If there is one lesson that resonates from years of watching markets, it's that earnings quality doesn't matter in cult stocks on the rise. Nobody wants to hear it. Look no further than Netflix. Or even Amazon.
All of which brings us to Tesla. Flying red flags over its earnings quality would appear to be foolhardy.
Still, to ignore it is just as foolhardy, especially given the first sentence of the most recent "shareholder letter" accompanying the fledgling car company's earnings. "Tesla reached profitability in the first quarter of 2013 for the first time in our ten year history," it stated.
Furthermore, lower in the same letter Tesla says: "We believe that the accepted automotive industry approach of focusing on margin improvement,profitability and deliveries are the more meaningful metrics for measuring progress."
If profits matter going forward, so does earnings quality. And according to Gradient Analytics, the earnings quality gets a grade of 'F."
What stands out the most?
"So many things," says Gradient research director Donn Vickrey."By declaring themselves profitable, I said there is just no way. How can this be at this point in the cycle? It has to be purely a paper profit and at that some elements of the paper may be lower quality than usual."
Paper or not, Vickrey believes whatever Tesla's profitability, it isn't sustainable.
Rather than go through all of his points, let's focus on just one: warranty accruals. 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?
Under accounting rules, Vickrey says, if you don't know what they'll be "they should be higher, not lower."
Put another way: it could be yet another possible hit to earnings.
All in, Gradient estimates that once nonrecurring, unsustainable "and cosmetic" benefits are removed — rather than reporting a profit of $11.3 million, Tesla would've lost $91 million. And that doesn't include a more conservative warranty accrual. The good news, that's better than the $464 million it lost a year earlier — but not "profitable."
And we're not even talking about anything to support the current valuation.
My take: We've seen this before. Cult stocks like this run over any and all skeptics and critics — and Tesla is likely to continue leaving tire marks for the foreseeable future. Earnings quality, or lack thereof, rarely matters at this phase of a growth company's cycle. But Tesla makes such a big point of talking "profitability" that it should.
And what I know is this: investors may not care about earnings quality now, but one day it's likely they will wish they had. This has nothing to do with Tesla the car, and everything to do with Tesla's potential vulnerability with its stock.
P.S.: Tesla the stock is very dear to CEO Elon Musk. According to Tesla's proxy, his option grants are tied heavily to the company's market cap. Onward...