Tesla's Warranty Estimates Matter

| About: Tesla Motors (TSLA)

Summary

Properly estimating warranty provisions is important for reporting accurate profit.

Inaccurate warranty provisions can shift profit between reporting periods.

Tesla has added $21M to previous estimates warranty accruals.

In the past, we've written a few articles examining Tesla's (NASDAQ:TSLA) warranty provisions and attempted to estimate what Tesla's true warranty costs might be. I received several emails and got many comments on one article in particular. Most of the discussion centered around the methodology we chose to use to examine Tesla's warranty provision practices. I want to explain our methodology and thinking behind how we parsed Tesla's warranty numbers as well as update that article with the latest information from Tesla's past two quarters (2015Q4 and 2016Q1). It's worth noting that Tesla appears to have reclassified some revenue from its "Automotive" segment into its "Services and Other" segment since our last article as well so the numbers from FY2015 through FY2013 will be different from our previous article.

Parsing Warranty Accrual Information

Let's first look at Tesla's warranty information and what each line item signifies. Below is the warranty information from Tesla's latest 10-K.

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Accrued warranty - beginning of the period: This is the total amount of accrued warranty provisions Tesla carried on their books at the start of the fiscal year. Basically, Tesla estimates they will perform $129M worth of warranty work from the beginning of the year until the end of time on all the vehicles they have sold to date (the beginning of their fiscal year).

Warranty costs incurred: These are the actual warranty costs Tesla incurred during the 2015 fiscal year. Tesla performed $52.7M worth of warranty work which is deducted (shown as a negative number) from the accrued warranty balance.

Net changes in liability for pre-existing warranties, including expirations: This is the line item Tesla uses to adjust its existing warranty provisions for all vehicles sold prior to fiscal 2015. If vehicles were turning out to be more reliable than Tesla thought, Tesla would adjust the accrued warranty balance downward (i.e. record a negative number). If vehicles were turning out to be less reliable than Tesla first thought, Tesla would need to add to the accrued warranty balance. In this case, Tesla made a minor change and adjusted the accrued warranty balance upward by $1.4M.

Provision for warranty: This is where Tesla records its estimated warranty expenses for all of the new vehicles it sold in fiscal 2015. Here Tesla estimates it will have $103M in warranty expenses over the lifetime of the vehicles it sold in fiscal 2015.

Accrued warranty - end of period: This is accrued warranty balance at the end of fiscal 2015. We take the beginning balance and make all the adjustments we previously talked about and that gives us our ending warranty accrual balance which in this case is $180M.

Our Methodology

Now that we understand what each part is, let's talk about why we chose to just look at the provision for warranty line item and ignored the changes in previous warranties. The easiest way to explain our logic is to show you a hypothetical example of two versions of the same company's warranty practices.

In our example, we have a high growth company that goes through a high growth phase with revenue increasing 20% each year before entering a steady state phase. In the example, we will look at an abbreviated version of a sample income statement that shows revenue, cost of goods sold (COGS) less any warranty accruals, warranty provisions and any warranty adjustments, SG&A expenses, and net income. To make things simpler, our company has no financing expenses and lives in Grover Norquist's fantasy land and pays no taxes.

Our company's cost of goods sold (ex-warranty accruals) is 60%. SG&A is a flat $100,000 each year. The company's true warranty work performed is 4% of revenues.

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In our first example, our company has an irrational rosy outlook on how much its warranty costs will be and estimates them to only be 2% of revenues, not the 4% they will actually be. However, it will eventually have to perform all of the warranty work even if it underestimated how much it would perform. So, in the next fiscal year, we assume that the warranty work does indeed get done and the company has to adjust its warranty accruals.

After a couple of years pass, the company (or its accountants) recognizes the true warranty costs and begins to correctly estimate provisions. By the last year in our example, no adjustments to warranty accruals are needed because the company got everything correct the first time around. In our example for the six years shown, the company earns net income of $832,800 and had total warranty provisions of $159,200.

Now let's take a look at the same company, except this time, management is accurate at forecasting warranty provisions at 4% right off the bat. All the other numbers are the same as the previous example.

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The company earns the same $832,800 in net income as before and has total warranty provisions of $159,200. Exactly the same as before.

So why does it matter? Well, look at the net income the company reports during its high growth phase in scenario one versus scenario two. In year one, there is $90,000 in net income versus $80,000, in year two. We have $118,000 in net income versus $116,000, and in year three, we have $161,200 in net income versus $159,200. By incorrectly estimating true warranty costs, the company is able to appear more profitable until it actually begins estimating warranty costs accurately. The difference is even more pronounced when a company is growing rapidly. Warranty costs from one year may not be recognized until two, three, or even more years in the future. When they are recognized through the adjustments to a company's warranty accrual balance in future years when the company has greater revenue, the adjustments will appear smaller in context.

As we see in the example, over time, the warranty costs will be equal. The same thing applies to Tesla, over time its reported warranty provisions and adjustments will converge on their true value. What we want to do is determine if Tesla is following the path of the company in our hypothetical example in scenario one or if its estimates are accurate and it's more like scenario two. Thus, we want to focus on provisions and not any adjustments.

Updated Warranty Analysis for Tesla

We've updated our warranty analysis for Tesla adding data from the past two quarters and also making a slight correction to our previous table. In previous versions, we neglected to deduct net changes in liability for pre-existing warranties from cost of goods sold to get our adjusted cost of goods sold number.

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As we can see, Tesla's warranty costs are steadily increasing as a percent of Model S and Model Xs on the road. Warranty provisions are also increasing as shown below.

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We can see that Tesla has increased its provisions for 2016, no doubt a result of the new Model X. We can also see provisions and actual warranty claims as a percent of the value of Teslas on the road are increasing as well.

With the Model X debuting and the Model 3 supposedly arriving in several years, it is important for investors to monitor Tesla's warranty provision policies and how its estimates versus actual repair work performed is playing out. From now back until FY2012, Tesla has had to increase warranty accruals by a total $21M over and above its initial estimates. We think based on anecdotal reports about Tesla's build quality and power train longevity as well as the data reported here that there may be more warranty expenses than Tesla is currently estimating.

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.