Product warranty costs in the semiconductor and printed circuit board industry tend to flow towards the manufacturers of the machines that are used to make the parts, rather than to the parts themselves.

In an analysis of a hundred semi and PCB manufacturers, Warranty Week has found a noticeable split between the device manufacturers and their suppliers. But this is quite unlike the splits seen in the automotive and computer industries, where those located further up the supply chain have generally lower warranty costs.

Slowing Growth in Claims

Altogether, these hundred manufacturers reported $748 million in claims during 2006, up 2.5% from 2005 levels. As the chart in Figure 1 suggests, this represented a slowdown in growth rates, which in this business is actually a good thing. The Growth rate from 2004 to 2005 was 11.5%, and it was 13.8% from 2003 to 2004.

Of the 80 manufacturers for whom warranty claims rates could be calculated at the end of both 2005 and 2006 (some are still not completely compliant with FASB FIN 45 disclosure rules, and four are late with their recently due financial statements), 50 reported annual declines in their claims rates and 30 reported increases.

However, even many of those showing incredible increases were coming off a low 2005 figure. For instance, PMC-Sierra Inc., makers of data communications-related chips for customers such as Hewlett-Packard and Cisco Systems, saw its claims rate rise from 0.004% at the end of 2005 to 0.18% in 2006. That's more than a 4000% jump, which would give fright to virtually any chief financial officer. But in reality, 0.18% is still way below the industry average of 1.3%, so it's really nothing to worry about.

At the other extreme, Silicon Image Inc. went from an 0.1% claims rate in 2005 to a 0.02% claims rate in 2006, for a decline of 88%. Keeping in mind that declines of more than 100% are not possible, this is a massive movement. But in reality, the company is simply going from a merely small warranty cost to a really tiny warranty cost.

What's surprising is how much company Silicon Image has at the sub-one-percent level. Among the 80 companies for which annual comparisons were possible, there was actually one with an even lower claims rates: Genesis Microchip Inc. And then there were 39 others with claims rates below 1%, 35 companies between 1% and 5%, and four over 5%.

Making Suppliers Pay

Most of those below 1% manufacture chips and boards, while most of those over 1% make test systems and production machinery. While there are some exceptions, there does seem to be a split along these lines. For instance, as we've charted in Figure 2, Novellus Systems Inc. and Applied Materials Inc. are in a range of 2% to 7%, while Advanced Micro Devices Inc. and Cypress Semiconductor Corp. are down around 0.5% to 1%.

We'd put more companies on the chart, but then it would get too crowded, especially at the bottom. But this should be sufficient evidence to support the theory that production machinery makers suffer far higher warranty costs than those who use the machinery to make semiconductors and printed circuit boards.

It's a good thing they report their warranty costs at all, particularly the device manufacturers. For while AMD and Cypress fully comply with FASB FIN 45 disclosure requirements, competitors such as Intel Corp., Texas Instruments Inc., Analog Devices Inc., and Micron Technology Inc. make absolutely no warranty disclosures at all. Their stated reason is that their warranty costs are "immaterial," and therefore not worth the effort.

The question is, how small does it have to be to become immaterial and insignificant? There's no language in FIN 45 that allows companies to make that determination -- nothing that says that 1%, or 0.1%, or even 0.01%, is so low that it isn't worth measuring. FIN 45 was designed to force companies to disclose all the guarantees they make, and it came about after undisclosed guarantees helped companies such as Enron to collapse in scandal. Perhaps one day the U.S. Securities and Exchange Commission will awaken from its slumber and begin enforcing the rules.

Lowest Claims Rates

In Figure 3, we took the top 50 warranty providers in the semiconductor and PC board industry, and figured out which 10 had the lowest warranty claims rates. Then we compared them to claims rates seen at the end of 2005. Six were up and four were down, but all 10 were far below a level most would call significant. So why did they bother when these very large companies didn't?

Source: Warranty Week from SEC data   

Genesis Microchip and Silicon Image didn't make the cut because they paid out so few dollars in warranty claims. Genesis paid out $476,000, while Silicon Image paid out only $38,000 (on product sales of $250 million). All of the top 50 paid out $1 million or more in claims per year.

Highest Claims Rates

At the other extreme, there are numerous companies in the semiconductor and PC board industry that experience higher than average warranty expenses. In Figure 4, we've once again sifted through the top 50 warranty providers, this time to find the 10 with the highest warranty claims rates.

They're not on this chart because they're careless or sloppy, though. It's not because their quality is so much lower than those in Figure 3. We think they're here because of the way warranty costs seem to be pushed backwards up the supply chain in this industry. In other words, perhaps the reason the cost of warranty is so "immaterial" to Intel and TI is because it's so very real and obvious to some of their equipment suppliers.

Source: Warranty Week from SEC data   

That's not to say that everything is fine. At the top of the list, Photon Dynamics Inc. turned in a 7.2% claims rate during the fourth quarter of calendar 2006, based on $1.5 million in claims on $21.4 million in sales. A year ago, the company paid out $550,000 in warranty claims on $41,6 million in sales. And so, as claims trebled and sales halved, the claims rate shot up 440%.

The good news, however, is that other companies are on the downswing, having seen their claims rates peak in 2004 or 2005. For instance, Novellus Systems had a claims rate at or above 6% for most of 2005, peaking in the third quarter when it paid out $22.7 million in claims. In contrast, the fourth quarter of 2006 saw a claims rate just under 5%, as it had been for most of last year. Sales are up, claims are down, and what a difference a year makes!

What Causes the Volatility?

There does, in fact, seem to be a lot more volatility in this industry segment, as compared to others such as automotive and appliances. We think there are three reasons. First, most of these equipment suppliers aren't making millions of units. Actually, some of their machines can cost millions of dollars each. So they don't sell many -- certainly not in the volumes seen for washing machines or family sedans. And, with such a small installed base to service, repair rates will be more unpredictable.

Second, those who do make millions of devices make them more or less the same way every time, or at least they try to. So if there's a problem, it's going to be widespread but at the same time localized. In other words, if there's a 1% defect rate all year, chances are there will be one batch that's 90% defects and 99 batches with close to 0% defects. That's a recipe for volatility.

Third, the semiconductor and PC board industry is quite young in comparison to the 96-year-old Whirlpool or the 104-year-old Buick or the 170-year-old John Deere. Perhaps because they've been manufacturing longer, selling longer, and repairing longer, they have a better grip on warranty costs?

Images of Volatility

In Figures 5 and 6 we're spotlighting two companies -- one from the equipment side and the other from the device side. Both have claims rates that have remained within a range of 0.5% and 2% for the past few years. But that is where the similarity ends.

Lam Research makes plasma etching machines and cleaning equipment that semiconductor manufacturers use to produce their products. Nvidia makes graphics chips for computer and video game console manufacturers. So one is on the equipment side and the other is on the device side.

Lam Research has a rather volatile track record, not only in terms of claims (in blue) and claims rates (in red), but also in accrual rate (in green). The red and the green lines hardly ever meet. And in fact, one seems to be rising while the other is falling.

The company's warranty reserve fund now has over a $45 million dollar balance, up from $30 million at the end of 2005 and only $13 million at the end of 2003. But claims have never been over $3 million per month. And, in fact, the reserve was just under $40 million in size in 2004, when claims averaged less than $2 million per month. So this is a good example of how volatile it gets in this industry.

In contrast, Nvidia exhibits much more volatility in terms of claims paid, with a high quarter of $16.3 million and a low quarter of $1.9 million coming within a year of each other. And its claims rate has grown from 0.5% to 1.7% over the past four years, though it was most recently back down under 0.7%.

Parallel Rates

But notice how the claims and accrual rates seem to move together, whether they're going up or down. The two seem intertwined like strands of a rope. What this means is that the company is observing changes in payouts, and is compensating by adjusting its accruals accordingly. As volatile as these rates have been, the company's warranty reserve has remained between $8 million and $13.5 million in size for the past four years.

Again, we think it has a lot to do with the nature of the business, and the ability (or inability) to spot trends. For equipment suppliers such as Lam Research, warranty costs are unpredictable, because their installed base of equipment is so small. For device manufacturers such as Nvidia, warranty costs are more predictable, though they tend to spike during bad quarters and plummet during good ones. But at least the company can see it coming, and can adjust its accruals accordingly.

The pattern seems to hold elsewhere in the industry. For instance, at Applied Materials and Novellus, the claims and accrual rates hardly ever cross, while at Honeywell International and Cypress Semiconductor, they move in parallel. But they all seem to move significantly over time. Unlike in the computer or automotive business, there doesn't seem to be a single major semiconductor or PC board company for which warranty costs can be said to be stable over the past four years.