April 16, 2015

Computer OEM Warranty Report:

As the industry shifts from desktops to laptops to smartphones, warranty expenses rise as the form factor shrinks. And after decades of competition, a few large players with huge warranty operations are left where once there were dozens of manufacturers.

There's not much to say about warranty trends in the computer industry. So usually, we combine it with a look at disk drives and peripherals, looking for an analog of how warranty works in the automotive industry between OEM and supplier.

This time, we think there are two trends among the OEMs that need to be spelled out in detail: first, the migration from desktop to laptop to handheld has caused relative warranty costs to rise, and second, the computer industry has in a few decades undergone the kind of consolidation it took a century to accomplish in Detroit.

Back in 2003, when we first started measuring product warranty expenses, this industry category was comprised of a list of 25 manufacturers, led by Hewlett-Packard Co. and also including Dell Inc.; IBM Corp.; Sun Microsystems Inc.; Gateway Inc.; Apple Inc.; Palm Inc.; Silicon Graphics Inc.; and Unisys Corp., among others. But over the years, Sun, Palm and Gateway were acquired, Dell went private, leaving the U.S.-based industry basically comprised of HP, IBM and Apple, along with a little bit of Unisys, Silicon Graphics, and a newcomer named Xplore Technologies Corp., which makes rugged tablets for field service, public safety, and other harsh environments.

The Big Three

So basically, we're talking about just three giant companies and three smaller companies. And yet it's still the second-largest category when it comes to warranty-providing industries, behind only the automakers. Back in the March 19 newsletter, we pegged the industry's claims total at $5.971 billion last year, down by $1.4 billion from 2013 levels. In this week's newsletter, we will show how that happened.

In Figure 1, we're highlighting HP and Apple, and are counting the claims payments of all the computer OEMs since 2003. Because Apple is on a fiscal year that ends in September, we're counting their first fiscal quarters in one calendar year and their second through fourth fiscal quarters in the following calendar year. With HP, we're mapping all of their fiscal years to these calendar years.

Figure 1
Worldwide Warranty Claims
of U.S.-based Computer Manufacturers
(claims paid in US$ millions, 2003-2014)

Figure 1

The first thing that jumps out of the chart is that everybody paid fewer claims. Apple was down by $341 million. HP was down by $215 million. And IBM was down by $89 million. But the biggest decline was caused by the departure of Dell from the statistics, following its leveraged buyout in October 2013. Last year, we stuck a placeholder estimate in the data for Dell's fourth quarter, but this year we have no data at all.

Overall, then, HP, Apple and IBM were responsible for less than half the $1.4 billion decline in claims payments. The rest was caused by the departure of Dell. And while there was an accompanying 2% overall product sales gain, there was a very wide divergence in sales trends among the top three. Apple saw sales of its iPhones and other hardware grow by 26%. HP saw its product sales rise by nearly 2%. But IBM saw annual sales in its "Systems and Technology" category slip by 23%, which very nearly matched its 2013-to-2014 decline in claims payments.

Computer Warranty Accruals

It wasn't much different with the accruals these computer manufacturers made in calendar 2014. The entire industry's accruals total fell by $1.77 billion, of which about half was caused by the absence of Dell. But everybody put less aside" Apple was down by $796 million; HP was down by $167 million; and IBM was down by $106 million.

Figure 2
Worldwide Warranty Accruals
of U.S.-based Computer Manufacturers
(accruals made in US$ millions, 2003-2014)

Figure 2

Note that in calendar 2013, Apple set aside a whopping $5.75 billion in warranty accruals, a figure which remains the largest accrual amount ever reported by an American manufacturer in a single year. Outside the U.S., only Volkswagen AG has ever set aside more money in a single year to cover future warranty obligations.

Smaller and Smarter

Amazingly, from calendar 2008 to calendar 2009, Apple actually reduced its accruals, even though these were the second and third years of iPhone sales. The company quickly made up for the shortfall, however, in part by setting aside well over a billion dollars in accruals in calendar 2010. And it's in 2010 that the smartphone began to dominate the computer industry.

It's a sad fact that the smaller and more powerful a computer becomes, the higher its relative warranty expense. Compared to selling price, the warranty expenses of laptops are higher than they are for desktops. Notebooks and tablets are higher than laptops. Smartphones and handhelds are higher than notebooks. And when you widen the covered perils, as with protection plans that include accidental damage protection plus loss and theft coverage, the warranty expenses rise even more.

So what you're seeing in Figures 1 and 2 as the emergence of Apple is partly due to the explosive growth of the iPhone, and partly due to the shift in the product line from desktops and notebooks to handheld. In Figure 6 we will show in more detail how Apple's warranty expenses mounted in terms of their percentage of revenue. But here we can see how the company became one of the world's biggest warranty providers in any industry.

Meanwhile, HP has been steadily reducing its annual accruals since they peaked at $3.35 billion per year in fiscal 2008. Last year was the sixth in a row that saw HP set aside less money than the year before. Some of that is due to declining sales, but most of it is due to rising product reliability. And of course all of it is due to a declining need for funds to pay future warranty claims.

IBM, in the meantime, set aside only $240 million in accruals in 2014 -- less than a quarter as much as it did in 2003 ($971 million). That's the outcome of a decade-long migration away from hardware sales and towards service provision. Hardware comprised less than ten percent of the company's total revenue in the final quarter of 2014. In contrast, IBM Global Services accounted for 56% of the company's total revenue in the same period.

Rising Warranty Reserves

Warranty reserve funds are where the accruals go, and from where the claims are paid. But their balances never quite equal the addition of accruals and the subtractions of claims, because there are other adjustments to be made for foreign currency fluctuations, acquisitions, divestments, and other corporate changes.

Among the big three computer makers, however, only IBM made any sizeable adjustments to its warranty reserves in 2014. During the fourth quarter, it removed $126 million from its warranty reserve in what would officially be called a change of estimate. These happen when a company concludes that its accruals in the past have been excessive, and therefore the funds are no longer needed to pay warranty expenses. So the excess funds are taken from the warranty reserve and go straight to net income (after taxes are paid).

In Figure 3, the "Other" category virtually disappears as a result, because IBM reduced its balance from $376 million at the end of 2013 to $197 million at the end of 2014. And Silicon Graphics, Unisys, and Xplore Technologies together keep only about $18 million on reserve. These are dwarfed by Apple's $5.2 billion balance and by HP's $2 billion balance.

Figure 3
Worldwide Warranty Reserves
of U.S.-based Computer Manufacturers
(reserves held in US$ millions, 2003-2014)

Figure 3

Of course, Dell is still paying warranty claims and we assume it is still keeping a warranty reserve fund replenished. But it's no longer disclosing the data. And other computer makers such as Lenovo, Acer, Asus, Sony, and Toshiba are also paying claims and making accruals. We just don't know how much.

Overall, warranty reserves grew from $6.4 billion in 2013 to $7.4 billion in 2014. But as was mentioned, most of that increase came from Apple and HP. Most of the decrease in the "Other" category came from the departure of Dell and its $900 million in warranty reserves. And in spite of that, 2014 was the fifth straight year that warranty reserve balances grew in the computer industry, but again, most of that was due to Apple. HP's balance topped out in 2008 at just over $2.6 billion.

Warranty Expense Rates

Using yet another metric for product sales, we've created an additional pair of metrics for the percentage of sales going towards warranty expenses. In Figure 4 below, the claims rate is calculated by taking the claims totals from Figure 1 and dividing them by sales. The accrual rate is calculated by taking the accruals totals from Figure 2 and dividing them by sales.

Figure 4
All U.S.-based Computer Manufacturers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 4

It's pretty obvious that we have two trends in this 12-year time series. From 2003 until 2012, the expense rates slowly declined, with some bumps along the way. And then from 2013 onwards, they began to rise, or at least they stopped falling.

As was mentioned, the long-term story of this industry is how it started out with 25 members in 2003 and after consolidations and buy-outs ended up with basically three big and three small members by 2014. What we think we're seeing in Figure 4 is the weight of two of those big three remaining members.

From 2003 until the present, one of the most successful warranty cost-cutting organizations has been HP. Warranty teams from all over the world collaborated and conspired to cut costs, raise product reliability, and make the warranty process more efficient. In Figure 5 you can see the results of that effort.

Saving HP a Billion Dollars

Back in 2003, HP was paying over four percent of its product revenue in warranty claims -- almost $2.4 billion a year. By 2008, the bill was over $3 billion a year, but product sales has grown past $91 billion, so the claims rate was down below 3.3%. It fell below three percent in 2013 and fell as low as 2.6% in early 2014. Meanwhile, sales continued to grow.

If HP spent four percent of its product revenue on warranty claims in 2014 the bill would have been $2.9 billion. Or, to put it another way, HP is saving itself more than a billion dollars a year in claims not paid, because it reduced its claims rate from 4.2% in mid-2003 to 2.6% in early 2014. The detail of that progression is seen in Figure 5.

Figure 5
Hewlett-Packard Co.
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 5

Meanwhile, once the iPhone was launched in June 2007, Apple began to change from a computer company into a smartphone company. And as we mentioned, dollar for dollar the smartphones incur more warranty expense than the desktops and notebook computers. In Figures 1 through 3, you can see the emergence of Apple as a major player in world manufacturing and warranty provision. In Figure 6, you can see the transition from computer to smartphone.

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

Figure 6

Basically, the company's claims rate meandered between one percent and two percent from 2003 to 2012. And then in 2013 and 2014 as the product mix shifted, it went a bit wild. In early 2013 the accrual rate went as high as 3.9%, which would be high for any manufacturer of any product. But it's fairly typical for what amounts to a miniature handheld supercomputer that can be dropped, dunked, or sat upon. The same thing happened to Palm Inc before it was acquired, and the same thing is happening now to Research in Motion Ltd. makers of the Blackberry.

So what we see in Figure 4 is really the transformation of the industry average from one dominated by HP's cost-cutting to one dominated by Apple's miniaturization. The year the leadership changed was 2012. It doesn't mean that manufacturers stopped cutting warranty costs in 2012. But it does mean that smaller is more costly, and it will continue to be until the next decade of cost-cutting efforts begin.

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