December 22, 2003

The Warranty Reserve:

Manufacturers apparently allowed their reserve fund balances to shrink by some $2 billion during the third quarter, not only because of a 4% rise in claims but also because of numerous downwards changes of estimate and cuts in accrual rates.

Are manufacturers making a conscious effort to reduce their warranty reserves, putting otherwise idle cash to work in response to quality improvements? Or is what we're seeing in the third quarter of 2003 merely a statistical inflection point as product sales begin to once again climb?

Most of the major manufacturers' third quarter financial reports have now been filed with the Securities and Exchange Commission. Of the 750 manufacturers who in the past have reported warranty expenditures, nearly 700 have now filed either their Form 10-Q or Form 10-K reports with the SEC. The only major warranty providers among the remaining 50 companies are Deere & Co.; Hillenbrand Industries Inc.; Joy Global Inc.; Rofin-Sinar Technologies Inc.; and Semitool Inc.

In weeks past we've highlighted the greater-than 4% rise in warranty claims seen since the second quarter, and the differences between warranty claims and warranty accruals in ten product categories. This week, we'll take a look at what is apparently the shrinking capacity of the warranty reserve, as expressed by the ratio between claims and reserves.

Imagine a tank of water containing X gallons of water, which is draining at a rate of Y gallons per minute. The ratio X/Y would express the number of minutes the water in the tank would last if it were not refilled. Likewise, imagine the warranty reserves of a manufacturer as a tank, and the amount of claims they report as the rate of outflow. Expressed in warranty-months, the ratio between the balance of the reserve fund and the amount spent each month on claims is a measure of the capacity of the "tank."

Warranty Capacity

There are two ways to measure that capacity. One is to take a measure of all the reserve funds and all of the claims, which results in a weighted average that mostly reflects the warranty accounting of industry heavyweights such as General Motors, Ford, Hewlett-Packard, IBM, Dell, Caterpillar, and United Technologies. The top 25 warranty providers account for 79% of all the warranty reserves and almost 72% of the claims registered by all U.S. manufacturers. So the decision-making of the chief financial officers of those 25 companies has an enormous bearing on the overall ratios.

Another way to measure warranty capacity is to treat each reserve fund, each ratio between accruals and claims, as the outcome of a company's internal decision-making. Every company must decide for itself what percentage of sales to put away to finance future warranty claims, and each CFO must decide how much money is enough to keep in the reserve fund. If every CFO's planning assumptions could be expressed as a ratio, then rather than a weighted average, what might be preferable would be a simple median -- the point at which half the ratios are above and half the ratios are below.

It seems that the CFOs have recently begun to think they don't need to put aside as much as they have in the past. After two consecutive quarters in which the median ratio between reserves and claims was near 14.5 warranty-months, the figure for the third quarter has apparently dropped to 13.5 warranty-months. We say apparently because clearly not every company has yet been heard from. If, as is possible, the last companies to file their 10-Q and 10-K statements report increased reserves and decreased claims, the aggregate ratio could indeed snap back to the 14.5 warranty-month range where it has been all year.

There are at least three possible reasons for this apparent drop. First, John Deere and around 50 other companies have yet to file their financial statements for the third quarter or their fiscal years ended Sept. 31. Second, almost 250 companies saw their claims rates rise as a percentage of sales -- ten rose by more than 2%. And third, around 270 companies decreased the size of their warranty reserves during the calendar quarter running from June 30 to Sept. 30.

Shrinking Reserves

The net effect of these three factors is to reduce the aggregate capacity of warranty reserves from 14.5 to 13.5 warranty-months. While this may seem like a small shift, in truth it represents almost $2 billion. Warranty claims brought against manufacturers stand at $17.5 billion for the first nine months of 2003, so a reduction of one warranty-month currently equals $1.9 billion in fund shrinkage.

Some manufacturers shrank their warranty reserves through changes of estimate for pre-existing warranties. Others did so by decreasing the amount accrued for newly-issued warranties during the quarter. Either approach ends up with the same result -- reduced reserves -- but accrual estimates are supposed to be based on a set percentage of sales, so most companies choose to make overt changes through a change of estimate.

By the end of the third quarter, fifty companies had cut the size of their reserves by more than 20%, including Dana Corp., Gateway Inc., and du Pont. For these 50 companies, because management concluded the reserves no longer needed to be so large, the money moved right to the bottom line as additions to net income and reductions in their cost of sales. If claims rates remain stable, each of these companies has enough in their reserves to feel comfortable.

Over the course of the past three quarters, Warranty Week has computed a total of 1,749 reserves-to-claims ratios for around 650 different companies. The median was 14.2 warranty-months, although the spread was extremely large -- from 0.1 to 2,899 warranty-months. What that means is that the most extremely optimistic company has on hand enough reserves to pay claims for the next 3.5 days, while the most conservative has enough to cover claims for the next 242 years. Clearly, there is more art than science to these companies' estimation techniques.

Warranty Personalities?

What's also somewhat surprising is how different industries seem to have their own distinct personalities when it comes to warranty accounting. Some, such as the computer industry, tend to have higher-than-average claims rates and lower-than-average warranty reserve capacity. Others such as heating, ventilation and air conditioning (HVAC) have quite the opposite personality, keeping higher-than-average reserves on hand despite experiencing lower-than-average claims rates.

The automotive industry tends to be slightly higher than average in both respects. Currently, all manufacturers experience warranty claims at a rate around 1.8% to 2.0% of product sales. GM, Ford, and their suppliers tend to fall into a range of 2.0% to 2.5%. And while the typical manufacturer keeps the capacity of its reserves in the range of perhaps 13 to 15 warranty-months, the automotive companies seem to feel more comfortable in the range of 18 to 20 warranty-months. While anything between 10 and 20 warranty-months is in the comfort zone, 20 is towards the conservative side while 10 is towards the optimistic side.

Then there are the fortunate few who both experience low claims rates and maintain low levels of reserves. New homes, medical and scientific equipment, and semiconductor equipment seem to fall into this category. Manufacturers in these industries sometimes allow their reserves to fall below 10 warranty-months in size, with claims sometimes dipping below 1%.

It's a function of not only what they sell, but how long it is expected to last and how long it will be covered by a product warranty. If the warranty runs for 90 days and if the item is borderline disposable anyhow, the manufacturer will behave one way. If the product is covered by a lifetime warranty and the founder's grandchildren are the ones now running the company, they're likely to act a different way.

In the chart below, we've divided the manufacturing world into four quadrants. The light blue dots in Quadrant I represent industries with high reserves and low claims rates. The darker blue dots in Quadrant II represent the high/high combination. The red dots at bottom right represent the high claims/low reserves pairing, while the orange dots in Quadrant IV represent industries with the low/low combination. The black lines dividing the chart into quadrants represent the weighted average for all manufacturers, or in the case of the warranty reserve-to-claims ratio, the median.

Warranty Claims
and Reserves-to-Claims Ratios
in 12 Industries,
Third Quarter, 2003

Besides HVAC, industries that fall into the frugal and conservative quadrant include mining equipment, power generation equipment, and aerospace. Besides computers, those in the lower-right quadrant include disk drive manufacturers and, surprisingly, makers of recreational vehicles. The reason that's surprising is that their automotive peers are mostly up in Quadrant II, although in truth that has a lot to do with the warranty accounting of Ford and GM. Others in the top-right quadrant include makers of telecommunications and broadcasting equipment, and makers of farm, lawn, and garden equipment and tools.

Of course, not every company in a specific industry is in the same quadrant. In just the aerospace industry, warranty experience ranges from the 1% claims rate and 9.2 warranty-months of military avionics maker L-3 Communications to the 3% and 26 warranty-months seen at Rockwell Collins. Smaller startups are literally all over the chart. One smallish maker of genetic test equipment is experiencing a warranty claims rate of 25%, while keeping reserves with a capacity only slightly longer than three months. Some 35 manufacturers reported no claims at all during the third quarter (which makes their reserves-to-claims ratio infinitely large).

Changes of Estimate

A surprising 184 companies made changes of estimate for pre-existing warranties -- 89 downward and 95 upward. In dollar terms, the biggest downward revisions were reported by General Motors, Ford Motor, Nortel Networks, Lexmark International, and AutoZone. The largest upward revisions were reported by General Dynamics, IBM, Midas, Boeing, and Cummins.

General Motors and Ford have removed $351 million and $258 million, respectively, from their warranty reserves so far this year. However, because their reserves were so vast to begin with, these amounts represent changes of less than 5% for each. The revisions at Lexmark and Nortel represent around 20% of their reserves, and at AutoZone the amount removed represented around 30%. General Dynamic's upwards change of estimate represented almost a 70% increase in the size of its reserve fund. For IBM, Boeing, and Cummins, it represented under 10%.

In percentage terms, it was the smaller companies that made the largest relative changes of estimate. Eight companies more than doubled the size of their warranty reserves through upwards changes of estimate: Midas Inc.; Novitron International Inc.; TriQuint Semiconductor Inc.; Caliper Technologies Corp.; Avanex Corp.; Entegris Inc.; Flexsteel Industries Inc.; and Computer Network Technology Corp. Midas, in fact, because of a change in the way it sells and distributes auto parts, had to add $38.5 million to a reserve fund that was only $500,000 in size. That amount represents a 7000% increase!

Around 52 companies reported changes in warranty reserve fund balances caused by fluctuations in currency exchange rates. Of those, 45 were gains and 7 were losses, which means most of the U.S. companies dealing in international warranty claims payments are benefiting from the declining dollar. The vast majority of the fluctuations were smaller than $1 million, but 14 were larger than $1 million, including Ford (+$276m); GM (+$68m); and Paccar (+$15m).

In next week's column, we'll complete the analysis of this quarter's cycle of warranty reports with a look at some of the companies that are not fully disclosing their warranty reserves, accruals, and claims figures. Meanwhile, readers are advised to keep checking back for updates of the online versions of the Dec. 8 and Dec. 15 editions of Warranty Week, which already have been revised to reflect all the 10-Q and 10-K reports filed last week. While the early word is that claims are up and reserves are down, a few more reports could go a long way towards flattening out these fluctuations.

Many Warranty Week readers, especially those in the manufacturing industries, are taking next week off. However, rest assured that these columns will be waiting for you upon your return. If you're already packing for the getaway, have a happy holiday, and a prosperous new year!

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