July 10, 2007

Xbox Warranty Costs:

For a company that's never reported a warranty expense, Microsoft sure has a problem on its hands, now that it lengthened the Xbox 360 warranty to three years and took a billion-dollar charge to finance those repairs. But outside of the warranty community, does anybody really care?

If nothing else, the Microsoft Xbox 360 debacle has put warranty on the front page, and has given all of us a lesson in the importance of warranty. But does anybody outside our small circle of warranty professionals really understand how big a failure this is?

Launching just in time for the 2005 holiday season with a meager 90-day warranty in North America, the sleek game console was an instant hit. Until last month's iPhone launch, it was probably the last time anybody lined up to be the first on their block to buy something.

The 90-day warranty wasn't much of an issue, because after all, who cares about warranty? But just in case anybody wanted longer coverage, Microsoft also began selling its own extended warranties at a quite reasonable price of $25 a year. With a failure rate of 3% and an average cost of repair of $140, that would have resulted in a loss ratio around 17%. Even if the failure rate turned out to be 5%, the loss ratio would have been only 28% -- somewhat above the comfort zone, but not dangerously so.

However, by the end of 2005, some of the first reports of a design flaw appeared, with customers alleging that the units overheated during normal use. And now, 18 months later, Microsoft has announced a warranty lengthening that will cost it upwards of a billion dollars.

What Defect?

For most of that year and a half period, the Microsoft marketing machine denied there was a problem, a fallacy that continued right up until the middle of last month, when Todd Holmdahl, the corporate vice president of Microsoft�s Gaming and Xbox Products Group, told the San Jose Mercury News "we don�t have a high defect rate."

Two weeks later, Microsoft took a $1 billion-plus charge to finance a growing mountain of repairs, and lengthened the game console's warranty to three years worldwide (in Dec. 2006 it had been lengthened to one year in North America, and all along in Europe it had been at the statutory minimum two years). In a July 5 press release, Microsoft stated:

"As a result of what Microsoft views as an unacceptable number of repairs to Xbox 360 consoles, the company conducted extensive investigations into potential sources of general hardware failures. Having identified a number of factors which can cause general hardware failures indicated by three red flashing lights on the console, Microsoft has made improvements to the console and is enhancing its Xbox 360 warranty policy for existing and new customers.

"Microsoft stands behind its products and is taking responsibility to repair or replace any Xbox 360 console that experiences the "three flashing red lights" error message within three years from time of purchase free of charge, including shipping costs. Microsoft will take a $1.05 billion to $1.15 billion pre-tax charge to earnings for the quarter ended June 30, 2007 for anticipated costs under its current and enhanced Xbox 360 policies."

That charge is likely to show up in Microsoft's Form 10-K annual report for the fiscal year ended June 30, in which its game console revenue is expected to be somewhat north of $4 billion. Good thing that its stockholders are so forgiving. The announcement was made last Thursday after the markets had closed. The previous day was a holiday, but the closing price of shares in MSFT on July 3 was $30.02. The closing price on July 5 was $29.99 per share, and was $29.97 on Friday. So one could say that shares of Microsoft were down a few pennies per share on news of a major warranty debacle. As one subscriber wrote to us yesterday, "Wall Street yawns."

But here's the problem: Microsoft has never complied with existing warranty accounting rules, and has never acknowledged spending even a single dollar on a warranty claim. The FIN 45 rules designed to force public companies to disclose the magnitude of all the guarantees they've made before they blow up in the face of investors Enron-style, were largely ignored by Microsoft in regards to warranty. And guess what? The guarantees blew up in the face of investors.

Warranty Accounting Rules

There have been occasional feints by Microsoft towards partial FIN 45 compliance, however. At the end of fiscal 2003, the company disclosed a $12 million warranty reserve balance, a $29 million accrual, and a blank in the column for payments made. And then a year later, Microsoft reported a further $7 million accrual, a $19 million ending balance, and once again no claims paid.

When Warranty Week first reported this news, an auto executive wrote an email to us, exclaiming "Come on! You mean to tell me they've never paid a claim? Impossible!" What could we say? This is a company that had gotten the better of the Clinton administration, had stonewalled the European Union, and had fended off the combined mischief of Sun Microsystems, Oracle, Netscape, and many others. Anything is possible.

And then at the end of the next fiscal year, Microsoft stated in its 10-K: "Our warranty accrual totals $14 million as of June 30, 2005. There has been no significant activity impacting the results of operations for any period presented." So how then did the balance fall from $19 million to $14 million? Nobody cared.

Microsoft said nothing about its warranty reserves for three quarters, and then the impossible happened again in the next 10-K: "Our warranty accrual totals $10 million as of June 30, 2006. There has been no significant activity impacting the results of operations for any period presented."

At least now we can rest assured that in this just-completed fiscal year there has been plenty of significant activity impacting the results of operations. Maybe some of it will make it into the annual report. And maybe now some of the same people who recently investigated the warranty accounting practices of Dell and Delphi can find a few minutes in their busy schedules to figure out how the movement of millions of dollars qualifies as "no significant activity." But then again, if Wall Street can shrug off a billion dollars, what's a few million?

The façade of invincibility didn't really begin to crack until early this year, when the BBC television program "Watchdog" called the Xbox 360 a "clapped-out old banger," -- in the King's English, that's a dilapidated and noisy old car. The TV show had by then collected some 250 complaints about the game console, many of them from angry owners who had to pay £80 to £85 for out-of-warranty repairs.

Microsoft responded the very next day, telling the Web site GamesIndustry.biz "we have received a few isolated reports of consoles not working as expected," and "there is no systemic issue with Xbox 360." But reports of unusually high failure rates continued to appear in blogs and magazines.

The Red Ring of Death

Wags began to call it the "Red Ring of Death" syndrome, named after the circle of lights whose illumination signaled the demise of the console. This summer, as temperatures rose, people began calling it simply "heat stroke." Engineers said the unit was being inadequately cooled, and some suggested that stringing the power cord in the air like a clothes line might help.

Others said there was a flaw with the new kind of solder used in the manufacture of the printed circuit boards, which caused it to melt and/or crack after roughly a year's worth of normal use. Ironically, that meant the failures frequently happened just after the warranty ran out, to the delight of warranty conspiracy theorists everywhere. Even more bizarre, some advice columnists suggested covering the fan portal with a towel -- turning the Xbox interior into an easy-bake oven -- which somehow re-melted the solder and repaired the unit. If that didn't work, well, you could just ship it back to Microsoft, minus the towel.

But Microsoft continued to claim there was no design flaw or cooling problem, even after gamers provided photographic evidence of a repaired console returned to its owner with an extra heat sink installed. Gamers speculated that this extra heat sink was installed by Microsoft to provide additional cooling for the Xenos graphics processing unit.

The technicians at Micromart, a UK-based repair facility, told the Times of London there was a design flaw that they couldn't fix, so they would no longer be accepting Xbox 360 units. "It's a motherboard problem," support representative Geoff Croft told the newspaper. "There's a lot of components soldered onto it, and because of the overheating, there's faulty contact between the parts and the motherboard."

The newspaper article also said that Microsoft itself was so overwhelmed with repairs that it had begun shipping units from the UK to the Czech Republic for warranty work, adding weeks of delays to the process. Another technician estimated the overall failure rate was between 25% and 33%.

That range also came up in a report on the Daily Tech Web site, which quoted an unnamed Best Buy customer service department manager as saying the failure rate for the Xbox 360 console was "between a quarter to a third" of all units sold.

Pushing Extended Warranties

The manager then went on to say that Best Buy urges its customers to purchase an extended warranty for their Xbox, which opens up yet another issue with the unit. If these service contracts were priced and sold under the assumption of a 3% to 5% failure rate, and if the actual failure rate turned out to be much higher, then some of these service plans must have been running at a loss from the get go. But at least the retailer's customers were protected.

The unnamed Best Buy manager also mentioned how happy he was that Microsoft had lengthened the warranty from 90 days to a year, because that meant he didn't have to pay for these repairs until the second year of the contract. But the article also noted that EB Games nearly doubled the price of its Xbox 360 extended warranties in early 2007 to counter what they termed "alarming failure rates." The chain also amended its policies to allow for replacements with refurbished units instead of repairs of existing units or replacements with new units.

Which brings us to the subject of money. Let's assume Microsoft has sold 12 million Xbox 360 consoles worldwide since 2005. Out-of-warranty repairs are said to cost their owners around $140 each. But just for argument's sake, let's say they're only $100 each. The cost of repairing every Xbox 360 ever sold would therefore be $1.2 billion. That's not that far off from the $1.05 to $1.15 billion mentioned by Microsoft in its release.

In FIN 45, companies are directed to reveal the maximum liability they face for all their guarantees -- of leases, stock prices, etc. But for warranty, the Financial Accounting Standards Board said such a disclosure would be absurd, because it would imply a 100% return rate. So instead, companies are directed to reveal the opening and closing balances in their reserve fund, and so on.

Not a Recall?

What these back-of-the-envelope figures suggest is that somebody must be expecting close to a 100% return rate on the Xbox 360, and is accruing for it now. In the old days, that used to be referred to as a recall. But if you call it an expansion of warranty coverage instead and nobody does the math, nobody calls it a recall. But if the failure rate really is 25% to 33% so far, it will only climb as these units age and continue to bake. So by 2010 this "warranty enhancement" will have amounted to a de facto recall anyway, with nearly every console coming back at least once during its first three years of usage.

Or let's look at it from a different angle. Let's assume that Microsoft has maintained a warranty reserve that varies between $10 million and $20 million in size. Furthermore, let's assume this level was equal to 10 months' expected claims (which is actually a bit higher than the levels maintained by Sony, Thomson, or Pioneer). At a payout rate of $1 to $2 million a month, Microsoft might have therefore been expecting to fix 10,000 to 20,000 units per month, assuming the average cost of repair cost was $100 per unit. Therefore, this billion-dollar charge would be equal to the expected warranty repair bill for the next 42 years. Talk about missing your forecast!

Here's the central problem: Microsoft is a software company trying to become a consumer electronics company. It's trying to go from an environment where the cost of a warranty claim is the postage on a new CD to a hardware environment where the wrong solder or not enough heat sinks can cost you a billion dollars. Software warranties are much like puppy warranties: they exist to make you feel good. Just don't try to make a claim.

From a warranty point of view, it's much easier for computer hardware companies such as Dell, Apple, and Hewlett-Packard to make the jump into consumer electronics. They already have the production and quality control infrastructures in place, and they're already managing a warranty chain that's accustomed to paying out serious amounts of money for repairs. Case in point: as bad as the iPod's battery and cracked screen problems were, Apple has never paid out more than a quarter-billion dollars a year in warranty claims and its claims rate never rose above 2.1% of hardware revenue.

The highest warranty claims rates of the past few years have accompanied recall debacles such as what happened with pacemakers and bullet-proof vests, where there's a safety imperative behind the recall. In such instances, claims can eat away at 30% or even 40% of sales revenue, especially if current sales stall after the bad publicity spreads.

If Microsoft's game console revenue comes in around $4.5 billion for the fiscal year just ended, the cost of this warranty enhancement might top 25% of hardware revenue for the year -- that is, if it decides to begin fully complying with FIN 45. That will be quite a jump for a company that's never reported a warranty claim before.

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