February 19, 2015

Early Look at Annual Warranty Data:

About half the big companies have now reported their year-end 2014 warranty expense data. And while little has changed for most of them, a few are now getting back to normal after seeing expense rates soar in 2013 and earlier last year.

After following American manufacturers for a dozen years, it's become relatively easy to spot when a company's warranty costs get out of control. Even when they don't give a reason for the turbulence, the numbers speak for themselves.

Usually, we wait until the Warranty Chain Management Conference ends before diving into all the annual data that appears around this time of year. But given how recall and warranty costs have been in the news so often in recent months, why delay?

For a variety of reasons, as of today 56 of the top 100 warranty providers have already reported their sales revenue and warranty expense figures for the final quarter of 2014. Some are following fiscal years that end in months besides December. Others are simply putting their annual reports together faster, releasing them in February rather than in the traditional March timeframe.

Together, these early reporters represented 64% of the product revenue and 76% of the warranty claims of the entire top 100 last year. So there are clearly some very large companies and very large warranty providers among the group.

Avoiding Repetition

To avoid repetition, we won't repeat any of the warranty cost-cutters profiled in the January 15 newsletter, but be aware that three of those cost-cutters: Hewlett-Packard, Ciena and Toro, are also among the early reporters who have already detailed their year-end 2014 warranty expenses.

The six we have chosen to profile this week include two OEMs from the computer and networking industry, two OEMs from the passenger car industry, and two from the heavy equipment sector. Each has shown a newsworthy change in their warranty expense rates, primarily in the downward direction. For three of those six, this represents the end of a manufacturing crisis that saw warranty costs soar.

With some of them, it all depends what warranty metric you're looking at. For example, Apple Inc. has seen its warranty claims rate fall in the recent past, but its accrual rate has risen. In Figure 1, we can see an accrual rate that's once again back over three percent, and a claims rate that's once again below two percent. Which of those rate changes is more meaningful?


Figure 1
Apple Inc.
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 1


Both the claims rate and the accrual rate are calculated by dividing the relevant warranty expense by the product sales total. However, since you're always fixing last year's product sales with this year's money, there's always a time lag on the claims rate. And it's highly susceptible to distortion if sales are rising or falling rapidly.

In the quarter ended December 27, 2014, Apple saw product sales climb by 26%. So even though its claims cost fell only slightly, from $1.06 to $1.04 billion, that sales rise helped reduce the company's claims rate from 2.0% a year ago to 1.6% at the end of 2014. In other words, the drop is a distortion caused primarily by fast-rising sales volumes.

On the other hand, the green line, representing the company's warranty accrual rate, is set by the company itself, relying on the best estimates of what the product warranties will end up actually costing. Accrual rates were high in 2013 because the company believed that higher warranty costs were on the way. And the claims rate did peak at 3.3% in June 2013, but it's half that high now.

Massive Warranty Accrual Total

Still, in the year ending September 27 and in the quarter ending December 27, Apple chose to keep its accrual rate over three percent. And given how good sales have been lately, those are enormous amounts of money being set aside. In the most recent quarter, Apple set aside over $2 billion in accruals -- more than GM, Ford, and HP combined.

Cisco, in contrast, chose to cut its accrual rate to only 1.5% in the quarter ended last October. And that's the lowest it's been since the middle of 2011. It's also a full percentage point below where it was a year ago, when Cisco for the first and only time raised its accrual rate above 2.5%.


Figure 2
Cisco Systems Inc.
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 2


The decrease in accruals follows a decline in claims, which are now back to 2012 levels. In its financial statements, Cisco notes the presence of lower warranty costs, but declines to provide a reason for their appearance. Then again, years ago it also declined to provide a reason for the uptrend that began in 2011.

Warranty & Recall Costs

We're under no such illusions with General Motors. It's been clear for almost a year that warranty and recall costs were going to rise, and indeed they did. GM's claims rate is now the highest it's been since the financial crisis, but as can be seen in Figure 3, its accrual rate is now returning to earth after skyrocketing to 5.6% in early 2014.


Figure 3
General Motors Co.
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 3


In a November 2014 newsletter, we detailed the increase in GM's expenses on three fronts: warranty, recalls, and other adjustments. But as that newsletter explained, most of those unexpected recall expenses and other adjustments were booked in the first half of 2014. Things were returning to normal even in the third quarter.

GM filed its annual report with the U.S. Securities and Exchange Commission two weeks ago. For the year, the company reported claims payments of $4.33 billion, warranty accruals of $2.54 billion, recall accruals of $2.91 billion, and other adjustments of $1.19 billion.

Claims continued to be paid at an elevated rate right until the end of the year, as can be seen by the claims rate rising to nearly three percent. However, in the fourth quarter alone there were only $252 million in recall accruals and $92 million in other adjustments. In other words, the company is now spending the money it set aside in the first half of 2014. But it's no longer setting aside as much as it did when this manufacturing crisis first began.

Temporary Increase?

At Ford, the situation is a little different. As can be seen in Figure 4, the company's claims rate went back above two percent in the second half of 2014. But its accrual rate hardly changed, suggesting the company believes this rise in expenses is temporary.


Figure 4
Ford Motor Co.
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 4


Ford didn't separate warranty and recall costs when the manufacturing crisis began last year, like GM did, so we have only three warrant y metrics to consider: for the year, claims payments totaled $2.85 billion, accruals totaled $2.11 billion, and other adjustments totaled $1.75 billion. And that means Ford's claims were greatest in the third quarter, accruals were greatest in the second quarter, and adjustments were greatest in the third quarter. All three metrics were smaller in the fourth quarter.

In other words, the numbers suggest that the crisis has passed, and this supports the way the company has kept its accrual rate close to 1.5% for 10 consecutive quarters now. It would not be surprising if Ford's claims rate falls back under two percent this year.

Steady Warranty Expense Rates

For Ingersoll-Rand, it will soon be three years since the company's warranty expense rates settled in to their new range of 1.1% to 1.5%, give or take a bit. Warranty expenses looked like they were rising in early 2012, but then they fell precipitously to their current range.


Figure 5
Ingersoll-Rand
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 5


The company has gained and lost some divisions over the past 12 years, and this no doubt has impacted its warranty expenses. But the rise in rates seen from 2008 to 2010 had more to do with a sales slowdown, which now seems to be over. We estimate that product sales were up 4.4% in 2014, while claims payments were down by $10 million.

End of the Crisis?

At Navistar, the numbers continue to suggest a turnaround. In Figure 6, one can see four straight quarters of declining warranty expense rates in the fiscal year that ended in October 2014. This week, we're adding another quarter's worth of data to the charts included in the November 13 newsletter, and the same pattern continues: both Navistar's claims and accruals are down, though sales are flat.


Figure 6
Navistar International Corp.
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 6


The problems struck Navistar about a year before they hit GM and Ford. Navistar began raising its accrual rate at the end of 2012, and its claims rate began to soar in early 2013. For GM and Ford, 2013 was pretty good but 2014 was really bad. And for GM, at least, the second half of 2014 was better than the first half.

The big surprise, however, is that Navistar continues to remove excess funds from its warranty reserve fund, a big reversal of the recent trend. During five of the last 12 quarters, the company had to make upward adjustments of $100 million or more by adding funds to its warranty reserve fund. But in its third fiscal quarter, it took $29 million out of the reserve, and in its fourth fiscal quarter it took out another $10 million. More importantly, these were the first and second downward adjustments of the past three years.

Smaller Adjustments Now

These adjustments are usually much smaller in relation to claims and accruals. For instance, in all of 2013 there was a total of $918 million in adjustments made by all U.S.-based manufacturers, against $27.8 billion in claims and $29.6 billion in accruals. Besides GM, Ford, and Navistar, Boeing Co. was the only manufacturer to make an adjustment larger than $100 million in size last year. And only 14 companies made adjustments between $10 and $100 million in 2013.

Therefore, these huge adjustments are really the exception to the rule. And their relative scarcity in 2014 suggests that the number of warranty surprises is small. Navistar is now actually taking money out. GM and Ford are now making only small adjustments to their reserves after making their big adjustments in the first half of last year. This suggests that the manufacturing crisis has indeed ended for not only GM and Ford, but also for Navistar. That doesn't mean the numbers are good, or getting better. But at least they're no longer getting worse.





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