November 3, 2011

Warranty Adjustments, Part 2:

In the past few years, a small group of companies has made repeated and relatively large upwards adjustments to their warranty reserves. Are they simply bad at predicting the future? Or have they found a way to make their warranty costs look lower than they really are?

Warranty managers usually get it right when it comes to estimating future repair costs. But sometimes, there comes a surprise that was so unexpected that there's simply not enough funds on hand to cover the sudden rise in costs.

In times like that, the company needs to make what's called an upwards change of estimate. Besides the normal and routine amounts they accrue as products are sold, they need to make a one-time adjustment to their warranty reserve balance.

The thing about these adjustments is that they rarely get any attention. So this week, we've made a list of the 275 or so adjustments we've seen since the beginning of 2009, and ranked them in search of the biggest.

Figure 1 was the easiest to compile. We simply listed the ten biggest adjustments by dollar amount, after eliminating duplicates. For instance, if a company made a warranty adjustment in its first quarter, it might repeat the figures in its annual report. We would eliminate one or the other entry, so that only the largest adjustment within a fiscal year would make the list.

Top Warranty Providers

As can be seen below, the top warranty providers took most of the top spots. Last year, General Motors was the largest warranty provider based in the U.S. Ford was number three, and Caterpillar was number five. United Technologies was #12, and Boeing was #18.

Those five companies took the top eight spots in Figure 1. But each of them also spent hundreds of millions, and in some cases billions, on warranty claims last year. So a nine-figure adjustment, while it looks big to us, is relatively small to them. In seven out of the ten cases, the adjustments represented less than 20% of the pre-adjustment reserve balance.

Figure 1
Top U.S.-based Warranty Providers:
Largest Unfavorable Changes of Estimate
2009 to 2011
(Amount in US $ Millions)

  Company  Period   $ Amount   $ Reserves 
  Ford Motor Co. Jun09 $495 $3,346
  General Motors Co. Jun11 $366 $6,789
  United Technologies Mar11 $281 $1,136
  General Motors Co. 2010 $210 $7,030
  Ford Motor Co. 2010 $203 $3,147
  General Motors Co. Dec09 $202 $7,062
  Caterpillar Inc. Jun09 $197 $1,201
  Boeing Co. 2010 $170 $999
  Mohawk Industries Inc. 2009 $125 $56.5
  Johnson Controls Inc. 2009 $115 $204

  Source: Warranty Week

The column farthest to the right lists the company's warranty reserve fund balance before the adjustment was made. That's just a quick way to show how relatively small these adjustments are for most of these companies. As was mentioned, in seven instances the adjustments represented less than 20% of reserves. For United Technologies, the adjustment represented 25% of reserves. For Johnson Controls, it represented 56%.

The outlier on this list is Mohawk Industries, in whose case the adjustment is more than twice the size of the pre-adjustment balance. That's a sure sign of trouble.

If the absolute measurements of Figure 1 tell us little, the relative measurements in Figures 2 through 5 will hopefully tell us lots about a company's warranty adjustments. Each of the top ten lists below details the ten biggest upwards warranty adjustments since 2009, calculated through relative comparisons with warranty reserves, claims, accruals, and product sales.

Merger Adjustments

Some of the adjustments are related to mergers and acquisitions, and the assumed liabilities that go with them. But most are markers for costly and unexpected product failures, which result in claims levels that send the warranty reserve fund into deficits that are covered by one-time additions. The problem is, companies don't always make it easy to tell the difference.

At the top of the list in Figure 2, for instance, is the comparison for a $309,000 addition made by White Electronic Designs Corp. in the fiscal year ended September 30, 2009. That doesn't sound like much, especially in contrast with the hundreds of millions of dollars listed for each of the companies in Figure 1.

However, White's warranty reserve, before it made the adjustment, had a balance of only $72,000. So that addition was almost 7.4 times as large as the balance was at the beginning of that year. And as we'll see in subsequent charts, it was also multiple times larger than either the claims or accrual totals that year.

Thankfully, the sudden increase was caused by White's sale of its Display Systems Division in April 2009. Under the terms of that sale, White retained the warranty liability for all products sold by that division, so it had to suddenly accrue an additional $309,000 to cover that expected liability.

But here's the irony: Six months later, Microsemi Corp. announced its intention to acquire White, a deal that was completed at the end of April 2010. And Microsemi does not publish its warranty data. So while those accounting entries didn't disappear, they most certainly did disappear from external view.

Figure 2
Top U.S.-based Warranty Providers:
Largest Adjustments vs. Reserves
2009 to 2011
(Amount in US $ Millions)

  Company  Period   $ Amount   x Reserves 
  White Electronic Designs 2009 $0.309 7.4
  Energy Conversion Devices Sep09 $33.7 5.7
  Mohawk Industries Inc. 2009 $125 2.2
  Daktronics Inc. 2009 $15.1 1.2
  ThermoGenesis Corp. 2010 $0.513 1.0
  Hubbell Inc. Sep09 $5.60 0.8
  TransAct Technologies 2010 $0.172 0.7
  Modine Manufacturing Co. 2010 $5.56 0.6
  Johnson Controls Inc. 2009 $115 0.6
  Lennar Corp. 2009 $69.5 0.5

  Source: Warranty Week

Seven other companies that made the top ten list in Figure 2 also made at least one other top ten list, which suggests that some of these adjustments are overly large no matter what's used as a base for comparison. For instance, that same acquisition by White made two other top ten lists.

Repeat Appearances

In this newsletter, there are five top ten lists for a total of 50 entries. But all 50 entries are accounted for by only 23 companies, some of which have multiple entries on multiple lists. In fact, while White made three lists, two companies made four lists. And in one of those cases, the cause was a massive product failure.

In the White case, the adjustment was caused by a divestiture. Sometimes, however, the adjustment is caused by an acquisition. Take the case of solar manufacturer Energy Conversion Devices Inc., which made four lists. On August 19, 2009, the company acquired Solar Integrated Technologies Inc. And then in its financial statement for the quarter ended September 30, 2009, the company reported a $33.7 million increase in its warranty liability. The thing is, the company had only $5.9 million in its warranty reserve at the time, so this acquisition drove that balance up significantly.

And then there are the adjustments that are caused by product disasters. Mohawk Industries Inc., a floor tile and carpet manufacturer, always kept its warranty reserve fund balance as low as possible. Up until 2008, it rarely kept more than a seven-month supply of funds in the reserve, essentially a pay-as-you-go system with a slight financial cushion.

But then the company launched a new line of commercial carpet tiles, which had a new type of adhesive on the bottom to keep them in place. And the new adhesive didn't seem to be working. Basically, the entire product line was coming back defective.

In the first quarter of 2009, the company had to add $110 million to its warranty reserve fund to cover the cost of these claims. In the fourth quarter, it had to add another $15 million to the fund, bringing the year's total warranty adjustment to $125 million. That was more than twice the balance the company's warranty reserve carried at the beginning of that fiscal year. And it was large enough to get Mohawk onto four of the five lists in this newsletter.

Relative Comparisons

As was seen in Figure 1, that $125 million adjustment was the eighth biggest seen in the ten quarters between Jan. 1, 2009 and June 30, 2011. And it was the third largest boost to the warranty reserve balance, as listed in Figure 2. So it should come as no surprise that it's also among the largest adjustments when compared to warranty accruals (Figure 3).

Warranty claims are what you pay. Warranty accruals are what you expect to pay. Therefore, what Figure 3 is really measuring is the difference between what was expected to happen and what really happened. However, Mohawk barely makes the list in Figure 3 because its $125 million adjustment was only 2.4 times as large as its $52 million regular accrual total for the year. In other words, the adhesive disaster was only 2.4 times as large as the rest of the company's warranty budget was that year.

And that means there have been nine instances since 2009 where the upwards adjustment in warranty reserves was more than 2.4 times accruals. We've already attributed the Energy Conversion Devices and White Electronic Designs to an acquisition and a divestiture, respectively. But what about the two Itron adjustments?

We should mention that we tried to eliminate all duplications on our list by taking only one upward adjustment per company per fiscal year. So, over the course of ten quarters spanning at most three fiscal years, a company could make the raw list no more than three times.

Amazingly, 36 companies made the raw list three times each. Of course, not every one of those adjustments made a top ten list. The only company whose maximum of three adjustments each made a top ten list was General Motors. And all three of those made only the largest-dollar-amount list in Figure 1. GM made no other appearances.

Only three companies saw two out of their maximum of three adjustments make a top ten list. Those three companies were Boeing Co., Itron Inc., and ThermoGenesis Corp. And again, one of Boeing's entries made only the largest-dollar-amount list in Figure 1.

Six companies had the maximum of three adjustments, of which only one made any top ten lists. Those companies were Daktronics Inc.; Harris Corp.; Lennar Corp.; Modine Manufacturing Co.; Mohawk Industries Inc.; and Symmetricom Inc.

Annual Adjustments

And then there were 26 companies that made an upwards adjustment at least once in each of the past three fiscal years, but did not make any top ten list at all. In other words, their warranty reserves fell short, but not so short that they were proportionally among the largest.

Those 26 companies were; Astec Industries Inc.; Cascade Corp.; Dana Holding Corp.; First Solar Inc.; FMC Technologies Inc.; Graco Inc.; Harley-Davidson Inc.; IBM Corp.; Invacare Corp.; Lennox International Inc.; Lexmark International Inc.; LSI Corp.; M/I Homes Inc.; Masco Corp.; Moog Inc.; Oplink Communications Inc.; Quantum Corp.; Quantum Fuel Systems Technologies Worldwide Inc.; Ryland Group Inc.; Teleflex Inc.; Terex Corp.; Toll Brothers Inc.; Toro Co.; VeriFone Systems Inc.; Whirlpool Corp.; and William Lyon Homes.

So in a very roundabout way, what we've found is that only GM had three adjustments that all made it onto a top ten list, and only two companies had two out of three of their adjustments on a top ten list.

For instance, utility meter manufacturer Itron is both third and fourth on the list in Figure 3. In the quarter ended June 30, 2010, the company listed $14.4 million in "Other changes/adjustments to warranties." And then in the quarter ended March 31, 2011, it made a $9.0 million adjustment. Each was in a different fiscal year, so we counted both. And then Itron also made a $7.6 million upwards adjustment in 2009, but that didn't make any top ten lists.

The 2010 adjustment was the result of an arbitration between Itron's UK subsidiary and Cinclus Technology. The customer alleged that the meters it bought from Itron in 2007 ended up all being defective, because they were susceptible to electromagnetic interference produced by other household electronics. And the customer demanded not only their complete replacement, but also the cost of labor associated with this demand.

The cause of the more recent adjustment is unclear, but Itron noted in its 2011 financial statement that its gross margins "were impacted unfavorably by a warranty charge of $7.7 million related to certain products in Brazil." And that's all it had to say about it. But as this Zacks investment research bulletin details, it hasn't gone unnoticed by Wall Street analysts.

These adjustments were multiple times larger than Itron's accruals during the same periods. And in fact each was several times larger than regular claims during the same periods. In other words, they were significant budget items. And one was so large it actually exceeded half the company's sales, which landed it on the list in Figure 5.

Warranty Arbitration Adjustments

The largest adjustment on the list in Figure 3 belongs to Boeing, however. In the quarter ending March 31, 2009, the company made a $108 million change of estimate, which was more than twice as much as its regular accruals and 1.7 times its claims payments. It was also equal to nearly 18% of the company's profits that quarter. The cause was an arbitration decision over a satellite that failed in 2004.

Figure 3
Top U.S.-based Warranty Providers:
Largest Adjustments vs. Accruals
2009 to 2011
(Amount in US $ Millions)

  Company  Period   $ Amount   x Accruals 
  Energy Conversion Devices Sep09 $33.7 31
  White Electronic Designs 2009 $0.309 18
  Itron Inc. Jun10 $14.4 5.0
  Itron Inc. Mar11 $9.01 4.8
  Symmetricom Inc. Sep10 $0.185 3.4
  Hubbell Inc. Sep09 $5.60 2.9
  Boeing Co. Mar09 $108 2.6
  Meritage Homes Corp. Sep09 $1.74 2.4
  Lennar Corp. 2009 $69.3 2.4
  Mohawk Industries Inc. 2009 $125 2.4

  Source: Warranty Week

As can be expected, six of the top ten in Figure 3 are repeated in Figure 4. That's to be expected because, since claims and accruals totals are usually close to each other, it would be no surprise to find that an adjustment twice as large as one would also be twice as large as the other.

What we're measuring here is the magnitude of the negative surprises. We know they're surprises because if they were expected the funds would have already been in the warranty reserve. And we know they're negative surprises because they represent net additions, unlike the net subtractions we covered in last week's newsletter.

Both of the Itron adjustments are on the list below, as is the $108 million Boeing adjustment. But the biggest adjustment of all came from United Technologies, which in the quarter ended March 31 of this year added an extra $281 million to its warranty reserve. After Ford and GM's mammoth adjustments, that was the largest upwards change of estimate we found.

Another Acquisition

The good news is, it's just another accounting entry, caused almost entirely by the December 2010 acquisition of the remaining half of wind turbine manufacturer Clipper Windpower. Though the company has only 750 employees, it manages over 6,500 Megawatts of windmills worldwide. United bought the first half of the company in early 2010, and the remainder at the end of last year.

In July 2010, United agreed to guarantee all of Clipper's wind turbine warranties. And as can be seen by the size of the adjustment, such liabilities can be huge over the long term. In a future article we're going to look more closely at the length of wind and solar equipment warranties, and the importance of reliable insurance underwriting. For now, we'll simply note that the $281 million was more than twice as much as United Technologies spent that quarter on warranty claims for Carrier, Pratt & Whitney, Otis, Sikorsky, and the other units within the company.

Figure 4
Top U.S.-based Warranty Providers:
Largest Adjustments vs. Claims
2009 to 2011
(Amount in US $ Millions)

  Company  Period   $ Amount   x Claims 
  Energy Conversion Devices Sep09 $33.7 87
  Itron Inc. Jun10 $14.4 4.3
  White Electronic Designs 2009 $0.309 4.3
  Spansion Inc. Jun09 $0.811 2.4
  United Technologies Mar11 $281 2.3
  ThermoGenesis Corp. 2010 $0.513 2.2
  Donaldson Co. Inc. Oct10 $2.17 2.2
  Itron Inc. Mar11 $9.01 2.0
  Boeing Co. Mar09 $108 1.7
  Meritage Homes Corp. Sep09 $1.74 1.1

  Source: Warranty Week

The two that made only one top ten list were Donaldson and Spansion. Donaldson added $2.17 million to its warranty reserve, due to a warranty problem that the company said arose in its Retrofit Emissions Products Group.

Spansion's upwards adjustment was only $811,000, but that was more than twice as much as the company paid out in claims that quarter. So even though it was smaller in dollar terms, it was proportionally larger as a multiple of claims payments.

We tried to make a correlation between these negative surprises and net profits, but it didn't work out. First of all, only 17 of the 29 companies on any of these top ten lists were profitable at the time they made the adjustments. And of those 17, while eight of the adjustments were greater than 15% of net income, nine were less than 6% of net income.

Only in the case of Caterpillar's $197 million adjustment in the middle of 2009 did the amount added to the warranty reserve even begin to approach the company's net income. In three other cases -- Itron, Daktronics and Ford -- the adjustment was about half as large as net income.

Adjustments vs. Net Losses

On the opposite end of the spectrum, 12 of the companies were unprofitable at the time they made the adjustments. But here, we have two examples of what a negative surprise can do to a company. For instance, Mohawk's $125 million carpet tile fiasco helped cause a $5.5 million net loss for the year. And when Energy Conversion Devices was finished accounting for its acquisition of Solar Integrated Technologies, its $33.7 million adjustment was almost three times larger than its $12 million net loss.

But in no other case with no other companies would the adjustment, on its own, have made the difference between a profit and a loss. So while we could find multiple examples where the adjustments exceeded reserves, claims or accruals, in only those two cases did the adjustments exceed the size of the net loss.

Comparisons with sales produced even smaller ratios. Of course, that also makes sense, because even in cases such as Mohawk or Itron where everything comes back defective, it's just one product line.

Only in the case of Energy Conversion Devices did the adjustment begin to approach product sales in magnitude. And that was an acquisition, not an unexpected defect. As can be seen in Figure 5, in no other case did an adjustment exceed 6% of sales.

Figure 5
Top U.S.-based Warranty Providers:
Largest Adjustments vs. Sales
2009 to 2011
(Amount in US $ Millions)

  Company  Period   $ Amount   % of Sales 
  Energy Conversion Devices Sep09 $33.7 92%
  ThermoGenesis Corp. 2010 $0.513 5.8%
  Harris Corp. 2010 $22.6 4.6%
  ThermoGenesis Corp. 2009 $0.422 4.6%
  Mohawk Industries Inc. 2009 $125 4.4%
  United Technologies Mar11 $281 3.0%
  Marine Products Corp. 2009 $1.09 2.8%
  Daktronics Inc. 2009 $15.1 2.6%
  Itron Inc. Jun10 $14.4 2.5%
  Affymetrix Inc. 2010 $0.644 2.5%

  Source: Warranty Week

Still, many of these adjustments had to have been painful at the time. For instance, surgical equipment maker ThermoGenesis ran a 2.9% accrual rate in 2009 and a 3.5% accrual rate in 2010. But once you add in those annual adjustments, you can see that upwards of 7.5% of product sales revenue is really going to fix failures. In other words, the real accrual rate is more than twice the routine accrual rate.

Harris Corp. had a relatively high regular accrual rate of 5.8% in 2010. But add in a 4.6% adjustment to that and you have a true warranty cost above 10% of hardware revenue. Affymetrix, a manufacturer of very specialized semiconductors used in genetic research, already had a 10% regular accrual rate in 2010. So the extra 2.5% upwards adjustment didn't help.

Are They Really Unexpected?

Which brings us to an interesting series of questions. As we noted, three dozen companies seem to routinely cover accrual deficits with these "unexpected" adjustments, as demonstrated by their recording of at least one change of estimate in each of the last three fiscal years.

Should we begin to include these adjustments along with the regular accruals? Should we begin to list two accrual rates, one with and one without adjustments included? Or should we keep the formula as is?

There's also another consideration. When Wall Street analysts decide whether a company has met, beaten, or missed earnings projections, they usually exclude one-time adjustments. And these are one-time adjustments. So what a habitually-warranty-adjusting company could do is to switch a portion of their warranty expenses from the recurring column to the "one-time" list.

In other words, it could pay to always be on the low side with warranty projections, and to accumulate a deficit, even if the adjustments that are ultimately required to cover the shortfall result in a considerable one-time hit to net income. Then again, if the shortfall is the result of an arbitration or a lawsuit, it would make little sense for the defendant to accrue for the expense unless they lose the case.

Readers' opinions, whether for publication or for private consumption only, would be appreciated.

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