Here's A Simple Explanation Of How Tesla's New Warranty Policy Affects Earnings

| About: Tesla Motors (TSLA)


Tesla updated its Model S drive unit warranty.

I've estimated the cost impact of this for Q3 and in future quarters.

I believe the cost to be immaterial to the long term future of the company, and that Tesla has made the right decision for both customers and shareholders.

Friday afternoon Tesla (NASDAQ:TSLA) announced an improvement to the warranty it offers on the Model S electric sedan. All cars ever sold will retroactively get an 8-year warranty on the drive unit.

This is great for customers, but it does open the door to questions from shareholders. Is this an expensive extra perk going forward? How will this affect the next quarter's financials? Aside from the near-term financial impact, was this a smart move for Tesla?

Elon Musk, in his blog post revealing this change, has written, "This will have a moderately negative effect on Tesla earnings in the short term." While those with a solid accounting background will understand exactly what this means, the mainstream media does not. So I'd like to offer a simple explanation of what's happening and how it affects the financial statements.

Here's how the accounting works:

When Tesla sells a car to a customer they book revenue based upon the selling price. They also record expenses related to building, delivering and servicing the car during the warranty period. These expenses are charged to the "cost of good sold" (COGS) line on the income statement. Gross margin, measured in percent, is what is left over between the sale price and the COGS.

Most of the COGS line pertains to actually building the car. A smaller dollar amount represents Tesla's estimate of how much it will cost to service the car under warranty during the warranty period. Tesla charges this warranty amount to the income statement with each car sold, and simultaneously creates an accrued liability (warranty reserve) on the balance sheet.

In other words, some of Tesla's cash has been earmarked for warranty repairs. Based on 10Q filings from the first half of fiscal 2014, Tesla sets aside about $2,700 per car for future warranty work.

That figure, $2,700, was an estimate based on the old warranty policy. Now that Tesla has retroactively improved the warranty for its customers, the company must calculate how much it would have set aside if they offered an 8-year warranty on drive units from day one. Obviously there will be some incremental cost for this above the $2,700.

The extended warranty, which covers years five through eight of the Model S life, is priced at $4,000. Let's assume the drive unit should account for ten percent of this fee. It's just a guess, and readers are free to apply their own guess instead of mine.

What this means to the financials:

Using this $400 estimate I arrive at two financial statement cost estimates.

First, and most important to long term shareholders, I figure the gross margin will be hurt by about 40 basis points (0.4 percent) because of the bump-up in warranty expense on each car sold from this quarter onward.

Second, and less important to long term shareholders, I estimate a one-time charge of about $16 million to account for the catch-up of the warranty reserves on approximately 40,000 cars sold prior to the current quarter. Remember that this is a one-time expense because Tesla must earmark another $400 (or substitute your own estimate) for warranty repairs compared to the company's previous estimates under the old warranty policy.

So when Elon Musk writes about a moderate short term effect on earnings he means the one time charge in Q3 and a smaller, ongoing effect on gross margin.

It's important to point out that this has no bearing on whether or not Tesla's prior warranty reserves were adequate. It is the change in warranty policy driving additional cost.

Investors are free to judge for themselves what these costs mean. Personally, given my long term focus, I believe this warranty change was the right thing to do for everyone involved. As a Tesla Model S driver I feel the company has put its money where its mouth is. As a shareholder I feel that it's important for a young company like Tesla to offer as much comfort to new customers as is reasonably possible. Happy, comfortable customers generate more referral business. We all know Tesla's biggest sales channel is word of mouth.

When Tesla reports Q3 numbers, you should expect the media to jump all over the additional warranty charge without understanding what it means. You'll know better. And for those of you thinking long-term what really matters is the actual reliability of Tesla vehicles and the effect it has on sales, not the one-time charge associated with catching up the warranty accrual on the balance sheet.

Disclosure: The author is long 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.