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Summary

  • Many reports are circulating about Model S drivetrains needing to be replaced.
  • The cost of these replacements is likely to significantly worsen Tesla's operating losses.
  • The $15,000 ex-warranty replacement cost may significantly affect the resale value of the car and thus the cost of Tesla's "Resale Value Guarantee" program.

There are an increasing number of reports about Tesla's (NASDAQ:TSLA) Model S drivetrains needing complete replacements, either because of unusual noise or outright failures. Perhaps most highly visible is that Edmunds' test car recently received its fourth unit while Motor Trend went through two. If one reads the comments under these articles as well as numerous threads both on Tesla's own message forum (here and here are two of the latest) and that of the "Tesla Motors Club," it appears that these aren't isolated cases and that when performed out of warranty the repair costs approximately $15,000.

This potential drivetrain problem has significant negative ramifications for Tesla's profitability due to the expense of repairs performed under warranty as well as future liabilities incurred under the company's "Resale Value Guarantee" program. (The resale issue is likely to occur because as word of the problem spreads, secondary buyers may refuse to pay original owners Tesla's guaranteed price of approximately 48% of the initial cost of a three year-old car that may need a $15,000 repair-- or multiple $15,000 repairs-- at any time, thereby forcing Tesla to make up the difference.) Now let's try to quantify the impact of this on Tesla's income statement...

Tesla's most recent 10-Q states that Q1 2014 warranty expense was $9.3 million. If this was distributed among 28,000 cars (Tesla had delivered approximately 31,000 by the end of that quarter, but many of those came in late June and thus probably wouldn't have yet needed warranty work), it would come to $332 per car per quarter which is $1328 per car per year which-- over a four year warranty period-- would be $5300 in repairs per car. (Keep in mind that this was before the company started retrofitting the titanium undershields, a project first announced on March 28th; thus, presumably none of that expense was in this figure.)

Now, one might argue that these warranty repair costs were particularly high because they covered many cars built early in the production cycle that may have had relatively minor defects that might have been engineered out of the newer cars, and I agree that this is possible. However, as the bulk of the Model S's were less than a year old in Q1 of 2014, I think it's also reasonable to assume that as those cars age into years two, three and four of their warranty periods (and their mileage continues to accrue), their warranty expense may increase significantly, perhaps overwhelming whatever savings Tesla may enjoy on fewer later-production squeaky sunroofs, balky door handles, etc. Thus, I think it's reasonable-- based on the information in hand-- to guess that Tesla's current "lifetime warranty repair run-rate" of approximately $5300 per car (as outlined in the paragraph above) could wind up running 50% higher, to as much as $8000 per car.

Regardless of whether the lifetime warranty expense is $5300 or $8000 or somewhere in between, as of Q1 Tesla appeared to be accruing a "normalized reserve" of only approximately $2800 per car (adding $17.93 million to the reserve while delivering 6457 cars, with that $17.93 million figure excluding a one-time addition of $2 million more to pay for the titanium undershields-- hence the 10Q shows a total addition of $19.93 million). If this calculation (and the calculations above) are correct, Tesla could be "under-reserving" by as much as $2500 to $5200 per car, and if the company sells 35,000 cars per year that would be $87.5 million to $182 million which (assuming 143 million fully diluted shares) would negatively impact EPS by .61 to $1.27 per fully diluted share.

As mentioned earlier, in addition to the potential warranty under-reserve is a potential liability for the "Resale Value Guarantee." This program appears to apply to approximately 18% of the cars sold by Tesla, as according to the 10Q the company delivered 6457 cars in the quarter and 1181 utilized the guarantee. However, as there were no Chinese or UK sales in this figure, let's assume going forward that only 15% of the cars will use this program, as while China may become an increasingly large percentage of Tesla's sales, it's probable that as word of the drivetrain replacements becomes more widespread, an increasing number of buyers may use this guarantee as a form of "depreciation insurance." (It's also possible that Chinese and European buyers may themselves begin to demand the resale insurance provided by such a program, but let's put that aside for now.)

So if Tesla is on a 35,000-car annual run-rate and 15% of those cars take advantage of the resale guarantee, it would amount to 5250 cars per year. And if due to the drivetrain failure reports those used cars wind up selling for $15,000 less than Tesla currently anticipates, it would cost the company an additional $79 million per year, which is approximately .55 per fully diluted share in additional losses.

Thus, these two potential problems (a warranty under-reserve and a Resale Value Guarantee under-reserve) could combine into $1.16 to $1.82 a share in annual loss based on just a 35,000-car annual run-rate-- if Tesla sells more cars next year the loss contribution from these problems could be even greater. (To put this figure into perspective, the consensus estimate for Tesla's non-GAAP earnings this year is currently $1.18/share; thus, these problems could eliminate those earnings entirely and perhaps turn them into a significant loss.)

Perhaps at some point Tesla will provide more clarity as to the significance of the drivetrain problem. Those of you who own the stock should demand it.

P.S. While we're on the subject of Tesla's warranty, some of you may be wondering what percentage of battery life the company guarantees will be available during the battery's eight-year warranty period. Unfortunately, the answer to that question appears to be "as little as it can get away with." Here's the exact disclaimer in the 10-Q:

"The New Vehicle Limited Warranty... covers the battery for a period of eight years or 125,000 miles or unlimited miles, depending on the size of the vehicle's battery, although the battery's charging capacity is not covered... The battery pack's charging capacity is not covered under the New Vehicle Limited Warranty or any Extended Service plan."

So what exactly is Tesla guaranteeing? That the car will start?

Disclosure: The author is short TSLA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Source: Tesla May Have A Huge Unfunded Warranty Problem Due To Defective Drivetrains