November 5, 2015

Warranty Adjustments:

When a company finds that its actual warranty costs are above or below its predictions, it makes a change of estimate and adds or removes funds from its warranty reserve. While in general, removals are good and additions are bad, some companies seem to be correcting their estimates in every single quarter.

When a company sells a product covered by warranty, it is supposed to make its best guess of that warranty's future cost, and set that amount aside as an accrual. Over time, it is supposed to use its actual claims cost to help it adjust those estimates up or down.

These so-called changes of estimate can be found in the financial statements of most manufacturers under a variety of different labels. Distinct from other figures such as claims paid, accruals made, or the beginning and ending balance in the reserve fund, they represent corrections of past predictions that turned out to be too optimistic or too pessimistic, as the case may be.

If you treat them like weather forecasts, then an upward change of estimate, which adds funds to cover unexpected costs, is a bit like predicting a sunny day but finding it rains. A downward change of estimate, in which a manufacturer takes out funds that proved to be unnecessary, is a bit like predicting rain but finding it to be a sunny day.

Both are incorrect, but who really cares about the latter? It's only when you predict costs to be low but they turn out to be high that somebody gets upset. And it turns out that this happens frequently in warranty management, though most of the errors tend to be small. But still, who needs a weatherman whose forecast is always wrong?

In the following four tables, we've taken the warranty data compiled for U.S.-based manufacturers over the past six quarters and looked for companies that make changes of estimate. We found 113 companies that made at least one upward change of estimate (adding funds unexpectedly), and 158 companies that made at least one downward change of estimate (taking money out). But most of them made numerous changes of estimate, while many more companies made one, two, or even no changes of estimate, suggesting that the error-prone companies seem to be repeat offenders.

Unexpected Cost Increases

Let's start with the most painful group. These are the companies that suddenly discover they need to increase their warranty reserves by a third or more, because costs that were supposed to be low turned out to be high. That has an immediate effect on profitability, because funds have to be accrued and spent on claims unexpectedly.

For instance, Medtronic plc, the Dublin-based medical equipment company that was formerly known as Medtronic Inc. until it acquired Covidien plc and moved its headquarters to Ireland, had to add an extra $74 million to its warranty reserve fund in the fiscal year ended April 24, 2015 -- what it called a "technology upgrade commitment." That was more than twice what it had in its entire warranty reserve fund at the beginning of the fiscal year.

Medtronic said the $74 million charge related to a change in the program for home-based heart monitors due to industry conversion from analog to digital technology. So it wasn't tied so much to the failure of a warranted product as it was to its replacement due to obsolescence. But it was still a large amount of money.

Beazer Homes has had some extreme swings in its warranty accounts, as we noted in our August 13 report on the amounts of warranty accruals made by the builders of new homes. But in its fiscal year ended September 30, 2014, Beazer Homes had to add an extra $9.8 million to its warranty reserve, "changes in liability related to warranties existing in prior periods."

Most of that was linked to leaks found in homes built in Florida and New Jersey, the company said. "We consider these charges were unexpected in nature and are not expected to be recurring," It noted. But they still took at least 30 cents off net earnings per share in a year that was otherwise stellar.

Toll Brothers, meanwhile, made three different changes of estimate in its fiscal 2014 annual report. It added $2.91 million to its warranty reserve as an "increase in accruals for homes closed in prior years." Then it added $7.55 million as a "reclassification from self-insurance accruals." And finally, it added $24.95 million for a "charge related to stucco-related claims."

When we added those together, the total was $35.4 million, and that was most of the reason the builder's warranty reserve doubled in size that year, from $43 to $86 million. The company said it expects some additional repair costs to be covered by outside insurance carriers. But these charged had to have taken at least 19 cents off earnings per share.

Reduced Net Earnings

And so it goes. The companies listed in Figure 1 each experienced an upward change in estimate that forced them to add unplanned amounts of accruals to their warranty reserve fund to cover unexpected expenses. The net effect is to reduce current earnings to pay for underestimated past expenses, which generally upsets current shareholders and angers upper management.

These are the 20 biggest increases, in percentage terms, when compared to the warranty reserve balance at the beginning of the period. Because of all the different possible permutations for fiscal years, we didn't label the beginning or ending date of these periods. Instead, we labeled either the fiscal year (2014 or 2015), the calendar quarter, or the portion of the year (6 months or 9 months of fiscal year '14 or '15) during which the report was taken.

The third column represents the beginning balance in the warranty reserve. The fourth column contains the increase caused by the change in estimate, in millions of dollars. The fifth column calculates the relative size of that increase as a percentage of the beginning balance.

Figure 1
Top 20 Upward Warranty Expense Adjustments
by U.S.-based Companies
Ranked by Percentage Increase
Jan. 2014 to June 2015
(in $ millions and as a % of reserves)

     Warranty   Change  Impact
    Reserve of Upon
  Company   Period  Balance   Estimate   Reserves 
  Medtronic plc 2015 $32.0 +$74.0 +231%
  Beazer Homes 2014 $11.7 +$9.8 +84%
  Toll Brothers Inc. 2014 $43.8 +$35.4 +81%
  Mikros Systems Corp. 9mo14 $0.035 +$0.028 +79%
  Mattson Technology Inc. 2014 $1.79 +$1.29 +72%
  InvenSense Inc. 9mo14 $0.080 +$0.055 +69%
  Modine Manufacturing 2014 $12.6 +$8.3 +66%
  Visteon Corp. 6mo15 $21.0 +$13.0 +62%
  Advanced Micro Devices 2014 $17.0 +$9.0 +53%
  Clarcor Inc. 2014 $1.60 +$0.82 +51%
  Ultratech Inc. 2014 $1.14 +$0.57 +50%
  Quanex Building Products 9mo15 $0.671 +$0.317 +47%
  Capstone Turbine Corp. 2014 $2.30 +$1.05 +45%
  Ford Motor Co. 2014 $3,927 +$1,746 +44%
  Vocera Communications 3Q14 $0.582 +$0.250 +43%
  M/I Homes Inc. 2014 $12.3 +$5.2 +42%
  ZBB Energy Corp. 2014 $0.480 +$0.184 +38%
  Applied Micro Circuits 4Q14 $0.175 +$0.067 +38%
  KB Home 2014 $48.7 +$17.5 +36%
  Pro-Dex Inc. 4Q14 $0.213 +$0.076 +36%

    Source: Warranty Week from SEC data

In the roughly 3,000 quarterly reports gathered from around 500 companies between January 2015 and June 2015, there were about 325 upwards changes of estimate reported. So that's about one in nine reports containing an upward change in estimate.

But some of them were duplicates, in that a company reports a change in estimate in its first quarter financial statement, and then repeats it in the half-year, nine-month, and full-year financial statements. We didn't include them all; only the largest in terms of percentage.

This happened to at least 19 companies, including Capstone Turbine Corp.; Daktronics Inc.; D.R. Horton Inc.; Data I/O Corp.; Dixie Group Inc.; Dresser-Rand Group Inc.; Graco Inc.; Lexmark International Inc.; Masco Corp.; Mattson Technology Inc.; MGC Diagnostics Corp.; Select Comfort Corp.; Spartan Motors Inc.; Terex Corp.; Thermo Fisher Scientific Inc.; Toll Brothers Inc.; Trimble Navigation Ltd.; Ultratech Inc.; and William Lyon Homes. We erased three and kept just the largest.

Repeat Offenders

Therefore, it's not as common as one-in-nine. Those 329 upwards changes of estimate came from only 113 different companies, and 76 reports came from the above-named 19 companies. Basically, each company that reports any changes of estimate is averaging three reports across six quarters -- half the time. So what we can conclude is that many companies that are error-prone seem to be repeat offenders.

The thing about the data in Figure 1 that's most surprising, however, is how many small companies are involved. When we looked at the companies making foreign exchange adjustments in the October 22 newsletter, many of the smaller companies didn't register, simply because they're not as likely to be exporters, and therefore they do business primarily in U.S. dollars. But in Figure 1, we can see that nine of the 20 adjustments were under a million dollars, and all but five were under $10 million.

So another conclusion that we're going to make is that while some small companies made some relatively big errors, there were lots of big companies that made relatively small errors. But they still involved millions and sometimes billions of dollars.

Therefore, in Figure 2, let's look at the 20 biggest upward changes of estimate over the last six quarters not as a percentage of pain, but in the number of dollars involved. Once again, we're going to erase the repeats, leaving just the largest adjustment per company per fiscal year.

When we look at it from this angle, and compare Figure 1 to Figure 2, only four of the most painful adjustments were also among the 20 largest adjustments: Ford's $1.746 billion adjustment; Medtronic's $74 million adjustment; Toll Brothers' $35.4 million adjustments; and KB Home's $17.5 million adjustment. The other 16 adjustments listed in Figure 2 are large, but not painfully so.

Then again, there are still more than $5.2 billion worth of corrected errors just in this top 20. And several of the largest manufacturers and warranty providers are included here, including all three Detroit automakers, meaning that nobody's perfect. Everybody from time to time puts a little less into their warranty reserves than they should have. These adjustments are the result.

There are, however, five repeats within the Figure 2 list, in cases where a company made very large upwards changes of estimates in two different fiscal years. For instance, Fiat Chrysler Automobiles (FCA) added $616 million last year and $384 million so far this year. Ford added $1.746 billion last year and $495 million so far this year. And GM added $1.187 billion last year and $329 million so far this year. Cummins and Western Digital also repeated. So once again, it looks like some companies that are error-prone seem to be repeat offenders.

Figure 2
Top 20 Upward Warranty Expense Adjustments
by U.S.-based Companies
Ranked by Absolute Size of Increase
Jan. 2014 to June 2015
(in $ millions and as a % of reserves)

     Warranty   Change  Impact
    Reserve of Upon
  Company   Period  Balance   Estimate   Reserves 
  Ford Motor Co. 2014 $3,927 +$1,746 +44%
  General Motors Co. 2014 $7,601 +$1,187 +16%
  FCA US LLC 2014 $3,800 +$616 +16%
  Ford Motor Co. 9mo15 $4,785 +$495 +10%
  FCA US LLC 6mo15 $4,685 +$384 +8.2%
  General Motors Co. 6mo15 $9,646 +$329 +3.4%
  Medtronic plc 2015 $32.0 +$74.0 +231%
  Navistar International 2014 $1,349 +$55.0 +4.1%
  Boeing Co. 1Q14 $1,570 +$47.0 +3.0%
  Cummins Inc. 2014 $1,129 +$41.0 +3.6%
  Western Digital Corp. 2015 $182 +$41.0 +23%
  Toll Brothers Inc. 2014 $43.8 +$35.4 +81%
  Hewlett-Packard Co. 9mo14 $2,031 +$29.0 +1.4%
  Western Digital Corp. 2014 $187 +$28.0 +15%
  Harley-Davidson Inc. 2014 $64.1 +$19.1 +30%
  Eaton Corp. 2014 $189 +$19.0 +10%
  Tesla Motors Inc. 2014 $53.2 +$18.6 +35%
  Cummins Inc. 9mo15 $1,283 +$18.0 +1.4%
  Dana Holding Corp. 2014 $54.0 +$18.0 +33%
  KB Home 2014 $48.7 +$15.5 +36%

    Source: Warranty Week from SEC data

The reason we're listing these changes of estimate in size order is to show how some of the most massive corrections are really quite small on a relative scale. For instance, both Cummins and Western Digital had to make $41 million adjustments in their most recent fiscal years. But while that was a relatively large adjustment for Western Digital (almost one-quarter the size of its reserve fund), it was a relatively minor correction for Cummins (3.6% of its beginning balance).

And then Cummins again had to make an $18 million adjustment in its most recent SEC filing. So did Dana. But while it was a one-third increase in reserves for Dana, it was only 1.4% for Cummins.

As this edition of Warranty Week was going to press, FCA filed its financial report for the first nine months of 2015 with the U.S. Securities and Exchange Commission. Its claims and accrual rates were well within the normal range, but the company also reported a $1.35 billion change of estimate.

Had the report been filed a day earlier, we would have included it in our tables above. Based on it being equal to 29% of the automaker's opening balance, it would not have made the list in Figure 1. But based on its sheer size, the upwards adjustment would have bumped up FCA's second appearance in Figure 2 from fifth to second place.

Also, this means that while the company made $384 million in upwards change of estimates during the first half of its fiscal year, at some point during months seven, eight or nine it made another $967 million adjustment. Those are two separate and massive adjustments that would have both made it onto the Figure 2 list.

Found Money

And then there are the many companies that made downward changes of estimate, either after they realized their past accruals had been excessive, or because their product reliability rose or their repair costs fell, making some portion of past accruals unneeded. Either way, the effect is the same: a company is saying that their warranty expenses aren't as high as they predicted.

How they say it is a matter of semantics. Semiconductor manufacturer Entropic Communications Inc. called them "expirations," to differentiate them from "settlements made during the period," which are claims payments. What the company is essentially saying is that the warranty periods of the relevant products ended without any claims paid, so it is withdrawing the unused funds from the warranty reserve. Notably, a few months after Entropic did this, it was acquired by MaxLinear Inc.

International Lottery & Totalizator Systems Inc., which manufactures computerized wagering systems and electronic voting terminals, called it a "warranty reserve expense adjustment." During the first nine months of the fiscal year that began on May 1, 2013, the company took out $185,000, which was more than was in the reserve at the outset. That's because it added $355,000 in reserves, which was too much given there were only $91,000 in claims. And a few months later, the company was acquired by Berjaya Lottery Management (HK) Ltd.

And then there were three companies that took out as much as they started with in warranty reserves: IMAX Corp., Monolithic Power Systems Inc., and Avago Technologies Ltd. IMAX called it a "revision." Monolithic Power called it an "unused warranty provision." Avago called it a "change in estimate -- released to cost of products sold."

In each case, the amount left behind was not zero, because while the change in estimate was as large as the beginning balance in the warranty reserve, there were additional accruals made and claims paid. So these weren't the only transactions made. The point is, though, five companies took out as much or more than they started with, which marks these adjustments as massive in size, at least on a relative basis.

But while the label attached to these adjustments changes from one company to the next, the effect is always the same: idle funds become active, moved to more productive purposes or passed on to the bottom line as net income. These are the companies that made the biggest corrections, to their companies' benefit.

Figure 3
Top 20 Downward Warranty Expense Adjustments
by U.S.-based Companies
Ranked by Percentage Decrease
Jan. 2014 to June 2015
(in $ millions and as a % of reserves)

     Warranty   Change  Impact
    Reserve of Upon
  Company   Period  Balance   Estimate   Reserves 
  Entropic Communications 2014 $0.050 -$0.067 -134%
  International Lottery & Totalizator 9mo14 $0.139 -$0.185 -133%
  Avago Technologies Ltd. 3Q14 $2.00 -$2.00 -100%
  Monolithic Power Systems 2014 $0.451 -$0.451 -100%
  IMAX Corp. 2014 $0.007 -$0.007 -100%
  Quanex Building Products 2014 $3.68 -$3.40 -92%
  American Axle 2014 $14.3 -$8.7 -61%
  Pixelworks Inc. 2014 $0.329 -$0.195 -59%
  InvenSense Inc. 2014 $0.123 -$0.071 -58%
  Optical Cable Corp. 2014 $0.190 -$0.103 -54%
  Fuel Tech Inc. 2014 $0.596 -$0.311 -52%
  Finisar Corp. 2014 $4.16 -$2.02 -49%
  International Game Technology 2014 $4.40 -$2.10 -48%
  Optical Cable Corp. 1Q15 $0.100 -$0.048 -48%
  American Science & Engineering 2014 $0.397 -$0.179 -45%
  AXT Inc. 2014 $1.05 -$0.47 -45%
  Overland Storage Inc. 9mo14 $0.790 -$0.344 -44%
  GrafTech International Ltd. 1Q14 $1.05 -$0.45 -43%
  U.S. Auto Parts Network 2014 $0.296 -$0.123 -42%
  Xplore Technologies Corp. 2015 $0.285 -$0.116 -41%

    Source: Warranty Week from SEC data

There's only one repeat in Figure 3: Fiber optic and copper wire manufacturer Optical Cable Corp. makes two appearances, first for taking $103,000 out of its reserve fund in 2014, and then again for taking out $100,000 in early 2015. These are two separate amounts, made in two separate years, so we felt they should both be included.

Also, Overland Storage, while it made a massive withdrawal from its reserve fund in the first nine months of 2014, never got to the end of that fiscal year. In early December 2014, it was acquired by Sphere 3D Corp., a Canadian cloud computing company. Sphere 3D, in turn, accounted for the warranty reserves it acquired, and will report its claims and accruals going forward.

Now we get to the really large withdrawals. While the relative impact of the amounts taken out of reserves in Figure 3 is large, the amount of dollars generally isn't. Only five of the 20 adjustments exceeded a million dollars, and none exceeded the $10 million level.

Overall, however, we have counted 370 downward changes of estimate since the beginning of 2014, and some of them have been quite large. Sixteen were over $10 million, and two of those were over $100 million. In fact, it took $7 million or better just to get into the top 20 listed in Figure 4.

Figure 4
Top 20 Downward Warranty Expense Adjustments
by U.S.-based Companies
Ranked by Absolute Size of Decrease
Jan. 2014 to June 2015
(in $ millions and as a % of reserves)

     Warranty   Change  Impact
    Reserve of Upon
  Company   Period  Balance   Estimate   Reserves 
  Boeing Co. 2014 $1,570 -$200 -13%
  IBM Corp. 2014 $376 -$120 -32%
  Boeing Co. 6mo15 $1,504 -$90 -6.0%
  Navistar International 1Q15 $1,197 -$57 -4.8%
  General Electric Co. 2014 $1,370 -$50 -3.6%
  Hewlett-Packard Co. 6mo15 $1,956 -$46 -2.4%
  United Technologies 2014 $1,360 -$40 -2.9%
  Honeywell International 2014 $405 -$34 -8.4%
  AGCO Corp. 1Q15 $285 -$21 -7.3%
  United Technologies 6mo15 $1,313 -$19 -1.4%
  Brunswick Corp. 2014 $120 -$19 -15%
  Foster Wheeler 9mo14 $74 -$15 -21%
  Rockwell Collins Inc. 2014 $121 -$15 -12%
  Brunswick Corp. 6mo15 $111 -$10 -9.2%
  Colfax Corp. 2014 $66 -$10 -15%
  Ingersoll-Rand 2014 $247 -$10 -4.0%
  American Axle 2014 $14 -$8.7 -61%
  KLA-Tencor Corp. 2014 $43 -$8.5 -20%
  Infinera Corp. 2014 $23 -$7.7 -34%
  Rockwell Collins Inc. 9mo15 $104 -$7.0 -6.7%

    Source: Warranty Week from SEC data

Within this top 20, there were four repeats: Boeing, Brunswick, Rockwell Collins, and United Technologies. Intriguingly, three of those four are from the aerospace industry. But each of those adjustments within the pairs came in different fiscal years. So they are separate transactions. And it doesn't seem to be any more common in one industry than another.

Meanwhile, comparing the top 20 lists in Figures 3 and 4, there was only one repeat: American Axle & Manufacturing Holdings Inc. took $8.7 million out of its warranty reserve in 2014, and this was both a large amount and a large percentage of its beginning balance. Usually, it's one or the other, but not both.

Manipulating Reserves?

The bigger question is what kind of company puts $10, $50, or even $100 million too much into its warranty reserve fund, and then suddenly decides it needs to take out the excess money? In the past, some of the biggest withdrawals were criticized by investors for seeming to be timed to bolster otherwise weak earnings.

Perhaps we should have compared some of these most massive changes of estimate to net income, to see if that's true. But just a quick look at the top suggests maybe it's not. For instance, Boeing removed $200 million in excess funds from its warranty reserves in 2014, after taking out $178 million in 2013. In those two years, net earnings topped $5.4 and $4.6 billion, respectively. Boeing took out another $90 million in the first half of 2015, but net earnings exceeded $4.4 billion for the period.

IBM took out $120 million from its reserve fund in 2014, but net income was over $12 billion. Navistar took out $57 million and it's losing money, but we've noted multiple times that it's now at the tail end of a horrible rise and fall in its warranty expenses. So while the extra money helps, it's hardly an artificial manipulation of reserves.

We could keep going down the list and perhaps we'd find a suspicious withdrawal sooner or later. But we'd rather celebrate the fact that in 370 cases over the past year and a half, spread among 158 different companies, actual warranty expenses didn't live up to expectations.

We will reach one more conclusion, however. Or more accurately, we will support an earlier conclusion with one more fact. Of the 113 companies that made upward changes of estimate and the 158 companies that made downward changes of estimate since the start of 2014, an amazing 34 companies made changes of estimate in every single quarter -- six in a row.

And though the reports for the third quarter of 2015 are only partially in at this point, we found three companies that have already made it seven in a row: Brocade Communications Systems Inc.; Finisar Corp.; and Lennar Corp.

This supports the point we made before: when it comes to warranty expense predictions, many of the companies that are error-prone seem to be repeat offenders. Even a broken clock is right twice a day. But these three companies haven't been right for seven consecutive quarters.

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