How Tesla Stretches Earnings Quality

This article appeared Monday, Aug. 18 on RealMoney.

SAN DIEGO (RealMoney) -- After the market closed Friday, Tesla (TSLA)  CEO Elon Musk posted an item on the company's blog announcing an "infinite mile warranty" on the Model-S' drive train to match the warranty on the car battery. It was classic Musk, going where no car company has ever gone.

Then, at the bottom of the post, he added:

"To investors in Tesla, I must acknowledge that this will have a moderately negative effect on Tesla earnings in the short term, as our warranty reserves will necessarily have to increase above current levels."

Wall Street is likely to roll its eyes, but it really shouldn't.

What he's really doing is putting a positive spin on his disclosure that warranty reserves were too low.

Why care?

In May of last year I wrote a piece about Tesla's sketchy earnings quality.

I made two points.

One, as with most growth companies, flying red flags over the earnings quality of cult stocks is foolhardy.

Two, ignoring the earnings quality in cult stocks is just as foolhardy.

This was just after Tesla was crowing about having had its first profitable quarter ever. Forensic accountant Donn Vickrey, then of Gradient Research, wasn't impressed. He had given the company's earnings quality an F based on all sorts of levers it had pulled to give the illusion of profitability.

There were so many that he zeroed in on one: warranty reserves.

As he explained at the time:

"This is the amount the company puts aside for expected warranty expenses -- a non-cash charge that hits earnings as a cost of goods sold. The lower the provision, the less of a hit to earnings.

"It's highly subjective, and Tesla current reserves at a rate, relative to sales, in-line with Ford and General Motors. But its warranty is longer than mainstream auto companies and 'its product is based on new technology with unproven reliability,' according to Gradient's report on Tesla. 'Of particular concern: The firm's eight-year, 100,000 mile battery warranty could prove to be extremely costly.

"But what if the company is so new it simply doesn't know -- so uses existing auto companies as a benchmark?"

Vickrey went on to say, at the time, that "Under accounting rules .... if you don't know what they'll be they should be higher, not lower."

Or as I said in my original piece, if reserves were higher, "It could be yet another possible hit to earnings."

Enter Musk's Friday blog entry:

"The Tesla Model S drive unit warranty has been increased to match that of the battery pack. That means the 85 kWh Model S, our most popular model by far, now has an 8 year, infinite mile warranty on both the battery pack and drive unit. There is also no limit on the number of owners during the warranty period.

"Moreover, the warranty extension will apply retroactively to all Model S vehicles ever produced. In hindsight, this should have been our policy from the beginning of the Model S program. If we truly believe that electric motors are fundamentally more reliable than gasoline engines, with far fewer moving parts and no oily residue or combustion byproducts to gum up the works, then our warranty policy should reflect that.

"To investors in Tesla, I must acknowledge that this will have a moderately negative effect on Tesla earnings in the short term, as our warranty reserves will necessarily have to increase above current levels. This is amplified by the fact that we are doing so retroactively, not just for new customers. However, by doing the right thing for Tesla vehicle owners at this early stage of our company, I am confident that it will work out well in the long term."

Reality: Just as investors ignored earnings quality a year ago, they're likely to ignore it today, even as Tesla concedes, without actually coming out and conceding, that its warranty reserves were too low.

It's now very clear that as a new company, with new technology, Tesla should have erred on the side of caution. Accounting rules are subject to interpretation and Tesla chose to interpret them aggressively. By doing that, the decision to increase warranty reserves reinforces Vickrey's view back then that Tesla's profits really weren't profits after all.

And it shows that as slick and cool as its Model S and upcoming models may be -- and as smart, creative and ingenious as Musk clearly is -- Tesla management is not beyond pulling out all stops to make its financials look better than they really are. It strikes to the company's ambitious culture, which is good when it comes to cars, bad when it comes to its financials.

All of which is just something to keep in mind as Tesla goes and grows. For Tesla, it's not just about the quality of its cars. At some point earnings quality will matter, too.

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Herb Greenberg, editor of Herb Greenberg's Reality Check, is a contributor to CNBC. He does not own shares, short or trade shares in an individual corporate security. He can be reached at herbonthestreet@thestreet.com.

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