January 6, 2011

Appliance Service Contracts:

While hard data is difficult to find, one retailer discloses lots of details about extended warranty sales in its financial statements. But as detailed as these metrics are, they may not apply to other less forthcoming retailers.

As we resume our tour of the extended warranty marketplace, we begin what may turn out to be a multi-month journey with a look at appliance service contracts. Specifically, we're looking at one of the top national appliance retail chains, and the extended warranty revenue and expense figures the company has released over the past six years.

Lowe's Companies Inc. operates more than 1,725 stores in the United States, Canada and Mexico. James Lowe opened his first hardware store in 1946 in North Carolina, and his brother-in-law Carl Buchan drove an expansion of not only the number of stores, but also of the average size of the stores and the number of products they each carry.

There's no scandal here. There's just some routine financial data, and it's been in the public domain for almost six years. So any of a dozen trade publications could have covered this ground at any time since 2005. All they'd need to do is read some financial statements.

If there's any news here, it's that Lowe's reveals what others conceal. In the realm of household appliance service contracts, we've found virtually no other credible source of extended warranty data. Sears and most other large appliance retailers barely acknowledge their sales of service contracts, let alone provide any details in their financial statements. In contrast, Lowe's discloses not only service contract sales volumes, but also their expense levels.

We don't mean to single out Lowe's as some sort of benchmark for the entire household appliance industry. And given the amount of non-warranted products the company sells (as well as the absence of electronics, computers, or automotive gear from its product line), we're not sure if the ratios we've developed for this week's newsletter would even apply to those other chains.

Extended Warranty Accounting

Lowe's most recently reported its financial figures for the third quarter of the fiscal year that began at the end of January 2010. And it began selling service contracts in 2005. So we have not-quite-six years of data to examine, though the early-year data is a bit rough and incomplete.

Lowe's uses the term "extended warranty" to describe what they sell, so we shall use it interchangeably with service contract, service plan, extended protection plan, and several other phrases used across the industry. In simple terms, an extended warranty is sold to cover the cost of repairs or replacements over a period of multiple years, usually as an extension or enhancement of the underlying manufacturer's product warranty. At Lowe's, in fact, extended warranty coverage doesn't begin until the manufacturer's warranty ends.

Accounting rules specify how that revenue must be reported. In instances where the seller retains the risk, the revenue must be reported over the life of the contract. The Financial Accounting Standards Board's Technical Bulletin Number 90-1, "Accounting for Separately Priced Extended Warranty and Product Maintenance Contracts," (published December 17, 1990), directs the seller to recognize revenue gradually, either by the straight-line method (1/X per year for an X-year contract), or in proportion to some actual claims emergence trend data.

Lowe's chooses to use the straight-line method. So if it sells a four-year protection plan for $180, it will immediately defer the recognition of all that revenue, and will then recognize $45 per year until the four years have passed. It could also recognize the revenue quarterly, monthly, weekly or even daily. It doesn't matter. The concept is that it recognizes the extended warranty at the same rate over the life of the service contract.

So let's take a look at what Lowe's has reported as its additions to extended warranty deferred revenue on a quarterly basis for the 23 quarters since January 29, 2005. But let's not look at just the amounts. Let's also calculate a ratio by comparing the additions to deferred revenue to the figures for total revenue.

Figure 1
Lowe's Companies Inc.
Extended Warranty Claims
and Claims Rate, 2005-2010
(in US $ millions and as % of total sales)

Figure 1

In Figure 1, we see a generally upward trend in these additions to deferred revenue, with a slightly seasonal pattern. That means extended warranty sales are greatest in the second fiscal quarter of each year -- a period that covers the months of May, June, and July. And they're generally smallest in the months of November, December, and January.

No Christmas Rush?

We mention this only because it seems to contradict the traditional wisdom that consumer products and their associated product protection plans sell best during the Christmas season. That may be true for consumer electronics (or maybe not -- we won't get around to them for several months). And it might even be true for household appliances sold at other chains. But the data in Figure 1 says it's not true at Lowe's. And that's all the data we have so far.

The second part of Figure 1 is a comparison of the additions to deferred revenue to the overall sales total of the company. There are big problems with this, however. First of all, "appliances" comprised only 9.6% of Lowe's $47.22 billion in sales reported for the year ended January 29, 2010. And it comprised an even smaller slice of sales in previous years. But there are also seemingly warranty-friendly product categories on the list such as outdoor power equipment, tools, lawn & landscape products, and others. So perhaps a third of the company's product line is extended warranty-friendly?

However, if we were to begin trying to separate the company's total sales into extended warranty-friendly and unfriendly slices, we'd be replacing the math with our own theories and conjecture. We'll have to assume that Lowe's tries to sell a service contract on anything that deserves one, and that the proportion of products that deserve one to total sales has remained about the same over the past five years.

It's no different from the problem we face with diversified manufacturers and their product warranties. If they make air conditioners and seat belts, how are we supposed to allocate product warranty expenses between the product lines? We could guess, but then we'd just be measuring our own guesses. So let's stick to the public data.

By the way, although these charts are labeled "2005-2010," they're missing data for the final quarter of 2010. That's why there's a blank column in each chart -- one we hope to fill with data in late March when Lowe's publishes its annual report.

Extended Warranty Costs

Figure 2 will look familiar to anyone who has followed our product warranty analyses over the years. In this chart, we're listing quarterly claims totals and the claims rate at Lowe's, but it's for extended warranty claims rather than for manufacturer product warranty claims. And again, we're using total revenue because that's all we have that's reliable.

Figure 2
Lowe's Companies Inc.
Additions to Extended Warranty
Deferred Revenue per Quarter, 2005-2010
(in US $ millions and as % of total sales)

Figure 2

The data for 2005 and early 2006 is absent because that's when the company first began selling the service contracts. And most of the products those service contracts covered also had at least a year's product warranty. So of course there were few if any claims during the first year of the program.

The total for claims paid per quarter generally rose during the 2006-2010 period, and in fact hit a high of $28 million during the August-to-October quarter. But that is also to be expected, as more and more four-year contracts get to the end of their life. And although we've mentioned the danger of comparing extended warranty figures to total revenue, $28 million worth of expenses in an $11.587 billion quarter is not going to break the bank.

Flattening Cost Ratios?

The thing to watch in future years is whether the line in Figure 2 eventually flattens out. Most extended warranty sellers don't have to deal with this metric, however, because most pass on the risk to a third party insurance underwriter. So they collect their sales commissions up front, and have no further duty to perform, no risks to endure, no repairs to make, and no reason to defer the reporting of revenue. The pre-tax costs of sales commission revenue are miniscule: training, golf trips, etc. Therefore, the revenue they report in such a case is more or less pure profit.

This is why it was possible to determine years ago that extended warranties accounted for more than all of Circuit City's net income. The retailer was getting 4% of its revenue from extended warranty sales commissions and was running the company at a 3% profit margin.

In other words, if that electronics chain stopped selling extended warranties, it would have lost money selling products alone. Or to put it another way, Circuit City was essentially selling three $500 TVs for $495 each so it could sell one of them with a $120 warranty and pocket the sales commissions. No wonder they wouldn't take "no" for an answer!

Conditions are very different with household appliances. Here, service contracts are less a source of profits and more a source of service. There will be repairs. And there typically won't be a "hard sell." In fact, like certain games in the casino, this may be a sector where the "house loses" on a regular basis when consumers place their wagers on the likely ratio between premiums paid and future repair costs.

Cash Flow Chart

Lowe's employs the services of third-party administrators (AIG WarrantyGuard and NEW Customer Service Companies Inc. until October 2010 and Assurant Solutions and its affiliates since then). But the company is ultimately self-insured. So it retains the risk. And therefore it's paying for repairs out of its own pocket, even if those repairs are administered and performed by outside entities. So it has to defer revenue from the program and recognize it gradually over the life of the contract.

We want to look at one more metric, which again is a metric we made up given the available data. Simply put, we wanted to compare the amount of money coming in to the amount of money going out. But because of the long lag time between when a service contract is sold and when it's used, we couldn't simply compare service contract sales to service contract claims.

Instead, we're again deferring to the skills of the Lowe's financial team. They decide when to recognize the extended warranty revenue, and they count the amounts reported as claims. We don't know what they count and what they exclude. We're just comparing the two figures that they report.

If we were inside the company, we could see all the expenses that go into the mix -- not only claims paid but also administrative fees, marketing costs, training, compliance and other legal costs, etc. But we're not, so all we can see is the amount reported as claims paid.

Not Profit Margins

We mention this because what follows in Figure 3 is not a complete picture of extended warranty revenues and costs. So therefore, the percentages are not an accurate expression of profitability or gross margin. This is not a chart of the loss cost or the combined ratio of the Lowe's extended warranty program. In fact, we're not sure what they are, besides a comparison of two metrics: 1) extended warranty revenue recognized and 2) extended warranty claims paid.

Figure 3
Lowe's Companies Inc.
Extended Warranty Revenue
Recognized per Quarter, 2005-2010
(revenue in US $ millions and
claims as % of recognized revenue)

Figure 3

The recognized revenue stream has obviously been growing steadily since the program began nearly six years ago. In fact, there's never been a down quarter, though there have been flat periods in both 2009 and 2010. It may be a young program, but it sure does look to be well-run from the outside.

Rising Sales

The recognized revenue total for the first nine months of the current fiscal year is $126 million, up from $111 million in the same period a year ago. Full-year recognized revenue totals are likely to surpass $170 million in this fiscal year, up from $150 million in the year ended January 29, 2010.

The ratio between recognized revenue and claims is something we're not going to read too much into. But we'll note that the ratio has only twice exceeded 50%, and hasn't been below 30% since the program was very young. So we're going to state this as a fact: the ratio between claims cost and revenue recognized is usually between 30% and 50% at Lowe's. Or to put it another way, claims consume between 30% and 50% of Lowe's extended warranty revenue. As to where the rest of the revenue goes, and what proportion is profits, we cannot say.

Is it the same for Sears, Home Depot, Best Buy, and others? Is it the same for televisions, washing machines, computers and other product lines? Probably not. But it's true for Lowe's, and Lowe's is a major retailer of both household appliances and service contracts. And we can conclude that at Lowe's, at least, between a third and half of an appliance service contract premium will eventually go to paying claims.

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