November 10, 2011

Warranty Adjustments, Part 3:

While all exporters must deal with foreign exchange fluctuations, some companies seem to be affected more than others. In fact, when compared to other warranty metrics, some of these fluctuations are huge. Is that caused by the unique nature of their businesses, or is it a sign of sloppy warranty accounting?

As if tracking warranty accruals and claims rates isn't esoteric enough, now we're looking for companies that make unusually large adjustments to their warranty reserve funds because of foreign currency fluctuations.

Only a fifth of the 550 or so U.S.-based manufacturers whose warranty expenditures we currently track have made such adjustments since 2009. But for some companies, these adjustments have been so large that we're left wondering whether anyone is keeping track of these metrics internally.

And by large, we're saying that the size of the currency translation adjustment is considerable in comparison to the rest of the warranty process. It's large in comparison with other metrics such as warranty claims, accruals, or reserve balances. It's not just large because it's denominated in hundreds of millions of dollars.

Largest Transactions

But before we get around to making comparisons with other warranty metrics, let's list the largest foreign exchange adjustments we can find. Figure 1 contains the ten largest currency-related adjustments reported by U.S.-based warranty providers since the beginning of 2009.

Figure 1
Top U.S.-based Warranty Providers:
Largest Foreign Exchange Adjustments,
2009 to 2011
(in US $ millions)

  Company  Period   $ Amount   $ Reserves 
  General Motors Co. Sep09 +$203 $7,062
  General Motors Co. Jun10 -$160 $6,760
  Ford Motor Co. Jun10 -$122 $2,958
  General Motors Co. Jun11 +$121 $6,926
  Ford Motor Co. Sep09 +$117 $3,285
  General Motors Co. Mar09 -$107 $7,900
  Ford Motor Co. Jun11 +63.0 $2,674
  Paccar Inc. Jun10 -$37.2 $335
  Deere & Co. 2009 +$20.0 $727
  Paccar Inc. Jun11 +$19.6 $428

  Source: Warranty Week

Obviously, seven of the top ten transactions were reported by one of the top passenger car makers. The other three were reported by makers of large vehicles such as trucks and farm equipment. And of course, all ten were reported by large companies with large warranty departments and large export and overseas manufacturing activities. In other words, large foreign exchange adjustments are made by companies with large international operations.

The most notable aspect of the data in Figure 1 is that some of the transactions were reported within the same year. For instance, GM made a downward adjustment in early 2009 and an upward adjustment almost twice as large later the same year. That just goes to show how fast and how much a company's holdings can change given the swings in the value of the dollar.

Usually, these foreign exchange adjustments are both frequent and routine. And in most cases, they're relatively small in comparison with other warranty metrics. For instance, as large as the sums of money are in Figure 1, only one is more than 1/10th as large as the overall warranty reserve fund balance.

Most Frequent Transactions

A total of 39 companies made a warranty-related foreign exchange adjustment in each and every one of the ten quarters between the start of 2009 and the middle of 2011. They are: Actuant Corp.; AGCO Corp.; Associated Materials LLC; Cascade Corp.; Checkpoint Systems Inc.; Circor International Inc.; Clarcor Inc.; Cognex Corp.; Commercial Vehicle Group Inc.; Curtiss-Wright Corp.; Deere & Co.; Dresser-Rand Group Inc.; Ford Motor Co.; General Motors Co.; Goodrich Corp.; Greenbrier Cos. Inc.; Hardinge Inc.; Ingersoll-Rand plc; Itron Inc.; Joy Global Inc.; Kadant Inc.; Key Technology Inc.; Lincoln Electric Holdings Inc.; Modine Manufacturing Co.; Moog Inc.; NACCO Industries Inc.; Oclaro Inc.; Paccar Inc.; Pentair Inc.; PerkinElmer Inc.; Regal-Beloit Corp.; Robbins & Myers Inc.; Rofin-Sinar Technologies Inc.; Sirona Dental Systems Inc.; Teleflex Inc.; Tennant Co.; Terex Corp.; Twin Disc Inc.; and Wabco Holdings Inc.

An additional 28 companies made the foreign exchange adjustment in all but one or two of the ten quarters we examined. They are: American Axle & Manufacturing Holdings Inc.; Armstrong World Industries Inc.; BorgWarner Inc.; Crane Co.; Cummins Inc.; Dana Holding Corp.; FEI Co.; Fuel Systems Solutions Inc.; Gardner Denver Inc.; Harman International Industries Inc.; Hurco Companies Inc.; Johnson Controls Inc.; L-3 Communications Corp.; Lear Corp.; Lennox International Inc.; Manitowoc Co. Inc.; Masco Corp.; Mettler-Toledo International Inc.; MTS Systems Corp.; Oshkosh Corp.; Powell Industries Inc.; Power-One Inc.; RAE Systems Inc.; Sauer-Danfoss Inc.; Stanley Black & Decker Inc.; Thermo Fisher Scientific Inc.; TRW Automotive Holdings Corp.; and Woodward Inc.

Therefore, these are the 67 most international U.S.-based warranty providers. Their operations outside of their home base are so vast that they more or less constantly need to adjust their warranty reserve balances to reflect changes in the value of the U.S. dollar in relation to the several other currencies in which their warranty bills are denominated.

There were an additional 44 companies that made foreign exchange adjustments between one and six times during the ten quarters. And then there were more than 400 companies that never made a single foreign exchange adjustment during the past two-and-a-half years. Some may have combined their foreign exchange adjustments with other warranty reserve balance revisions. Others simply may not do warranty work outside the U.S., or may not pay for it in any currency besides U.S. dollars.

Increases vs. Decreases

Altogether, the 111 companies that made any foreign exchange adjustments made a total of 808 such adjustments in the ten quarters since the start of 2009. Of those, 430 were increases and 378 were decreases.

While that 53/47 ratio may seem close to balanced, that was rarely the case in practice. For instance, in the first half of 2010, there were only 13 increases and 147 decreases. In the first half of 2011, there were 146 increases and only 5 decreases.

The reason for the swing is of course the underlying movement of the U.S. dollar. In early 2010, the dollar strengthened tremendously, briefly hitting $1.19 to the euro. And that led many warranty providers to adjust their balances downward (fewer, stronger dollars were needed to pay foreign claims).

In the first half of 2011, the dollar weakened, falling to $1.48 to the euro. So it took more weaker dollars to pay foreign claims, leading to more upwards adjustments. In general, the balance adjustments are made in the opposite direction of the dollar.

But it's impossible to generalize, because these warranty providers operate in so many countries, and those currencies don't always all move in the same direction. In addition, some manufacturers may use hedging strategies that either exaggerate or reduce the need for adjustments. Also, we should note that unlike what we saw with upwards or downwards changes of estimates, manufacturers rarely explain why they're making these foreign exchange adjustments, or why they're sometimes so large.

In Figure 1, we simply listed the ten largest foreign exchange adjustments since 2009. And we listed the ending balance in each company's warranty reserve fund, to make the point that while the dollar amount of the adjustment may have seemed large, the amount of unadjusted dollars was much larger.

In other words, while Ford and GM made lots of large adjustments, only once did it involve an amount equal to more than 4% of their warranty reserves. Most times, the adjustment amounted to only 1% or 2% of their reserves, which for companies that do a considerable amount of business outside the U.S. isn't really much.

Largest Amounts in Comparison

But that's not what we're looking for. What we're seeking are adjustments that cannot be explained merely by fluctuations of the U.S. dollar. And the way we tried to find them was not by merely looking at their size alone. Instead, we looked for adjustments that were unusually large in comparison to overall warranty reserve balances, to claims paid, to accruals made, or to product sales revenue.

In Figure 2, we note, there are no repeats from Figure 1. In other words, none of the foreign exchange adjustments that were very large in sheer dollar amounts were also very large in comparison to the overall warranty reserve balance.

In percentage terms, only one entry from Figure 1 was even close to making the top ten in Figure 2. Paccar's $37.2 million adjustment from last year represented 11.1% of its reserves in June 2010. Meanwhile, Moog's $1.58 million adjustment from 2009, which was tenth on the list in Figure 2 below, represented 11.4% of its warranty reserves. Therefore, Paccar's eighth place finish in absolute terms translated into a sub-tenth place finish in relative terms.

Figure 2
Top U.S.-based Warranty Providers:
Largest Foreign Exchange Adjustments
vs. Reserves, 2009 to 2011
(in US $ millions)

  Company  Period   $ Amount   % of Reserves 
  Baldwin Technology Co. 2009 -$0.686 26%
  Foster Wheeler AG Jun10 -$19.2 20%
  Del Global Technologies 2010 -$0.122 19%
  Oclaro Inc. 2009 -$0.431 19%
  Cascade Corp. 2009 -$0.245 19%
  AsiaInfo-Linkage Inc. 2010 +$0.008 18%
  Harman International Mar09 -$17.5 15%
  Sirona Dental Systems 2010 -$1.19 13%
  Modine Manufacturing 2009 -$1.18 12%
  Moog Inc. Jun09 +1.58 11%

  Source: Warranty Week

Overall, only a few of the entries at the top of the list in Figure 2 seem unusual. For instance, printing press maker Baldwin Technology made a downward foreign exchange adjustment of $686,000 in 2009. But because its claims outpaced accruals by a wide margin that year, its warranty reserves were severely. And therefore, the ending balance that year was only about four times larger than the foreign exchange adjustment.

Foster Wheeler, a global engineering and construction company, made a $19.2 million downward adjustment in the middle of 2010, an amount which was partially a change of estimate and partially a foreign currency adjustment. That left only $94.2 million in its warranty reserve, which was only about five times as large as the adjustment. Put another way, the adjustment was equal to 20% of the reserves.

Of all the manufacturers we track, these were the two largest foreign exchange adjustments made, relative to the balances left behind at the end of the period noted. That's not necessarily bad, but it is unusual. It's like calculating who pays the highest tax rate, or who took the most sick days last year. There may be good reasons why they're at the top of the list, which we don't pretend to know. But the lack of an explanation doesn't make the relative size of these adjustments any less unusual.

By the way, the largest upwards adjustment in Figure 2 was made by AsiaInfo-Linkage, whose seemingly tiny $8,000 increase was nevertheless equal to 18% of its $44,000 warranty reserve balance at the end of 2010. But that's no shock when one considers that the telecom equipment company has regional headquarters in Santa Clara, Calif., Beijing and Singapore, uses ASIA as its stock ticker symbol, and has its home page translated into Chinese. The relative size of the adjustment is merely a symptom of its international reach and its high level of cross-border activity.

Most Unusual Transactions

If anybody has any explaining to do, it's the companies listed in Figure 3 below. Each one of them made a foreign exchange adjustment that was equal to or larger than the amount they set aside as warranty accruals over the same period. In a few cases, it was much larger.

For instance, the railroad boxcar manufacturer Greenbrier made a $528,000 downward adjustment in 2009. But that year it added only $32,000 in new accruals to its warranty reserve fund, despite reporting $463 million in product sales. That's highly unusual.

Meanwhile, powertrain manufacturer BorgWarner made a $3.9 million adjustment in the first quarter of 2009. But it accrued only $200,000 during the same period, meaning that foreign exchange adjustments were 14.5 times larger than accruals. Granted, the company usually accrues more. And indeed, it paid out $15.3 million in claims during the same quarter. So perhaps the better question would be why accruals were so low that quarter?

Figure 3
Top U.S.-based Warranty Providers:
Largest Foreign Exchange Adjustments
vs. Accruals, 2009 to 2011
(in US $ millions)

  Company  Period   $ Amount   % of Accruals 
  Greenbrier Cos. Inc. 2009 -$0.528 1,650%
  BorgWarner Inc. Mar09 -$2.90 1,450%
  Del Global Technologies Jan09 +$0.064 376%
  Lear Corp. Jul11 +$2.50 250%
  Rofin-Sinar Technologies Mar09 -$0.807 209%
  Midas Inc. Sep09 +$0.400 200%
  Foster Wheeler AG Jun10 -$19.2 175%
  Clarcor Inc. May10 -$0.384 159%
  Moog Inc. Jun09 +$1.58 107%
  Masco Corp. Mar09 -$2.00 100%

  Source: Warranty Week

Adjustments by Foster Wheeler and Moog made appearances in both Figures 2 and 3. And in fact, that same adjustment by Foster Wheeler is also going to make appearances in Figures 4 and 5 as well. That's how unusual it is. It's the only company to make it onto four charts, although GM made four appearances in one chart (Figure 1).

Elsewhere, no single adjustment made it onto three charts, although Ford, Del Global Technologies, and Paccar each had three different adjustments that each made a top ten chart. So that makes the Foster Wheeler adjustment seem all the more peculiar. It was among the ten largest in every comparison we made.

Comparisons to Claims Paid

In Figure 4, we're comparing foreign exchange adjustments to claims payments. And a quick glance at the percentages suggests that none of the adjustments were as unusual as those at the top of the list in Figure 3. Yes, eight of the ten adjustments were larger than claims paid, but none were more than three times larger than claims -- not even Foster Wheeler's.

We suspect this is because while the size of both these foreign exchange adjustments and accruals are made by choice, the size of claims payments is more or less dictated by the product line. One can cut accruals to zero on a whim, but claims payments aren't so easy to avoid.

Only Foster Wheeler and Clarcor made both the claims and accrual lists. And Clarcor was towards the bottom of both Figures 3 and 4. However, Clarcor, like Paccar, also just missed out on making it onto the list for Figure 2 (its adjustment-to-reserves ratio was 11.3%). So that $384,000 transaction was somewhat large for such a small company.

Then there was one other company besides Foster Wheeler to make it onto the lists in both Figures 4 and 5. And that was the company at the top of the list below: Harman International Industries. The manufacturer includes a foreign exchange adjustment in almost every quarter's warranty accounting, as would befit a worldwide operation with several well-known audio equipment brands such as Harman Kardon, JBL, dbx, and Infinity.

And indeed, the $10.5 million adjustment it made in 2010 wasn't even as large as some of the others it made in 2009 and 2011. But what made this one stand out was that it came in a quarter where there were only $4.1 million in claims payments. Accruals were a more normal $13.4 million that quarter. In other words, the reason it sticks out is not because of itself, but because of the comparison.

Figure 4
Top U.S.-based Warranty Providers:
Largest Foreign Exchange Adjustments
vs. Claims, 2009 to 2011
(in US $ millions)

  Company  Period   $ Amount   % of Claims 
  Harman International Sep10 +$10.5 256%
  Del Global Technologies Oct10 +$0.094 235%
  Foster Wheeler AG Jun10 -$19.2 229%
  Power-One Inc. Apr11 +$1.10 138%
  Del Global Technologies 2010 -$0.122 118%
  Lear Corp. Apr10 -$3.10 107%
  Rofin-Sinar Technologies Mar10 -$0.639 103%
  American Axle & Mfg. Mar10 -$0.100 100%
  Maxwell Technologies Mar09 -$0.074 87%
  Clarcor Inc. May10 -$0.384 76%

  Source: Warranty Week

Of the ten companies in Figure 4, it was the only appearance for six of them. And besides the already-mentioned Foster Wheeler, Clarcor, and Harman, the only other company to make it onto another list was Del Global Technologies. The medical equipment maker was also listed in Figure 2, because its $122,000 adjustment was almost one-fifth the size of its warranty reserve fund.

Altogether, there were 46 different transactions, made by 28 different companies, that accounted for the 50 entries on these five top ten lists. Del Global was one of the few to have two entries on one list, and was also unusual in that one was an increase while the other was a decrease (they were in different fiscal years, however).

Repeating Companies

In Figure 5, there are three companies with two entries each: Fuel Systems Solutions, Paccar, and Wabco Holdings. Here, we're comparing the size of the adjustment to the amount of product sales. The percentages aren't as large because the whole warranty budget would normally be 5% or less of sales. So just the foreign currency adjustments to that warranty budget would normally be a very small percentage of that 5%. For instance, 5% of 5% is 0.25%. And that would be on the high side.

Or so you would think. Battery manufacturer Energy Conversion Devices, which made frequent appearances in our previous newsletters for their unusually large changes of estimate, leads the pack this time as well. Its $864,000 foreign exchange adjustment was reported during a quarter in which the company had $65 million in product sales. So that adjustment was equal to 1.3% of sales all by itself. And that in turn was more than half the size of both the company's claims and accruals during the quarter.

So should we be shocked to hear that the company halted production this week, allegedly because of excess inventory? Should we be surprised that it also plans to lay off 500 people? Perhaps we shouldn't be so cruel. But the truth is that while it's fine for a company to make an appearance here or there on one or two of the lists in the October 27, the November 3, or in this week's newsletter, this is a company whose repeated appearances makes us suspect it is not in control of its warranty process.

Figure 5
Top U.S.-based Warranty Providers:
Largest Foreign Exchange Adjustments
vs. Sales, 2009 to 2011
(in US $ millions)

  Company  Period   $ Amount   % of Sales 
  Energy Conversion Devices Sep10 +$0.864 1.3%
  Harman International Sep10 +$10.5 1.3%
  Paccar Inc. Mar09 -$17.7 1.0%
  Wabco Holdings Inc. Mar09 -$3.30 1.0%
  Foster Wheeler AG Jun10 -$19.2 1.0%
  Wabco Holdings Inc. Jun09 +$3.00 0.9%
  Fuel Systems Solutions Sep10 +$0.797 0.9%
  Paccar Inc. Jun10 -$37.2 0.9%
  Fuel Systems Solutions Jun10 -$0.874 0.9%
  Twin Disc Inc. Sep10 +$0.488 0.8%

  Source: Warranty Week

Usually, when it comes to evaluating warranty budgets, we compare claims and accruals to sales. And while we can't readily compare every company's percentages to each other without knowing what they count as a warranty expense, we can compare a company to itself over time, by looking for a baseline. If the claims rate or accrual rate suddenly changes from the "normal" baseline, we know that something meaningful has changed.

Furthermore, as we did in the October 6 and the March 18 newsletters, once we know what's "normal," we can then rank the biggest changes among the top 100 warranty providers, based on changes in claims rates, accrual rates, or warranty reserve balances.

What we're usually looking for in these instances are the biggest improvements or deteriorations in product reliability, using warranty metrics as a proxy. However, in this newsletter and in the October 27 and November 3 newsletters, what we're looking for are transactions that are far larger than normal.

No Reasons Needed?

The difference is, while many companies will reluctantly disclose the reasons why they suddenly had to add a massive amount of funds to their warranty reserves (see Nov. 3), they don't usually say why they're removing funds (see Oct. 27).

One can guess that they did so because the excess reserves were not needed. But why were they no longer needed? Was the original accrual rate estimate too high? Or has product performance improved more than was expected? Most companies don't say.

This week we looked at an even less examined metric: foreign exchange adjustments. Companies rarely if ever explain these. It's simply assumed that the value of the currency pairs a company employs to pay its worldwide warranty costs changed, and adjustments were needed.

However, think about the meaning of the comparisons this week. In Figure 2, for instance, we listed ten companies whose warranty reserve fund balances allegedly changed by 10% or more because of currency fluctuations in the markets they serve. Where, in Zimbabwe?

A sustained 10% change in the value of the pound, euro, dollar or yen would be highly unusual. The euro-dollar currency pair, for instance, even after all the recent turmoil, is only one penny below its level of November 10, 2010. Yes, it's risen to $1.48 and fallen to $1.31 since then, but even those are the extremes, not the averages.

Why Not Everyone?

But even if we accept that 10% quarterly swings are possible, we have to ask the question: Why didn't it happen to everybody? If there were 111 companies reporting currency adjustments, why was the ratio over 10% for only 12 of them?

In Figures 3 and 4, we found numerous companies whose foreign exchange adjustments exceeded either their claims payments, their warranty accruals, or both. That's a bit like reporting that the month's interest on a bank account exceeded both deposits and withdrawals. Yes, it can happen under peculiar conditions, but it's as unlikely as having a food bill that equals or exceeds wages.

In Figure 5, we compared foreign currency adjustments to sales. And while it's by no means unsustainable for a company to be making such adjustments that are equal to one percent of sales, in a few cases these companies have claims rates lower than that.

In the end, what we're doing is simply identifying and making a list of the companies at the fringes of the bell curve. We don't always know why they're there, but there they are. And in some cases, what we're finding is that carelessness in warranty accounting is a marker for turmoil in the warranty process, which itself can be a leading indicator of distress across the entire company.

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