November 22, 2005

Appliance Warranties:

As with computers and cars, warranty claims in a range of 2% to 3% are typical for most appliance brand names. But unlike cars or PCs, warranty costs for appliance and HVAC manufacturers appear to be highly seasonal.

Manufacturers of major appliances aren't all that different from automakers. They take sheet metal, motors, and various electronic components and assemble them into a finished product.

They also aren't all that different from computer manufacturers. Today's washing machines, dishwashers, refrigerators, and heating and cooling systems contain both hardware and software, so that when something breaks it's possible that all it needs is a update of the control software.

More basically, what the automakers, computer makers, and the manufacturers of consumer appliances and heating/cooling systems all apparently have in common are similarly-sized warranty expenses. In the November 9 issue, Warranty Week detailed how the warranty claims rates of HP, Dell, and IBM each seem to be converging on the 3.5% mark, as if that's a natural level for computer manufacturers. In the November 15 issue, we showed how both GM and Ford were spending somewhere between 2.5% and 3.0% of their vehicle sales revenue on warranty claims.

This week, we're going to show by example how several of the large appliance manufacturers also find their warranty claims rates in that same general range. Whirlpool, for instance, seems to be repeating an annual cycle in which first quarter claims average 3.0% to 3.1% of revenue and fourth quarter claims rates fall closer to 2.2%. Maytag has remained within a range of 2.8% to 3.5% for the past 11 quarters, according to financial figures filed with the U.S. Securities and Exchange Commission and collected by Warranty Week.

Spending More on Warranty

We're not saying that warranties are the same whether they're issued for computers, dishwashers, or sedans. But it does seem as if in these three industries, the major OEMs -- the well-known brand names sold by retailers and dealers to end user customers -- expend similar proportions of their sales revenue on warranty work. While all manufacturers on average spend 1.7% or 1.8% of their revenue on warranty claims, these brand name OEMs spend closer to 3% on warranty work.

In this column, we're combining the usually separate appliance industry and the heating, ventilation, and air conditioning (HVAC) industry into one great big category with 55 members. We're including companies such as United Technologies and Honeywell which are only partially in the appliance business, and we're excluding companies such as General Electric who have stated that most of their warranty expenses arise from other product lines (electrical power equipment, in GE's case). Kitchen, personal, and household appliances are in, but outdoor power tools and gardening equipment are out.

We're also repeating a couple of members of the automotive or computer manufacturing clubs in the appliance category. Some, such as Ingersoll-Rand clearly belong in both, because they make products such as refrigerated trucks that have a place in each industry. Others, such as Honeywell, Rockwell Automation, Modine Manufacturing, and Johnson Controls supply electrical and electronic components to multiple industries. And since they don't report their warranty expenses industry by industry, we have to include them in multiple categories.

In addition, some of the appliance makers such as Whirlpool, American Standard, and Maytag don't report service revenue separately from product revenue. At the very least, they must be enjoying some success with their sales of extended warranties. They also must be bringing in some revenue from repairs performed after all warranties have expired. So what we've done is deducted from their reported revenue totals an amount we believe is representative of what each is receiving from non-product sources, based on ratios and amounts reported by close competitors.

In Whirlpool's case, for instance, we're deducting 10% of revenue from the total before dividing it into warranty claims. If this were not done, the company's latest claims rate would have been 2.5% instead of 2.8%. If more accurate figures for service revenue were to become available at some future date, we'd go back and recalculate new claims rates to replace these estimates.

Seasonal Claims Pattern

The Whirlpool chart below shows a company that usually starts the year with a high claims rate that usually drifts lower as the year winds down. It happened in 2003. It happened again in 2004. However, for the first three quarters of 2005 the claims rate has actually been rising. It remains within the historical range seen in 2003 and 2004, but the trend line has now reversed itself.

Figure 1
Whirlpool Corp.
Warranty Claims & Accruals
in % of Sales & $m per Quarter
1Q 2003 to 3Q 2005

Whirlpool is among the major appliance makers who recently cut back their product warranties to one year (see Warranty Week, October 18 edition, for details). But that new policy didn't take effect until November 1, so it won't begin to show up until the fourth quarter of 2005. Interestingly, the company's reported claims rates at June 30 and September 30 of this year were both higher than at the same points of either 2003 or 2004. So it should prove interesting to see where the next few quarters fall.

In addition, Whirlpool and Maytag are now in the process of merging. After receiving preliminary approvals from the SEC to proceed, Whirlpool is now issuing the new shares of stock with which it will pay for the merger. Maytag is now mailing out a proxy statement and prospectus to its shareholders in advance of a special Dec. 22 shareholder meeting. If the merger proceeds as anticipated, next year the two companies will combine their respective warranty reserve funds.

Right now, as Figure 2 details below, Maytag's warranty claims rate seems to be slightly higher than Whirlpool's. But as was the case with Dell in the computer industry, this may be due more to our underestimation of Whirlpool's service revenue (or overestimation of Maytag's) than to any meaningful difference in the products themselves.

Figure 2
Maytag Corp.
Warranty Claims & Accruals
in % of Sales & $m per Quarter
1Q 2003 to 3Q 2005

By the way, a J.D. Power and Associates 2005 Major Home Appliance Study released on November 9 found various Whirlpool brands on both sides of the industry average in terms of customer satisfaction. Maytag was a bit above the average for refrigerators and dishwashers, and a bit below average for ranges, cooktops, and ovens.

There may be little correlation between warranty claims rates and customer satisfaction, however. Are some customers more satisfied because the company's products never break, or because they're treated so lavishly when repairs actually are required? And are other customers more dissatisfied because warranty work is frequently required, or because the manufacturer is so reluctant to make repairs for free?

In other words, high warranty expenses may have more to do with the cost of customer care and less to do with reliability. Low claims rates can be achieved both by not answering the phone and by building products that never break. High claims rates can be the result of a more thorough and accurate accounting methodology as easily as they could arise from products that require frequent repairs. So let's chalk up the difference between Whirlpool and Maytag to unknown factors for now. After they merge, however, perhaps we'll see how differently two companies can measure the same thing.

Differences in HVAC Manufacturers

Next we'll take a quick look at a few HVAC manufacturers. The problem, however, is that some of the largest are actually part of diversified companies. Carrier is part of United Technologies. Trane is part of American Standard. So what they report as warranty expenses are only partially from HVAC sales, and partially from everything between jet engines and plumbing fixtures. Therefore, unlike Whirlpool, General Motors, or Dell, their warranty claims rates are not representative of a single industry.

The two we selected as representative of HVAC are York International and Lennox International. York has interests in both residential and commercial/industrial HVAC, but at least currently it is more or less an HVAC "pure play" (but it's now in the process of merging with Johnson Controls, which also is a major automotive parts supplier). Lennox also sells decorative fireplaces and chimneys, but the bulk of its revenues arise from residential and commercial HVAC sales.

The warranty experience of York over the past 11 quarters has seen claims range between $13 and $24 million per quarter, and the resulting claims rate vary between 1.6% and 2.6%. The highest number for both, as seen in Figure 3, actually happened during the winter of 2005, when one would not expect much cooling to be needed. But here's the difference between an appliance maker and an HVAC manufacturer: one makes air conditioners for the window in the summer, while the other makes heating and cooling systems for all four seasons.

Figure 3
York International Corp.
Warranty Claims & Accruals
in % of Sales & $m per Quarter
1Q 2003 to 3Q 2005

It would be perfect if York and Lennox were as similar as Whirlpool and Maytag. However, as can be seen below, Lennox spends significantly less per quarter on warranty claims, and spends a significantly lower percentage of its sales on claims as well. While York is in a range of 1.6% to 2.6%, Lennox is in a range of 1.0% to 1.3%. Both detail their product vs. service revenue totals sufficiently, so our own faulty estimates are not the cause. But that begs the question: why are their claims rates so different?

First Quarter Peaks in Claims?

Notice, however, how both companies seem to experience seasonal peaks during the first quarters of the year. And remember that both Whirlpool and Maytag also showed evidence of a seasonal peak in their claims rates during the first quarter. Part of that must be due to the timing of the sales cycle versus the repair cycle (e.g. products sold at the end of one year are first fixed during the beginning of the next year). But this does seem to be a feature that the HVAC and appliance industries do not share with either auto or computer manufacturers. While the seasonal bumps are obvious in these charts, they're largely absent from the charts of GM, Ford, HP, Dell, or IBM.

Figure 4
Lennox International Inc.
Warranty Claims & Accruals
in % of Sales & $m per Quarter
1Q 2003 to 3Q 2005

In Figure 5 below, we've combined the claims reports of 55 different HVAC and appliance manufacturers (and some of their parts suppliers). However, even with the elongated scale it's hard to see more than 15 or 20 of them. And of course, it's difficult to label more than the top six without using fine print.

And so, for those of you with magnifying glasses, the teal slice labeled IR is Ingersoll-Rand, and the dark blue unlabeled layer is York International. The pink slice is Johnson Controls, and the bright green slice is Masco Corp. NACCO Industries Inc. is in white, and Applica Inc. is in lavender. Rockwell Automation is the layer in sky blue.

As a whole, the claims totals of these 55 manufacturers have ranged from $393 million in the third quarter of 2003 to $513 million in the second quarter of 2005. For some seemingly seasonal reason, the amounts spent on claims are always highest in the second quarter and lowest in the third quarter (as a percentage of revenue, the peak is always in the first quarter, however, when sales are lower). However, note how the ups and downs of just one major vendor such as United Technologies can change the totals significantly.

Figure 5
Top U.S.-based HVAC & Appliance Makers
Product Warranty Claims
in $ Millions per Quarter
1Q 2003 to 3Q 2005

Source: Warranty Week from SEC data

TurboChef's Overwhelming Story

Finally, we end with a cautionary tale about what can happen when a small manufacturer gets involved with a very large customer. Back in March 2004, TurboChef Technologies Inc. announced a deal with Subway Restaurants to be the exclusive supplier of rapid-cook ovens to more than 20,000 of the sandwich chain's outlets worldwide. Apparently, Subway was feeling the pinch because of the ability of some of its rivals to toast their sandwiches, so their chosen solution was to deploy these high-speed TurboChef Tornado ovens in every shop.

Almost immediately, this little company with a good idea began ramping up its production line to meet the needs of its major new customer. Product revenue, which totaled only $946,000 during the quarter in which the Subway deal was announced, grew more than twenty-fold in the subsequent year, topping $19.7 million in the first quarter of 2005. The company also swung from a $1.98 million operating loss in the first quarter of 2004 to a $1.28 million operating profit in the first quarter of 2005.

But even that couldn't last. Product revenue fell back to $10.2 million in the second quarter of 2005, and notched up to $11.4 million in the third quarter. TurboChef is now approaching the final phase of its worldwide rollout, having delivered 23,000 ovens to Subway.

Meanwhile, a series of warranty claims related to an upgrade necessitated by the runaway success of Subway's hot sandwich menu helped costs to spiral. The ovens were being used more than was forecast and so they were wearing out faster than initially forecast. TurboChef said its engineers determined that a change in the control software would improve the longevity and reliability of the ovens. They performed extensive testing of the revised software, and the test results indicate that the software change resolved the oven�s longevity and reliability issues. TurboChef changed the software installed in new units on the production line, and it began upgrading software in the installed base, including replacing parts that were damaged or believed likely to lead to future warranty claims.

As a result of this accelerated upgrade program, quarterly warranty claims paid, which were only $47,000 in the quarter in which the Subway deal was signed, had grown to $1.45 million during the first quarter of 2005; $3.16 million in the second quarter; and $5.46 million in the third quarter ended Sept. 30, 2005.

So what happens when a company has product revenues of $11.4 million and warranty claims of $5.46 million? As is seen by the red line in the chart below, the warranty claims rate soars to nearly 48% of sales. Yes, that's correct: 48%. In an industry where a 5% claims rate is high and 10% is dangerously high, TurboChef is now approaching 50%.

Figure 6
TurboChef Technologies Inc.
Warranty Claims & Accruals
in % of Sales & $m per Quarter
1Q 2003 to 3Q 2005

Because of spiraling warranty costs and other factors, the operating profits of early 2005 turned into massive losses by midyear. The first quarter of 2005 was the last to show an operating profit. The operating loss in the second quarter was $6.2 million. In the most recent quarter, the operating loss was $17.1 million -- significantly larger than product revenue.

Also in the most recent quarter, TurboChef set aside an additional $6.8 million to finance future warranty claims, after having set aside an extra $2.8 million in the second quarter. Combined with the normal accrual of $611,000, that means 65% of current revenue is being set aside to fund future warranty claims. The green line in Figure 6, which charts only the normal accruals, would actually be above the red line if these extraordinary changes of estimate were included.

One could worry about the company's ability to continue operating, but there are none of those qualifications in TurboChef's financial statements. Instead, the company says its oven design has now been "successfully battle tested in high numbers," thanks to its heavy use. Meanwhile, a Subway executive was quoted in the Nov. 2 press release as stating that the new ovens have had a "transformational effect on our business in terms of our ability to add new, exciting and high quality menu items that have strengthened our competitive position and resulted in a dramatic increase in sales."

One wonders how much more success TurboChef can afford.

Back to Part Two   Go to Part Four

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