October 20, 2011

Warranty Acquisitions:

Big companies are buying smaller companies all the time. But then they have to merge their product lines, combine their warranty reserves, and publish all the details. Divestitures, meanwhile, also happen once in a while, but not as often as entire companies are sold as a single unit.

What happens when a company buys or sells a line of business that generates product warranty costs?

When it's an acquisition, the amounts already accrued and sitting in a warranty reserve fund, awaiting claims to be paid, are usually included in the liabilities transferred over to the buyer.

When it's a divestiture of a business unit or product line, the seller usually reduces its warranty liabilities by the amount transferred over to the buyer's books. And when it's an entire company that's sold, the company's entire warranty reserve is combined with the buyer's accounts.

The thing is, while acquisitions are somewhat common, divestitures are not. Or to put it more precisely, while it's common for big companies to buy smaller companies, it's not as common for big companies to sell off pieces of themselves. Most times, it's the entire company that's sold as a unit.

Merging Warranty Reserves

In a search of our database of recent warranty expense records for U.S.-based manufacturers, we found 189 mergers or acquisitions worth an aggregate of $616.7 million in additional warranty liabilities assumed by the parent companies. But we found only 40 partial company spin-offs, asset sales or divestitures worth a collective $151.4 million in divested warranty liabilities during the past ten quarters.

What was far more common was an entire company sale. When the acquirer was also an U.S.-based hardware manufacturer, we'd usually see the other side of the transaction in the warranty tables of the buyer, listed as an increase in warranty liabilities. But when the acquirer was a foreign company, or when the company went private or was acquired by a private equity firm, it simply disappeared from the list. Those outstanding warranty claims were still paid, but the U.S. Securities and Exchange Commission wasn't told.

Figure 1
Top U.S.-based Warranty Providers:
Top Ten Acquisitions,
2009 to 2011
(adjustments in +US$m)

  Acquiring Company  Acquired Company   Quarter   Increase 
  Associated Materials LLC Carey Acquisition Corp. 4Q10 +$58.2
  Stanley Works Black & Decker Corp. 1Q10 +$51.5
  PulteGroup Inc. Centex Corp. 3Q09 +$42.4
  Energy Conversion Devices   Solar Integrated Technologies 4Q09 +$38.5
  Ciena Corp. Nortel�s Metro Ethernet Networks 2Q10 +$26.0
  Terex Corp. Port Equipment Business 3Q09 +$24.2
  Danaher Corp. Beckman Coulter Inc. 2Q11 +$20.6
  Helen of Troy Ltd. Kaz Inc. 1Q11 +$20.6
  Westinghouse Air Brake   Brush Traction Group 1Q11 +$13.4
  Agilent Technologies Inc. Varian Inc. 3Q10 +$13.0

  Source: Warranty Week

In the last ten quarters, the biggest warranty acquisition adjustment of all was reported by Associated Materials LLC. In its annual report for 2010, the company detailed how it merged with Carey Acquisition Corp. and how its warranty reserve grew in size by $58 million because of that merger. On October 12, 2010, the company had a warranty reserve fund balance of $35.15 million. The next day, once the merger was completed, that balance had jumped to $93.39 million. By the end of the year, it had grown to $94.71 million, thanks to an excess of accruals over claims.

Stanley Black & Decker

The second-largest warranty acquisition of the past two-and-a-half years was the merger of Black & Decker Corp. and The Stanley Works into an entity now called Stanley Black & Decker Inc. The merger was completed on March 12, 2010. It was first reflected in the books during the financial report covering the first quarter of 2010, when the new parent company added $51.5 million to its warranty reserve fund to reflect a "liability assumed in the merger."

Black & Decker, meanwhile, filed its last annual report for the calendar year 2009, and never filed a separate financial report covering the first quarter of 2010. Its final annual report listed a year-end 2009 warranty reserve fund balance of $50.7 million -- slightly less than the fund evidently held ten weeks later on March 12.

One need only glance at the chart below to see what happened after the companies merged. For years, Stanley Works' warranty expenses were tightly bound in a range between 0.5% and 0.6% of revenue. But then beginning in 2010, the claims and accrual rates rose, eventually topping one percent for the first time.

Figure 2
Stanley Black & Decker Inc.
Warranty Claims & Accrual Rates, 2006-2011
(as a percentage of product revenue)

Figure 2

Pulte Homes Inc. acquired Centex Corp. in August 2009. And in its financial report for the quarter ended September 30, 2009, the newly-renamed PulteGroup Inc. reported a $42.4 million increase in its warranty reserves due to the acquisition. That turned out to be the third-largest warranty acquisition adjustment seen in the past ten quarters.

Energy Conversion Devices Inc. acquired Solar Integrated Technologies Inc. on August 19, 2009. In its financial report for the quarter ended December 31, 2009, the company added a liability of $38.5 million to its warranty reserve fund due to the merger. And that turned out to be the fourth-largest warranty acquisition for the past ten quarters.

Scooping Up Nortel

The fifth-largest warranty acquisition was of Nortel�s Metro Ethernet Networks business by Ciena Corp. Ciena bought the optical networking and Ethernet assets of the Nortel unit in a transaction that was completed on March 19, 2010. In the financial report for the quarterly period ended April 30, 2010, Ciena added $26 million to its warranty reserve fund due to the acquisition.

Ciena's warranty reserve balance grew from $40.2 million in October 2009 to $64.7 million in April 2010. But that also includes an adjustment that reduced the company's warranty liability by $3.3 million, which removed an excess of warranty accruals that the company said was caused by an error in the methodology used to compute the annual failure rate. And, of course, it includes all the routine claims paid and accruals made during the period.

In recent years, Terex Corp. has made numerous acquisitions. It acquired the construction equipment company A.S.V. Inc. on February 26, 2008. It acquired the Port Equipment Business from Fantuzzi Industries S.à.r.l on July 23, 2009. Among the $512 million in liabilities assumed in that deal were an additional $24.2 million in warranty liabilities, detailed in the financial report for the quarter ended September 30, 2009.

Danaher Corp. made its top ten acquisition just a few months ago. On June 30, 2011, Danaher acquired all the outstanding shares of common stock of medical test equipment maker Beckman Coulter Inc. And that transaction closed just in time to be included in the financial report for the quarterly period ended July 1, 2011. The company said its warranty reserve fund balance grew from $130.1 million to $152.2 million after accounting for the acquisition plus a slight excess of accruals over claims.

Small Appliance Acquisition

Helen of Troy Ltd., in its annual reports for the fiscal year ending February 28, 2011, reported what turns out to be the eighth-largest warranty liability acquisition since 2009. It acquired portable heater/humidifier manufacturer Kaz Inc. on December 31, 2010, and reported an increased warranty liability of $20.6 million in conjunction with that deal.

And although Helen of Troy's regular claims exceeded accruals during the fiscal year, and therefore somewhat reduced the reserve fund balance, this acquisition helped drive up the company's combined warranty reserve fund balance from $5.2 million at the beginning of the year to $24 million by the end of the year.

Westinghouse Air Brake Technologies Corp., also known as Wabtec, reported an acquisition-related increase of $13.4 million in its warranty reserves during the first quarter of 2011. That and a slight excess of accruals over claims helped boost its warranty reserve balance from $35.5 million at the end of December 2010 to $50.6 million at the end of March 2011.

Wabtec has made numerous railroad equipment-related acquisitions in recent years. It acquired the Brush Traction Group in February 2011, assuming $59.6 million in assets and $28.6 million in liabilities as part of the deal. This is the transaction most likely to be responsible for the boost in warranty liabilities. Acquisitions reported in 2010 include Swiger Coil Systems; the Bach-Simpson Corp.; G&B Specialties Inc.; and Xorail LLC. But together they boosted warranty liabilities by only a net $215,000.

Agilent Buys Varian

Our final top ten deal maker is Agilent Technologies Inc. The company, itself an HP spin-off formed in 1999, completed its acquisition of scientific instrument maker Varian Inc. on May 14, 2010. Coincidentally, Agilent completed the sale of its Network Solutions Division to JDS Uniphase Corp. two weeks before, on May 1.

In its financial report for the fiscal quarter ended July 31, 2010, Agilent announced the addition of a net $13.0 million in warranty liabilities to its warranty reserve. We don't know how much of that was due to Varian arriving as opposed to the JDS Uniphase sale. But JDS Uniphase never reported any boost in its warranty reserve balance caused by that acquisition. And Varian Inc. had $13.1 million in its warranty reserve as of April 2, 2010. So it's likely to be mostly or entirely caused by the Varian deal.

At the other extreme, companies are constantly selling off divisions, lines of business, brand names, and subsidiaries. If these business units issued product warranties, chances are that the divestiture includes some amount of transferred warranty liabilities.

Most times, it's the entire company that's acquired. That's why we found 189 acquisitions, but only 40 divestitures. Most of the difference, we believe, is accounted for by companies swallowed whole by their acquirer. Rather than report a 100% divestiture of their warranty reserves, most of the completely acquired companies simply cease reporting, and drop off our list.

Buying Entire Companies

So far in 2011, some of the bigger acquisitions have included Beckman Coulter Inc. and Bucyrus International Inc. We already noted Danaher's acquisition of Beckman Coulter above. In contrast, Bucyrus has yet to show up as a warranty liability acquisition on the books of its buyer, Caterpillar Inc. In fact, it may never show up. Caterpillar rarely makes any kind of adjustments to its warranty accounts -- not even for foreign currency fluctuations.

In total, we recorded 18 "complete" acquisitions in 2010. Some of the largest deals included 3Com Corp.; Baldor Electric Co.; CommScope Inc.; CPI International Inc.; Goodman Global Inc.; Palm Inc.; and the aforementioned Varian Inc. 3Com and Palm went to HP. Baldor went to the French firm ABB. CommScope, CPI and Goodman went private.

We recorded 27 "complete" acquisitions in 2009. Some of the largest of those deals included Black & Decker Corp.; Building Materials Corp. of America; Centex Corp.; Fleetwood Enterprises Inc.; Nortel Networks Corp.; and Sun Microsystems Inc.

Black & Decker, Centex, and Nortel were discussed above. Building Materials Corp. of America was acquired by GAF, which is privately-held. Fleetwood Enterprises was liquidated after going bankrupt. And Sun Microsystems was acquired by Oracle Corp., which has yet to begin reporting its warranty expenses.

Selling Small Units

And then there are the companies that sold only a part of themselves to another company. General Motors Co. leads this list of warranty divestitures, reducing its warranty reserve fund balance by $77 million in August 2009 to reflect the sale of its Saab business unit.

Figure 3
Top U.S.-based Warranty Providers:
Top Ten Divestitures,
2009 to 2011
(adjustments in -US$m)

  Divesting Company  Unit Sold   Quarter   Decrease 
  General Motors Co. Saab Automobile 1Q09 -$77.0
  ArvinMeritor Inc. light vehicle systems 3Q10 -$39.0
  Teleflex Inc. power systems 3Q09 -$8.6
  Oshkosh Corp. Geesink Norba Group 2Q09 -$7.1
  Ion Geophysical Corp. land division 1Q10 -$3.8
  Teleflex Inc. marine business 1Q11 -$2.5
  Oshkosh Corp. Brescia Antincendi Int'l 4Q09 -$1.6
  Jarden Corp. inflation in Venezuela 1Q10 -$1.0
  Applied Micro Circuits 3ware storage adapters 3Q09 -$0.8
  Endwave Corp. defense & security 2Q09 -$0.7

  Source: Warranty Week

The liability adjustment, which GM said was "due to the deconsolidation of Saab," was first reported during the first quarter of 2009, when the unit was still being held for sale. So that means the divestiture went into the books during that strange period of transition from the old GM to the bankrupt GM to the new GM, though the sale of Saab to what later became known as Swedish Automobile N.V. (formerly Spyker Cars) didn't become official until January 2010. And then Swedish Automobile went bankrupt last month.

To be sure, GM made other divestitures during its bankruptcy reorganization. But the way it did so was by not buying all the divisions of the old GM, now called the Motors Liquidation Company. So rather than spinning off Pontiac, Saturn and the other orphaned nameplates, the new GM simply declined to acquire them.

Exiting the Business

ArvinMeritor Inc., now known as simply Meritor Inc., reclassified its light vehicle business as a discontinued operation in the annual report for the year ended September 30, 2010. The company has spent the better part of two years trying to sell off its light vehicle systems business, so it can concentrate on commercial vehicles and industrial markets. Various buyers have been found for most of the units, except the gas spring and shock absorber units in Europe.

Teleflex Inc. we covered in last week's newsletter. The company divested $8.6 million in warranty liabilities in 2009 and $2.5 million in warranty liabilities in 2011, thus taking the third and sixth spots on our list. In fact, the manner in which it reduced its warranty claims rate from 0.4% to 0.01% over the past eight years through strategic divestitures like these is what led us to take a closer look at how mergers, acquisitions and spin-offs have impacted warranty accounts at other companies.

Fourth and seventh on our list is Oshkosh Corp. It's fourth for a $7.1 million divestiture of warranty liabilities in early 2009, related to its sale of the garbage truck maker Geesink Norba Group in Europe. And it's seventh for the separate $1.6 million divestiture later that year of the fire truck maker Brescia Antincendi International S.R.L., also located in Europe.

In March 2010, Ion Geophysical Corp. sold its seismic equipment businesses to a joint venture it formed with a unit of the China National Petroleum Corp. During that quarter, it reduced its warranty liabilities by $3.8 million in conjunction with that transaction.

Hyperinflation Write-Offs?

Jarden Corp. reported a net negative one million figure under the heading of "acquisitions and other adjustments" during the first quarter of 2010. That would imply a divestiture, but there were no divestitures that quarter. There were, however, a series of adjustments and write-downs related to inflation in Venezuela. So we suspect this is not a sale of warranty liabilities at all.

Ninth on our list is a $777,000 reduction in warranty reserves by Applied Micro Circuits Corp. The company sold its 3ware storage adapter business to LSI Corp. in April 2009. The initial price was $20 million. But after some adjustments for inventory (upwards) and warranty expenses (downwards), the actual price ended up at $21.5 million. So while the company reported the transfer of an estimated $777,000 in warranty liabilities, the actual amount transferred is closer to $500,000.

Finally, we have a $728,000 reduction in warranty liabilities reported by Endwave Corp. in 2009. The specialized chip manufacturer sold its defense and security business to Microsemi Corp. in April 2009, and reported the transaction in the quarter ended June 30, 2009.

The size of that final transfer on our list says it all when it comes to warranty cost divestitures. Across ten quarters of data, among more than 5,500 warranty expense reports, we found only eight warranty liability divestiture transactions greater than or equal to $1 million in size.

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