Why Tesla's Lease Accounting Is Less Devious Than You Think

Model S holds its value very well. Image source: Tesla.

Since 2013, Tesla Motors (TSLA -3.40%) has offered a resale value guarantee for its electric vehicles. Under the guarantee, a customer can exercise an option to sell the vehicle back to Tesla at a predetermined price calculated with a handful of variables, between 36 to 39 months after purchase.

The idea was that consumers might be a little concerned about the cars' ability to retain value, and the guarantee was intended to assuage those fears. CEO Elon Musk implemented the resale value guarantee simply because it was the right thing to do for customers.

Image source: Tesla.

But in doing so he created an accounting nightmare for investors and analysts alike because Tesla's financial results are a lot more complicated now, including various non-GAAP operating metrics.

Musk also inadvertently fed the bears.

To GAAP or to non-GAAP, that is the question
Keep in mind that the primary reason why companies generally utilize non-GAAP figures in the first place is that they believe that the adjusted figures better represent the economic reality of the business. It's absolutely true that many companies abuse non-GAAP metrics, so it's up to investors to decipher whether or not the adjustments are indeed appropriate or not.

I'm not a fan of companies excluding stock-based compensation from their results, which Tesla does as well, but I do think that the non-GAAP metrics for revenue are appropriate. Cars that are sold with the resale value guarantee must use lease accounting under GAAP rules. Here's the important part: Those cars are legitimately being sold to end customers.

As far as cash flow is concerned, Tesla does receive the full cash purchase price at the time of delivery. From the 10-K:

Vehicle deliveries with the resale value guarantee do not impact our near-term cash flows and liquidity, since we receive the full amount of cash for the vehicle sales price at delivery. However, this program requires the deferral of revenues and costs into future periods as they are considered leases for accounting purposes.

The cars that Tesla leases directly to customers are still accounted for as leases, which is clearly the relevant accounting method there. There are no non-GAAP adjustments made for leased vehicles.

Over time, the impact of these adjustments has grown in lockstep with Model S deliveries. Here is the amount of revenue that is deferred each quarter due to lease accounting for the resale value guarantee:

Data source: SEC filings.

This means that the difference between Tesla's GAAP revenue and non-GAAP revenue continues to grow, a divergence that bears often cite.

How it could hurt -- but it won't
There's only one way that these criticisms could come back to hurt Tesla: If a customer exercises the buyback option and sells the vehicle back at the specified price, and Tesla is unable to turn around and sell it at a comparable value, then the company will take a hit.

Simply put, all of these complications go away and the criticisms become irrelevant if Teslas do hold their resale value in the secondary market. The good news for investors is that secondary market values are actually higher than expected. Again, from the 10-K:

While we do not assume any credit risk related to the customer, if a customer exercises the option to return the vehicle to us, we are exposed to liquidity risk that the resale value of vehicles under these programs may be lower than our guarantee, or the volume of vehicles returned to us may be higher than our estimates, or we may be unable to resell the used cars in a timely manner, all of which could adversely impact our cash flows. Alternatively, in cases where customers retain their vehicles past the expiration of the guarantee period, the remaining deferred revenues and costs will be recognized at no gross profit.

Based on current market demand for our cars, we estimate the resale prices for our vehicles will continue to be above our resale value guarantee amounts. Should market values of our vehicles or customer demand decrease, these estimates may be affected materially.

Here's Jon McNeil, president of global sales, service, and delivery, on the last conference call:

[W]e're finding there is a very healthy after-market for these cars. The trading values in the market are significantly above our residual reserves on the cars, which is giving us some flexibility in terms of our financing partners offering very attractive monthly payments and loan terms, because the cars are holding -- Teslas are holding value at a much higher rate than we thought.

But don't just take Tesla's word for it. The U.K.'s CAP Black Book said in November that Teslas retain value better than any car. The National Automobile Dealers Association (NADA) also put out an Electric Vehicle Retention Report Card (link opens PDF) a year ago. Over all measured time frames, Tesla scored No. 1 in terms of EV value retention.

Here are the top one-year results:

Data source: NADA.

The top two-year results:

Data source: NADA.

And the top three-year results:

Data source: NADA.

This last table is particularly relevant. For context, the resale value guarantee assures that the value will be at least 50% of the vehicle base price, plus 43% of all options (including upgrading to a larger battery). Based on NADA's data, Tesla should have a cushion of about 7 percentage points after three years, on average.

The long and winding road
At the end of the day, all of the lease accounting and fuss about the related non-GAAP figures are much ado about nothing. They're simply byproducts of Musk reassuring customers that Tesla vehicles would hold value -- which they are.

The resale value guarantee won't be needed forever. Image source: Tesla.

Tesla makes a couple of other non-GAAP adjustments, such as the aforementioned exclusion of stock-based compensation (which I generally disagree with because it's a very real expense even if it's non-cash) as well as non-cash interest expense related to convertible notes, but the resale value guarantee lease accounting is the most significant adjustment since it affects top-line automotive revenue.

Ideally, now that Musk has proven his point, Tesla will step back from the resale value guarantee if it's no longer necessary to reassure customers. At that point, it will take a few years for the accounting effects to wear off, but then the concerns will fade in the rearview mirror.