December 18, 2008

Warranty Trends in 2008:

With the filing of the last few financial reports of this cycle, it's time to look at warranty costs by industry. The big story in 2008 is how falling sales have made warranty claims less affordable for some companies. Warranty reserves peaked at the end of 2007, but claims are still rising. And for hard-hit sectors such as autos and homebuilding, the worst may still be ahead.

Now that all but a handful of manufacturers have filed their annual or quarterly reports with the U.S. Securities and Exchange Commission, it's time to figure out some totals and trends for warranty spending in the year so far.

As manufacturers continue to feel the effects of the economic slowdown, they have collectively cut their warranty accruals by 4.7% to just under $21 billion for the nine months ended September 30, 2008, compared to the same period in 2007. That's to be expected as sales also fall.

But because warranty claims reported in 2008 reflect repairs made on products sold in earlier periods, there's a lag time between claims and sales that really begins to hurt when sales are falling. The total amount of claims paid so far in the first nine months of 2008 is up by 2.2% to just under $21.5 billion. All three quarters of 2008 have seen claims surpass $7 billion -- the first time that has ever happened.

With claims rising and accruals falling, one would expect the total amount of warranty reserves to shrink. And so far this year the balance has shrunk by more than $1.3 billion to $39.3 billion. That's the lowest collective warranty reserve balance has been for U.S.-based manufacturers since early 2006.

According to our revised figures, warranty reserves seem to have peaked at the end of 2007, when American manufacturers reported $41.3 billion in their respective warranty reserve funds. It has declined in each consecutive quarter this year, as can be seen in Figure 1 below.


Figure 1
All U.S.-based Manufacturers
Warranty Reserve Balances by Industry, 2003-2008
(in $ millions at the end of each quarter)

Figure 1

Legend


Note that we're continuing to use the same color code for industries as was used in the series of articles published from March 26 to May 8 of this year. Note also that because companies such as Dura Automotive have recently caught up on some of their past-due financial filings, some of the totals has changed for years past.

Traditionally, Warranty Week inserts a placeholding estimate for late companies and for those who file their warranty expense reports only once a year (instead of the required quarterly schedule). When the actual data becomes available, we update the database retroactively. In fact, some of the most recent data is highly likely to change again once major warranty providers such as General Electric, Black & Decker, Motorola, Honeywell and Eaton file their annual reports and reveal what has actually happened to their warranty funds during the first nine months of 2008, as opposed to our best guesses.

Cutting Warranty Liabilities

Among the biggest surprises of the year so far is how Ford Motor Co. has been able to slash its warranty reserve balance so dramatically, for a mix of reasons that include cost-cutting efforts, quality improvements, falling sales, and the divestiture of several luxury nameplates including Aston Martin, Jaguar, and Land Rover. Ford's warranty reserve balance peaked in June 2006 at a level of $6.3 billion; it has since shrank in size by more than $2 billion to $4.1 billion.

To help put this in perspective, only three American companies have ever had more than two billion dollars in their warranty reserve. Besides GM and Ford, only HP has gone above the $2 billion mark. And Ford has reduced its warranty liabilities by more than any of them: $2 billion in two years.

General Motors peaked later and has fallen less, with its warranty reserve hitting a high mark at the end of 2007 with a balance of $9.6 billion, and a contraction of only $600 million to date. Still, the two companies combined have the power to move averages, which indeed they did, as can be seen in the blue band of Figure 1, and in closer detail, also in Figure 2 below.


Figure 2
Automotive OEMs
Total Warranty Reserve Balances, 2003-2008
(in $ millions at the end of each quarter)

Figure 2


The automotive OEMs as a group saw their reserves peak at $18.7 billion in mid-2007, roughly a year after Ford hit its all-time high and half a year before GM did. Among makers of larger vehicles, Caterpillar and Deere still allow their warranty reserves to grow alongside sales volumes, while Navistar and Paccar are allowing their balances to fall a slight bit. But as a group, their collective warranty reserve balance is now back to 2004 levels, as is shown in Figure 2.

Bailout Watch

Ford also lowered its claims rate as a percentage of automotive revenue (but GM saw its claims rate jump to 3.4%), and both Ford and GM reduced the amount they set aside in accruals to pay future claims. At the end of September, the pair had a combined warranty reserve balance of $13.16 billion, which represents their best guess as to the future warranty liabilities generated by past sales> Interestingly, that figure is on par with the amount now being sought in government bailouts. In other words, another way of looking at it is to say that the automakers are now seeking a loan to help them pay their dealers for warranty work.

As the year comes to a close, they still haven't gotten their money (and Ford says all it really needs is a line of credit, just in case). But as they continue to assert that nobody would buy cars from a bankrupt manufacturer, for fear that the warranties would not be honored, an idea comes to mind. What if the automakers sought outside insurance for their warranties, decoupling the fate of their claims from the fate of their companies? What if they paid the premium for $13.16 billion worth of warranty insurance, and a third party administrator took over the payment and processing of claims? Perhaps they could even partner with an already-bailed-out insurance company such as AIG? They might even get to tap into the AAA debt rating of the Federal Reserve for their reinsurance.

Failing that, why not sell the vehicles as-is with no warranty, reducing the sticker price by $1,000 and encouraging buyers to seek extended warranty coverage on the open market? Maybe it's an absurd idea, but it's just as absurd for a company threatened with bankruptcy to be trumpeting to its potential customers that nobody should buy a car from a company threatened with bankruptcy. If they can't reduce the threat of bankruptcy, why not reduce the linkage between the manufacturer and the warranty?

Claims & Accrual Rates

In Figure 3 below, we've taken total for all claims paid and divided it by a weighted average of all U.S. manufacturing sales. The averages include all financial reports filed with the SEC before December 18, and for the handful of late and annual-only filers, we've inserted placeholding estimates.

These estimates can't be blamed for the apparently rising claims rate (in red) or the rising accrual rate (in green), because all they do is retain the most recent ratios until better data comes along. So while we don't yet know what GE's claims and accrual rates will be for 2008, we know what they were for 2007, and the estimates we used for 2008 are exactly the same.


Figure 3
All U.S.-based Manufacturers
Warranty Claims & Accrual Rates, 2003-2008
(as a percentage of product sales)

Figure 3


Granted, the scale in Figure 3 is stretched to the limit in order to better show the movement of the ratios over the past six years. And in reality, the recent rises follow multiple years of declines. But what's worrisome is that claims now outpace accruals. And the timing suggests that perhaps while manufacturers had an opportunity to focus on warranty cost reduction during the years 2003 to 2007, those efforts may have bottomed out last year. Now, declining sales and for some the very survival of the company may have taken precedence.

Then again, these ratios rely just as much on sales as they do on claims or accruals. In industries where sales have fallen by 30% or 40% or more, it's no surprise that the claims rate has gone up. Even if claims remained exactly the same, the rate would go up because sales went down.

Claims Paid in 2008

So far in the first three quarters, some 700 manufacturers have reported paying on the order of $21.6 billion in claims. That's up about $560 million from the same period in 2007, which in turn was up about $160 million from the same period in 2006.

As can be seen in Figure 3 above, manufacturers paid out around 1.7% of product revenue in claims costs through September 2008, up a slight bit from the 1.6% rate seen at the same point in 2007. The claims rate was about the same as a year ago at the end of the third quarter of 2006. And yes, these rates imply that the amount of manufactured goods sold under warranty was flat in 2007 at $1,340 billion and was down in 2008 to $1,280 billion. That's only a 7.5% decline in sales, which is far from the calamity now being described in the popular press.

Then again, these measurements stopped on September 30, a mere two weeks after the collapse of Lehman Brothers set off the worldwide financial panic. And for many manufacturers outside the trouble spots of automotive and homebuilding, sales were actually up in the first three quarters of 2008. So perhaps both sales and warranty costs will take a much steeper downturn in the fourth quarter, once the full effects of the bailouts is felt?

In Figure 4 below, we've taken all the claims for all the companies and assigned them to one and only one industry category each. This means that conglomerates with diverse product lines -- air conditioners and airplanes, for instance -- are assigned to the category in which most of their warranty expense is likely to be generated. And it means that some categories may be a slight bit larger or smaller than they would be if companies reported warranty by product line instead of one big set of enterprise-wide numbers.

Warranty Market Shares

We performed much the same "warranty market share" operation in the April 10 newsletter, in which a pie chart was provided for calendar 2007, and that chart was linked to a page containing additional pie charts for 2003 through 2006. Using the same color code, we've constructed below a pie chart for the first three quarters of 2008, which we'll once again link to that supplementary page for the sake of comparison.


Figure 4
All U.S.-based Manufacturers
Warranty Claims Paid per Industry, 9 Months 2008
(as a percentage of the $21.6 billion total)

Figure 4

Legend


There hasn't been a lot of change since the end of 2007, but a few categories have gained or lost a bit of share in that period. The automotive OEMs continue to pay out around 40% of all claims, as they have for multiple years. But their parts suppliers paid out a bit more -- 7% this year as opposed to 6% last year -- which suggests that supplier recovery efforts are having an impact.

Taken together, the automotive OEMs and their suppliers accounted for 46.1% of all product warranty claims, up from 45.2% in the same period in 2007. Computer and appliance manufacturers have also gained a percentage point each, while aerospace manufacturers saw their slice of the pie shrink from 5% to 3%.

As was mentioned, automotive parts suppliers have seen their collective warranty costs increase both on a dollar basis and as a percentage of sales. That increase is detailed in Figure 5. Nine-month claims have grown from $1.25 billion to $1.42 billion, and the most recent quarter's $511 million total was the highest ever.


Figure 5
Auto Parts Suppliers
Warranty Claims Paid, 2003-2008
(in $ millions per quarter)

Figure 5


Meanwhile, the collective claims rate of these 90 auto suppliers inched up to 0.71% in the most recent quarter, up from 0.58% a year ago and 0.62% two years ago. But at the same time, their accrual rate is actually falling a bit, from 0.72% in 2006 and 0.74% in 2007 to 0.69% in 2008.

It's possible that once Eaton and Illinois Tool Works file their annual reports, we'll have to revise these figures. But even without them, it's clear that for auto parts suppliers, warranty costs are on the rise. And for Ford, at least, warranty costs are on a downward trend. Does this mean that supplier recovery efforts are finally beginning to move the averages? Or does this once again have more to do with falling sales?

Homebuilder's Lament

For a demonstration of what happens to claims when sales plummet, one needs to look no further than the new home builders, who in several instances have seen their revenue cut in half in the past year. It should come as no surprise, then, to see in Figure 6 that claims are now down more than 44% from their year-end 2006 peak of $253 million.


Figure 6
New Home Builders
Warranty Claims Paid, 2003-2008
(in $ millions per quarter)

Figure 6


The claims rate just before that peak, in the third quarter of 2006, stood at 0.77%, while the accrual rate was 0.76%. By the third quarter of 2007, sales were falling so claims rose to 0.96%. But the accrual rate stayed about the same at 0.72%, which is as it should be whether sales are rising or falling.

Accruals rose slightly to 0.8% by the end of the third quarter of 2008, which is amazing given the steep drop in sales. But claims rose to 1.15%, because the homebuilders were fixing last year's homes with this year's reduced revenue. The claims rate was even higher in the middle of the year, peaking at a worrying 1.34% rate in the June quarter (in an industry where sub-one-percent rates are the norm).

Through it all, homebuilders such as D.R. Horton Inc. and Lennar Corp. have kept their accrual rates more or less the same as they were in 2007 and 2006. NVR and Hovnanian Enterprises actually increased their accrual rates as sales fell. But then there's the curious case of Pulte Homes, which cut its 1.2% accrual rate by almost a third in 2006-07, and by more than a third again in 2007-08, to only 0.5%. So are its houses really that much better? Or is the company hoping nobody notices how it's manipulating accruals?


Happy Holidays!

Incredibly, another year has flown by. This is the final newsletter of 2008 for Warranty Week, and we wanted to take this opportunity to wish all our readers and sponsors a very happy holiday, and a prosperous, safe, healthy and happy new year. We'll return with our first newsletter of 2009 during the week of January 5.





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