November 16, 2004

Public Warranty:

Of all the companies in the extended warranty business, most are either small units within very large companies, or they're family-owned or privately-held companies. Only one is publicly held, and lately that's been a problem for them.

This is the eighth week of our expanded tour of the extended warranty industry, and it seems like it's only beginning. We've been taking a look at some of the larger players, one per week, trying to spot their competitive advantage. This week, it's Warrantech's turn. But rather than a competitive advantage, we think they suffer from a significant competitive disadvantage: they're a public company, trading under the stock symbol WTEC.

Just about everybody else they compete with is either privately-held or is a very small piece of a much larger company. In the product warranty business, the complicating factor when it comes to market analysis are the many importers who still don't make their warranty expenditures public. This problem is most significant in the passenger car and consumer electronics industries, where respectively 40% and 90% of the products sold in the U.S. are imported. In the extended warranty business, however, roughly 100% of the players that are not called Warrantech are either privately-held or are part of much larger companies.

Living in a Glass House

That translates into a competitive disadvantage for Warrantech. It's as if Warrantech is living in a glass house while everyone else is living behind brick walls or in an office tower with ground floor security. Anyone can see that Warrantech reported just under $120 million in net revenues during the fiscal year ended March 31, and that it was ultimately unprofitable by just over $500,000 (or three cents per share). They can find out that Warrantech chairman Joel San Antonio is 51 years old, that he's been a director since the company was founded in 1983, and that his salary last year was $591,851 with a bonus of $59,226 plus some stock options.

That's not an amazing amount of detail, but none of his competitors are forced to publish their salaries for all to see. And none of his competitors have had to endure investigations by the Securities and Exchange Commission (except, perhaps, AIG: see this USA Today story). Nor have any of his competitors had to publicly explain the loss of key accounts, the finances of loans made to top executives, nor the ramifications of having a key insurance underwriter go bankrupt.

Joel San Antonio was contacted through intermediaries three weeks ago, requesting an interview on the subject of being the CEO of a public company in a private industry, but no response was received. Last Friday his assistant said he's been traveling, as she herself was leaving for a week's vacation.

If there's a follow-up reaction, we'll publish it. But the very point of this story is that Warrantech operates in public to such a degree that it really isn't necessary for them to be involved in a given article for it to happen. Warrantech's chief financial officer told USA Today he had no interest in participating in the AIG story. AIG also had no comment. Yet there's the story -- all 2500 words of it. By the way, for a more personality-oriented take on the saga of the Greenberg family's stewardship of AIG and Marsh & McLennan Co., take a look at a recent article in New York magazine.

It's the same story with Warrantech. Despite the "no comment" or no reply at all from its top executives, it is not difficult to track down people intimately familiar with its business who are willing to talk about it in detail. Richard West, senior analyst at J.M. Dutton & Associates LLC, said he's been following the stock for roughly eight years. "It's been a very interesting and sometimes frustrating experience," he said.

SEC Settlement

West remains officially neutral on the stock, although that may change as he prepares to publish yet another research report on the company, on the occasion of the company having finally settled all outstanding issues with the SEC. That SEC investigation has dogged the company for the past year and a half. The main problem had to do with how Warrantech reported the revenues generated by extended warranty contract sales. Without getting lost in the trivia of this proceeding, the SEC asked for changes, to which Warrantech complied. Then Warrantech found a better way, to which the SEC objected.

After lengthy negotiations, the SEC prevailed, and Warrantech restated its revenues in a way that turned previous profits into losses. Before the restatement, Warrantech had declared a net profit in the second, third, and fourth calendar quarters of 2003. After the restatement, each of those quarters included a net loss. Here is a list of all the before and after figures for the past five fiscal years.

Warrantech Corp.
Earnings per Share
Before and After Restatement

Fiscal Year Before After
2000 -.54 -.64
2001 +.12 -.78
2002 +.15 -1.08
2003 +.19 +.10
2004 -.03 -.03

"Just a whole lot of things have happened with this company," West said. "The SEC review took from April 2003 to October 2004. I had no idea which way it would go so I went to neutral." Still, that was just one of the factors negatively impacting the company in recent years.

Michael Shonstrom, an analyst with Shonstrom Research Associates LLC, also follows Warrantech. And like Richard West at J.M Dutton, he is paid by the company to write research reports about it. The company doesn't control the content of his reports, but they do fund its creation.

Streak of Bad Luck

Warrantech's situation, Shonstrom said, is more like a streak of bad luck. First it lost some important customers such as CompUSA Inc. and Staples Inc. to the Assurant Group. When it lost those two big retailers, it also lost all the attention and excitement it had been getting from Wall Street, he said. Then its auto extended warranty insurance underwriter went out of business. Then it had the run-in with the SEC. Nobody ever wins one of those.

In addition to the factors Shonstrom cited, West added the cost of legal fees for not only the SEC investigation but also the AIG lawsuit. Plus there was the cost of moving the company headquarters multiple times. And there is the post-Tyco stigma of the company having made significant loans to some of its officers and directors, and there was the recent news that two directors have recently said they will not be standing for re-election, which was curiously not posted on the company's Web site. It's like a string of non-recurring events that add up to a streak of bad luck. "I hate to say unlucky ... unfortunate?"

West said he thinks investors were put off by the unfortunate sequence of events, and of course the result was a fall in share price. Having spent all of 2003 above $1.00 a share, Warrantech has spent most of 2004 below $1.00 per share. Its closing price on Nov. 16 was 75 cents per share. West said he thinks investors are dwelling too much on the bad news, reading too much between the lines, and not looking deeper at the trends in revenue growth and operating profits.

The bottom line, he said, is that the accounting principles forced upon an extended warranty administrator are unusual enough to put a public company at a disadvantage. Specifically, he is referring to the principle of deferred revenue, under which a service contract sold now cannot be recognized as having been sold until a significant amount of time passes. "The average Joe does not understand it, and furthermore, if it's selling at 70 cents you're not going to have people worrying about it," he said.

Shonstrom noted that someday all this deferred revenue is going to have to be recognized, and it's going to translate largely into net income, because all the associated expenses have already been reported. He figures there's roughly $41.8 million in deferred revenue that's going to drop to the bottom line.

Worth a Buy?

Warrantech, Shonstrom said, has a book value around 98 cents a share. At its current price of 75 cents per share, he said he sees Warrantech as a stock worth accumulating. "We think it's an interesting value," he said. "It certainly is not one of our top picks. We think that down the road in the next year or two as they sort through all the issues that they've been through, and as you begin to see a growth pattern emerge, I think the stock will trade a good deal higher."

So how does a stock research analyst evaluate a company that's in an industry where virtually everyone else is either private or part of a much larger company? West said he looks for clues to Warrantech's future by examining trends in the products its service contracts cover. In other words, if U.S. auto sales are down, so will be Warrantech's auto extended service plan sales. If consumer electronics sales are up, so will be Warrantech's extended warranty sales. Besides domestic sales, he also has to look at trends in South America, which is becoming a larger share of Warrantech's overall revenue.

In the year ended March 31, roughly 69% of Warrantech's reportable revenue came from auto extended warranties, 26% came from consumer products, and 5% came from international. A few years ago, auto held a slightly smaller share and consumer products held a slightly larger share. International revenue has been growing faster than the company as a whole.

Shonstrom said he sees the fact that Warrantech is strong in both the automotive extended warranty and the consumer electronics extended warranty markets as yet another complicating factor. It's not just a case of one public company in one largely private market. It's really one public company split between two largely private markets. He knows how big each of Warrantech's slices are, but he doesn't know how big the two pies are in total.

Since he can't really talk about the quantitative side of either market, he talks more about the qualitative side. When looking just at Warrantech, he can talk about the key ratios and the trends in revenue and earnings over time. He notes that despite all the bad luck, the company has kept roughly $10 million in cash on hand. But then he has nothing to compare that to. Or more precisely, he can compare Warrantech to everything or anything, because nothing in particular is a direct match.

Warrantech can be compared to all insurance companies. Warrantech can be compared to all automotive manufacturers. Warrantech can be compared to all electronics retailers. But Warrantech isn't really in any of those industries. Instead, it's at the intersection of them -- an extended warranty administrator that buys insurance and sells service contracts on cars and home electronics, usually through dealers and retailers.

Here's the paradox. If Warrantech is losing money most of the time, or at least in four of its last five fiscal years, and if Warrantech is the public face of the extended warranty industry, does that mean the rest of the extended warranty industry tends to lose money too? Shonstrom said no. "Certainly, the larger corporations that are involved in it would not stay around were it to be unprofitable," he said. "It certainly wouldn't be as big as it is if it were not a profitable business."

Meanwhile, there are cases like AIG, which coincidentally through a legal case between it and Warrantech was forced to reveal in court papers that it had lost upwards of $500 million in recent years on automotive extended warranty contracts. As with the Warranty Gold Ltd. and National Warranty Insurance RRG situations, however, the common theme seems to be underpricing the risk, or more precisely not knowing the risk and guessing wrong when it came time to price it.

When it comes to pricing Warrantech's stock, actuarial tables and product failure rates are going to be of little use. Nobody can even estimate whether Warrantech has a 5% or a 1% market share. It seems just as arbitrary for the stock to have sold above $1.50 during the summer of 2003 as it does to have sold below 75 cents a share during the summer of 2004.

Taking Warrantech Private

Years ago, one publicly-held auto extended warranty company took itself private, and another was acquired by the Ford Motor Co. Warrantech, in fact, floated the idea of taking itself private in September 2003, but those plans were canceled two months later.

"The company's explanation was that they felt the shareholders' interest was best served by remaining public. You can read between the lines there," Shonstrom said. "I think they just weren't able to put together a decent-enough package. I think they needed to go get some third party financing, and I don't think they got the terms they wanted. That's my guess. But they haven't said so specifically."

West had similar sentiments. "This is my personal opinion," he said. "I had reports out there saying that Warrantech could sell within a 12 to 18 month period at $2.25, and Joel San Antonio was attempting to take them private at $1.65. Now there were only two reasons that he would have pulled it: 1) if he couldn't get financing, which I doubt because he wouldn't have made the offer, or 2) the independent corporate finance review came in with a higher price than he wanted to pay."

West added that he suspects we haven't heard the end of this -- that the buyout offer could be renewed at any time. With net revenues of $120 million and only 15.4 million shares outstanding, one would have to believe that any such offer would have to value the company at something considerably higher than its current $11.5 million.

Warranty Chain Management Conference Registration Opens

Registration is now open for the WCM Conference 2005 and registration forms may be downloaded via the following link: The WCM website has been updated to acknowledge both Hewlett Packard Co. and the SAS Institute Inc. as sponsors of the conference.

The conference agenda also is now available on the Web page: Most of the people whose presentations were approved by the selection committee should by now have been notified by conference organizer Alison Griffiths of ALG Associates LLC.

The next step is to begin planning the trip. Discount conference rates are available for hotel rooms between Feb. 27 and March 4, 2005, for a conference scheduled to take place on March 2 and 3. In other words, arrive early and stay late. Clam chowder in sour dough bread bowls is on Warranty Week's tab the night of March 1. Registrants who need overnight accommodations are strongly urged to make their hotel reservations with the Hyatt at Fisherman�s Wharf, the conference venue, as soon as possible via the following link: Reservations are subject to availability and will be secured on a first-come, first-served basis.

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