is 41.5. This indicates that the company has sufficient cash to operate and pay necessary debt. (Appendix 2)

Interest rate risk

Fluctuations of interest rate impacts the cash flow that the company produces. It is important to take into consideration the capital structure of the company, the larger the debt amount of a company the more it is impacted by interest rates. Corporate bonds that are issued by the company lose value when interest rates rise.

In 2019 Tesla’s debt to equity ratio is 3.95, which makes the company heavily dependent on debt. As interest rates are hitting all time low(Annual Report,2019), the risk of interest rates to rise is high. Tesla issues fixed rate corporate bonds, with maturity of 5 years that offer 2% coupon 10 years with coupon of 5% and 3 month risk-free treasury bill is 1.44%(ThomsonReuters, 2020) and are issued in the USA. Tesla also issues eurobonds that helps them to diversify risks. The risks are the possible rise of interest rates in the US, as major amounts of borrowings of Tesla are in Dollars.

Foreign exchange risk

Due to its large overseas operations, Tesla INC is greatly exposed to exchange risk movements, because when the supply chains went beyond borders, currency exchange risk turned out to be a key consideration for every company (Gilson, 2017). For example, during 2016, the Japanese yen was appreciated against dollars, although this is a pure external effect, but this had a huge impact on Tesla, as the price for imported batteries from Japan recorded huge spike and resulted in higher cost of production and lowers the profitability. The situation would be reversed if the dollars were appreciated against yen.

The policy consideration, Tesla INC management were applying to mitigate the risk of currency exchange risks are as follows:

Re-examine the supply chain for the company, increase reliance on local suppliers e.g instead of buying batteries, steel, fleet, oil & gas and other elements from abroad, try to minimize dependence on overseas suppliers and import only those elements which are not available in the local market.

Trying to make agreements to deal in local currency

Dealing in currency derivative to hedge the currency exchange risk (But derivative usually create other risks also)

Weighted Average Cost of Capital

The current share price of Tesla INC is US$ 914 with a total market capitalization of US$ 169 Billion. The capital structure of the company is heavily skewed towards the equity side and has the great capacity to raise long term debts. The WACC calculations are as follows:

Analysis on risk management strategies and recommendations for Tesla

Foreign exchange risk management strategy of forward contracts is recommended to hedge the risk. Forward contracts eliminate uncertainty in the exchange rate risk as a fixed currency exchange rate is agreed on for a set date and time for future transaction. Although forwards can hedge against currency losses in the case that the currency value depreciates, it also eliminates any possibility of profit if the currency value appreciates.

Tesla currently doesn’t adopt any hedging strategies against their foreign exchange risk. Over the past year, the company has seen a gain of $48 million and $2 million in foreign currency in their income (expenses) in 2019 and 2018 respectively (Annual Report,2019). According to Tesla's annual report, 2019, the company strongly believes in strengthening the US dollar therefore doesn’t adopt any strategy for hedging. We believe that tendencies in which exchange rates move may change therefore it is recommended to use hedging instruments to protect Tesla from exposure of Yuan. According to Appendix 3 over the two year horizon Yuan depreciates against the US dollar. Bloombers, 2019 states that the fall of Yuan has decreased the value of Tesla's earnings in China that are converted to dollars by 9%. Currently Tesla imports cars to China from the US, and sells approximately 6,400 of Model 3 for 323,800 Yuan(Kolodny, 2020). The strengthening of the US dollar, or depreciation of Yuan will not be beneficial for Tesla's operations. We recommend Tesla a 90 day Yuan/US forward contract for 1920 models of Model 3 which is 621,696,000 yuan. A 90 day Forward may secure and improve Teslas performance that will be reflected in Quarter reports, and a hedge of 30% of Model 3 is appropriate proportion. We can assume that a weak performance of Yuan was due to the Trade War between China and the USA, until the changes of circumstances Tesla may adopt Forward contracts.

Looking at Tesla’s interest rate risk strategies, according to their annual report of 2019, they use derivative tools to hedge some of their risks. However, using these might not be effective enough. Another strategy Tesla can look into is the use of forward rate agreement. This agreement allows the company to agree to borrow at a set interest rate on a set period of time with the lender. The FRA is a flexible hedging option for both parties, and can be closed by an offsetting FRA at a new price (Fincad.com, 2020). Tesla can diversify by issuing additional eurobonds therefore it will limit its US interest rate risk exposure.

The company is also currently exposed to liquidity risk. Looking at their cash flow for the recent year, it states that the current accounts receivable is at -$367 million, which means that money is owed to customers and this directly affects the firm’s cash flow negatively. Tesla should focus on improving its products, as one of the possibilities is that customers demand refunds. One possibility is to cut its expenses, and investments in R&D in order to focus on main operations.

On the credit risk side, the strategies that Tesla have taken to minimise the amount of debt is by negotiating with suppliers for cost reduction. It also adopted a massive restructuring by laying off workers and reducing production of old, high-priced car models.

Political risk is another risk factor the company can face when government regulations changes, a way that the company could mitigate this risk is through political risk insurance where it covers losses the business incur in the event of political circumstances.

Tesla should consider governance risk as it may damage the companies reputation and will lead to loss of trust from investors, customers and government. Published information should be better controlled and should not involve personal opinions. The CEO of the company should be restricted from the use of social media.

Bibliography

Editorial, R. (2020). TSLA.O - Tesla Inc Profile | Reuters. [online] Reuters.com. Available at: https://www.reuters.com/companies/TSLA.O [Accessed 28 Feb. 2020].

Smith, C. (1995). Corporate Risk Management. The Journal of Derivatives, 2(4), pp.21-30.

Gilson, S.C. and Abbott, S., 2017. Tesla Motors (A): Financing Growth. Harvard Business School case study (218-033).

Creditriskmonitor.com. (2020). Tesla Credit Update: Subscriber Concerns Persist, Record Debt | CreditRiskMonitor. [online] Available at:

Kolodny, L. (2020). Tesla faces a cash crunch with a $920 million debt payment due Friday. [online] CNBC. Available at:

Hull, D. (2019). Tesla board shake up seen as important step in governance. Retrieved February 27, 2020, from EconomicTimes:

Slane, J., Makower, S., & Green, J. (2018). Corporate governance case study: Tesla, Twitter, and the Good Weed.Retrieved February 27, 2020, from Harvard law school:

Kolodny, L. (2020). Tesla Shanghai factory won't mass produce Model 3s until mid-2020, JL Warren says. [online] CNBC. Available at:

Fincad.com. (2020). Forward Rate Agreements | Derivatives Risk Management Software & Pricing Analytics | FINCAD. [online] Available at:

Appendix

Current Ratio of Tesla has experienced an unstable performance of being above 1 in 2016, and dropped below 1 in the years of 2016 and 2017. In 2019 Tesla generates enough current assets to cover its short term liabilities. Quick ratio from 2016 to 2019 is below 1, which means that the company doesn’t have enough liquid short term assets. Operating Cash Flow Ratio is negative in 2016 and 2017 because Tesla suffered losses in operating activities, and the company started to produce profit in 2018 that shows in positive Op. ratio in 2018 and 2019.

To determine if the ratios of Tesla are appropriate in the industry, ratios of General Motors and Ford Motor are calculated. Ford shows best results in Current ratio and Quick Ratio, General motors is below 1. All 3 companies can’t produce enough cash flow from operating activities that are shown in ratios.