Warranty Claims:

Falling Claims

Companies in the chart above which saw the dollar amount of their net warranty claims fall in the third quarter, as compared to the second quarter, include Champion Enterprises, Gateway, Sun Microsystems, Hewlett-Packard, Applied Materials, United Technologies, Pulte Homes, Boeing, and General Dynamics. All the rest saw their claims amounts rise or remain the same.

Claims rates are computed by dividing claims amounts by product revenue. In cases where product-segment revenue figures were not available (e.g. Dell, Whirlpool, American Standard, Gateway, Maytag, Brunswick, and Ingersoll-Rand), subtractions were made based upon the services/consumables/finance reports of close competitors. Allowing for this uncertainty in the percentages, companies for which the claims rate fell included Lexmark, Champion Enterprises, Gateway, Fleetwood Enterprises, Cummins, Maytag, Applied Materials, Dell, Rockwell Collins, Navistar, Whirlpool, Cisco, Lucent, United Technologies, Agilent, Pulte Homes, Boeing, and General Dynamics.

Warranty reserve balances are reported by the manufacturers for the beginning and end of each financial period. Monthly claims figures are computed by dividing the quarterly total by three, resulting in an amount, called the warranty-month, which is different for each manufacturer. The capacity of a given warranty reserve fund can then be expressed in terms of how long the money would last at current spending rates. Companies which increased the relative capacity of their reserves, as a multiple of their monthly claims, include Lexmark, Champion Enterprises, Gateway, Sun Microsystems, Hewlett-Packard, Applied Materials, Dell, United Technologies, Pulte Homes, Boeing, and General Dynamics. All the others in the top 50 remained the same or fell slightly.

Plotting Vectors

The amounts are not as important as the direction of change. Companies such as Champion Enterprises, Gateway, Applied Materials, United Technologies, Pulte Homes, Boeing, and General Dynamics are fortunate to be moving in the right direction in all three respects. Others achieved two out of three.

Hewlett-Packard saw claims fall 7% to $583 million in the most recent quarter, almost reversing the rise it saw in the quarter ended April 30. It also saw the capacity of its reserve fund rise slightly. But because product revenue declined proportionally, the claims rate remained steady at 4.2%. Sun Microsystems saw claims fall by $3 million plus a slight rise in the capacity of its reserves. But because sales fell sequentially during the quarter (the first of its fiscal 2004), its claims rate jumped from 5.0% to 5.4%.

Then there were a few genuine surprises. United Technologies saw warranty claims absolutely plummet in the third quarter. After reporting $113 million in claims during the first quarter and $125 million during the second quarter, the air conditioning and aerospace conglomerate reported only $49 million in claims during the third quarter. This of course contributed to a decline in the company's claims rate, but it also magnified what has been happening with its reserve fund.

United Technologies began the year with $1.116 billion in its reserve fund, which, given the monthly claims total of $37.7 million, represented a 29-month cushion. By the end of September, the monthly claims total had dropped to $16.3 million, and the reserve fund had grown to $1.134 billion. Now the company has a 69-month cushion in its warranty reserve -- the highest of the top 50.

Deere & Co. was among the last of the major warranty providers to file its Form 10-K with the SEC. When it finally did so, the numbers revealed a rise in claims from $79 million in the second calendar quarter of 2003 to $116 million in the third calendar quarter of this year. For the company's fiscal year ended Oct. 31, Deere reported $321 million in claims, an amount representing 2.4% of product sales.

The median reserve fund capacity for all manufacturers tends to be in the range of 13 to 15 warranty-months, though industries such as air conditioning tend to be a bit higher than that. For instance, American Standard, owners of the Trane brand, currently have a reserve fund capacity of 26 warranty-months. Lennox stands at 37 warranty-months. Still, 59 warranty-months is unusually high, especially for a large manufacturer such as United Technologies.

Other notable percentage declines in claims amounts included Boeing (-43%), Gateway (-39%), Applied Materials (-25%), and General Dynamics (-21%). Boeing and General Dynamics also saw a corresponding surge in the relative size of their reserve funds. Boeing went from 33 to 58 warranty-months, and General Dynamics went from 34 to 52 warranty-months. In other words, at current claims rates, each company has enough in its reserve funds now to pay claims for between four and five years without making further accruals. Put another way, each could slash the size of their reserve funds by half, enjoy the corresponding surge in net profitability, and still be above the median.

Close to the Edge

At the opposite extreme are companies that spend more on warranty each quarter than their reserve funds contain at the end of each quarter. Beckman Coulter, with $13.5 million in its reserve fund and $7.7 per month in claims, has a cushion of less than two warranty-months -- by far the lowest among the top 50. Gateway Inc., which had previously been at that level, actually built up its cushion in the third quarter, despite allowing its reserve fund to shrink from $42 million to $33 million. The reason? Claims fell almost 40%, and the claims rate fell under 6%.

Meanwhile, Nortel saw quarterly claims more than triple to $82 million in the third quarter. This seems to have more to do with some accounting changes currently under way at the company than any real spike in claims, however. The company also adjusted accruals for items such as executive bonuses, and restated a discontinued operations write-off as an expense to continuing operations. Warranty claims remained under 2% of product sales.

L-3 Communications saw its claims more than double during the third quarter. During the first quarter, the military avionics company registered only $4.1 million in claims. In the second quarter this rose to $7.1 million. Then in the third quarter, it rose again to $16.8 million. However, revenue rose almost as fast, so the claims rate remains at only 1%.

Still the Lowest

It's the same story at Johnson Controls. Twice now, the automotive seating company has turned in the lowest claims rate among the top 50 warranty spenders (see the September 8 issue). However, claims in the third quarter were 88% higher than in the second quarter, which itself was 100% higher than the first quarter. Still, despite these increases, the company's claims rate remains at a stubbornly low 0.3% of product sales.

Other notable rises in claims totals include Standard Motor Products (+69%), Beckman Coulter (+66%), American Standard (+54%), and Eastman Kodak (+46%). Whether these are seasonal fluctuations or one-time increases remains to be seen. For while it is true that each company reported a jump in claims amounts as well as a corresponding rise in their third quarter claims rates, it's also true that each saw a slight decline in rates from the first to the second quarter. Perhaps where they are now is "normal," and where they were in the second quarter was the anomaly?

One final point needs to be made. Comparing one manufacturer against itself provides meaningful insight into the direction of change under way at that company. But comparing one manufacturer against another -- especially across industries -- is an uncertain and perilous undertaking. After three quarters of warranty data, it's becoming clear what's normal for a company or for an industry, and it becomes easier to measure the anomalies. However, there is still a significant amount of variance between companies concerning how they account for warranty costs, and how they report their business segments, service revenues, and finance income. While it's our goal to compare apples to apples, it's certain there are still some oranges in the box.