As we continue our tour of the vehicle service contract industry, we find that auto parts retailers are either A) ripe for development as new service contract sales outlets or are B) completely uninterested in participating.

In the consumer electronics and appliance fields, about the only retailers of any appreciable size that don't sell service contracts are Walgreen Co. and the Costco Wholesale Corp. And the latter company makes up for that principled stance by lengthening the warranties on some of the products it sells above and beyond what the manufacturers offer, and then absorbing the cost of doing so as a goodwill gesture towards loyal customers.

In the auto parts sector, the Costco model seems more like the rule rather than the exception. Particularly for items such as car batteries, shocks, and brakes, each of the top the retailers seems to be quite willing to go above and beyond the manufacturer's warranty, in the name of good customer relations.

Exceeding Manufacturers' Warranties

Take, for instance, Advance Auto Parts Inc. Last year it spent $34.7 million on warranty claims, a little over 0.6% of its retail revenue. It even maintains a warranty reserve fund, which as of the end of March contained nearly $30.5 million.

If anything, the rate at which Advance Auto Parts pays warranty claims on products it didn't manufacture is accelerating, as can be seen in Figure 1 below. That tall-looking first quarter 2010 column represents $15.66 million -- easily the highest quarterly claims total for the company, both in dollars and as a percentage of revenue.

What does Advance Auto Parts get for its money? It gets loyal customers, according to Shelly Whitaker, manager of public communications at Advance Auto Parts. "Our goal is to be the industry leader in customer service and satisfaction," she told Warranty Week. "We feel the cost is definitely worth the results."

Could Advance Auto Parts possibly offset some of these product warranty costs through service contract sales? It definitely could, perhaps on some of the products it sells or perhaps even as a third-party broker of full-blown vehicle service contracts (at least in states where non-dealer sales are allowed).

Yet it chooses not to, in order to avoid becoming entangled with insurance- and compliance-related chores. "Some states in which we do business restrict the sales of extended warranties and service contracts as a form of insurance and are regulated by that state�s insurance commission," Whitaker noted. "As a result, at this time we chose not to offer these packages so that our policy would be consistent throughout the entire store system."

Giving Service Contracts a Try

It's not the same at every auto parts chain. For instance, The Pep Boys - Manny, Moe & Jack, dipped their toes into the service contract waters in 2006, and after deciding they liked the results, waded in further a year-and-a-half ago. Yet the retail chain still continues to enhance certain product warranties, assuming the costs and making the reserves itself.

As can be seen in Figure 2 below, the Pep Boys have never paid out as much in claims per quarter as Advance Auto Parts, but they have at times exceeded the 0.8% of revenue threshold on a relative basis. In the fiscal year ended January 30, 2010, the company spent nearly $15.7 million on product warranty claims, an amount that represented around 1.0% of sales.

Service contracts are a more recent addition to the Pep Boys catalog. Dominic Sansone, president of Warrantech Automotive Inc., said the folks at the consumer product side of the house began doing business with Pep Boys about five years ago, administering a service contract program called PepGuard. That offering was initially available only for electronic products sold in the Pep Boys storefronts.

Labor Warranties Added

The PepGuard service contract program was then broadened to cover additional product lines such as scooters, he said. And then about a year-and-a-half ago, the companies launched the Pep Boys Labor Extended Warranty, which lengthens the cover on labor charges associated with parts installations from the standard three or six months to a full year.

Customers can buy this extended warranty for their personal, non-commercial vehicles, covering specific repairs made by Pep Boys technicians. The program is administered by Warrantech Consumer Product Services Inc. and is underwritten by Wesco Insurance Co., a unit of AmTrust Financial Services Inc.

"Say you replaced your alternator, and that came with a one-year warranty on the part, but the labor was only 90 days," Sansone explained. If that part failed before the year was up, but after the 90th day, the cost of a replacement alternator would be covered, but the cost of re-installing it would not be.

"So they came to us, because of the success they were having with PepGuard," he said, asking if they could develop an additional program that gave customers the option of paying to extend the labor cover to match the parts cover. And now that too has become a success for the companies, he added.

Training the Mechanics to Sell

The key to this success, Sansone said, is in the training of the service technicians to sell service contracts. This is not a trivial point. Even within franchised auto dealerships, where the center of service contract sales has always been the finance and insurance office, it's proven difficult to get mechanics and technicians to think like salesmen.

Inside the Pep Boys storefronts, the salesmen who sell electronics and scooters can be trained much like any other retail sales force. It's not all that different from how Sears or Best Buy trains their sales staff to sell service contracts.

But inside the service bay, it's not the same thing when a mechanic suggests an option to upgrade a one year parts/90-day labor guarantee to a full year term for both parts and labor. First of all, it's not something that every service provider offers. Second of all, if it's explained correctly, it can achieve a good attach rate.

It's certainly different from how the F&I office operates. They're selling comprehensive "bumper-to-bumper" service contracts for entire vehicles, and have the ability to wrap their thousands-of-dollars cost into a monthly lease or loan agreement. In the Pep Boys' service bay, the cost of the labor extended warranty is probably going to be quoted in the dozens-of-dollars range, which can be wrapped into the cost of the repair and can be printed right onto the repair order. But it's too small to be financed (except as a credit card transaction).

Declining Warranty Costs

At AutoZone Inc., in contrast, enhanced product warranties seem to be on the wane, and service contracts seem to have never taken hold. So in traditional retail terms, AutoZone is becoming less like Costco and more like Walgreen.

Figure 3 shows how the company ceased reporting upon its warranty claims cost in 2006. We've kept the figures going as estimates for 2007-2010 based on the meager amounts reported at the end of 2006, however: $1.2 million per quarter.

We say "meager" because as can be seen below, the retailer was actually a major warranty provider way back in fiscal 2003, when it paid nearly $95 million in claims -- an amount which represented nearly 1.8% of its total sales at the time.

Nowadays, all the company reports is the year-end balance in its warranty reserve fund. On August 29, 2009, the end of its most recent complete fiscal year, the balance was reported to be $12.4 million. In contrast, at the end of August 2003 the balance was nearly $78.5 million. In August 2002 it topped $82 million.

Shifting Warranty Costs to Franchisees

And then there are retailers that also used to be manufacturers, who are running off the warranty liabilities they accumulated in years past. Midas Inc., for instance, used to manufacture the replacement mufflers it installed into passenger cars. It used to also set aside a portion of that revenue to fund warranty claims. Now, that bill has been passed to the franchisees.

Over the past half-century, Midas has become well-known for the lifetime guarantee it offers for brake pads, shoes, mufflers, shocks and struts, which is valid for as long as the customer owns their car.

Bob Troyer, the director of corporate affairs at Midas, said it's not just a marketing gimmick. It's a very real lifetime warranty that continues to have a very real cost component.

"We've had people come into the shops with warranties they got back in the 1950s and 60s," Troyer said. And they expect their warranty claims to be honored. "It's actually what built the company," he added.

Troyer said that back in 1956, Midas founder Nate Sherman decided to base his quality message around the concept of non-transferable lifetime warranties. "Guaranteed for as long as you own your car" became a popular advertising slogan on outlets such as the Paul Harvey news network, and soon competitors had to match the offer.

Back then, Midas was manufacturing the mufflers itself, and the franchise locations were merely passing on the manufacturer's product warranty to their customers. But then in recent years, Midas exited the manufacturing and distribution business, and changed the way it funded the warranty reserve.

High Percentage of Revenue

As can be seen below in Figure 4, the trend at Midas for the past seven years has been to pay less in claims each quarter, combined with a claims rate that bounces once a year to incredible heights. The first trend, we suspect, has to do with its decision to exit manufacturing and put the warranty reserve into runoff mode. The latter trend, we suspect, is just an accounting anomaly that has more to do with the mix of rent, royalties, and replacement part sales.

At the end of 2006, the company had $33.4 million in its warranty reserve, after spending $6.4 million in claims that year (nearly 20% of its product royalties and replacement part sales revenue but only 3.6% of its total revenue). It also made $4.4 million in accruals that year.

But then in 2007, and again in 2008, the company made no additional accruals, after paying $5.3 million and $4.5 million, respectively, in claims during those years. Instead, it actually took money out after recomputing its future liabilities.

It did the same last year, reporting $3.4 million in claims and no accruals. The result is that the warranty reserve declined to $13.3 million by the end of 2009, and to $12.8 million by the end of March 2010. Troyer said the company has basically decided to run off the balance.

From now on, the product warranties on units sold since the company exited the manufacturing business will be funded by a small fee paid by franchisees for each installation they perform. So rather than reducing the cost of the lifetime warranties, the company has merely found a way to shift the responsibility for its cost.

No Service Contracts?

There aren't really any service contracts for sale within Midas. However, Troyer said some Midas franchise locations also sell tires, and for those tires they also sell road hazard tire and wheel coverage programs. But beyond that, he said he's not aware of any Midas outlets that sell vehicle service contracts or additional parts or labor coverages on their mufflers, brakes or shocks.

"But I have to preface that by saying that we're a franchise organization," he added. "We have 700 franchisees operating 1600 Midas shops in North America. So I can't speak 100% that somebody isn't doing something out there. But we do not, as a company."

Part of the reason for the low appeal of service contract sales is the lifetime warranty itself. Once a muffler is guaranteed forever, there's really no need to sell additional coverage. And part of the reason is logistical. These repair shops are set up to perform very specific aftermarket installations and repairs. They are not set up to fix everything that can go wrong on a modern vehicle. So selling a "bumper-to-bumper" extended warranty is a bit of a reach.

But could Midas one day decide to trade on its good name by selling full-blown exclusionary service contracts over the counter? Even if it requires the customer to go elsewhere for the actual repairs? Anything is possible, but Troyer doubts it's ever going to become a viable business for Midas.

"We've built a following of loyal customers based on the fact that we take care of them," Troyer said. "The idea of having the warranty is to assure the customer that we stand behind the work. We offer the product warranty and people ask the question, 'Well, how can you do that?' Well, it's just like any other warranty that you have on other products: We expect the product to work. And if there's an issue, we'll take care of it."

Never Say Never?

Therefore, the sale of service contracts has more or less been ruled out by spokespeople at Advance Auto Parts and Midas. But of course, one should never say never. While some say the US Fidelis saga has forever poisoned the non-dealer, direct-to-consumer sales channel, others say the combination of a trusted brand name and a physical presence could make others follow the Pep Boys example.

Without mentioning any names, Sansone said some of Pep Boys' competitors are now asking Warrantech about how they can bring service contract sales within their storefronts and/or service bays. The biggest challenge, he said, has not been related to compliance issues, which most administrators have well under control. Instead, it's been more in terms of software compatibility -- of finding a way to integrate the ability to price and sell a service contract into the storefront's existing computer systems.

Within some chains, each location may have a different repair order management system. And it might not be one of the top dealer management systems that the F&I offices within the franchised dealerships use, and with which the vehicle service contract administrators have already achieved compatibility. It was easier to do it for Pep Boys, because every location used the same software.

"Right now, Pep Boys does not use franchised stores," Sansone said. "They're all company-owned locations. So there's one operating system. And so in developing this rating module, where the extended labor warranty prints out on the repair orders, the challenge I've had is getting the rate to print on their system."

Down the road, it's possible that some of these auto parts retailers and independent service stations might decide to begin selling full-blown vehicle service contracts. If they did, they could become a significant new source of competition for not only the F&I offices at the dealerships, but also for the remaining companies selling direct to consumers.

People Are Talking

"There's definitely people talking to us, asking us to develop programs like that for them," Sansone said. He said there are a handful of U.S. states where that wouldn't be allowed, but in most states it would be legal. But would it be successful? Can anyone outside the F&I office sell vehicle service contracts successfully?

"It's going to be hard," Sansone admitted. "But there are products being developed now, with a lower price point that I think will make it easier, such as a month-to-month program that we're developing. As long as you pay, you have coverage. If you stop paying, you lose coverage. That will help make it easier for these people to sell."