August 24, 2017

Worldwide Construction Equipment Warranties:

With hard data covering almost three-quarters of the construction machinery sold worldwide, we manufactured an estimate of $2 billion for the entire industry's annual warranty costs. But we also found that sales are falling while warranty expense rates aren't changing much at all.

The global construction machinery industry, like the passenger car and civilian aircraft industries, is dominated by a limited number of very large manufacturers, many of which report their warranty claims and accruals totals in their financial statements. And as with those industries, it is possible to fill in the blanks and figure out the approximate size of the entire construction industry's warranty costs by estimating the expenses of the non-reporters.

In last week's newsletter, we detailed the warranty expense rates of seven construction equipment makers that were included in the top 10 list of the IC Yellow Table, published by the online magazine International Construction. The latest edition of the Yellow Table, published this past April, pegs the worldwide construction equipment revenue of the top 50 manufacturers at US$128.7 billion in 2016, a 3.2% decline from 2015 levels.

We cross-referenced the Yellow Table to our own product warranty expense records and discovered that 23 out of the top 50 construction equipment manufacturers include details about their claims and accruals in their annual reports. And we found they accounted for upwards of 73% of the industry's total revenue. So we decided to tabulate a worldwide figure for construction equipment claims and accruals by estimating expenses for that remaining 27%.

The first thing we needed to do was to translate the figures for the international companies into U.S. dollars. Among the 23 warranty expense-reporting companies, we have companies that report in not only American dollars, but also in Canadian dollars, Japanese yen, Chinese yuan, Korean won, Swedish kronor, and European euro. And so, we relied on the foreign exchange rates used in the July 6 report on worldwide automotive warranties and the July 20 report on worldwide aircraft warranties to help us make the translations.

Manufacturing Estimates

Next we had to make some adjustments to the warranty expense data we had on hand, to reflect the fact that construction equipment did not account for 100% of the claims and accruals reported by any of the top companies. For Caterpillar Inc., for instance, what the company reports as sales of machinery accounts for anywhere between 55% and 70% of the company's product sales per year. For Deere & Company, construction and forestry equipment accounts for anywhere between 13% and 23% of product revenue, depending on the year.

So what we did was to make an assumption that is probably not wise: we assumed that all a given manufacturer's product lines experienced the same claims and accrual rates as the total company did. That's probably not true -- in fact we know it's definitely not true for diversified companies such as Hitachi Ltd. and its construction machinery division. But we think it's close to true for not-so-diversified companies such as Cat and Deere.

And then we had to construct estimates for the 27 non-reporting companies in the Yellow Table's top 50. For some, we could find snippets of data, such as a year-ending warranty reserve balance or the total amount of accruals made per year. But for others, particularly the privately-held or government-owned companies, there was no information at all. So for those, we had to insert the average expense rates of similar companies into our estimates.

Fortunately, only four of the top 10 and eight of the top 20 companies in the 2017 edition of the Yellow Table do not report their warranty expenses. And the ones that do account for nearly three-quarters of total revenue. So our estimates, even if they're wildly wrong, won't throw off the totals by that much.

In total, we estimated the worldwide construction equipment claims total for 2016 to be slightly over $2.01 billion, and the worldwide accruals total to be $2.11 billion. In the pie chart below, the data for Cat, Deere, Komatsu, Volvo, CNH, and Terex is based on reported warranty data, while the data for the Liebherr Group, the Xuzhou Construction Machinery Group Company Ltd. (XCMG), the Sany Group, and JC Bamford Excavators Ltd. (JCB) is based on our own estimates.

Figure 1
Top Construction Equipment Makers Worldwide
Share of Claims Paid
(percent of US$2.01 billion total, 2016)

Figure 1

These do not line up at all with the Yellow Table market shares, which are based on construction equipment revenues. Here, we're basing the "market shares" on the percentage of the $2 billion worldwide claims total estimated to have been paid by each of the top companies. And the differences between the two pie charts are in turn based on the very real differences in the warranty expense rates reported by the companies themselves, as was detailed to some extent in last week's newsletter.

For instance, Caterpillar has 16.6% of the revenue but pays 27.0% of the claims. Deere has 3.8% of the revenue but pays 8.2% of the claims. This reflects the higher expense rates of the companies, as we detailed in the charts last week. Over the ten years we're looking at in this week's report, we found the worldwide average claims rate to be 1.5%, and the worldwide average accrual rate to be 1.6%. Companies such as Deere and Cat are somewhat above those benchmarks, because of longer warranties, costlier repairs, higher taxes, and other factors.

Meanwhile, three companies that were in the top 10 based on sales have dropped out of the top tier when it comes to warranty expenses. So Hitachi, Doosan, and Sandvik are out, replaced by CNH Industrial, Sany, and JCB. But since Figures 1 and 2 are based on their shares of expenses rather than sales, they're probably happy to be cut. And it means they spend less than average on warranty, which is probably a good thing.

Worldwide Accrual Shares

In general, accruals always seem to be a bit larger than claims, although in the long run, after changes in estimate and other adjustments, they would have to be equal. In the ten years of data we're looking at this week, accruals outpaced claims eight times. Only in the recessionary year of 2009 and in the anomalous year of 2015 did claims outpace accruals for this group.

In 2016, we estimate that the worldwide construction equipment manufacturers made $2.11 billion in accruals, up by about 12% from 2015 levels. Sales, by the way, were down by 3.2% according to the Yellow Table, so there must have been a change in expected warranty cost that prompted the additional accruals. (We also noted a slight upturn in expense rates, as will be seen in Figure 5.)

In Figure 2, the companies are the same but their places in line have changed. Volvo Construction Equipment, for instance, moves from fourth to second, and CNH and XCMG also swapped places. We noticed that in the reported warranty data, Volvo's accrual rate was a full percentage point higher than its claims rate. This is the result.

Figure 2
Top Construction Equipment Makers Worldwide
Share of Accruals Made
(percent of US$2.11 billion total, 2016)

Figure 2

Notice that the "other" category has widened somewhat as well. With claims, companies 11 through 50 accounted for 29.5% of the worldwide total. With accruals, they account for 30.5%. Also, Cat and Deere have a smaller share of accruals than they do of claims.

Worldwide Totals

Over the past decade, the worldwide totals for construction equipment claims and totals have risen and fallen, usually in keeping with sales trends. But as we will see in Figure 5, there have been small changes in the averages over time, which means that the expenses don't always change exactly in step with revenue.

In Figure 3, we're looking at the worldwide claims totals of the top construction equipment manufacturers. The portion in dark red is based on the totals we've gathered from the annual reports of the 23 companies that include claims payments in their financial statements. The pink portions are the estimates we've put together for the remaining 27 companies.

Figure 3
Top Construction Equipment Makers Worldwide
Claims Paid per Year
(in US$ millions, 2007-2016)

Figure 3

Notice that 2016 has the third smallest claims total of the last ten years. And 2015, at $1.9 billion, has the smallest of the past decade, edging out 2007. Meanwhile, the year 2008, at $2.6 billion, remains unsurpassed as the busiest of the decade.

It's hard to point to any one company to explain away these highs and lows. Caterpillar, Komatsu, and Doosan saw the largest increases in claims from 2015 to 2016, but none of them were very large. Deere, Terex, and Manitowoc saw the largest decreases, but again none were very large. However, all of these are warranty-reporting companies, so the data is what it is. It's not our additional estimates that produced the high or low annual totals.

Warranty Accruals per Year

The flip side is the ten-year trend in accruals made, which is charted in Figure 4. Once again, the peak year is 2008, and once again the bottom of the trough is 2015. And once again, the 2016 total is the third smallest of the ten.

Accruals totaled $2.11 billion in 2016, an estimate which is based on $1.47 billion in accruals made by the warranty-reporting companies, and $640 million in additional estimates made by privately-held and government-owned companies that do not report their warranty expenses publicly. That which we know is in dark green while that which we estimate is in light green in the chart below.

Figure 4
Top Construction Equipment Makers Worldwide
Accruals Made per Year
(in US$ millions, 2007-2016)

Figure 4

Except for the increase from 2015 to 2016, the worldwide accrual total has declined every year since 2011. Normally, this decrease would be good news, if it were caused by fewer or less costly repairs, but declining sales seems to be the cause. And at nearly $2.9 billion, the pre-recession year of 2008 remains the record high for this industry.

Again, the decline in accruals is not caused by the construction equipment makers learning how to reduce their warranty expense rates to their lowest-ever levels. As we saw in last week's newsletter, some have actually seen expense rates rise in recent years. Instead, it's more about declining sales combined with flat expense rates.

However, it's not purely a function of sales that's driving these claims and accrual rates up and down. According to the Yellow Table, industry sales were highest in 2011-2012, while 2008 was in third place. At the other extreme, the sales total in 2015 was the third lowest of the last ten years. In other words, the highs and lows of the past decade don't line up. But that's what's built into the data we know. It's not from the additional estimates.

Warranty Expense Rates

One big reason for the mismatch between revenue and expenses is the phenomenon of customer behavior during a recession. While they don't want to buy new equipment or replace old equipment, they desperately want to keep what they already have in good working order. In warranty terms, this means more repairs and less sales, which has a devastating impact on claims rates, since this is calculated by dividing product revenue by claims cost.

In Figure 5, that rise in claims seen for 2009 is caused primarily by the 35% decline in sales that year. Claims cost fell by only 13%, so of course the ratio between the two metrics rose from 1.6% to 2.1%. And then in 2010 it fell back to 1.5%, as sales picked up and claims remained about the same. Since then, the claims rate has remained very close to its long-term average of 1.5%, though it was up to almost 1.6% in 2016.

Figure 5
Top Construction Equipment Makers Worldwide
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2007-2016)

Figure 5

For the industry's average accrual rate, the recession had a less dramatic effect, because most companies cut their annual accrual totals by about the same amount as sales fell. For instance, while sales fell by 35% in 2009, accruals were cut by 32%. So there was still a slight rise, but only from 1.7% to 1.8%.

More notable is the gradual decline that followed, and the almost flat line that the industry's accruals held at 1.5% from 2012 to 2015. However, also note that the average accrual rate did in fact turn upwards last year, climbing above 1.6% (based on $2.11 billion in accruals made against $129 billion in revenue).

That's not alarming in the least, however. What's more alarming is how sales haven't risen in four years, and how warranty expense rates haven't fallen in an even longer period. Claims rates were lowest when sales were highest, and accrual rates haven't changed much in a decade. In other words, in this industry the rises and falls seen in warranty expense rates have little to do with actual cost reduction efforts, and lots to do with the ebb and flow of annual sales volumes.

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