Seeking Alpha questions whether Tesla is adequately reserving for warranty expenses
This Seeking Alpha report from earlier this week questions whether Tesla might struggle in the future with costs associated with its warranties. The summary of the report reads: "Tesla offers a powertrain warranty twice as long as competitors but provisions only 50% more. The company would have incurred $28m in additional costs so far this fiscal year if it reserved warranty expense at industry rates. Tesla has already had to increase warranty reserves once this year."

There have been several stories in the past questioning whether or not Tesla (NASDAQ:TSLA) has been maintaining adequate warranty reserves. We decided to take a comprehensive look at its warranty practices and how they compare to other established automakers.

For our investigation, we are going to examine how Tesla compares with the warranty practices of two broad market automobile manufacturers in General Motors (GM) and Ford (F) as well as two luxury automobile manufacturers Daimler (DDAIY) (maker of Mercedes-Benz) and BMW (BAMXY).

Manufacturer Warranty Provisions

At first glance it might appear that Tesla's warranty practices are up to par. The table below shows the warranty provisions that each manufacturer deducts from revenue for each company's latest fiscal year to cover expected warranty claims. We pulled the numbers from Ford's latest 10-K, GM's latest 10-K, Daimler's latest annual report, and BMW's latest annual report.

As you can see, broad market auto manufacturers like GM and Ford set aside less for warranty claims than luxury (or perhaps in BMW's case we'd describe them as up-market or high performance oriented) manufacturers like Daimler and BMW. This is to be expected as cars with more bells and whistles and higher-performance drivetrains will likely break more and be more expensive to repair. In this context, Tesla's reserve of approximately 3% of sales does not seem out of line.

Manufacturer Warranty Length

The concerns about Tesla's warranty provisions start to crop up when you look at its provisions in relation to the length of the warranty it offers. The table below shows the powertrain and bumper-to-bumper warranties that Tesla as well as our focus group of auto manufacturers:

Manufacturer Powertrain Bumper-to-Bumper GM 5/100,000 3/36,000 Ford 5/60,000 3/36,000 BMW 4/50,000 4/50,000 Daimler 4/50,000 4/50,000 Tesla 8/infinite 4/50,000 Click to enlarge

Source: Cars.com,Tesla press release, GM corporate website

While Tesla's bumper-to-bumper warranty is similar to BMW and Daimler, its powertrain warranty is much greater. It's twice as long in years and covers and infinite number of miles. We are going to focus on the powertrain warranties because they include the components most expensive to replace.

If Tesla's all important powertrain warranty period is twice as long as BMW and Daimler, then we would expect the warranty costs should be at least twice as high. While Tesla does claim that its powertrain has fewer moving parts, that does not necessarily make it more reliable or less prone to failure. In fact, there have been numerous reports of drivetrain failures in Tesla's (Edmunds.com experienced three during a long-term test, Motor Trend's Tesla needed a new motor, and members of the Tesla Motors Club have reported frequent drivetrain replacements). All this is anecdotal evidence of course, but our point is that just because the Tesla vehicles are all electric does not mean that they won't experience mechanical issues. There has been nothing so far that would point to Tesla vehicles being more reliable and less expensive to repair than gasoline or diesel powered vehicles in the same price range offered by competitors like BMW or Mercedes-Benz (Daimler).

Computing Tesla's Expected Warranty Provisions

We believe that at a bare minimum Tesla should be maintaining warranty provisions in line with manufacturers of similar high-priced, high-feature vehicles. BMW and Daimler reserved an average of 2.3% of automotive sales for warranty claims. Considering that Tesla's powertrain warranty is exactly twice as long (8 years versus 4), we would expect TSLA to have warranty provisions of approximately twice as much or 4.6% of sales. This number is likely very generous given that Tesla is still a young company using new, unproven technology.

If Tesla used what we believe is a more accurate warranty provision, the financials would change drastically. We have compiled a pro forma income statement for the company's current fiscal year, shown below, that shows the effect of the change in warranty provisions.

If Tesla were to provision warranty expenses in line with its competitors, it would be reporting a loss from operations that was $28M larger than what it did. Changes in warranty provisions are particularly important because they filter down the entire income statement. One dollar in reduced warranty provisions is an extra dollar in reported profits (or in Tesla's case a dollar of lower losses) while another dollar in increased warranty provisions is a dollar less of profit (or of increased losses).

Investors should keep a careful eye on Tesla's warranty practices going forward. Indeed, TSLA already excludes two types of warranty costs from its reported warranty provisions. From the company's latest 10-Q (our highlights are in red):

What this language means is that Tesla has (likely) outstanding liabilities in regards to warranty work it will have to perform on leased vehicles and vehicles sold under its resale guarantee program; however, it is not reserving for any of those costs now. Instead, the company is paying those costs out as it incurs them and including those costs in the cost of goods sold. While this does follow accounting rules, investors should realize that since Tesla is a growing company its warranty work performed for those two categories of cars will lag sales. Costs for vehicles sold now will not show up until several years down the road, and as Tesla's sales grow, those costs will grow as well. This unaccounted for warranty work may show up in the future as lower gross margins.

We also found a disclosure (shown below) by Tesla in that same 10-Q that the company had to bump up previous warranty reserves by $11.3 million.

Investors should diligently monitor Tesla's warranty provisions each quarter to make sure the company is properly reserving for warranty costs. We believe that TSLA's existing warranty estimates are too optimistic, and that as we saw with the company's last quarter, it will need to increase its warranty reserves in the future.