June 16, 2003

Home is Where the Warranty Is:

Most of the major homebuilders recently reported details about their first quarter warranty spending. Here are the results, organized into segments for site-built homes, motorized recreational vehicles, and prefabricated/manufactured homes.

When one thinks of warranty, what probably comes to mind first is the warranty provided with a new car or a major appliance. And although major segments of the American economy from brokerage houses to phone companies provide no warranties on the services they provide, new home construction is among the sectors where warranties are routinely provided to the customer.

New homes are sold with warranties covering major structural defects in the walls, roofs and foundation, as well as with warranties on the plumbing, electrical, and heating systems. Depending upon how the homebuilder structures itself, either it or its subcontractors are the first-line obligors for these warranties. In addition, if there are appliances such as refrigerators and washing machines put into the home before the sale, there will be manufacturer's product warranties involved. Even the carpeting and counter tops may come with warranties. But no matter who is ultimately responsible for warranty service, the primary homebuilder is usually the first point of contact for the customer.

Individual state and metropolitan area Home Builders Associations establish codes of ethics that outline best practices for warranty claims management. Most require the homebuilders and subcontractors to carry insurance, to respond to warranty claims in a timely manner, and to submit to binding arbitration in the event of disputes. The National Association of Home Builders sells a book entitled "Warranties and Disclaimers for Builders," written by David S. Jaffee; as well as a book called "Warranty Service for Home Builders," by Carol Smith. Both books also are sold online by Amazon.com.

What follows is what we hope is a statistically-valid example of a study of warranty costs within a specific industry -- in this case the new home market. Thanks to the efforts of the Financial Accounting Standards Board and the reporting requirements of FASB Interpretation No. 45, all publicly-held American companies are now required to reveal never-before-seen details about their warranty activity. While compliance has been spotty in some industries, in the case of new home builders all the top players and most of the mid-level builders have filed their financial statements in compliance with FIN 45.

Three Major Segments

Because warranty costs seem to vary by type of home built, Warranty Week organized the industry into three segments: site-built homes built from the ground up in a specific location; recreational vehicles driven under their own power away from a dealership; and prefabricated or manufactured homes transported in sections to a specific location. While there are definitely at least three vendors that make both RVs and manufactured homes, and while there may be a vague boundary between what constitutes a recreational vehicle and a mobile home (lumped in with manufactured homes), these three segments will work for now.

The first chart below lists just the 16 builders of site-built homes who reported details of their warranty spending in their latest financial statements. Centex Corp. and Capital Pacific Holdings Inc. reported annual figures, so their warranty claims cost was divided into four equal parts, and what you see below is 1/4 of their annual spending. Beazer Homes USA Inc., meanwhile, reported six month figures, so those claims were divided into two equal parts. It's highly unlikely that warranty claims were exactly the same in two successive quarters, but for the purposes of this column that's what we're assuming.

Readers should note that this means the data below is actually a mix of mostly facts with a few estimates. Centex, for instance, might have experienced all of its warranty claims during the first nine months of its fiscal year, and none in the three winter months. Beazer Homes might have incurred 70% of its $5.66 million in warranty cost during the fall, and 30% in the winter. Or maybe not.

Particularly in the very seasonal homebuilding industry, it's somewhat dangerous to make assumptions that every quarter's warranty spending is equal. However, even in the cases of these estimates, the percentage rates are all statistically valid, even if they're calculated over longer periods of time than their competitors.

In other words, Centex most certainly spent 0.3% of its home sales revenue on warranty over the course of its entire fiscal year. Whether the rate was exactly 0.3% during the first quarter or the fourth quarter is a question that even Centex vice president Neil Devroy couldn't readily answer. His own rule of thumb is $1,400 per home in expected warranty cost.


Warranty Spending
in the Site-Built Home Market
First Quarter 2003

(all figures in $ Millions and percent)


Site Built Homes Spent Percent
  on of
Company Warranty Sales
D.R. Horton Inc. $5.20 0.3%
Centex Corp. (1) $4.58 0.3%
Meritage Corp. $1.12 0.4%
Avatar Holdings Inc. $0.20 0.4%
Dominion Homes Inc. $0.52 0.5%
Capital Pacific Holdings (1) $0.41 0.7%
Ryland Group Inc. $4.25 0.7%
NVR Inc. $4.83 0.7%
M/I Schottenstein Homes Inc. $1.41 0.7%
KB Home $9.40 0.9%
Pulte Homes Inc. $15.75 1.0%
Lennar Corp. $15.92 1.1%
M.D.C. Holdings Inc. $7.05 1.3%
Beazer Homes USA Inc. (2) $5.66 1.7%
William Lyon Homes $1.42 2.0%
Arvida/JMB Partners L.P. $0.80 6.8%
Other $9.87  
Industry Total & Average $88.4 0.7%


Source: SEC Form 10-Q & Form 10-K

Notes:

  1. Derived from annual report data, estimated for the first quarter
  2. Derived from six month data, estimated for the first quarter
  3. Derived from nine month data, estimated for the first quarter


D.R. Horton Inc. is a company founded in Dallas in 1978 by Donald R. Horton. Today its operations extend nationwide into 20 states from Hawaii to Maryland, with a major presence in Arizona, California, Texas, and Washington.

The company spend $5,197,000 to satisfy warranty claims during the first quarter. With $1,777,829,000 in reported home sales during the period, its ratio of claims to sales came in at an industry-leading 0.3%. Obviously, the big question is what D.R. Horton is doing that makes its warranty claims costs so much lower than is the case with its competitors.

A person in the legal department unlucky enough to answer the phone while the boss was out of town told Warranty Week that the way Horton is set up, each division takes care of warranty individually. Instead of having a national warranty manager, there are people in each division managing warranty. What works in Atlanta doesn't necessarily work in Hawaii. So when routine matters arise, they don't have to come back all the way up to the top. Decisions can be made quickly, even at the local level within a specific community development. Major decisions are made during periodic gatherings of the division presidents, of which one took place last week. This reduces overhead and improves responsiveness, she said. Internally, they call this decentralization process "Hortonizing."

Louis Warren, D.R. Horton's project manager and business analyst for the warranty and customer survey systems within the MIS department, said the company is maintaining its 0.3% ratio even into the current quarter, and has been even lower than that within individual months. He agreed that one of the primary reasons for the company's below-average warranty cost is its decentralization, though he declined to use the term "Hortonize."

"The divisions are the masters of their domains, more or less," Warren said. "They are able to control their own destiny as far as the expenditures go. The divisions pretty much are bonused on their budgets, so they're real apt to take care of their homeowners." Right now, growth through referrals is a corporate priority, so each division is aiming for the best word of mouth that's possible, he added.

Warren said D.R. Horton remains the primary point of contact for the homeowner, but each subcontractor is responsible for the work they've done. "We hold our original vendors on a job accountable for their work," he said. "If we have a warranty call on a particular vendor, we ask that vendor to take care of that call. If for some reason that vendor isn't with us any more, or if we need to get a new vendor to that site, we hold some money in reserve to put against that cost."

Avoiding Warranty Cost Before the Closing

Larry Seay, chief financial officer at Meritage Corp., said his company runs basically the same warranty system in each of its major markets, with some degree of localization. "California may be implemented a tad bit differently than, say, Texas. There also are different laws in different states," Seay noted, as well as slightly different lengths of coverage for labor and structural warranties within each market. Some terms follow statutory requirements while others are responses to competitive conditions in each local market. But more or less it's the same warranty system in each state.

The major reason he cites for Meritage's below-average warranty cost is the way it detects and fixes problems before they become warranty issues. "During the construction period, we have a very rigorous quality control review with our superintendents," he said. "And we have a buyer walk-through, to make sure that when that house is delivered to the home buyer, anything that might have been done a little bit wrong during the construction process is noticed by the buyer or by the warranty people who conduct that walk-through. We take that buyer walk-through very seriously."

Another way Meritage keeps warranty cost down is by responding to claims as quickly as possible, he said. This produces the soft-cost benefit of a happier customer, but also produces a very real hard-cost benefit in terms of a reduced need for lawyers and lawsuits. In addition, Meritage passes on the cost of warranty service to the subcontractor whenever possible. Seay explained that what's listed as warranty cost on the company's financial statements is actually a combination of two items: the cost of overhead incurred while being the central point of contact, and the cost of situations that arise where Meritage can't bill back to a specific subcontractor, either because the source of the problem is hard to pin down, or because the subcontractor has gone under. So in effect, what's left is the net warranty cost of the program after bill-backs.

"When you're dealing with consumers, they don't want to have to call 20 people," he said. "So we act as the coordinator for a warranty problem. They call us, but to the extent that we have leverage on the subcontractor that performed the defective work, we will call them and have them go out and fix the problem. If we've stopped using a particular subcontractor, then we lose our leverage to get things done quickly. But we still have a legal obligation to go fix the problem. Ultimately, it's our warranty."

Driving Home a House

The chart below includes figures for the Big Three of RV sales: Fleetwood Enterprises Inc., Thor Industries Inc., and Monaco Coach Corp., who together hold around 64% of the market share in this industry segment on the basis of first quarter revenue. This segment also includes Winnebago Industries, whose name has become synonymous with RVs, as well as four smaller players: Coachmen Industries, Spartan Motors, Featherlite Inc., and Skyline Corp..


Warranty Spending
in the RV Market
First Quarter 2003

(all figures in $ Millions and percent)


Recreational Vehicles Spent Percent
  on of
Company Warranty Sales
Monaco Coach Corp. $2.08 0.7%
Featherlite Inc. $0.47 1.1%
Spartan Motors Inc. $0.78 1.3%
Winnebago Industries Inc. (2) $2.75 1.3%
Skyline Corp. (3) $2.76 2.6%
Coachmen Industries Inc. $3.92 2.7%
Thor Industries Inc. $9.88 3.0%
Fleetwood Enterprises Inc. (3) $19.68 3.6%
Other $6.15  
Industry Total & Average $48.5 2.4%


Source: SEC Form 10-Q & Form 10-K

Notes:

  1. Derived from annual report data, estimated for the first quarter
  2. Derived from six month data, estimated for the first quarter
  3. Derived from nine month data, estimated for the first quarter


Three RV homebuilders also sell prefabricated, manufactured homes: Skyline, Coachmen Industries, and Fleetwood Enterprises. Together they spent $26.4 million on warranty in the first quarter. How to split that up into RV warranty and prefab warranty is a task that requires some assumptions.

Skyline reported that 30% of their sales measured in dollars were RVs, and that 70% were manufactured homes. At Coachmen, the revenue was 73% RV and 27% manufactured homes. Fleetwood Enterprises reported 61.7% RV and 36.6% manufactured homes, plus 1.7% supply operations.

If one were to assume for a moment that warranty claims occurred at equal rates in the RV and the manufactured home industry, and not at all in the supply operation, one could therefore split those three companies' warranty spending according to those ratios. Their $26.4 million combined warranty spending would therefore go roughly 60% to RV and 40% to manufactured homes: roughly $16.2 million RV and $10.2 million manufactured homes.

Readers who believe in these assumptions and who want to eliminate the overlap between warranty spending for RVs and manufactured homes should therefore subtract $10.2 million from the total in the chart above, and subtract $16.2 million from the total in the chart below. However, given that two of the three companies in question reported nine month figures for warranty spending (meaning their single-quarter spending is already itself an estimate), and given that there is no reason to believe that warranty costs arise at equal rates in these two market segments, these additional estimates would make the charts even more speculative.

No matter what, though, there's a $26.4 million overlap between the lists for RVs and manufactured homes. So no matter what, that $26.4 million needs to be subtracted from the numerical sum of the three charts. In round numbers, then, that leaves us with $150.5 million spent on warranty claims in the new home warranty industry during the first quarter, both on stationary homes and on recreational vehicles.

Fun With Numbers

In the June 9 issue, Warranty Week provided an estimate of $126 million in warranty spending on new home sales. That estimate was based on industry groupings that placed Coachmen and Fleetwood wholly in the automotive category, and Skyline in the new home category. These three new charts divide that data up in a different way, pulling more than $45 million in warranty claims in from the automotive category to acknowledge that the definition of a new home for some people also includes recreational vehicles.

In other words, to get back to that $126 million number, add these three charts together, subtract the $26.4 million overlap, then add in the $45.8 million in RV warranty claims that was part of the automotive sector in the previous column. It's the same set of numbers, diced and sliced slightly differently to now include homes on wheels.

Oakwood Homes, by the way, filed for Chapter 11 bankruptcy reorganization in Nov. 2002. It doesn't actually make RVs if the definition is restricted to units that contain their own engines and can be driven around like a bus. It does, however, make mobile homes -- what it calls single-section manufactured homes. With their optional detachable hitches and steel frame construction, they could conceivably be towed around by a bus. However, to cut down on the overlap, which already is making these calculations somewhat complex, they will not be counted as "vehicles," and their sales and warranty costs will all be counted in the manufactured home category below. It should be noted, however, that their high warranty costs combined with some customer defaults on loans are what drove them into bankruptcy.



Warranty Spending
in the Manufactured Home Market
First Quarter 2003

(all figures in $Millions and percent)


Prefabricated Homes Spent Percent
  on of
Company Warranty Sales
Lincoln Logs Ltd. (1) $0.007 0.2%
Skyline Corp. (3) $2.76 2.6%
Coachmen Industries Inc. $3.92 2.7%
Fleetwood Enterprises Inc. (3) $19.68 3.6%
Oakwood Homes Corp. $7.07 6.1%
Champion Enterprises Inc. $15.74 7.5%
Cavalier Homes Inc. $6.91 12.1%
Other $5.18
Industry Total & Average $61.3 3.6%


Source: SEC Form 10-Q & Form 10-K

Notes:

  1. Derived from annual report data, estimated for the first quarter
  2. Derived from six month data, estimated for the first quarter
  3. Derived from nine month data, estimated for the first quarter


Lincoln Logs, we note, is a term best applied to a children's toy invented in 1916 by the son of architect Frank Lloyd Wright, and named in honor of reputed log cabin dweller Abraham Lincoln. These little wooden logs are now made by the Playskool Manufacturing Company of Chicago, a division of Hasbro Inc. But on the chart above, the name refers to a company called "the Original" Lincoln Logs Ltd. of Chestertown NY, located in upstate Now York on the southeastern slopes of the Adirondack Mountains. The company, now 25 years old, provides a 100-year transferable warranty on the do-it-yourself log home kits it sells. And according to Lincoln Logs field services manager Dave Patton, it expects to be around long enough to see some of those warranties expire unused.

Over the last three years, the company has sold 850 log homes and has incurred only two claims, he said. During its most recent fiscal year, Lincoln Logs' warranty cost was only $7,000 on a revenue base of $13,991,284 -- an industry-leading 0.2% rate.

Patton said one big reason for the low number of claims is the high hurdles the company establishes for the proper maintenance and care of the structure. These are not structures that can get by with one paint job per generation. They need constant patching and sealing, to keep the wind and water on the outside. So if a customer wants to make a warranty claim, the first question the company will ask is how well was the home maintained?

"We are very militaristic about that," Patton said. "You need to take care of the house. You need to use something other than Thompson's Water Seal." The cost of the required stains and waterproofing materials will vary in price from $30 to $55 per gallon, and multiple gallons are needed per home. Patton said the company will want to see those items listed on a receipt, and also will want to see pictures of the walls before entertaining the idea of a warranty adjustment.

Thankfully, this hands-on approach works well in the log cabin corner of the manufactured home industry, because customers are more concerned about upkeep than is typical. Patton said most customers do a lot of research before making a purchase, and for the most part they do in fact take proper care of their investment. He knows. He travels around the country all the time conducting day-long seminars about nothing but log cabins.

"You're talking about specialized housing," he said. "You're talking about a house that somebody will spend [researching for] an average of two-and-a-half years before they actually make a choice. You're talking about a market which had 1,250,000 housing starts last year and probably less than 1% were log homes."

The American Dream

More importantly, this is almost always a discretionary purchase and a second home for summers spent in the mountains -- not a primary home. Patton said this gives the customer the luxury of spending years on research, because they almost always have another home in the mean time. The log cabin is more a trophy home to be handled with care than it is a double-wide on a slab in a trailer park to be lived in until something better comes along.

Patton also noted that log homes are essentially sold as empty shells, with no inside walls or appliances. This difference, he suspects, is what drives up warranty costs at other companies on the list above. They face warranties not only on the walls and floors, but also the tiles and appliances in the kitchen and bathroom. Lincoln Logs faces considerably less exposure.

Warranty, however, remains a very important issue for his customers, Patton added. "It's right at the top. From a warranty standpoint, I can tell you that virtually 100% of the people deal with this issue after the sale. Once we deliver this house, there's a warranty card in there. Once they put stain on the wood and done what they're supposed to do to the outside of these buildings, they are then contacted by us to return that warranty card. Their warranty goes into effect only when they return that card."


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