The makers of medical equipment and scientific instruments aren't completely immune to the impact of the recent recession, but it does seem like the annual budget cycles of schools and universities has more of an effect on their sales revenue and repair budgets than anything else.

Like the aerospace and telecom equipment industries, the medical and scientific equipment industry is more of a business-to-business enterprise. These are the makers of the machinery that fills doctors' offices, hospital rooms, clinics, laboratories, and science classrooms. Much of what they make is filled with computers and electronics, and all of what they produce is designed for maximum uptime and reliability. With life-saving equipment, failure is not an option.

To examine trends in the warranty expenses of manufacturers in this industry, we began with a list of 196 U.S.-based companies that manufacture either medical devices or scientific equipment. And as we've done in the last two annual reports on this industry, in 2013 and in 2012, we separated out the companies that are making products which involve the use of either lasers or X-rays.

Our theory is that while most types of medical and scientific equipment are highly reliable and therefore have relatively low warranty expense rates, anything involving lasers or X-rays has a much higher warranty profile. And that proved to be true again this year. While most medical and scientific equipment has warranty expense rates somewhere between 0.5% and 1.0% of their selling price, anything involving lasers or X-rays is going to see expense rates upwards of 1.5%. Whether it's used for tattoo removal or dental imaging, the equipment is going to break more often and cost more to fix.

To prove this, we collected four warranty metrics from each of the 196 companies over the past 44 quarters (11 years). Three come from the warranty table that's usually inserted into the footnotes of each quarterly or annual report, and one comes from the income statement. And then we divided two of those metrics by another metric, to produce a pair of percentages.

Warranty Metrics

Let's start with the metrics from the warranty table. Every manufacturer that uses the accrual method to pay for its warranty costs is required to disclose the beginning and ending balance in its warranty reserve fund, the net amount of subtractions from that fund used to pay claims, and the net amount of additions to that fund in the form of warranty accruals, plus any adjustments required to account for foreign exchange, acquisitions, divestitures, or changes of estimate.

In Figure 1, we've totaled up the amount of claims payments for the past 11 years, counting the four quarters that end in any particular calendar year even if those periods don't correspond to a manufacturer's fiscal year. In other words, if their fiscal year ends on June 30, we count the third and fourth quarters of one fiscal year and the first and second quarters of the next fiscal year as the sum for any particular calendar year. That matters immensely, because some of the biggest warranty providers in the industry, such as Varian Medical Systems Inc., Hill-Rom Holdings Inc., Coherent Inc., Medtronic Inc., and Sirona Dental Systems Inc., don't end their fiscal years on December 31.

Figure 1 illustrates two essential facts about the medical and scientific industry. First, there's roughly a 6-to-1 ratio between the claims totals of the main body of the industry and those of just the laser and X-ray companies, though in some years it's been as high as 7:1 and as low as 5:1. And second, though there's no real recessionary trough in this industry, compared to what we've seen with passenger cars and new houses, 2008 is still the high water mark for claims payments.

The 196 companies paid $952 million in claims during calendar 2008, as opposed to $811 million in 2013 and $855 million in 2012. Or to put it another way, 2013 is in the exact middle, with five annual totals above $811 million and five below it. And again, unlike the automotive or housing industries, there's no multi-year up or down trend in evidence.

However, if we focus in on just the X-ray and laser companies, we can in fact spot a trend. For just these 24 companies, 2008 was also the high water mark for claims payments. In fact, claims were up a little every year for this group from 2003 to 2008.

And then in 2009, the recession took hold and claims fell precipitously. But then in 2010, claims were up a little. Then again in 2011 and 2012. And in 2013, claims hit $133 million, their second-highest total of the past 11 years.

So what we're seeing just for the X-ray and laser companies, and just for their claims payments, are two expansionary periods: from 2003 to 2008, and then again from 2009 to 2013.

Warranty Accruals

With warranty accruals, the patterns are a little different. First, as can be seen in Figure 2, 2008 was also the peak year for accruals made by the 196 companies together. However, the $938 million total for 2005 came in a very close second. And the $819 million total for the calendar year 2013 was closer to the bottom than it was to the top (it came in at eighth out of 11).

There also is a bit of a difference in the pattern of the X-ray and laser company accruals. They're also close to a 6-to-1 ratio, and they also have seen accruals grow a little each year from 2009 to 2013. However, 2013 is their biggest year for accruals, not 2008. In fact, 2008 is fourth.

Overall, though, what we see in Figure 2 is a market that goes up and down from year to year, paying only slight attention to the overall economy's booms and busts. In fact, last year the laser and X-ray group saw overall product sales fall 1.6%, while the others saw sales fall by 0.8%.

Expenses vs. Sales

Product sales is our third warranty metric, so the trend in top-line revenue does have an impact. Among the top warranty providers in the medical/scientific equipment industry, we've seen a mixed picture in 2013. For Danaher Corp. and Thermo Fisher Scientific Inc., sales were up slightly, but for Agilent Technologies Inc. and Hill-Rom Holdings, sales were down a bit.

The biggest sales move in our top 20 that wasn't tied to either a major acquisition or a bankruptcy was Illumina Inc., which is in the red-hot sector of genetic testing. Its annual sales were up 20% in 2013, while its claims and accrual totals were actually down a bit.

You know what that means. The reason we collect sales data is to divide claims and accrual totals by sales, to figure out what percentage of a company's product revenue is going towards warranty expenses. If product sales rise 20% but claims and accruals remain the same, those percentages are going to fall. But if those expense totals also miraculously fall, those percentages are going to plummet.

And so, it's no surprise for us to report that Illumina saw its claims rate fall from 1.8% in 2012 to 1.2% in 2013, while its accrual rate fell from 1.6% to 1.2% over the same period. That was one of the biggest drops in the entire industry.

In Figure 3 we can see the average claims and accrual rates for the medical and scientific manufacturers over the past 44 quarters. At the top we see the average for just the 24 makers of laser and X-ray equipment. At the bottom we see the average expense rates for the other 172 companies.

It becomes immediately clear that they're not the same. They're not even close. The warranty expense rates for the laser and X-ray companies are much higher. However, they're falling steadily, from a range of 2.0% to 3.0% in the 2003-2006 period to around 1.5% to 2.0% in the 2009-2013 period.

Meanwhile, the rest of the companies have seen only a relatively small improvement in expense rates from 2003 to 2013. Now they're towards the bottom of the 0.5% to 1.0% range, while in 2003-2006 they occasionally went above one percent.

School Calendar

That brings up another trend in the data. It's extremely seasonal, like lawn mowers, motorcycles and snow blowers. But it's not tied to the outdoor weather, as the sales and repair patterns are for those products. Instead, it's tied to the beginning and end of the school year, which in turn defines the purchasing budget of teaching hospitals and university laboratories, which in turn defines the annual boom and bust in product sales, usage, and ultimately repair cycles.

We also should note that particularly in the medical and scientific equipment field, it's very important to use the right figure for sales revenue. Because so many manufacturers in this industry make a significant amount of money from services, as well as from the sale of consumables and software, it's very important to compare warranty expenses to just warranted hardware product revenue when calculating the expense rate percentages.

For instance, while Agilent's total revenue was $6.78 billion, the company said $1.25 billion of that came from services. We have to subtract that out before calculating the company's claims rate and accrual rate. Thermo Fisher reported $1.875 billion in service revenue. PerkinElmer Inc. said almost 31% of its total revenue came from services. All this revenue has to be subtracted from the totals before dividing it into the claims and accrual expense totals.

Finally, our fourth warranty metric is the ending balance in the warranty reserve funds of the 196 medical and scientific equipment companies. As can be seen in Figure 4, their combined balances of $831 million at the end of 2013 is nowhere near the peak, which came in 2006. In fact, of the past 11 year-ending balances, 2013's comes in eighth overall.

For the laser and X-ray companies, the peak came a little later, in 2007. And since 2009, their combined reserve balances have remained very close to $100 million. That's because some companies such as Varian Medical Systems have chosen to keep their warranty reserve fund balance unchanged, while others such as Coherent Inc. let their balance shrink by relatively small amounts.

However, there wasn't much change among the other companies either. Medical test equipment maker Danaher allowed just a very small rise in its $141 million warranty reserve balance in 2013. Allergan Inc., which has lately been in the news as it fights off a hostile takeover bid from Valeant Pharmaceuticals International, allowed the size of its warranty reserve to contract just a little bit.

There are numerous reasons for increasing or decreasing the size of a company's warranty reserve. The better question to ask is whether a given balance is appropriate for the company, its product line, and its warranty program. For instance, in last week's newsletter, we found numerous solar cell companies with 25-year product warranties and relatively large warranty reserves, which would seem to be appropriate given the long duration of their warranties. In contrast, in the Computer Industry Warranty Report, we found numerous manufacturers that kept barely enough funds in their warranty reserves to pay claims for a year. Not coincidentally, most of their products are covered by a year's warranty.

How Much Is Enough?

In the medical and scientific equipment field, there doesn't seem to be much of a correlation between the type of product and the size of the warranty reserve fund. For instance, Hill-Rom Holdings makes hospital beds, and keeps a warranty reserve balance equal to about 20 or 21 months of claims payments. Tempur-Pedic International Inc., which makes hospital beds in addition to its consumer products, keeps only 10 or 11 months' worth of reserves.

St. Jude Medical Inc. keeps nine or ten years' worth of reserves on hand to fund claims payments for its line of pacemakers. It ended 2013 with a warranty reserve fund balance equal to 111 times what it was paying per month in claims. In contrast, Medtronic keeps only 15 to 25 months' worth of reserves on hand to fund its warranty expenses.

Boston Scientific Corp., which acquired the pacemaker product line of Guidant Corp. back in 2006, chose to keep its warranty reserve fund balance equal to the amount of claims it paid for 9 months at the end of 2011; 26 months at the end of 2012; and 84 months at the end of 2013. Granted, its claims payments were falling rapidly at the time, but shouldn't its warranty reserves also have been following the same pattern at the same time?

The truth is, there is no one ideal level for a given company's warranty reserve. One would think it should be kept close to the length of the company's product warranties. But this wouldn't really matter unless a company went out of business. In such a case, there would be enough left in the warranty reserve to pay off all claims until all product warranties expired.

However, many sick companies that are on their way out of business frequently raid their reserves long before filing for protection from their creditors. Some come within weeks of running out of funds to pay claims. Others repudiate their product warranty liabilities as soon as they can, following a bankruptcy filing.

At the other extreme, if a company has excess warranty reserves and that company is acquired, the buyer can take the excess out of the fund and move it immediately to net income -- even giving it to shareholders as a special dividend. Or they could use the excess to partially fund the acquisition itself.

There is no accounting rule covering the adequacy of warranty reserves. But if a company pays $4 million in claims during all of 2013, why does it need to keep $37 million in its warranty reserve? Conversely, if a company spends $4.3 million to pay claims during the year, why does it keep only $2.4 million in its warranty reserve fund? There is no right or wrong, but there is such a thing as reasonableness.