June 30, 2016

European Auto Warranty Report:

Warranty expense rates are climbing for several manufacturers in Germany, Italy, and France. But Volkswagen has set a new record for warranty costs in the automotive industry as it prepares to clean up the diesel engine mess. Daimler is the only OEM showing any stability in its warranty metrics, let alone cost reduction.

We now have warranty expense data for a baker's dozen companies manufacturing passenger cars and light trucks in the U.S., Europe, and Asia. It's too much data to fit into one newsletter, so it will take three weeks to get to all of it. This week, we will start with the five European OEMs: BMW AG, Daimler AG, Fiat Chrysler Automobiles NV, Volkswagen AG, and the PSA Group, formerly PSA Peugeot Citroen.

For each company, we propose to examine three key warranty metrics. Using publicly available tabulations of annual sales revenue and unit sales volumes, and details from the annual reports regarding claims paid and warranty accruals made per year, we will measure each company's claims rate as a percentage of revenue, and their accrual rates as both a percentage of revenue and on a per-unit-sold basis.

Although all five report their financials in euro, in certain cases below we will default to U.S. dollars, because in the weeks ahead we will also add Japanese, Korean, and Indian companies into the mix. In the claims rate calculations and the accrual rate as a percentage of revenue, the currency drops out of the equation anyhow. It only becomes an issue when, from year to year, the exchange rates between currency pairs changes radically.

Comparing Companies

A note of caution: although we're including multiple companies on each of these charts, direct comparisons between companies are risky at best. Different companies may have different methodologies for counting up their warranty costs. One might count parts cost at replacement value, while another might count parts cost at current retail prices. One might include 10% of the cost of a call center's overhead, while another might include 30%. Therefore, one company's higher expense rates might have more to do with their choices of how to count warranty costs rather than with the reliability or quality of their products.

Having said that, a company most certainly can be compared to itself over time. If a company has kept its claims rate steady for multiple years and it suddenly begins to rise or fall, we can certainly make inferences about the quality of its products or at least the efficiency of its warranty management process. In certain cases, the news of the day regarding safety recalls, mergers and acquisitions, or the cost of outright fraud will explain the changes. But we don't really have to explain the changes as much as observe that they have occurred.

Let's start with the warranty claims rates of three top German OEMs. Volkswagen, Daimler, and BMW control dozens of passenger car and light truck brands, not to mention some heavy truck and motorcycle brands as well. Their reach is worldwide, including China, and of course so is the warranty expense data they report.

In Figure 1, we can see that Daimler's claims rate has been declining since 2009, while BMW's claims rate has been rising since 2012. Meanwhile, VW's claims rate has been surprisingly stable -- a little above or a little below four percent for most of the past 14 years. That's surprising because of the serious nature of the allegations made against the company regarding diesel engine emissions testing fraud. But remember, this data spans the calendar years 2002 to 2015. The scandal broke in September 2015. So there's been barely four months of claims data since then -- far to short an interval to register an uptick.


Figure 1
Three German Auto OEMs
Warranty Claims Rates, 2002-2015
(as a % of product sales)

Figure 1


However, the usual way it works is for claims to follow accruals, with some built-in lag time. Claims are paid out of the warranty reserve fund as the repairs are made, on vehicles that were sold in the past. Accruals are added into the warranty reserve fund as the size of the future expenses becomes known. Usually, accruals are made at the time a vehicle is sold, in an amount that equals the best estimates of the future cost of its warranty. However, if a company discovers that its previous estimates were inaccurate, it can contribute additional accruals to the warranty reserve fund to make up for the predicted shortfall.

This is what happened to VW last year. As the size of the diesel engine emissions problem became clear towards the end of last year, VW had to begin to calculate the future cost of making amends. And so, it accrued €19.27 billion in new warranty provisions in 2015, a radical increase from the €9.72 billion accrued in 2014.

"This is primarily attributable to higher warranty provisions and provisions for the legal risks resulting from the diesel issue," the company wrote in its annual report. So we don't need to speculate about the reason behind this increase in accruals. But we don't know how much the company eventually expects the diesel issue to cost.

Paying Legal Costs

Normally, safety recall expenses are included along with routine warranty expenses, or at least they have been since Toyota, Ford, and a few other OEMs were the last to count them together. But legal expenses such as regulatory fines and lawsuit settlement costs? Those are most likely being accrued in other accounts, in addition to the extra €9.55 billion in accruals added into the warranty reserve. That was how Navistar International did it when it got into a legal dispute several years ago with Ford over diesel engine repair costs. Navistar stopped making regular warranty accruals for those units, figuring that the eventual cost would be settled in court, outside of warranty.

In other words, the additional €9.55 billion in accruals is VW's best guess of what it will cost to repair or replace the non-conforming diesel engines in cars that continue to be driven. As for the fines it might have to pay to the regulators, and the legal costs of defending itself in court, those are in separate accounts.

Still, as we can see in Figure 2 below, VW has always had a much higher accrual rate than its closest competitors. Now it's gone even higher. The 5.5% rate in 2014 represented €9.72 billion in warranty accruals against €177.5 billion in product revenue. The new 10.5% accrual rate represents €19.27 billion in accruals against €183.9 billion in accruals.


Figure 2
Three German Auto OEMs
Warranty Accrual Rates, 2002-2015
(as a % of product sales)

Figure 2


That amount is by far the largest annual warranty accrual total ever reported by any manufacturer worldwide. In U.S. dollars, assuming a $1.10 conversion rate, it represents $21.2 billion -- more than four times as much as was accrued by Apple Inc. last year and more than twice as much as both GM and Ford together set aside in 2014 in the midst of their massive recalls.

Daimler, meanwhile, continues to slowly decrease its accrual rate while BMW continues to slowly increase its own. This is to be expected, because accrual rate changes should be based on factors such as whether claims rates are rising or falling, and what the expectation is for that expense in the future. So while the two rates don't always rise and fall in parallel lines, they usually more or less move together.

The difference is when a crisis hits. In that case, the spike in accruals comes first, and then the claims rise a few quarters later. The accruals are added when the expense first becomes predictable, and then later, when the bills actually come due, the claims are paid. That's the way it happened at Toyota in 2009 when the unintended acceleration crisis hit, and that's what happened at GM in 2014 when the ignition switch problem became known. First came the accruals and then came the claims.

Warranty Costs Per Unit Sold

So far, we've measured each company's warranty expenses as a percentage of their manufacturing revenue. But in the auto industry, there's also another way to do it. If, as we've outlined, a company predicts its future warranty costs and then makes an accrual for that amount at the time of sale, then by dividing the total accruals by the number of vehicles sold, we can calculate the accruals per vehicle.

It doesn't work with claims, because cars sold in one year might need warranty work the following year, or the year after that. Also, some warranties expire on mileage, or wreckage, so you can never precisely know how many are still under warranty based on time alone. But it works out very well with accruals, because all automakers disclose the number of vehicles they sell per year, and they all supposedly make the accruals at the time of sale.

In Figure 3, what we've done is to take the number of vehicles reported sold by VW. BMW, and Daimler, and divided them into the same accrual totals we used in Figure 2. And then, using the same euro-to-dollar conversion rates as the manufacturers themselves do in their annual reports, we converted the accrual-per-vehicle figures into U.S. dollars. In Figure 7 we'll repeat the figures in euro, but first we wanted to make a point.


Figure 3
Three German Auto OEMs
Warranty Accruals per Vehicle, 2002-2015
(in US$ per vehicle per year)

Figure 3


Back in 2007, when Daimler still owned Chrysler, and was having some quality challenges with its heavy truck product line as well, it had to accrue a frightful amount of currency per vehicle sold, to cover warranty costs. At the time, the dollar was down to $1.46 per euro, so those frightful amounts became ghastly when converted into dollars.

Last year, when the diesel engine crisis hit, VW had to accrue a frightful number of euro to cover predicted costs. But thanks to the inept management of the eurozone, the dollar was up to $1.10 per euro. So the amount spent per vehicle wasn't as ghastly. While back in 2007 Daimler set aside the equivalent of US$2,269 per vehicle in warranty accruals, in 2015 VW set aside the equivalent of US$2,120.

That's important, because what matters most is where the warranty work will be done. If, back in 2007, the warranty work was done on Daimler trucks in Europe, then the claims would be paid in euro. But if the claims were for Chrysler vehicles, then the claims would be paid in dollars.

The same goes for VW. It's going to have to change some of those billions of euro into U.S. dollars to pay for the claims on an estimated 482,000 diesel passenger cars the company sold in the United States since 2008. And because the euro isn't as strong as it was back in 2007, it will be a lot more painful for VW than it was for Daimler.

But one should also note that while Daimler has kept its accrual rate per vehicle relatively steady for the last five years, BMW has continuously raised its accrual rate to the point where it's higher than Daimler's. And, sadly, it's the highest accrual rate BMW has reported since 2004, at least in dollars.

PSA and Fiat

Now let's shift the focus to France and Italy, where the PSA Group and Fiat are based. There are other manufacturers based in those countries as well, but they don't report their warranty expenses. And, we should note, the charts below contain warranty data from two distinct companies, Fiat S.p.A. and Fiat Chrysler Automobiles. But just as we've done with General Motors Corp. and General Motors Company, we'll pretend it's one continuous enterprise.

In Figure 4, we're charting the claims rates of the companies, with Fiat in orange and PSA Group in green. PSA has kept its claims rate relatively steady for 10 years, while Fiat has seen its claims rate rise for three years straight.


Figure 4
French & Italian Auto OEMs
Warranty Claims Rates, 2002-2015
(as a % of product sales)

Figure 4


The more important metric to watch, however, is the accrual rate. This is a signal of future performance and current sales, and here the picture is slightly worse for both companies. For Fiat, the integration of Chrysler seems to be driving up accrual rates to new heights, while for PSA, accrual rates are much higher than claims rates, and much more volatile.

Fiat's accrual rate rose to 4.4% last year. And at 3.6%, PSA's accrual rate is at its second-highest level of the last 11 years. Both saw their accrual rates rise for the second consecutive year. Granted, Volkswagen has done just fine for years with an accrual rate even higher. But German cars have a reputation for quality -- deserved or not. Fiat and PSA do not.


Figure 5
French & Italian Auto OEMs
Warranty Accrual Rates, 2002-2015
(as a % of product sales)

Figure 5


The unseen metric here, however, is the average selling price per vehicle. Simply put, BMW and Mercedes-Benz get a lot more money per vehicle than do Fiat and PSA. So if Daimler spends a thousand euro per car sold, it's a 2.3% expense rate. But if Fiat or PSA spend the same amount per vehicle, it's three or four percent of their revenue. So that's another reason not to compare these companies against each other. Luxury products have luxury warranties, with higher costs per unit but lower percentages of revenue.

However, as we also noted, companies can be compared against themselves. Granted, there are two different companies in the Fiat data below -- one including Chrysler and one not -- but that is a worrisome rise in accruals from 2013 to 2015. Fiat is now setting aside nearly $770 per vehicle sold, its highest-ever accrual rate. And, at $725 per vehicle, PSA is near the top of its range as well.


Figure 6
French & Italian Auto OEMs
Warranty Accruals per Vehicle, 2002-2015
(in US$ per vehicle per year)

Figure 6


While Fiat has Chrysler giving it a massive U.S. footprint, it makes little sense to convert PSA's warranty expenses into dollars, because the company has such a small presence in the North American market. So it's very unlikely to be paying claims in dollars.

VW, BMW and Daimler do in fact have a sizeable presence in the U.S. market, but still, most of their sales are made in Europe. So in this concluding chart, let's compare their accrual rates in their native currency rather than in dollars.

Here's the shock: when denominated in euro, and when we look at accruals per unit sold rather than accruals as a percentage of revenue, PSA had the lowest accrual rate among these five manufacturers last year. Yes, that's right, at €658 per vehicle, PSA was the lowest in 2015, despite an almost 10% increase from 2014 levels.


Figure 7
Five European Auto OEMs
Warranty Accruals per Vehicle, 2002-2015
(in euro per vehicle per year)

Figure 7


For the previous three years, Fiat had been the lowest of the five. PSA was the lowest in 2010 and 2011, and then Fiat was the lowest in all the previous years. In fact, from 2002 to 2004, the only automotive OEM we're tracking that spent less per vehicle than Fiat was Tata Motors Ltd., and that was before they acquired Jaguar Land Rover.

And then at the opposite extreme, VW had the highest accrual rate by far in the world in 2015, surpassing even Tesla Motors Inc. And, when compared in euro, its €1,925 per vehicle accrual rate last year was even higher than Daimler's in 2007. But Daimler had the highest accrual rate from 2007 to 2014. And BMW held the title nobody wants from 2002 to 2005. VW, though, held it once before, in 2006, when its accrual rate was €938 per vehicle sold.

Last year, €938 per vehicle would have earned it fourth place. But that's the unfortunate trend: in Europe, at least among these manufacturers, warranty costs are rising, for a variety of reasons. VW can blame Rudolf Diesel. Fiat can blame Walter Chrysler. The others can blame Greece, or Zika, or Brexit, or more likely, they'll say nothing at all and hope nobody will notice.





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