Improper revenue recognition is the number one method of accounting fraud among ill-intentioned executive management. As a result, investors like myself have a natural distrust of companies that engage in quirky revenue reporting practices, even when those numbers are explicitly presented in non-GAAP form. While there are no signs of Tesla (NASDAQ:TSLA) engaging in improprieties in the GAAP accounting treatment of its resale value guarantee program (in fact it has been historically conservative), the time has come, however, for it to end the program for shareholders' sakes. Doing so accomplishes two things: It shifts future liabilities from Tesla back to the consumer, and it cleans up Tesla's investor reporting, by eventually shrinking the swelling gap between non-GAAP and GAAP reporting. These are both results that bulls and bears should applaud, and the quicker Tesla makes this move, the better off everyone will be.
Resale Value Guarantee Refresher
While this topic of discussion was beaten to death in the early years of its adoption, newer Tesla investors may not yet have been exposed to the concept. In short, Tesla had a problem early on, when it was just starting to get its legs underneath it. It had a state-of-the-art car with awesome technology, but it was also incredibly expensive and the technology was not something people had seen or used before. New things make consumers suspicious, especially expensive new things. Consumers wanted protection that they were not buying a vehicle that was going to be worthless in a few years through no fault of their own.
No worries, Elon Musk quickly came up with a plan. What started out as a simple guarantee of maintaining residual value versus a competitor's luxury vehicle eventually morphed into an even stronger guarantee. Musk guaranteed that if a consumer bought a Tesla today (meeting certain financing conditions), he'd give them 50% of the base price back after three years, with a little less return of value on optional upgrades on the vehicle. This was a calculated move that paid substantial dividends for Tesla as it assuaged the fears of many buyers. Those who were once on the fence on forking out the money for a Tesla suddenly had a reason for being a little more confident in making that purchase.
From a GAAP accounting perspective, this created a problem, however. While Tesla receives 100% of the purchase upfront in cash, in the minds of accountants everywhere, the company also had a potential future liability in the form of that guarantee which may one day be called on.
As a result under GAAP, a car sold by Tesla today with the guarantee recognizes 50% of the revenue once the lease expires, with the rest of the 50% accumulated via straight line method (equally spread) over the three-year guarantee. If the guarantee is voided in any way, (car title is transferred to another party, loan paid off early, etc.) revenue can be recognized early as the guarantee is no longer a factor.
Before the Tesla bulls turn on me for bringing up this issue again, yes, Tesla vehicles currently hover in the 55%-58% retained value range after three years. This makes the likelihood of calls on Musk's guarantee offer low. However, there is no surety that this retained value won't change at some point in the future. Factors out of Tesla's control, such as a global recession, or factors within Tesla's control, such as manufacturer defects, could all push this retained value down. This is a burden that shareholders simply should not bear, and presents undue risk for a Tesla shareholder that already is giving the company immense leeway in regards to future company value. Shareholders are already bearing the price of valuing a company that currently makes no GAAP profit at north of $35B, making the equity a tempting target for dilution by management to raise cash. It simply doesn't need another overhang.
Resale Value Guarantee Liability Growing
At this point, Tesla has nearly 20,000 cars covered under the program - a total liability of $1.3B at 2015 year-end. While the value of Tesla vehicles will certainly not fall to zero, even a drop to 40% retained value would accrue a liability in excess of $150M once the loss between guaranteed value and actual value are realized, along with the inevitable costs of liquidating the cars in the used market. Shareholders do need to keep in mind that Tesla retained value rates are well above market averages for peers, and it's likely that those rates will bear the greatest fall in the event of pain for Tesla.
Additionally, Tesla is still growing. Sales are guided to grow 60%-80% in 2016, which means that liability on the balance sheet will likely breach $2B. As a result, the nominal dollar value gap between non-GAAP revenue and GAAP will continue to balloon.
The impact of the Model 3 release on the guarantee is unknown, but it certainly does not make sense to extend this offer to these buyers. Value retention on EVs is much higher in the luxury category than in the base, and tiering the guarantee will do nothing but divide Tesla owners into two distinct camps, something I believe Elon would like to avoid.
Overall, this program is nothing but a headache for shareholders, and it is time for it go. While the program was a shot in the arm for Tesla when it did not have the stellar reputation it has now, the company is now well-known with consumers. Usage of the resale value guarantee has fallen by consumers, with more and more shopping around for lower interest rates rather than going with Tesla-directed financing options that qualify for the guarantee. I'm hoping this program is wound down. Despite the short-term ammunition it might provide for Tesla bears, in the long term, it's the right decision for shareholders.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.