Extended Warranties:

When Wal-Mart Stores Inc. announced its intent last week to begin selling extended warranties on TVs and computers priced over $300, some people began to wail like it was the end of the world. The world's largest retailer, they feared, was about to become the world's largest extended warranty sales agent, at the expense of Circuit City Stores Inc., Best Buy Inc., Sears/Kmart, and others.

Wal-Mart's claims administrator will be N.E.W. Customer Service Companies Inc., a sponsor of this newsletter, and its underwriter will be AIG Warranty Guard Inc. These are the same pair of companies who have already partnered to run Best Buy's extended warranty program, as well as the program at Kmart Holdings Corp. With Aon Warranty Group as its underwriter, N.E.W. also had been administering the extended warranty program at Sam's Club, the $31 billion "members only" division of Wal-Mart aimed at small businesses. So its is eminently qualified to take on such a potentially huge account as this.

Skills such as the ability to train sales staff and more basically, to answer phones and process claims, are in abundance at N.E.W. More importantly, N.E.W. keeps its own database of product failures and employs a full-time actuary to ensure that its contracts are priced appropriately. From N.E.W.'s point of view, everything it needs to allow Wal-Mart to become a successful extended warranty retailer is in place.

But Can They Sell?

From Wal-Mart's point of view, however, there are still a few missing pieces to the puzzle. First and foremost, does the average Wal-Mart associate have the skills and training required to sell a product and then sell an extended warranty? These things don't sell themselves. Just ask any online retailer who uses clickable yes/no radio buttons on a Web page instead of a well-trained salesperson to sell extended warranties. It's just too easy to say no, and even on a good day, well over half the buyers will indeed say no.

To successfully sell an extended warranty, the sales associate must first tout the features and benefits of the product in order to close the sale of the actual box. Then, without scaring off the buyer, they must pivot in place so they can thrill the buyer with tales of technology gone awry, or repair costs spiraling out of control. The only way the buyer will be able to sleep at night? Why, all they need to do to ensure their peace of mind is purchase an extended warranty, or in Wal-Mart's terminology, a Product Care Plan.

Wal-Mart's 1.6 million "associates" are well-known for their friendliness, but are they really going to be able to finesse the sale of an extended warranty? And if they can't, then who will? The cashier? Meanwhile, Wal-Mart's customers are well-known for their ability to find a bargain. That's why they go there, because of Wal-Mart's everyday low prices. But are these really the kind of shoppers who can be convinced to pay an extra 10% or 15% for the sake of their peace of mind?

A while back, extended warranty sales revenue dropped at Circuit City, and the company blamed the dip on its reliance during the holiday selling season on new and untrained temporary staff. These holiday temps were competent, helpful, and eager, but they just weren't the type of employees who could execute that perfect pirouette, turning from selling the unit to selling the insurance for the unit. We'd suggest Wal-Mart's upcoming holiday season will be filled with stories like this, where it was just too easy for the customer to say no to the extended warranty sales pitch, if they even get to hear it.

World's Largest Retailer

Of course, Wal-Mart is still the world's largest retailer. In the fiscal year ended Jan. 31, Wal-Mart reported revenue of $285.2 billion, and net income of $10.27 billion. Meanwhile, Sears Roebuck reported $36 billion in revenue and a $507 million net loss. Kmart reported revenue of $19.7 billion and $1.1 billion in net income. Best Buy reported $27.4 billion in revenue and $984 million in net income. Circuit City reported revenue of $10.47 billion and net income of $60 million. Suffice it to say that Wal-Mart is larger than all of them put together.

However, Wal-Mart is probably not the world's largest electronics retailer (at least not yet). That title is still probably held by Best Buy, because only 8% or 9% of Wal-Mart's and Sam's Club total revenue is likely to be classifiable as consumer electronics. And as profitable as apparel or food may be, they're usually not warranted products. So really, in terms of extended warranties, Wal-Mart has about as much of a potential market as Best Buy.

It's incredible that Wal-Mart waited until 2005 to begin experimenting with the sale of extended warranties, and that it waited until late October to make it official. Very few major retailers don't sell either their own or some third party's extended warranties (tops on the list now? Costco and Walgreen's). Furthermore, the Sam's Club unit has been selling extended warranties for 14 years, which makes the delay all the more curious: it's not as if they were unfamiliar with the lucrative economics of extended warranty sales.

Rumor is that the founders of Wal-Mart thought extended warranties did not represent a good value to the consumer. How to make them a good value, then? Sell them at low markups, which is exactly what Wal-Mart seems to now be doing. For a circa $1600 plasma TV, Wal-Mart's service contracts are $149, Circuit City is $260, and Best Buy is $400. For a circa $1600 Toshiba laptop, Wal-Mart's service contracts are $103, Circuit City is $265, and Best Buy is $300. There are some differences in the plans, but the most obvious difference is in their price.

It could be that Wal-Mart doesn't really anticipate selling very many service contracts, because their sales associates won't push them too hard. However, if a potential buyer comes through the door looking for a laptop or a plasma screen covered by an extended warranty, at least now Wal-Mart won't have to tell them to shop elsewhere. They've eliminated a negative, and they've done so in a way that passes on the value to their customers: foresaking much of their own potentially significant sales commissions.

When Best Buy or Circuit City sell an extended warranty, they immediately take their cut as a sales commission and pass the remainder onto their administrator. Warranty Week estimates that the full retail value of the extended warranties sold by Best Buy is in the neighborhood of $1.3 billion per year, and is $800 million at Circuit City. We don't know precisely what share of the total is kept by these retailers as sales commissions, but let's assume it's close to 50%. That would suggest Best Buy's extended warranty sales commissions are close to $650 million per year, and Circuit City's are close to $400 million per year.

Not Much Revenue?

In percentage terms, that means extended warranties are a paltry 2.4% of total revenue for Best Buy, and only 3.8% of Circuit City's domestic U.S. sales revenue. One could wonder what's the big fuss, then. However, that misses the real point, which is the profitability of this little sliver of the pie. What we're going to do is take you through a series of six charts which will lead you to the conclusion that extended warranty revenue typically exceeds net income for these two companies.

First, let's start with what we know for certain. In each Form 10-Q or 10-K financial statement, Circuit City usually reports either the percentage of revenue that comes from extended warranties, or the dollar amount, or both. And of course it always reports its total revenue and net income (or loss). For the past 11 quarters, the share of Circuit City's total domestic U.S. sales revenue attributable to extended warranty sales commissions has varied from $72 to $138 million per quarter, and from 3.0% to 4.1% of sales, as the chart below illustrates.

Source: Warranty Week from SEC data

It's rather difficult to discern the dollar amounts represented by the blue line, isn't it. That's the precise point. They're so close to the bottom that they don't look like much. If this were a pie chart, extended warranty would look like the thinnest of slices. But let's look at it another way. Circuit City has been profitable in only three of the past 11 quarters, so we can't compute what percentage of profits are represented by extended warranties. However, we can plot the actual data points. In Figure 2, the red line represents net income or loss, and the blue line represents extended warranty sales commissions. These are actual numbers.

Figure 2
Circuit City Stores
Extended Warranty Revenue vs. Net Income
Nov. 2002 to July 2005

Source: Warranty Week from SEC data

Only once during this period has net income exceeded extended warranty revenue, during the quarter that included November and December 2003, and January 2004 -- the 2003 holiday season. And even in that quarter, extended warranty represented 59% of the total. Of course, we're neglecting to include any costs that are associated with extended warranties, assuming the commissions are pure profit. While that may not be true, you get the point. Besides the three quarters in which Circuit City was profitable, there have been six additional quarters in which the company was just slightly below break even. Without extended warranty revenue, these quarters would have shown much larger losses.

In fact, let's break all the accounting rules and let's subtract out all the extended warranty revenue from the figures for net income (or loss). This would shift the curve down by roughly $100 million per quarter, reflecting the sales total for Circuit City if it were collecting no extended warranty sales commissions at all. As can be seen in Figure 3, this would have been difficult for Circuit City, leaving them with only one profitable quarter, no profitable years, and the ire of shareholders left wondering why the company hadn't compensated for selling hardware at essentially break even prices by selling insurance at a profit.

Figure 3
Circuit City Stores
Net Income Without Extended Warranties
Nov. 2002 to July 2005

Source: Warranty Week estimates

As mentioned, Figures 1 and 2 are graphs of actual data. Figure 3 is part actual data and part conjecture. Unfortunately, Best Buy makes no disclosures at all about its extended warranty revenues, so what follows will be mostly conjecture. Let's start with a chart of Best Buy's actual quarterly revenue (in green) and Warranty Week's estimates (in blue) of the retailer's quarterly extended warranty sales revenue (a constant 2.4% of sales).

Figure 4
Best Buy
Extended Warranty Revenue vs. Total Revenue
Nov. 2002 to July 2005

Source: Warranty Week estimates

As was seen in Figure 1 above, the blue line in Figure 4 seems to scrape along the bottom. But while extended warranties at Circuit City are 3% to 4% of sales, we're estimating only 2.4% at Best Buy, because of both a different product mix and a different sales environment. Plus, you wouldn't believe the next two charts if we assumed 3% or 4%.

In Figure 5, we're plotting Best Buy's actual net income (in red) against our extended warranty estimates (in blue). As the chart below shows, Best Buy was unprofitable only once in the last 33 months: in the fiscal quarter that included Feb., March, and April of 2003. But look closer, and you'll notice that net income exceeded extended warranty revenue only six times, and of those six, did so convincingly only twice (in what we're calling the first quarters of 2004 and 2005, or what Best Buy would call its fourth fiscal quarters, which include the holiday months of November, December, and January).

Figure 5
Best Buy
Extended Warranty Revenue vs. Net Income
Nov. 2002 to July 2005

Source: Warranty Week estimates

Circuit City has in most quarters been slightly above or slightly below break even. Without extended warranty revenue, it would have been a consistent money-loser. Meanwhile, Best Buy's margin in most quarters outside of the holidays is in the range of 2.0% to 2.8%, implying that without that extended warranty revenue stream the company would be essentially running at break-even levels. That's how important extended warranties can be: though they're only a few percentage points of total revenue, they can be the source of most or even all of a major consumer electronics retailer's profits, and can even represent the difference between profit and loss.

We won't repeat the format of Figure 3 for Best Buy, because all that would do is shift the red line down by $150 million or so, bringing the imaginary purple line very close to zero. Instead, what we'll end with in Figure 6 is a plot of the ratio between what we're estimating to be Best Buy's extended warranty revenue and what the company is reporting as its net income.

Figure 6
Best Buy
Extended Warranty Revenue as a Percent of Net Income
Nov. 2002 to July 2005

Source: Warranty Week estimates

For those who insist of sticking to the rules of math, the ratio for the second quarter of 2003 should be impossible to express because the denominator is negative, and a positive number cannot be divided into a negative number. We're just setting it to equal zero, on the theory that since there were no profits, 0% of the profits came from extended warranties.

Interestingly, on only two other occasions was the ratio below 50%. In other words, using this model where a constant 2.4% of Best Buy's revenue comes from extended warranty sales commissions, on only two occasions did those commissions comprise less than half the company's profits. And those were both holiday sales quarters, during which both sales and profits typically soar.

Meanwhile, on four occasions according to our rough estimates, extended warranty commissions actually exceeded net income (over 100%). Twice more the ratio fell just below 100%. And for the past six months the ratio has been stuck at 87%. So in reality, only twice in the last 11 quarters has less than 7/8ths of Best Buy's profits come from extended warranties.

Now imagine, if you will, that those extended warranty commissions are under a perceived threat by the entrance of a major new competitor in the form of Wal-Mart. No wonder so many people were thinking it was the end of the world when they heard the news. For while extended warranties may not be the biggest line of business in terms of dollars, they're by far the most important source of profits for many retailers.