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November 20, 2008

Warranty Cost Cutting:

Among the top 100 warranty providers, more than half have reduced the percentage of sales they allocate to warranty costs in the past year. Some have cut their accrual rates by a third, a half, or even more. And many have also seen their claims rates fall, suggesting not only cost cutting but also quality improvements.

Despite all the turmoil in financial markets, many of the top U.S.-based warranty providers have reduced the amount they set aside to pay warranty costs in the year ended September 30, 2008.

Out of the top 100 U.S.-based warranty providers, as ranked by the amount spent on warranty claims so far this year, 57 saw their accrual rates decline, as measured by the percentage of product sales revenue allocated to pay future warranty claims. Of those, 33 reduced their accrual rates by more than 10% and twelve reduced their accrual rates by more than a third.

If the finance departments of these manufacturers are responding to increases in product quality by cutting warranty accrual rates, this is very good news for American companies. But if they're artificially cutting expenses by underfunding their warranty reserves to boost profits (or reduce losses), this could be very bad news. It would mark a return to the era of WorldCom and Enron, whose book-cooking antics marked the depth of the last financial panic.

The problem is that one can't tell if these reductions are legitimate or not until some time passes. Warranty accruals are forecasts of future costs, and as such they cannot be proven right or wrong except in hindsight.

In looking at the corresponding warranty claims rates for the past year in hindsight, however, it looks like only 28 of the 57 companies have also seen their claims rates decline since September 2007. Normally, reductions in accruals would follow reductions in claims. When a drop in one isn't confirmed by a drop in the other, suspicions rise.

Top Accrual Reductions

The chart below ranks the 50 biggest decreases in warranty accrual rates in the past year, as measured at the end of the third quarters of 2007 and 2008. Warranty accruals are measured in both millions of dollars and as a percentage of product sales. The magnitude of the percentage declines are omitted, but they can be easily inferred from the difference between the two rates.

The companies at the top of the list have cut these percentages by the greatest proportions. Delphi, for instance, has cut its accrual rate by more than three-quarters, from 1.3% in September 2007 to 0.3% in September 2008. We profiled the company in the November 13 newsletter, along with Navistar International Corp., another manufacturer towards the top of the list.

Further down the list, if the percentages have decreased from year to year but the dollar amounts have not, this means that sales are rising faster than warranty accruals. Therefore, the percentage rate declines though the dollar amounts rise.

At the very bottom of the list, the accrual rates for Manitowoc and L-3 Communications fell by such small amounts that we had to lengthen the number of decimal places so they wouldn't be obscured by rounding errors. Still, a decline is a decline, and in the chart below, all 50 companies saw a decline in their year-over-year accrual rates.

Top U.S.-based Warranty Providers:
Biggest Declines in Warranty Costs,
Accrual Rates in Sep. 2008 vs. Sep. 2007
(in $ millions and percent of sales)

   Accruals   Accrual   Accruals   Accrual 
  Made in Rate on Made in Rate on
  Company  9mo '07   9/30/07   9mo '08   9/30/08 
  Delphi Corp. $264 1.3% $47 0.32%
  Juniper Networks Inc. $32 1.7% $25 0.5%
  Microsoft Corp. $1,034 4.3% $127 1.8%
  KLA-Tencor Corp. $48 2.6% $21 1.3%
  Lam Research Corp. $47 2.1% $30 1.2%
  Pulte Homes Inc. $52 0.83% $21 0.47%
  3Com Corp. $33 3.3% $20 2.0%
  BorgWarner Inc. $52 1.3% $35 0.8%
  TRW Automotive $43 0.43% $33 0.27%
  Garmin Ltd. $66 3.9% $95 2.5%
  Navistar International $182 2.1% $147 1.4%
  Joy Global Inc. $23 1.4% $24 0.95%
  Quantum Corp. $16 3.5% $16 2.5%
  Polaris Industries Inc. $31 2.7% $29 2.0%
  Jarden Corp. $87 3.6% $87 2.7%
  AGCO Corp. $100 2.2% $123 1.6%
  Ford Motor Co. $2,569 2.2% $1,803 1.7%
  Thermo Fisher Scientific $30 0.42% $26 0.33%
  Applied Materials Inc. $142 1.9% $94 1.5%
  DRS Technologies Inc. $14 1.1% $26 0.92%
  Agilent Technologies $42 1.3% $38 1.1%
  Danaher Corp. $70 0.88% $70 0.74%
  EMC Corp. $107 2.6% $124 2.2%
  Whirlpool Corp. $470 3.1% $493 2.7%
  General Dynamics $56 1.5% $54 1.4%
  Sherwin Williams Co. $22 0.36% $20 0.32%
  Goodrich Corp. $39 0.81% $39 0.72%
  Cisco Systems Inc. $395 1.7% $376 1.5%
  Champion Enterprises $31 4.3% $23 3.8%
  Nortel Networks Corp. $182 2.7% $164 2.4%
  Pentair Inc. $52 2.0% $48 1.8%
  Textron Inc. $139 1.6% $146 1.5%
  Cummins Inc. $298 3.1% $319 2.9%
  Paccar Inc. $240 2.3% $233 2.1%
  IBM Corp. $331 2.3% $294 2.1%
  Dell Inc. $884 2.7% $959 2.5%
  Masco Corp. $42 0.88% $35 0.82%
  Sun Microsystems Inc. $208 3.7% $206 3.5%
  Toro Co. $37 2.5% $36 2.4%
  KB Home $40 1.0% $17 0.93%
  Briggs & Stratton $26 1.94% $24 1.86%
  Brunswick Corp. $86 2.5% $73 2.4%
  Harman International $40 2.2% $112 2.1%
  Boeing Co. $137 0.56% $128 0.54%
  Visteon Corp. $36 0.45% $33 0.44%
  Lexmark International $204 18.5% $166 18.1%
  Harley-Davidson Inc. $38 0.94% $38 0.92%
  Deere & Co. $384 2.5% $428 2.4%
  Manitowoc Co. Inc. $40 1.37% $45 1.35%
  L-3 Communications $24 0.512% $26 0.508%

Source: Warranty Week from SEC data   

What we're doing essentially is comparing each company against itself this year and last year, and then ranking the magnitude of the changes. Because companies might compute warranty costs differently, including or excluding items such as training or call center costs, we can't compare one company against another. However, if companies are consistent over time, their results in 2008 can be compared to their results in 2007.

We focused on accrual rates because they're less vulnerable to changes in sales volumes than claims rates. If, as is common in this post-panic world, sales are falling sharply, a company would be using a reduced pool of funds to fix last year's sales. That would drive up the claims rate even if quality was increasing or remaining the same.

In contrast, the accrual rate should remain more or less proportional to sales, unless there's been a change in quality, unit pricing or product mix. If a company sells 1,000 widgets and estimates the future warranty costs to be $10 per unit, it should accrue $10,000 to cover those expenses. If sales fall to 500 units, the company should reduce accruals to $5,000. The accrual rate remains the same: $10 per unit.

So if the accrual rate falls by 50% or more, that should signal some big gains in quality, big price increases, or rising sales of products with relatively lower warranty costs. Absent any of these factors, the accrual rate should remain the same.

23 Missing Companies

Among the top hundred warranty providers, 10 companies have chosen to report their warranty costs only once a year, and 13 had not yet filed their third quarter financial statements with the SEC as of Nov. 20, 2008. Those 23 companies will be included in the year-end warranty cost report, which is expected to be published in March 2009. In their absence, we pulled in 23 replacement companies from further down the list.

Among these 50 warranty cost-cutting companies, five stand out for the remarkable way they have cut both claims and accrual rates during the past year or more. And being as the old saying states that a picture is worth a thousand words, we'll cut the word count down considerably by including five company snapshots below.

Networking security company Juniper Networks has actually seen claims fall faster than accruals, but as can be seen in Figure 1, both rates have fallen precipitously in the past four quarters. In addition, whatever happened to the company in 2003 and early 2004 is now a distant memory. Claims and accrual rates peaked in the second quarter of 2004, and except for a bump or two in 2006 and 2007, have been relatively steady until recently. And then, a pronounced drop began in 2008.


Figure 1
Juniper Networks Inc.
Warranty Claims & Accrual Rates, 2003-2008
(in $ Mil & percentage of product sales)

Figure 1


3Com Corp., another network hardware supplier, has been on a pronounced multi-year downtrend in warranty costs, which can be seen in Figure 2. Incredibly, in 16 of the past 17 quarters, 3Com's claims rate has been sequentially lower than it was in the quarter before. So it's been one long and smooth slide down from the near-6% claims rates seen in mid-2004. There have been a few more bumps up and down in the accrual rate since then, but it's clear that in the long term it too has been trending downwards.


Figure 2
3Com Corp.
Warranty Claims & Accrual Rates, 2003-2008
(in $ Mil & percentage of product sales)

Figure 2


Automotive supplier BorgWarner saw its warranty costs spike in early 2007, when a quality problem came to light in a product it made in 2004 and 2005. In the first quarter of 2007, the company had to set aside an additional $14 million to deal with the problem, sending its accrual rate skyward.

And then the accrual rate began falling back to the "normal" range, falling for the next four consecutive quarters. This year it's begun to creep up again, but in the year-to-year comparison, it's down by more than a third, from 1.3% to 0.8%.

Claims, meanwhile, exceeded 1% of product revenue only once in the past six years, as the company worked off its warranty problem during 2007. Now the company's claims rate also is back into the "normal" range.


Figure 3
BorgWarner Inc.
Warranty Claims & Accrual Rates, 2003-2008
(in $ Mil & percentage of product sales)

Figure 3


Disk drive maker Quantum Corp. has reported an accrual rate lower than its current 2.5% level only twice in the preceding 22 quarters. Its claims rate has been lower than it is now only once before (since 2003). So in both respects, the company is now at the low end of what has been "normal" for at least the past six years. And since warranty expense reporting began only six years ago, there's no way to know what happened before.

Other top data storage companies haven't been so lucky lately. While EMC Corp. saw its accrual rate fall from 2.6% to 2.2% in the past year, Western Digital Corp. and Seagate Technology actually increased their respective rates during the same period. All three of those competitors also saw their claims rates rise in the past year, with Western Digital seeing the biggest percentage jump. Meanwhile, Quantum's claims rate fell by almost a quarter, from 4.9% in September 2007 to 3.8% this year.


Figure 4
Quantum Corp.
Warranty Claims & Accrual Rates, 2003-2008
(in $ Mil & percentage of product sales)

Figure 4


Finally, here's a snapshot of consumer products company Jarden Corp. The company didn't begin reporting its warranty expenses until 2005, so we have no data in Figure 5 for either 2003 or 2004. But in the past four years, Jarden twice surpassed the 5% claims level that usually signals danger. And then it quickly declined.

Both times, those spikes occurred in the first calendar quarter of the year. Most companies that follow such a seasonal pattern sell products that rise and fall with the weather, such as snowmobiles or lawn mowers. And then there are some that seem to pack the financial report filed at the end of their fiscal years with as much expense as they can sweep into it.

Neither seems to be a factor here. While Jarden has some well-known outdoor and sporting brands such as Coleman and Rawlings under its wing, its sales are dominated by household appliances sold under brand names such as Sunbeam, Crock-Pot, and Mr. Coffee. And its fiscal year ends on Dec. 31, before these spikes occur. Still, the beginning of 2008 passed with only a minor upward tick, and warranty costs have fallen since.


Figure 5
Jarden Corp.
Warranty Claims & Accrual Rates, 2003-2008
(in $ Mil & percentage of product sales)

Figure 5


At the other extreme, six of the top 100 warranty providers more than doubled their accrual rates in the past year. That unfortunate bunch includes A.O. Smith Corp., Advance Auto Parts Inc., Boston Scientific Corp., Eastman Kodak Co., Hovnanian Enterprises Inc., and Nvidia Corp. All six of them were responding to massive spikes in their respective claims rates, which shot up between 80% and 250% over the same period.

Stock Market Correlation?

Out of curiosity, being as this was the day the U.S. stock markets hit fresh new multi-year lows, we looked to see whether investors have rewarded any of the accrual-cutting companies for reducing their warranty expenses by such large amounts. The short answer is no. Warranty does not seem to have any bearing on a company's share price, or at least not during this financial panic.

Common shares of all five companies spotlighted above are down more than 60% since the market peaked on October 9, 2007, as opposed to a 52% fall for the Standard & Poor's 500 Index. Quantum, in fact, is down an incredible 97%, from $3.80 a share in October 2007 to only 11 cents today.

Since that market peak, Jarden is down 75%, 3Com is down 69%, and BorgWarner is down 65%. In fact, five years ago, when 3Com first reported claims and accrual rates rising above the 5% danger level, its common shares were selling for exactly five times as much as they did today.





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