This recession began with massive numbers of home loans going bad, so it's no surprise to find that new home builders have been among the companies most impacted by the nearly two-year-old credit crisis. If people can't sell the home they're in and they can't get a loan, it's highly unlikely they'll be in the market to buy a new home any time soon.

Of the 45 publicly-held homebuilders that also report their warranty costs, only one -- California Coastal Communities Inc. -- reported a sales increase in the second quarter of 2009. The rest reported sales declines of anywhere from 23% to 54%. Warranty claims also fell, but not as fast as sales, leaving the homebuilders with less cash to make repairs. And every month, both prices and unit sales seemed to fall.

Back at the Warranty Chain Management Conference in March, your editor opined that perhaps the new home industry had finally hit bottom, as evidenced by the very weak upturn in the claims total observed from the third to the fourth quarter of 2008. Now, with two additional quarters of data, it's pretty clear that the notch was only a ledge on the cliff -- that the market was still falling at a rapid pace.

Bottom of the Downturn?

Yet in Figure 1 below, there appears to be another ledge on the cliff, formed as the industry's claims total rose marginally from $95.3 million in the first quarter of 2009 to $98.3 million in the second quarter. Irrational exuberance? Wishful thinking? Only time will tell if this new notch was the bottom of the trough or just another pause in the decline. And meanwhile, we're in the curious position of heralding a tiny increase in warranty costs as a possible sign of recovery.

That $193.6 million claims total for the first half of 2009 is the lowest figure ever recorded for the new home industry. It's down 37% from the same period in 2008. Before that, the lowest level the industry had ever seen was reported in 2003, when the first half claims total was $286 million. Back in 2007 the total was over $400 million and even last year it was over $300 million.

January Lows?

But while Figure 1 definitely documents the peak, firm evidence of the trough remains elusive. It's possible that the latest notch is the bottom of the trough, and the upturn in the second quarter is the beginning of the recovery. But that's what we thought about the third quarter last year. And that was clearly not the bottom.

Still, some of the independent sales and price data now being reported also suggest that the worst may be behind us. Just today, the National Association of Realtors said that although single family home sales fell from July to August 2009, they remain above both year-ago levels and January 2009 levels. Average sale prices also fell month to month, but they also remain above their January 2009 lows.

So until the data contradicts us (again), let's call January 2009 and the first quarter of 2009 the bottom of the U.S. residential housing market. In the second quarter, claims were up an encouraging 3.1% but accruals were up by a screaming 15%, from $51.7 million to $59.6 million. And given that claims are the price you pay to fix what you already sold, while accruals cover the costs you expect to arise from what you're selling now, one would expect to see a strong upturn in accruals long before a jump in claims.

In an April 23 newsletter, we looked at new home accrual rates in terms of both dollars and on a per home basis. The feeling was that in the depths of a recession, where sales have come to a near standstill, accruals would be a better metric than claims. Surprisingly, it seemed that some homebuilders were quite arbitrarily massaging their accrual rates.

In previous newsletters, such as the September 25, 2007 report on new home and appliance warranties, or the June 20, 2008 report on new home and RV warranties, we favored the claims rates, even though sales declines were already beginning to distort the meaning of the percentages. In this newsletter, we'll look at both claims and accruals, hopefully showing why neither alone tells the whole story.

Constant Accrual Rates

Even in a severe sales downturn, the accrual rate should remain about the same, unless there has been a dramatic change in either product quality, product price, or the cost of repairs. If the predicted cost of future warranty work on a new home is $1,000, and if neither the quality of the home nor the price of fixing it has changed, then a company should accrue $1,000 each time such a home is sold, whether it was sold in 2005, 2007, or 2009. On a home priced at $200,000, such an accrual would result in an 0.5% accrual rate.

If, however, the cost of materials and the labor employed to do the warranty work is falling, then perhaps $1,000 is too generous an amount to set aside for it? Perhaps the average expected future cost of warranty work per home has fallen to $750? But if in the mean time the average home price has declined to, say, $150,000, that $750 still implies an 0.5% accrual rate.

Theoretically, the price of a product is not tied to the cost of repairing it, but as this recession has taught us, they frequently move together. In Ireland, the average cost of home improvements is falling. In the UK, the average cost of auto repairs is falling. And in the U.S., the average cost of new home warranty work is falling, along with the cost of materials and the price of the homes themselves.

It's a complex set of interlocking assumptions, but it seems to be one that America's largest homebuilder seems to have navigated well. As can be seen in Figure 2, D.R. Horton has kept its accrual rate extremely close to 0.5% for six-and-a-half years, as Figure 2 shows (green line), while its claims rate has steadily risen from 0.3% to 0.8% (red line).

That steadiness in accrual rates is further confirmed by a continued steadiness in the accruals being made per home. In the April 23 newsletter, Figure 2 showed how D.R. Horton's accruals per home sold has remained tightly bound within the $1,000 to $1,200 range since 2006.

We're happy to report that this trend has continued. The company's accrual rate per home sold was $1,032 in the first quarter of 2009 and $1,014 in the second quarter of 2009. And as Figure 2 in this week's report shows, those amounts per home still equate to around 0.5% of sales revenue.

In hard numbers, Horton's sales were down 37%, claims were down 43%, and accruals were down 44% from a year ago. That all translates into a claims rate that slipped from 0.7% a year ago to 0.6% in June 2009, and an accrual rate that remained at 0.5%. The 0.8% claims rate seen at the end of 2008 remains the all-time highest.

Falling Sales Cause Higher Claims Rates

That recent peak in Horton's claims rate may look ominous, but upon closer inspection it looks to be just another distortion caused by falling sales volumes. Although the defective Chinese drywall problem is just beginning to figure into the cost of repairs for many builders, it's not quite here yet. The problem now is a lack of sales. The homebuilders' biggest warranty challenge over the short term is going to continue to be trying to fix last year's unit sales with this year's dwindling supply of cash. And then, hopefully after a recovery is in full swing, the drywall replacement costs will kick in.

At Lennar Corp., the accrual rate trend was never as flat as it was for D.R. Horton, and the claims rate has jumped up further, faster, and more recently. Why is that? It can't be Chinese drywall, because Lennar is dealing with that crisis by making extraordinary changes in estimate (adding $15 million in 2008, and $28.7 million more so far this year) that don't show up in this chart as an elevated accrual rate. But they do show up as additional warranty reserves: Lennar's balance had been in decline since the end of 2006, but it's up again this year.

When it comes to the shape of the curves in Figures 2 and 3, we can't help but think that these are snapshots of how well-run but battered companies respond to a devastating downturn in sales. Still, a quick look at the scale on the left and right axes shows that Lennar's warranty costs are at least twice as high per dollar as they are for D.R. Horton. While Horton is accruing roughly 0.5% of its homebuilding revenue for warranty work, Lennar is accruing closer to 1.0%. And while Horton's claims rate peaked at 0.8% in the depth of the recession, Lennar's peaked at 2.7%.

In terms of accruals per home, for most of the past three years Lennar has been accruing closer to $3,000 per home, as was detailed in Figure 3 of the April 23 newsletter. In 2009, those accruals per home have dropped somewhat to the $2,500 level. But they're still more than twice as high as D.R. Horton's.

This is not to say that Lennar builds better or worse homes than D.R. Horton. The difference may be due to the average size or price of the homes, or perhaps to the prevailing local cost of labor and materials for all the warranty work. It may be that D.R. Horton is simply better at getting its sub-contractors to pay a higher share of claims costs. Or it could be any of several other factors. We're simply saying that while both companies appear well-run and firmly on top of their warranty costs, even during a severe recession, on a relative basis one is keeping its warranty accruals half the size of the other's.

It's the flatness of the accruals lines that makes us say that. Sales are down 37% at D.R. Horton and are down 23% at Lennar. Any warranty or finance department that can keep its accrual rates so close to a flat line through a downturn this severe deserves the label "well-run." Its polar opposite would be a company that checks with Wall Street analysts to see what's expected of earnings this quarter, and then adjusts accruals to make those numbers happen.

Incorrect Predictions

It's not supposed to be done that way, but good luck proving a manipulation complaint beyond a reasonable doubt when you're tracking a finance executive's predictions of future costs. Predictions can't be wrong until they're examined in hindsight. If incorrect predictions were a crime, one prison would be filled with economists while the one next door was filled with weathermen and gamblers.

It's just a question of how wrong can you be? And how often can you be wrong? With a metric such as accruals per home, one would need to do a lot of explaining if one were to suddenly revise the rate from $2,300 per home to $850 per home, then back again.

Yet that is exactly what Pulte Homes seems to have done in the past two years. In Figure 4, it is clear that the accrual rate per home has fallen below $1,000 twice in the past two years after rising as high as $4,000 per home at the end of 2006.

We've changed the metrics (and the color code) in Figures 4 and 5 to look at accruals per home (dark blue line) rather than accruals per dollar of revenue (the green line of Figures 2 and 3). These amounts are calculated directly from the homebuilders' own financial reports, which list both the number of homes sold and the accruals made. So do these wild swings reflect changes in quality or repair costs? Or are they something else entirely? Have we spotted a company that's essentially predicting beach weather in the middle of winter?

In April, Pulte announced its intent to acquire Centex Corp., thereby becoming the biggest homebuilder in the U.S. and dethroning D.R. Horton. In Figure 5, we've charted the latest warranty data from Centex, and it appears that the companies will be a good match for each other. Centex has kept its accrual rate per home close to $1,000 for 15 months now, but twice in the past 30 months it allowed accruals to plunge to the $500-per-home level. In 2006 it once accrued as much as $1,900 per home sold.

Elsewhere, at least two homebuilders -- KB Home and Beazer Homes -- made houses in 2006 and 2007 that were apparently built so well that the companies found it appropriate to make absolutely no accruals at all during certain periods. In other words, their financial accountants must have predicted that some of their homes were so well-built that they would need no warranty work at all. The very next quarter, accruals sprang back to levels of $2,000 or more per home, but the companies were just as silent about these apparent quality reversals as they were about their flawless predecessors.

But let's leave that to the regulators to sort out. Compliance and enforcement seem to be on the upswing this year, so perhaps all those economists, weathermen and gamblers will be more realistic with their predictions from now on? Let's hope so.

Warranty Management at Smaller Builders

In the mean time, let's take a look at some of the smaller homebuilders, and see how they weathered the recession. In Figure 6, we're providing a snapshot of the Toll Brothers, a luxury home builder that has expanded far outside its original Philadelphia-area roots.

The lines for the Toll Brothers in Figure 6 aren't as flat as they were in Figures 2 or 3, but we don't see the fjords of Figures 4 or 5 either. Claims and accrual rates have rarely strayed far outside a range of 0.5% to 0.8%, though both metrics have become somewhat more erratic in recent quarters. So far this half-year, the trend for claims is up while the trend for accruals is down.

Toll Brothers has seen sales fall by half, and warranty claims fell by only a third. Inevitably, the claims rate rose from 0.8% in the middle of 2008 to 0.9% in the middle of 2009. Accruals, however, were cut from $13 million in the first half-year of 2008 to $4.6 million in the first half-year of 2009, so the accrual rate fell faster than sales, from 0.8% to 0.6%. The company's warranty reserve, meanwhile, contracted around 10% in size, from $61 million to $54 million.

Normally, these homebuilders find it easy to keep warranty costs under 1% of sales revenue. Even in the recession-induced chaos of 2008 and 2009, builders such as Lennar and Pulte have kept claims rates below the 3% level. Accrual rates, as we mentioned, should change little over time because accrual amounts should be explicitly pegged to sales.

High Warranty Costs?

We say that as background material in order to introduce Figure 7, which tracks the warranty costs of Hovnanian Enterprises, a major builder that's turning 50 years old this year. In the quarter ended April 30, 2009, the company reported $16.6 million in warranty claims and $382 million in sales revenue. That's a 4.4% claims rate. Accruals topped $9.5 million, for a 2.5% rate. Incredibly, that equates to $6,500 per home sold.

Hovnanian has always accrued warranty funds at a rate much higher than its peers. As we charted in Figure 8 of the April 23 newsletter, accruals per home went as high as $10,813 in late 2007, before returning to more normal levels late last year. But now the accrual rate per home is back up to elevated levels, as is the accrual rate per dollar of revenue. In fact, in the quarter ended January 31, 2009, both Hovnanian's claims and accrual rates were above 3%, and its accruals per home topped $8,900.

One could almost suspect that Hovnanian was selling mobile homes. For while it's true that the site-built home industry can generally keep its net warranty costs under 1% of revenue, that's not true with either modular homes that are trucked in and assembled, or with recreational vehicles that can be driven around the country. For some reason, those industry segments are plagued by some of the highest warranty costs of all.

We'll include snapshots of two major providers of what are referred to as prefabricated homes to illustrate our point. In the September 10 newsletter, we included a warranty snapshot for Winnebago Industries Inc. and mentioned the bankruptcies of Fleetwood Enterprises, Monaco Coach, and other top RV makers. That industry, which always experienced warranty costs a bit above the levels seen for passenger cars, was hit even harder by the sales decline.

Manufactured Housing

Now, we'll take a look at some of the makers of prefabricated homes, also known as mobile homes, modular homes, or manufactured homes. We won't attempt to tackle the subtle differences between those marketing terms, except to say that these units differ from an RV in that they typically don't have steering wheels or windshields. And they differ from site-built homes in that they're typically built in a factory.

In June, Cavalier Homes announced its intent to be acquired by Southern Energy Homes Inc., also known as SEhomes Inc., which is a manufactured home brand controlled by Clayton Homes, which in turn is ultimately owned by Berkshire Hathaway Inc. But just before that transaction was completed last month, the company filed its final Form 10-Q quarterly financial statement with the U.S. Securities and Exchange Commission. So what follows in Figure 8 is in a way both a hello and a goodbye to the company.

In the most recent quarter, Cavalier's sales fell 53%, but warranty claims fell 52%, so the claims rate was relatively unchanged at 6.4%. Accruals also fell at close to the same rate, so the latest accrual rate as a percentage of sales stood at 6.8%. Neither percentage is alarming, nor are they out of step with the pattern seen over the past four years. But what is noteworthy is that a major manufacturer that's not in dire straits (e.g. Coachmen Industries) and is not covering excessive hardware costs with profits from the sale of supplies (e.g. Lexmark International) has consistently paid out more than 5% of its revenue for multiple years without much consequence. And now it's part of legendary investor Warren Buffett's holding company.

Finally, lest anyone think we're singling out Cavalier, we present a warranty snapshot for Champion Enterprises. Along with others such as Cavalier, Cavco Industries, Coachmen, and Skyline Corp., Champion Enterprises is yet another example of the curious intersection between manufactured housing and high warranty costs.

The Worst May Be Behind Us?

A year ago, Champion's warranty claims rate was 4.8% and its accrual rate was 4.0%. While both of those are a bit high, they're still below the red line of 5%. But then sales fell 54%, and claims didn't. So the claims rate rose to 6.5%. Meanwhile, accruals actually fell a little faster than sales, so the accrual rate dropped to 3.9%. The scary thing is that both these metrics have improved somewhat since the first quarter, as Figure 9 illustrates.

For both Cavalier and Champion, it's a similar story. Back when warranty cost reporting first began in 2003, both were at the very high end of the scale. And then they learned how to reduce their warranty costs, improving just a little bit every year. But then the recession hit, and all that progress was undone.

Fortunately for Cavalier, an acquisition came just in the nick of time and so their story gets a happy ending. For Champion, though, the stock was punished so badly that it's been below $1 a share for the entire year. Had the stock exchange been enforcing its own rules, Champion could have been banished to the pink sheets by now.

Still, it could have been worse. This downturn could have gone on for another year. Instead, for the quarter ended July 4, Champion Enterprises CEO William Griffiths said in an earnings press release that he saw "signs of stabilization" and even some "signs of improvements." In fact, he was bold enough to state, "we are optimistic that the worst of this cycle may be behind us."