I wrote a lot of this article about two months ago. After the prior earnings call, a number of bears dug into the 10-Q and decided that Tesla had played with warranty numbers to attempt to show a profit. I ended up not publishing it because by the time I had done all of the research to feel pretty solid in my conclusion, it seemed like no one was pushing that Tesla had inappropriately played with its warranty accrual numbers anymore.
Then, yesterday, as I was getting ready for the earnings call, I stumbled across the latest Tesla Bull vs. Bear debate, this time between Galileo Russell of Hyperchange and Gordon Johnson of GLJ Research. I generally don’t link to the FUD articles, and I’m not going to again here because Yahoo Finance had one of its hosts state (and I’m not kidding), “they haven’t really designed anything new at Tesla, the Model S is, what, 16 years old, and it’s kinda getting a little dull, boring.” [Editor’s note: WTF?!?!?!?]
However, I’m instead going to link to a response video from the channel Solving the Money Problem, where the host of that channel, Steven, breaks down the various comments in the video. I usually try to steer away from slanted coverage on the stock in my analysis (queue the comments that I write slanted coverage), but I feel like this is the best way to actually watch this one. For the most part, Steven’s responses are the same arguments that I would have made if I was breaking down the whole video. Here’s the link if you want to see it.
Anyway, in this debate, Johnson brings up the same argument about the warranty. His quote: “you take those [one time adjustments in Q3] out, you adjust their warranty accounting to actually account for the amount of warranty they need, and they’re losing money.”
Well, Gordon is rated as #4,433 out of 5,871 analysts on TipRanks (with an average return of -0.7% I might add). Maybe he knows something that I don’t — I’m not rated, after all — but this topic made me dig up his ranking for a closer look, because the warranty claims were so incredibly wrong. It’s stunning how off they are.
A lot of this information is a bit older, but I think it’s just as relevant now, and depending on what we see in the 10-Q adjustments, it may be even more relevant for you to think about when that comes out.
After the claims about the warranty adjustments in Q3 came out, I figured it was worth trying to dig into where Tesla’s warranty reserves ranked compared to other automakers, and if its adjustment was appropriate or not. On the surface, this was a bear argument that seemed to have merit to me — I’ve said before that there are certain accounts you can play with to sort of massage your profits legally, and warranty is one of those accounts. How you account for things each quarter could affect outcomes each quarter in a subtle but significant way.
After a ton of research, I stumbled on a website called “warrantyweek.com” that I wish I had just found at the start of my research, as the website’s work confirmed mine and dug even deeper than I had gotten. If you want to really learn how warranty accounting works, enjoy the rabbit hole I just linked to. They don’t publish articles often, but they are full of the wonky stuff that I love to read so that I can really understand what I’m looking at. If you’re just here for the Tesla stuff, I’ll cover that in a moment.
Warranty Week published an article on November 9th diving into the claim that some stock analysts started making that warranty expense data should be one of the leading indicators of a company’s true financial health, and whether Apple and Tesla made adjustments to purposely try to help cook their books to manipulate their stock price.
The first big idea to get from this is that warranty expenses cannot be checked by an external observer to figure out their math. And, since you don’t know if a company saved the right amount of money for warranties until after time has passed, claiming that a company is using its warranty accrual method to either hide or enhance profits is an easy target to blame for analysts who made the wrong call about a stock, as it may take months or years before the company shows if its accrual rate was correct, by which point those analysts will have been able to move on to other things.
In other words, warranty accounting is a really nice scapegoat for your not-so-great calls.
Additionally, warranty accruals are really wonky, because you make adjustments for previous quarters in the same cost center that you make additions due to current products sold, so it becomes a mess for outsiders to be able to sort out. Internally, Tesla may have made a determination to change the amount it is holding for warranties, but it doesn’t need to show us what the change was or why. And, for the record, this isn’t just a Tesla thing, this is true of the whole industry.
It gets even messier later, as certain companies don’t include recalls in their warranty repair column, while others do. There has been a bit of a debate in the last few months whether Tesla classifies too many repairs as “goodwill” or not. If it is doing this, it is ending up with much larger accrued warranty repairs at the expense of current profits, which would seem to be a strange outcome for them to want based on some more data I’m about to get into. It’s also worth noting that whether a repair is classified internally as “goodwill,” “warranty,” or whatever, internal classifications do nothing for the lemon law, so Tesla is not classifying repairs as “goodwill” to avoid that.
Anyway, back to the matter at hand, one of the things analysts didn’t point out about the whole warranty debate was that Tesla added $37.75 million to its warranty reserve fund in the Q1 2019. While we can’t be certain about the reason for the adjustment, it’s just as likely Tesla figured out it was larger than needed, so the company pulled back the majority of that to its income statement.
There is an argument that could be made by a bear that Tesla “hid” additional warranty expenses in Q1 so that it could pull them out of Q3 to pad an earnings statement, but that isn’t a sustainable way to run a company. You can only push and pull warranty money so much, and if you start having warranty expenses that you can’t cover with what you’ve accrued, your company is caught manipulating earnings, which would not be good for the company or its stock price.
Does Tesla Save Enough for Warranty Repair?
We won’t see the actual Q4 warranty details until the 10-Q comes out, but no matter what it says, there is a bull case that Tesla is actually stashing more away for warranties than it should. A different article warrantyweek.com published on July 18 confirmed a lot of my research and included prettier graphs. The conclusion? Tesla owns the lowest claims rate and the highest accrual rate in the US-based portion of the industry.
Now, the caveat I mentioned: companies can opt to classify a lot of this stuff differently. Maybe Tesla is using the “goodwill” category to classify more than it should. As warrantyweek points out, warranties are a fascinating thing (as is accounting!) as companies can decide how to categorize things. From that article:
“So what we might be measuring is not a difference in quality or the cost or frequency of warranty work, but the different ways they account for parts cost or recalls. In fact, Ford didn’t begin including recall expenses along with warranty until 2012, while GM has done so since 2003.”
So … it’s totally legal and legitimate to classify things under warranty however it makes sense. As part of that, the article shows in charts that in the past six years, Tesla has had the highest accrual ratio by percentage on a per-year basis in five of the last six years, with only GM higher in 2014 when it had a abnormally high number of recalls. Warrantyweek suggests that this high ratio may be due to Tesla being worried about how much warranty work electric vehicles will need, but as the website states (along with a chart showing Tesla spending nearly 1% less than every other automaker each year in warranty repairs), “How long do we have to wait for events that never happen?”
From my research, Tesla may have been allocating more money to its warranties due to the original Model S vehicles having significant drivetrain issues, as well as not insignificant door handle issues. The data on Model 3 repairs, however, seems to indicate that serious issues are extremely rare.
In other words, Tesla probably can reclaim even larger amounts of its warranty reserve legitimately. For instance, in 2018, Tesla set aside a whopping average of $2,200 per car sold for its warranty costs. Ford, by contrast, set aside $432.
If you’ve studied the industry, it seems that once electric cars are made to be reliable, they stay that way. I’m not anticipating a major bunch of warranty work needed for Model 3s, as Tesla noted has publicly often that the model was designed to fix the issues that the company learned from the Model S and X programs. Contrast that with an internal combustion car that has significantly more parts that can go wrong yet sets aside far less money for those issues.
Perhaps the most telling stat this article notes is “claims capacity,” a metric that says how long the reserve balance would last if nothing was added to it. As an example, if Tesla had $24 million in its warranty account and spent $1 million a month, it would last 24 months. Based on what Johnson said as he attempted to create FUD around Tesla in the debate, you would think that Tesla has far less in reserve than other companies and needs to bring it up, right?
Well, of course not. Over the past 65 quarters, Tesla has averaged 38 months of claims capacity in reserve at any given point in time. During the same time, GM claims capacity has averaged 26 months. Its warranty money would run out a full year before Tesla’s does. The best that Ford has done in those prior 65 quarters is 24 months. When the article was written, Ford had only 12 months of claims capacity.
If Tesla dropped its warranty reserves to the claims capacity ratio that GM or Ford averaged, it would be able to claim over $200 million in additional revenue back.
Again, in a different way for emphasis — Tesla could claim $37 million out of its warranty reserves fund for the entire year and, so long as no major issues arise, still have more money in its warranty reserves for claim capacity than Ford or GM.
My first conclusion is, man, warranty stuff is far more fascinating than I had any idea. Go read warrantyweek.com if you’re interested by this stuff.
My second and more relevant conclusion is that Tesla’s warranty accounting is done to industry standards, and appears to be higher than necessary. It’s worth also pointing out that since Tesla was founded, it has had the lowest warranty claims rate of any manufacturer in 9 out of 10 years, with the outlier being 2010, when its only vehicle was the original Roadster.
That is stunning to me, as, again, there were issues with early drivetrains.
However Tesla decides to classify its warranty accruals on its 10-Q when it comes out, it’s good to be armed with the data again now, as I’m guessing we’re going to see a lot more highly rated analysts point to it as proof that their bear calls were correct and Tesla is just cooking the books. It’s too bad they don’t have the same tools that unranked amateurs like myself have to look up actual warranty information.
Or, maybe it just sounds like they know what they’re talking about to people who don’t know how any of this works. Maybe it’s just a nice way to attempt to save face.
I am a Tesla shareholder who has purchased shares within the preceding 12 months. Research I do for articles, including this article, may compel me to increase or decrease stock positions. However, I will not do so within 48 hours after any article in which I discuss matters that I feel may materially affect stock price is published. I do not believe that my voice could or should influence stock price by itself, and I strongly caution anyone against using my work as your sole data point to choose to invest or divest in any company. My articles are my opinion, which was formulated using research based on publicly available data. However, my research or conclusions may be incorrect.