November 13, 2014

Chrysler's & Tesla's Warranty Adjustments:

Compared to GM and Ford, their recent mid-course corrections to their warranty expense rates are modest. But for others, the relative size of these adjustments compared to regular accruals can be an early warning indicator of trouble ahead.

When a company initially underestimates its warranty costs, it has to later adjust its estimates and add more funds to cover the increased cost. Most of the time, these adjustments are minor, but during a crisis they can become as large as the regular amounts.

In last week's newsletter we looked at the way recalls have recently magnified the impact of warranty accrual costs at General Motors Co. and Ford Motor Co., forcing them to make billions of dollars worth of adjustments. But it isn't just them, and we apologize if by singling them out we left the impression that the problem is theirs alone.

This week, we'll look at the warranty accruals and additional adjustments of two more passenger car makers: Chrysler Group LLC and Tesla Motors Inc. In addition, we'll check in on one of the largest heavy truck manufacturers, Navistar International Corp., and the recent progress they've made in reducing their warranty expenses back to sustainable levels.

Chrysler's Warranty Expenses

Let's start with Chrysler. Technically, the company is 100% owned by Fiat S.p.A., and is formally a subsidiary of Fiat Chrysler Automobiles NV. In its annual reports, Fiat combines Chrysler's warranty expenses with its own. However, Chrysler also now files its own financial reports with the U.S. Securities and Exchange Commission, and those reports include warranty expense data.

In Figure 1 we've charted the quarterly claims payments reported by the Chrysler Group since 2009. That initial report was for the period from June to December 2009, so we've cut it into two equal parts covering the second half of that year.


Figure 1
Chrysler's Product Warranties
Quarterly Claims Paid, 2009 to 2014
(in Millions of U.S. Dollars)

Figure 1


As can be seen from the data, the Chrysler Group has paid a little more or a little less than $400 million per quarter in claims from the time of its inception. The last four quarters have all been above $400 million, and the most recent quarterly payment total hit $584 million.

From 1998 to 2007, the company was part of Daimler-Benz AG, and its warranty expenses were consolidated with its parent company's. From 2007 to 2009, it was majority-owned by Cerberus Capital Management LP, and did not have to report because it was a privately-held company. Daimler continued reporting its warranty expenses in its annual reports, but no new data was released by Chrysler.

Chrysler filed for bankruptcy protection in the depths of the recession, in April 2009. When Fiat came on the scene a few months later, it acquired the company from Cerberus initially in partnership with the U.S. and Canadian governments as well as one of the labor unions. Fiat later bought out those partners, and merged its own passenger car operations with Chrysler's.

Public Debt Offerings

Chrysler's stock does not trade publicly. Instead, the stock of Fiat Chrysler Automobiles trades in New York under the ticker symbol FCAU, and in Milan under the symbol of FCA (it is nominally headquartered in Slough, outside of London). However, because Chrysler Group has made public debt offerings, it is required to report its finances to the SEC. And those reports include warranty expense data.

In Figure 2, we're tracking two additional warranty metrics. The dark green bars represent what we'll call the "regular accruals" of the Chrysler Group, while the yellow bars represent additional accruals -- what Chrysler calls "net adjustments to pre-existing warranties."


Figure 2
Chrysler's Product Warranties
Quarterly Accruals Made, 2009 to 2014
(in Millions of U.S. Dollars)

Figure 2


In most cases, the adjustments are minor, as can be seen above in the data for 2010 and 2011. But in recent quarters, the adjustments have sometimes added 20% to 36% to the total. And since we usually track just the "regular accruals" of any given company, the effect of the additional set-asides goes unreported.

As we did last week with GM and Ford, this week we'll chart both the regular accrual rate and the new accrual rate, which includes the boost from the adjustments. In the chart below, the old accrual rate is in green and the new rate is in dark blue.


Figure 3
Chrysler's Product Warranties
Claims Paid & Accruals Made as a
Percentage of Product Revenue, 2009 to 2014
(in Percent)

Figure 3


It's not as dramatic as the boost in expense rates seen with GM and Ford, once the cost of recent recalls and other unexpected adjustments is included. But it does raise Chrysler's accrual rate from under three percent -- where it's been since 2012 -- to 3.5%, which is a new high for the post-Cerberus era.

Also, please note that the company's claims rate is rising, although it's a relatively small increase. For two years Chrysler's claims rate stuck close to 2.2%, after falling in steps from 2009 to early 2012. But it was back up to 2.3% by the middle of 2014, and was at 2.5% in September 2014. And the accrual adjustments suggest the company expects it to climb a bit further soon.


Figure 4
Tesla's Product Warranties
Quarterly Claims Paid, 2008 to 2014
(in Millions of U.S. Dollars)

Figure 4


Now, let's turn to the electric car manufacturer whose stock has been soaring since early 2013 (it was up more than two percent just today). Tesla Motors, named after the esteemed inventor Nikola Tesla, is a fraction of the size of Chrysler, Ford or GM. It expects to deliver only 33,000 vehicles this year, though it expects that total to grow rapidly in the years ahead.

In warranty terms, while we're talking billions of dollars a year for GM, Ford, and Chrysler, we're still talking low-number millions for Tesla. In Figure 4, we can see that the company paid out more than $10 million per quarter in claims for the first time during the third quarter of 2014. For the first nine months of the year so far, it has paid out $29.8 million in claims.

Luxury Claims Cost

Since its founding, it has paid out $58.8 million in claims, which, when measured against its total output to date (47,000 vehicles since 2012) equates to a very respectable $1,250 in claims cost per vehicle so far, which is comparable to what Daimler and BMW pay for their luxury brands.

In terms of accruals, we also have the recent appearance of some sizeable adjustments to consider. In Figure 5 below, the dark green bars once again represent "regular accruals," while the yellow bars represent what Tesla calls "changes in liability for pre-existing warranties."

The company didn't even begin making these adjustments until the middle of 2013, and they didn't really become sizeable until earlier this year. But in the third quarter of 2014, Tesla set aside $26 million in regular accruals and an additional $15 million in adjustments, driving up its quarterly total to $41 million.


Figure 5
Tesla's Product Warranties
Quarterly Accruals Made, 2008 to 2014
(in Millions of U.S. Dollars)

Figure 5


Again, it's small potatoes compared to GM, Ford, or Chrysler, but in Tesla's realm it means more than a third of the company's total accruals came from special accruals during the most recent quarter. That's the news. It's not the amount of adjustments; it's their size relative to the regular accruals.

In Figure 6 we've charted the impact of these additional accruals during 2013 and 2014. As can be seen in the dark blue line versus the green line, there were no adjustments during the first quarter of 2013 so both the old and the new accrual rates were 2.6%. But the adjustments added about one percent to the accrual rate in the next few quarters, and in the third quarter of 2014 they boosted the company's accrual rate by about 1.7%.


Figure 6
Tesla's Product Warranties
Claims Paid & Accruals Made as a
Percentage of Product Revenue, 2008 to 2014
(in Percent)

Figure 6


Since its founding, Tesla has made $150 million in regular accruals and a net $22 million in adjustments (it took out $10 million in the final quarter of 2013, though negative adjustments are not shown in Figure 6). That equates to about $3,670 per vehicle, which is much higher than its gasoline-powered competitors. But as can be seen in Figure 6, because of a higher average selling price per vehicle, it's never been more than 6% of total revenue at Tesla. So it's on the high side but not incredibly so.

Massive Manufacturing Excursion

To see what effect extra-large accruals and adjustments can have on a company, one needs look no further than Navistar. But, we're happy to report, the crisis seems to have now passed. Claims are now on a downward trend; accruals are back to normal levels, and the painful additional adjustments to accruals have ceased.

In Figure 7, we're tracking the quarterly claims payments made by Navistar to its customers and repair service organizations. Payments began to really hurt in late 2012, when the company's inability to meet 2010 ultra-low sulfur diesel-fueled engine emissions standards set by the U.S. Environmental Protection Agency began to translate into claims costs and non-compliance penalties.


Figure 7
Navistar's Product Warranties
Quarterly Claims Paid, 2003 to 2014
(in Millions of U.S. Dollars)

Figure 7


The company paid $637 million in warranty claims in the fiscal year ended October 31, 2013, up from $455 million the year before and $399 million in fiscal 2011. That was exactly six percent of its product revenue, up from 3.6% in fiscal 2012 (sales fell from $12.8 billion to $10.6 billion).

The real damage, however, came from Navistar's warranty accruals and adjustments. Under the accrual method used by most companies, money is set aside when a product is sold, and is spent when the product is repaired under warranty. So it becomes an expense when the money is first set aside, coming straight out of net income.

Huge Adjustments Made

Over the years, Navistar has made some dramatically huge accrual adjustments, as can be seen in Figure 8. The adjustments have exceeded $100 million per quarter no less than six times, including five times since fiscal 2012 began. In fact, in three of those five instances, the size of the adjustments exceeded the regular accruals.


Figure 8
Navistar's Product Warranties
Quarterly Accruals Made, 2003 to 2014
(in Millions of U.S. Dollars)

Figure 8


We're going over old ground here, which we covered previously in the March 27, 2014 newsletter. However, this time there's a happy ending to our story.

In Figure 9, we've taken all the upwards quarterly adjustments made since the beginning of fiscal 2010 and added them to the company's regular accruals, and recalculated the accrual rate. As is obvious, the company has at times been setting aside an unsustainable seven or even eight percent of its product revenue to fund its warranty expenses.

End of the Crisis?

However, in the first quarter of fiscal 2014 Navistar set aside only $52 million in adjustments to complement its $71 million in regular accruals. In the second quarter, the adjustments dropped to $42 million though the regular accruals rose to $82 million. In the third quarter, which ended on July 31, 2014, Navistar again made $82 million in regular accruals, but it actually removed $29 million from its warranty reserve fund (a negative adjustment).


Figure 9
Navistar's Product Warranties
Claims Paid & Accruals Made as a
Percentage of Product Revenue, 2003 to 2014
(in Percent)

Figure 9


So here's the happy ending. Navistar's claims rate is back down to just over five percent for the first nine months of this fiscal year. Its regular accrual rate is back down to three percent, and its new accrual rate, which reflects the end of upward adjustments, is also back to normal. By the time it reports its annual figures in late December, the company's warranty metrics should be well below crisis levels.

Early Warning Indicator?

We usually don't include these special adjustments in our calculations of accrual rates, because usually they're just small corrections -- a little bit up or down. But when they get to be one-fifth as large as regular accruals, they can signal the beginning of a manufacturing excursion. And when they get to be one-half as large, or even larger than regular accruals, we know a full-blown warranty crisis is under way.

Right now, GM is weathering a crisis while Ford is close to that level. Navistar, however, is now post-crisis. And Chrysler and Tesla, while they're now paying for past mistakes through their additional accrual adjustments, haven't yet risen to the level where we'd use the word crisis. But watch that five percent mark. In the automotive industry, that's the threshold of pain when it comes to warranty expense rates.





AMT Warranty Corp.
Warranty Chain Management Conference
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