Warranty in the Auto Industry:
Spending on warranty claims showed a slight decrease during the second quarter, while claims rates and reserve fund balances were both up and down. Here are the details.
Spending on warranty claims within the automotive segment of the manufacturing industry actually fell modestly during the second quarter. Spending on claims in the first quarter totaled $2.634 billion, falling by 0.6% to $2.618 billion during the second quarter. Contributing to this phenomenon were the large decreases in the volume of claims turned in by companies such as General Motors, ArvinMeritor, Cummins, Navistar, and Caterpillar. Mitigating against it were the large increases in the volume of claims registered by Ford, John Deere, Honeywell, and Paccar.
Some say that the amount of warranty work within the automotive industry is plummeting, as manufacturers turn out more durable products and as their claims departments sharpen their eyes and reduce both mistakes and fraud. If this indeed is the trend, it hasn't yet shown up in the statistics. We don't have 2001 and 2002 data to compare against, but the claims history seen during the first quarter of 2003 was more or less duplicated in the second quarter.
The only change we saw that would qualify for the label "massive" was at a manufacturer of batteries for scooters and wheelchairs, whose claims rate dove from 37% in the first quarter to 23% now. Yes, that means almost a quarter of the company's product revenue is consumed by warranty. We'll spare them the publicity, however. The point is that very few radical rate changes were observed, and very few data points were that far outside the norm.
Making a List
Currently, Warranty Week is tracking 106 U.S.-based automotive product manufacturers, of which 80 fully reported upon their warranty activity for the second quarter, eight made partial reports, five have yet to report, and 13 filed their financial statements with no mention of their warranty activity. Undoubtedly, there are more to be found, but the problem isn't finding them. The challenge is to separate the manufacturers who don't issue product warranties from those that issue warranties but don't comply with current disclosure requirements. Reader assistance in this area would be welcome and appreciated.
To construct this report, we used a rather liberal measure to decide whether a given company was an automotive manufacturer or not. We looked at the word automotive: able to move by itself. The list therefore includes not only traditional truck and passenger car manufacturers, but also those making driver-operated lawn, farm, and construction vehicles, and/or replacement parts for those products. It also includes several of the top manufacturers of car audio systems, tires, batteries, and repair tools. Also included are a handful of companies specializing in railroad and mass transit vehicles, as well as those making recreational vehicles.
The list does not, however, include companies manufacturing parts and systems intended for either boats or airplanes, and it does not include companies whose land vehicles are intended for the military. Also not included are companies providing GPS-assisted navigational systems, although some of those units are now finding their way into passenger vehicles. Those manufacturers will be included in a separate category for aeronautics, space, and defense companies. Likewise, manufacturers of prefab homes, which although they may be delivered on wheels are really meant to remain stationary, are not counted alongside the RV vendors.
Golf carts and motorized scooters are in, but bicycles and foot-powered scooters are not. Motorized wheelchairs are in, but self-powered units are not. However, here's where it gets a bit tricky. The companies making the motors and batteries for those units are in, but the companies selling the finished product are for the most part categorized as sports equipment or medical instrument makers.
Checking it Twice
The statistics surrounding warranty claims, accruals, and reserves can sometimes get a bit confusing. For instance, at John Deere the amount of claims jumped from $63 million during the first quarter to $79 million in the second quarter. That was a $16 million increase, and was among the largest in the category. Yet the percent of product sales consumed by warranty claims at Deere remained rather constant at 2.1%, because sales also increased. At Goodyear, meanwhile, the amount of claims fell by $900,000 from one quarter to the next, but the claims rate remained the same because sales volumes fell by a proportional amount.
Claims volume on its own is probably not a good measure of warranty. However, expressed as a rate, and compared to product sales, it turns into a good measure of a company's warranty activity. Of the 80 automotive companies that reported upon their warranty activities during the second quarter, 34 saw the percent of product sales consumed by claims increase, and 46 saw their claims rate fall. Most of the rate changes, however, were rather modest. None of the increases were over 3%, while only one manufacturer saw its claims rate fall by more than 2%. In fact, 66 of the rate changes were in a rather narrow range of ± 0.5%.
The size of a company's reserve fund also is a rather poor measure of warranty. It's like measuring a tank of water in cubic feet. What does it mean? Tell me how many glasses of water that represents, or how many people it could support. So what we do in this report is ask the question: if no funds were ever again added to a company's reserves, how long would those reserves last given current spending rates? Such a ratio between claims and reserves can be expressed in warranty-months. Twelve warranty-months is the ability to pay the next year's worth of claims without exhausting current reserves. Of course, no company would run down their reserves that way. They would always accrue additional amounts to keep the fund more or less stable in size.
There are, however, numerous ways to change that ratio. If a company sees that claims rates are falling, they can make a change of estimate that cuts the size of the reserves. If a company believes future claims will rise, they can begin building up the reserves through both higher accrual rates and a change of estimate. If the amount of claims falls and the reserve remains unchanged, the ratio will increase, since the same amount of funds would pay claims for additional months into the future.
Changes in Estimate
Among the 80 auto companies, 43 saw the ratio between claims and reserves increase, possibly reflecting a more conservative shift in their outlook for future claims rate. However, for 17 of those, the claims rate fell, which in and of itself would increase the ratio between claims and reserves. In other words, there may have been no change in outlook -- only a change in the ratio. Treasurers and CFOs now have the option of making a change in estimate to shrink the reserve fund proportionally, or to leave things alone in case claims rates rise.
The remaining 37 decreased the ratio between claims and reserves, possibly reflecting a more optimistic outlook for future claims rate. However, for all but eight of those cases, the claims rate actually rose, meaning that the fall in the claims-to-reserves ratio may not have been intentional. Perhaps some of those CFOs will now conclude that their reserves are no longer adequate, and perhaps they will increase their accrual rates in the third and fourth quarters.
Interestingly, 34 of the 80 companies made changes of estimate during the second quarter -- 20 up and 14 down. Midas, Cummins, ArvinMeritor, and Honeywell made the largest increases in dollar terms, but nothing comes close to the $264 million and $136 million downward changes of estimate made by GM and Ford, respectively. As detailed in the Aug. 18 edition of Warranty Week, those cash infusions helped both companies report profitable second quarters within their automotive sectors.
Although it's not detailed here, the accrual rate -- the allocation for new warranties issued divided by new product sales -- is definitely part of the data collection effort. Right now that data more or less mirrors the claims rate, with slight differences. However, if changes in claims rates or in the claims-to-reserve ratios produce a more noticeable change in accrual rates or a more obvious deviation between the rates, we'll report on that trend.
Here is a list of the top 20 automotive warranty companies, measured by their claims total during the second quarter (second column), and ranked by the percent of sales that represented for each company (third column). The fourth column includes the claims-to-reserves ratios computed using data from the second quarter reports. Figures in black represent increases from the first quarter, while figures in red represent decreases from the first quarter.
Warranty in the Auto Industry
Top Spenders on Claims,
Second Quarter, 2003
|Claims||% of Product||Months in|
|Deere & Co.||$79||2.1%||15|
Key: increases in black,
decreases in red.
Source: SEC Form 10-Q & Form 10-K
Notice that while GM was down in terms of both the absolute amount of claims and their percentage of sales, Ford was up in both respects. The changes were minor in both cases. GM saw claims fall by 5.5%, while its claims rate fell from 2.83% to 2.77%. Ford saw claims rise by 3.1% while the claims rate bumped up from 2.44% to 2.48%. The point is, though, that they didn't fall by 20%, as some are now claiming in reports of declining amounts of warranty work within the dealer channel.
Diesel engine manufacturer Cummins and recreation vehicle maker Fleetwood Enterprises are atop the chart above with their 3.1% claims rates, which were the highest among all auto manufacturers reporting more than $10 million in claims during the quarter. For both, however, 3.1% represents a noticeable improvement. During the first quarter, Cummins stood at 3.5%, and Fleetwood was at 3.4%. Within the list of all 80 automotive suppliers, Cummins and Fleetwood are eighth and ninth, respectively, in terms of claims rate as a percentage of product sales.
Five automotive companies, including Adept Technology Inc.; DT Industries Inc.; Glas-Aire Industries Group Ltd.; Harman International Industries Inc.; and Twin Disc Inc.; had not filed their financial reports for the second quarter by Friday, Sept. 12, so figures derived from their first quarter reports have been used as PlaceHolder estimates for the time being. The primary reason for this delay is that most of the companies are about to publish their Form 10-K annual reports based on fiscal years ending around June 30. That may not happen until the end of Sept. or later, since it generally takes 10-12 weeks from the end of a company's fiscal year for them to file their annual report. All five fully reported on their first quarter activity, publishing Form 10-Q reports in the May time period.
Looking ahead, this lag time between the end of fiscal years and the filing of annual reports is going to force a delay in the fourth quarter reports. Of the companies that file Form 10-Q reports in the April/May and July/August timeframes, most didn't publish their last Form 10-K annual reports until mid-to-late March 2003. Only one out of three published their 10-K by the end of February, which was to have been the cutoff date. Therefore, while the Warranty Week third quarter report can still be completed in December 2003 based on reports filed through the end of November, the fourth quarter report may have to wait until early April 2004.
Also, be sure to check back in a month or so, because as those companies file their annual reports, our PlaceHolder estimates will be replaced by their actuals. That will necessarily change both the industry totals and the averages, though not by as much as is likely in the computer and semiconductor industries, where several large players are still preparing their 10-K reports. In addition, as was done with Cummins and Exide, which both only recently resumed publishing their 10-Q reports, data will be added retroactively to past quarter's reports as it becomes available. Also, we expect many of the non-complying companies to adopt FASB FIN 45 later this year and early next year. Some may publish warranty data for all of 2003, requiring further revisions to our lists.
In addition to these 85 automotive manufacturers who are currently providing the required details about their quarterly warranty activity, there are at least 44 manufacturers that for one reason or another are not disclosing the size of their warranty accounts.
Companies reporting only partially about their warranty activity include the Alamo Group Inc.; Cycle Country Accessories Corp.; Graco Inc.; Phoenix Gold International Inc.; Rockford Corp.; Starcraft Corp.; and UQM Technologies Inc. Each of these manufacturers provided figures for the beginning and/or ending balance of their warranty reserve fund, but not the aggregate figures for claims and accruals. As such, they are not yet in full compliance with the requirements of FASB FIN 45.
Warranty-issuing automotive component manufacturers who did not report any warranty activity at all in their 10-Q statements include Advance Stores Co. Inc.; American Axle & Mfg. Holdings Inc.; Autoliv Inc.; Cascade Corp.; Delphi Corp.; Eaton Corp.; Energy Conversion Devices Inc.; Federal-Mogul Corp.; Kingsley Coach Inc.; Methode Electronics Inc.; Motorola Inc.; Parker Hannafin Corp.; Textron Inc.; and Wabash National Corp. If these companies are providing product warranties and are not disclosing that activity in all their interim and annual financial statements, then they are not in compliance with FASB FIN 45.
During the first quarter of 2003, four of the above companies -- Cascade Corp.; Energy Conversion Devices; Phoenix Gold International; and UQM Technologies -- actually did report upon their warranty activity. Therefore, they have gone from compliance in the first quarter to non-compliance during the second quarter. Cascade and UQM, it should be noted, made their first quarter disclosures in what was for them an annual report, and then made their non-disclosures in a Form 10-Q report covering the second quarter (their first fiscal quarters). FASB FIN 45 does not permit this type of once-a-year disclosure. Warranty activity reports are "to be made by a guarantor in its interim and annual financial statements," as FIN 45 states in paragraph 2, page 1.
Automotive manufacturers ultimately based outside the United States and therefore exempt from reporting their warranty activity to the SEC include Alstom; Bayerische Motoren Werke AG; Bridgestone Corp.; CNH Global N.V.; DaimlerChrysler AG; Fiat S.p.A.; Henlys Group plc; Honda Motor Co. Ltd.; Hyundai Motor Co.; Kawasaki Heavy Industries Ltd.; Komatsu Ltd.; Kubota Corp.; Mitsubishi Corp.; Nissan Motor Co. Ltd.; Peugeot Citroën S.A.; Renault S.A.; Robert Bosch GmbH; Scania AB; Sumitomo Corp.; ThyssenKrupp AG; Toyota Motor Corp.; Volkswagen AG; and Volvo AB. Undoubtedly there are many others who import automotive products into the U.S., and many other international companies that own U.S.-based parts manufacturing subsidiaries. This is a list of just some of the majors.
Industry averages were computed for both the claims rate and the relative size of the warranty reserve. The weighted average claims rate turns out to be 1.9%, based on product sales of $271.6 billion and claims of $2.618 billion. Warranty reserves stood at $18.3 billion at June 30, meaning that auto manufacturers had enough in reserve to pay the next 21 months of future claims at current rates. However, this measure is significantly skewed upwards by the huge funds kept in reserve by GM and Ford. The median, which better reflects the planning assumptions of each company, stood at 17 months, meaning that the claims-to-reserves ratio was above 17 at half the companies and below 17 at half the companies.
We'll adopt 1.9% and 17 months as the midpoints for the automotive industry in the second quarter. In the chart below, those midpoints are used to divide the 80 auto warranty reporters into four quadrants. There are 40 dots above the median and 40 dots below the median, but because of the way that weighted averages work, there are only 23 dots to the right (Quadrants II and III) and 57 to the left (Quadrants I and IV).
Warranty in the Auto Industry
Industry Averages for Claims Rates and Reserves
Second Quarter, 2003
Companies with above-average reserves coupled with below-average claims rates include ArvinMeritor, A.O. Smith, American Standard, Briggs & Stratton, Dana Corp., Ingersoll-Rand, and ITT Industries. These companies, represented by light blue dots in Quadrant I, enjoy more-than-adequate warranty reserve fund levels and low warranty claims rates. Of the four quarters in the chart, this is the best place to be.
Companies with both above-average reserves and above-average claims rates include GM, Toro, Cummins, Ford, Caterpillar, and Paccar. These companies, represented by the darker blue dots in Quadrant II, have more-than-adequate reserves but their claims rates are above the industry average.
Companies with below-average reserves and above-average claims rates include John Deere, Exide, Fleetwood Enterprises, Navistar, Polaris, Standard Motor Products, and Thor Industries. These companies, represented by the red dots in Quadrant III, are paying out more per dollar of revenue than their competitors, and have less reserves to cover those payments.
Companies with below-average reserves and below-average claims rates include AGCO, AutoZone, Goodyear, Harley Davidson, Honeywell, Johnson Controls, and Terex. These companies, represented by the orange dots in Quadrant IV, have smaller-than-average reserves but also have lower-than-average claims rates.
Distance from the Center Point
It's not as important which quadrant a company is in as it is how distant a given point is from the industry average. Companies far above or far below the horizontal lines have too much or too little in reserve, in comparison with their peers. Those with too much funds in reserve are withholding profits from their shareholders. Those with too little are exposing their companies to a potential crisis if claims should suddenly surge, as would happen during a recall. However, only three companies are noticeably below their peers in regards to their claims-to-reserve ratio. Only five companies had absurdly large claims-to-reserve ratios (greater than 120 warranty-months).
Likewise, the points to the far left and far right represent companies that deviate the most from the auto industry's 1.9% average claims rate. Companies to the far right are either having manufacturing problems, or their warranty operations are too inefficient and costly to run. Those to the far left are either too stingy with their warranties, super-efficient with claims processing costs, or are making very high quality products.
But, as the old saying goes, a picture is worth a thousand words. Very few dots are far outside the cluster, meaning that very few companies deviate significantly from the industry average. Therefore, with only a handful of exceptions, auto companies are planning and spending on warranty within an acceptable range.
The best place on the chart would be in the middle, where the two lines intersect. Such a company would pay 1.9% of product sales in warranty claims, and would have 17 months of future claims payments in reserve at current claims rates. For instance, a company with $100 million in product sales would pay $1.9 million in claims per quarter, and would have $10.75 million in its reserve fund at the end of the quarter. Or a company with $2 billion in sales would pay $38 million in claims and would have a reserve of $215 million.
Unfortunately, no such company exists. However, at least 14 companies are in a cluster near the mid-point, with claims rates between 1% and 3% and claims-to-reserve ratios between 14 months and 20 months. After a few more quarters of data have been collected, we'll be able to put these dots into motion, to see if indeed they are converging or diverging. If it doesn't end up looking like the Joshua Light Show, we'll present it to you in the form of an animated graphic.
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