Warranty Reserves:

Warranty claims are old news. Accruals predict the future. The amount set aside from current sales to fund the cost of future warranty claims is a company's prediction of product reliability. If a company foresees frequent and costly repairs, it will put a high percentage of its sales revenue aside. If a company foresees rare and inexpensive repairs, it will put much less aside in its warranty reserve fund.

Fortunately, after three complete years of warranty cost reporting by some 900 American manufacturers, it is now possible to calculate some highly reliable benchmarks for warranty reserves and accruals. Warranty Week took the warranty statistics gathered over the past 12 quarters and tracked the change in four key metrics:

1. The percentage of current product revenue set aside as current warranty accruals,
   
   
2. The percentage of current product revenue paid out for warranty claims,
   
   
3. The amount of money held in the warranty reserve fund, expressed in dollars, and
   
   
4. The capacity of the warranty reserve fund, expressed as the number of months these funds would last given the current claims rate.

Industry Benchmarks

We have some benchmarks for you, each of which is based on thousands of measurements. The average accrual rate for these 900 companies is 1.82%, meaning that on average, American manufacturers set aside 1.82% of current product revenue to fund future warranty claims. The average claims rate, meanwhile, is 1.74%, which means that accruals are outpacing claims, which implies that warranty reserve balances are increasing. And indeed, the collective warranty reserve balance of these 900 manufacturers stood at $39.0 billion at the end of 2005, up from $37.6 billion at the end of 2004 and $35.3 billion at the end of 2003.

Warranty reserve capacity has remained more or less the same over the past three years, despite the rising balance. It's stayed very close to 17 months, which means that manufacturing companies, on average, prefer to keep in reserve an amount of money close to 17 times what they pay out in claims in a month. We'll explain more about that in a few paragraphs.

What's remarkable is how companies and indeed whole industries seem to choose a level for their warranty reserves and accruals and then stick with it over the course of multiple years. It's as if they each have a warranty "signature" that changes only slightly over time, to the point where some of the labels on the charts that follow could be removed and the companies or industries they represent would still be obvious.

The Warranty Table for 2005

Let's start with some general statistics and totals for all manufacturers. During 2005, U.S.-based manufacturers reported $27 billion in warranty claims and $28.4 billion in warranty accruals. They began the year with $37.6 billion in their warranty reserves and ended it with $39 billion. And there was a surprisingly small net $31 million increase in warranty reserves caused by a variety of changes of estimate, acquisitions, and foreign currency fluctuations. In millions:

Figure 1 tracks the warranty reserve balance and the accrual rate for all reporting manufacturers. As we'll see next week, compliance with the warranty reporting rules of the Financial Accounting Standards Board's Interpretation Number 45 (FIN 45) is somewhat less than total. However, at least 765 made at least a partial effort in 2005, and another 137 did so in 2004 and/or 2003.

As Figure 1 shows, the collective warranty balance of all these manufacturers has gradually increased over the past three years. Quarter to quarter, it declined only once, by $29 million from the second quarter to the third quarter of 2003. The balance jumped by large amounts at the ends of 2003 and 2004, but not at the end of 2005. Admittedly, this may change, because right now we're including only placeholder estimates for some of the late-reporting companies such as Navistar International, Delphi, Terex, and Dresser Inc. As their actual balances are reported, we may see a more pronounced late-year bump.

Perhaps that's the problem with measurements of the warranty reserve. A few large warranty providers can change the trend or the total of the whole group based upon the outlook of just a few individuals. In 2005, for instance, General Motors reduced the balance of its warranty reserve by $187 million. In truth, there are only 25 companies that have a total balance larger than $187 million. And the hundreds of smaller companies get lost within the total.

Comparing Companies to Themselves

Just as it's better to compare a company against itself when tracking changes in the claims rate, it's possible to express the warranty reserve balance as a function of claims paid. This equalizes the impact of both large and small companies, because it would not compare GM against some small manufacturer. Instead, it would compare GM and all the other large warranty providers against themselves.

Here's how it works: GM paid out just over $1.15 billion in claims during the fourth quarter of last year, and it ended the year with a $9.1 billion warranty reserve. That means it ended the year paying claims at a rate of $385 million a month, and its warranty reserve was 24 times as large as the amount it paid in claims per month. Let's call that the capacity of the warranty reserve: 23.7 months.

Now let's take a look at telecom equipment provider ParkerVision Inc. The company paid out $24,377 in claims during the fourth quarter of 2005, and it ended the year with $9,950 in its warranty reserve. Therefore, it averaged $8,126 per month in claims, and its warranty reserve capacity was therefore 1.2 months.

Add in the capacities of 900 other warranty reserve funds, and track the results over 12 quarters, and you have the results depicted in Figure 2. Now, the blue bars represent the average ratios between reserves and claims, and the green line represents the average accrual rate.

As is noted on the chart, the average warranty reserve capacity has remained very close to 17.2 months over the past 12 quarters. Likewise, the accrual rate has remained slightly above or below 1.8% over the same time period. Therefore, we're going to nominate these numbers to be benchmarks for all American manufacturers. The average U.S.-based manufacturer puts aside 1.8% of current product sales to fund future warranty claims, and keeps in reserve 17.2 times as much money as it currently pays out in warranty claims.

Having calculated the averages, it's now possible to tell whether a given company is above or below average. With two different averages, we can divide the world of manufacturers into four quadrants, as is done in Figure 3.

Any companies that land in the upper right quadrant are pursuing a strategy that brings them higher-than-average warranty accrual rates and leaves them with higher-than-average warranty reserve balances. Conversely, any companies that land in the lower left quadrant are pursuing a strategy that brings them lower-than-average warranty accrual rates and leaves them with lower-than-average warranty reserve balances.

There's nothing wrong about falling into either quadrant. It's the difference between being an optimist and a pessimist; between being cheerful and grumpy. Or, to put it another way, it's a bit like forecasting the weather. In San Diego they predict sunshine every day and they're usually right. In Seattle they predict rain, and it rains.

Companies in the upper-right sector expect high claims rates for their products, and they occur as expected. It's as if they live next to a river and protect themselves with flood insurance. Companies at lower left expect low claims rates and are proven right. They're putting their summer homes right on the beach, but the winds remain calm year after year.

It's the companies in the other two quadrants that have some explaining to do. Companies in the upper-left quadrant are essentially preparing for a storm that never arrives. They are setting aside a large proportion of their current revenue to fund future claims, and they have more money in their reserves than they really need. Shareholders would be well-served if the size of these warranty reserves were reduced through either smaller accruals or one-time changes of estimate.

Forgetting Their Umbrellas

Companies in the lower right quadrant are essentially forgetting their umbrellas. It's raining steadily and they're predicting sunny days. They're putting less aside than most other companies, and they're paying out more than most other companies. They're leaving themselves open to a crisis during which a spike in claims exhausts reserves and begins to wipe out profits.

The further a company is from the center, the more its warranty methodology diverges from the all-manufacturer average. Of course, there may be very good reasons why a company chooses to diverge. In the automotive industry, for instance, warranty claims do indeed occur at a higher-than-average rate, and properly funding the reserve fund to deal with that is financially prudent. With new home sales, the builder is rarely out more than 1% of the closing price for warranty claims, so it makes no sense to keep large reserves on hand.

Figure 4 graphically details the warranty methodology of the five largest warranty providers: GM, Ford, HP, Dell, and IBM. It's no coincidence that two make cars and three make computers: as the newsletters of April 25 and May 2 detailed, these are the industries with the highest claims rates. They also have some of the highest accrual rates of all manufacturers, which is what places them to the right side of the graph.

Where they differ significantly, however, is in the thickness of the reserve fund cushion that makes them comfortable. Clearly, IBM and HP feel comfortable with a thin cushion, while GM prefers a thicker cushion. Dell and Ford are somewhere in between, and in fact have been both above and below average at different points during the last three years.

Note how the 12 measurements for both Ford and HP remain in a tight cluster. What this means is that in spite of their different choices for the appropriate size of their respective accruals and reserves, once made they stick very closely to their choices. Ford prefers a thicker financial cushion while HP prefers less. GM is higher vertically but more scattered horizontally, which means that it too prefers a thickly-cushioned warranty reserve, but that its accrual rate varies over time. Dell is more scattered vertically, which means the ratio between claims and reserves varies over time, as the thickness of its financial cushion increases.

We should note how the figures for Dell were derived. First, last year we revised upwards the estimate for the percentage of Dell's revenue that comes from non-warranted sources such as services, finance, software, and consumables. Our estimate was 10% but has now been revised retroactively to 22%. Second, Dell reports a combined figure for extended warranty sales and basic product warranty accruals. For the nine months ended Oct. 31, 2005, we estimate Dell's basic warranty accrual to be just under $1.3 billion, and Dell's extended warranty sales to be just over $2 billion, out of a combined reported figure of $3.318 billion.

Again, there's no right or wrong with where a company ends up on the board. It's more a measurement of risk, like choosing to live next to a beach or a river. And it's a measure of how companies deal with that risk, like whether or not they buy flood insurance. And the whole concept of a 100-year flood means that an optimist who buys no insurance at all may come out ahead for 99 of those years.

It's not feasible to chart all 900 warranty-reporting companies, so we're going to group them into industries instead. It turns out that each of the 12 industries tracked in the next two charts also display something of a warranty "signature," though we'll admit that this is heavily weighted by the largest warranty providers within the group.

In Figure 5, the higher-than-average accrual rates of both the auto OEMs and computer OEMs is clearly visible, as is their difference in reserve capacity. Data storage manufacturers, meanwhile, seem to be very close to the industry averages on both axes, with dots in all four quadrants. New homes and semiconductors are both at bottom left, while aerospace and appliances are both at top left.

With tongue firmly in cheek, Warranty Week has previously noted the similarities between airplanes and air conditioners. However, United Technologies is common to both groups, so the similarity is no great shock. What's surprising is that the other 65 aerospace manufacturers and the other 50 HVAC and major appliance manufacturers fall so closely near each other. Clearly, these two groups are on average expecting a storm that never seems to come.

In Figure 6, we're charting five more industries that wouldn't fit onto the chart above. For good reason: they're all making smaller-than-average accruals, and keep warranty reserve capacities more or less the same as semiconductor manufacturers, new home builders, and appliance manufacturers.

The makers of sports equipment -- everything from bowling and billiards gear to guns, golf clubs, and hiking boots -- show up with more or less the same warranty signature as telecom equipment vendors. As far as we can tell, the two groups have no members in common. Slightly above and to the left of those groups are the makers of building materials, fixtures, and furniture. Slightly below and to the right are the makers of medical and scientific equipment.

Furthest to the left are the auto parts suppliers, which once again reinforces just how little supplier recovery there is in the automotive industry. And given their spread both above and below the all-manufacturer average for reserve capacity, it's clear that they're keeping more or less the appropriate amount of money in their reserves, given the low rate of claims they face.