January 26, 2012

Consumer Electronics Warranties:

Most of the best-known brands are imports. Most of the domestic brands are made by computer, appliance or telecom companies. Most of the emphasis is on sales of service contracts. So how can we analyze just the product warranty expenses of U.S.-based consumer electronics manufacturers?

This is why we hardly ever analyze the U.S.-based consumer electronics product warranty sector: there are too many exceptions.

First of all, in recent decades the market has been dominated by Asian and European importers, some of which report their warranty expenses, but none of which report very much warranty expense (except when they also make computers).

Second of all, because many of the importers are known for their product quality, consumer electronics tends to be more of a concern for those involved with extended warranty sales, which means it's more about the retailers and administrators, and less about the manufacturers and repair companies.

And third, many of the top U.S.-based manufacturers of consumer electronic products are really computer companies, or telecom equipment companies, or even home appliance manufacturers, who just happen to also be making CE gadgets such as smart phones or radar detectors.

For these reasons, we haven't done an in-depth analysis of consumer electronics product warranties since 2007. So before we switch gears next week to begin previews of the Warranty Chain Management Conference in Orlando, we thought it might be a good time to fit one in.

Top CE Companies or Computer Companies?

We looked over our list of U.S.-based manufacturers, and found 77 that make some type of consumer electronics product. Admittedly, some of those connections are quite tenuous. For instance, our largest "CE" manufacturer, as measured by warranty claims payments, is Hewlett-Packard Co., which sells digital cameras, speakers, televisions, projectors, and all sorts of game console accessories. And our second-largest is Apple Inc., makers of the iPod, iPad and iPhone, not to mention Apple TV.

Are they CE companies? No, they're computer companies that are turning into CE companies, just as Motorola Mobility Holdings Inc., Polycom Inc., Broadcom Corp. and Plantronics Inc. are coming into CE from the telecom equipment direction. And there are others whose primary activity is in aerospace equipment or auto manufacturing, who just happen to also sell popular electronic items to consumers.

As far as we can tell, the top U.S.-based warranty providers whose primary business is CE are Microsoft Corp., Garmin Ltd., and Harman International Industries Inc. And therein lies another irony of the CE market: While Microsoft is thought of as the king of PC software, most of the warranty-bearing hardware it sells are game consoles. So as far as warranty goes, Microsoft is primarily a CE company.

Garmin, meanwhile, has adapted aviation- and boating-oriented navigation equipment to use by consumers in passenger cars. It's primarily a consumer-focused company, while many of its GPS navigation system competitors are more focused on trucking, shipping, avionics, and other business-oriented applications. But they're all here among the 77 companies we're analyzing this week, because they all have a presence in CE.

Recession Then Recovery

In Figure 1 below, we've added up the claims payments of the 77 companies for the 35 quarters between Jan. 1, 2003 and Sept. 30, 2011. They almost hit $1.4 billion during one quarter in 2008, which by far was their peak year for claims payments. Then those claims payments hit bottom in mid-2010, dipping below $1.1 billion for the first time since 2007. And then claims payments began to rise again, almost reaching $1.3 billion in the third quarter of 2011.

Figure 1
Consumer Electronics Warranties
Claims Paid by U.S.-based CE Companies
(in US$ millions, 2003-2011)

Figure 1

The importers aren't included in these figures, but their track records have been similar. Claims peaked in 2008, fell in 2009, and rose in 2010 and again so far in 2011. It wasn't as dramatic as the dips in new home warranties or recreational vehicle warranties, but the pattern is similar.

In Figure 2, we're tracking consumer electronic warranty accruals. One can see the same dip in 2009, followed by a recovery in 2010 and 2011. But then there's that anomaly in the middle. In the second quarter of 2007, for the first and only time, the industry accrued more than $2 billion in a single quarter. And second place is almost $600 million lower. What happened?

The Xbox Factor

Call it the Xbox factor. In that spring quarter, which corresponded to the final quarter of Microsoft's fiscal year, the Xbox 360 manufacturer set aside an incredible $974 million in warranty accruals to cover the cost of alleged defects and repairs. That was almost half the entire industry's total accruals, even if we include HP and Motorola. So of course it sticks out like a sore thumb.

Figure 2
Consumer Electronics Warranties
Accruals Made by U.S.-based CE Companies
(in US$ millions, 2003-2011)

Figure 2

As a percentage of Microsoft's hardware sales, the Xbox accruals exceeded 16% of total revenue that year. In fiscal 2006, that same ratio between accruals and sales was 0.9%. Two years previously, it was 0.2%. So no doubt, its impact was felt at headquarters, no matter what was said publicly about failure rates or repair costs.

On the claims side, the peak came in early 2008, when Microsoft's Entertainment and Devices Division spent an incredible 11% of its sales revenue on warranty claims payments. In contrast, in the most recent calendar quarter, the company's claims rate slipped back down to 0.4%.

Watching the Percentages

And that's the thing about warranty expense. It doesn't matter as much how much. What matters more is the percentage. In general, a claims-to-sales ratio or an accruals-to-sales ratio under 5% is manageable. Anything under 1% is incredible.

As can be seen in Figure 3, even with the inclusion of so many computer warranties, the ratio in the U.S.-based CE industry is manageable and is headed for incredible. It's already there for some of the importers. For instance, Panasonic Corp. averages warranty expenses of 0.5%. Canon is between 0.4% and 0.7%. Sony, which of course also makes computers, is a bit higher at 0.8% to 1.2%.

In Figure 3, we see the U.S.-based industry turning in the lowest scores of the past nine years in the most recent quarters. These ratios have been dropping since at least 2009. And in this case, the lower the ratio, the better.

Figure 3
U.S.-based Consumer Electronics Companies
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2011)

Figure 3

The Xbox effect can be seen in the way the green line spikes in mid-2007, briefly hitting 3.2%. And then the claims rate rose above three percent in 2009, the first time that's happened since 2003.

Except for the Xbox, we can't point to a specific CE product causing these CE industry warranty benchmarks to rise. So they're probably caused by products sold into other markets by companies only partially in CE. And to show you what a major factor that can be, we took the 77 at-least-partially CE manufacturers and grouped them by their primary industry.

Primary Industries Revealed

In Figure 4, the "cause" is a bit easier to see. It's the same claims data as was included in Figure 1, but it's color-coded by each warranty provider's primary industry.

The dramatic rise of Xbox claims can be seen in the growth of the CE sector. And then the spin-off of Motorola Mobility can be seen in the telecom sector in 2008. But the inescapable conclusion is that the computer companies are dominating this so-called CE industry.

Figure 4
Consumer Electronics Warranties
Claims Paid by U.S.-based CE Companies
Grouped by Their Primary Industry
(in US$ millions, 2003-2011)

Figure 4


Normally, we would not count these crossovers. Apple and HP would be counted as computer companies. Motorola would be counted as a telecom company. And so on. And that would leave a rather small list of manufacturers. Over the years, an average of only 8% of the CE industry's claims payments were made by companies whose primary business was CE.

As the Xbox 360 problem has been fixed in recent years, allowing Microsoft to cut its warranty costs considerably, the "pure CE" share has become an even smaller sliver. In the third quarter of 2011, less than 3% of the claims listed in Figure 4 were paid by companies whose primary business was CE. That's the lowest it's been since early 2004.

The bulk of the "industry's" claims payments are made by computer companies, primarily Apple and HP. If one adds in the various computer peripheral companies and disk drive makers that also make CE gadgets, the "computer" share of the CE industry approaches 80%.

New Data from Apple

Earlier this week, Apple reported its financial figures for the fourth quarter of 2011. And what it revealed was astonishing: warranted product sales up 77% to $46.5 billion, over $400 million in claims payments, but a claims rate well under one percent.

One can debate which of Apple's products are CE, which are telecom equipment, and which are computers. But since it publishes only one set of warranty figures, we cannot divide its expenses up accurately. However, in Figure 5 we can see why the CE industry's overall warranty costs have been declining in recent quarters: Apple's claims rate is at its lowest level since 2006 -- a time when there was no iPhone or iPad.

Figure 5
Apple Inc.
Warranty Claims & Accrual Rates, 2003-2011
(as a percentage of product revenue)

Figure 5

Note there are 36 quarters of data in Figure 5. Most other manufacturers will be publishing their year-ending data in February and March. And in April we'll take a look at the overall nine-year trends in detail. But for Apple, at least, the trend is clear: rapidly rising sales causes rapidly rising warranty costs. For instance, claims payments in calendar 2011 were more than four times as large as in calendar 2008.

However, thanks to consistent quality and heavy reliance on service contracts for repair funds, Apple has managed to reduce the percentage of revenue it spends on warranty work. Sales rose awful fast, but costs rose a little slower. It's a warranty cost reduction success story. And because of the company's size, its effects are causing the entire CE industry's percentages to fall (Figure 3).

Warranty Reserves

Now, let's turn our attention to warranty reserves. The Xbox effect can be seen in Figure 6 in the steep jump the balance took in mid-2007. The peak, however, came a little later, in early 2008, when these 77 CE manufacturers had nearly $5.5 billion in their warranty reserve funds. Then their balances briefly dipped below $4 billion in mid-2009, before recovering to their current $4.9 billion level.

Figure 6
Consumer Electronics Warranties
Reserves Held by U.S.-based CE Companies
(in US$ millions, 2003-2011)

Figure 6

Now that all the Xboxes have been fixed, the largest CE warranty reserve funds belong to Apple and HP. At the end of 2011, Apple's balance was approaching $1.7 billion. As of October 2011, HP's balance was $2.45 billion. From there, it's a long drop to where companies such as Motorola, Western Digital Corp., Microsoft, Rockwell Collins, and Harman International each have between $100 million and $300 million in their warranty reserves.

Reserve Capacity

However, as with claims and accruals, the rate means more than the amount. And with reserves, we like to measure the rate at which the money is being spent. For instance, if a company has a $15 million reserve fund, and it is paying claims at a rate of $1 million a month, one could say their reserve fund has a capacity to pay claims for 15 months. If their reserves dropped to $10 million but their claims payments dropped to $400,000 a month, their reserve capacity would rise to 25 months. If reserves rose to $30 million but claims rose to $1.5 million a month, the reserve capacity would be 20 months.

As we said at the outset, warranty isn't typically a major consideration for most CE vendors. Outside of computers, the claims rates aren't very high. And except when disaster strikes, the reserves aren't very high.

As a multiple of claims paid per month, most CE vendors have a year or less capacity in their warranty reserve funds. In Figure 7, we've plotted a line for both the 77 CE vendors we're spotlighting this week and the hundreds of other manufacturers whose products are outside the CE sector. And while all manufacturers keep their reserves at an average capacity of 16 or 17 months, the CE vendors are down around 11 or 12 months.

Figure 7
Consumer Electronics Warranties
Reserves Held by U.S.-based CE Companies
Compared to All U.S.-based Manufacturers
(in $ millions & months, 2003-2011)

Figure 7

Of course, most CE warranties last for only one year, so this level is entirely appropriate. In fact, some CE warranties cover only parts for one year. Labor is covered for only 90 days. That's bound to turn some potential warranty claims into disposals, as consumers consider the cost of labor vs. replacements.

Warranties vs. Service Contracts

Also, some of those potential manufacturer's warranty costs are instead going to be picked up by service contracts. And indeed, one of the major selling points behind the AppleCare Protection Plans are their ability to extend technical support coverage past the 90-day mark.

As we mentioned at the outset, extended warranties are a very big deal for consumer electronics vendors. Product warranties? Not so much.

In the computer industry, meanwhile, product warranties are a very big deal. But in CE? Not so much.

Now, as the two markets intermingle, with computer-like devices such as smart phones and tablets becoming popular consumer items, product warranty is becoming a much bigger deal for the handheld device makers. So are extended warranties.

But the problem, as always, is the inability to isolate and analyze just the CE market. The largest CE brands are imports, and most of the largest domestic CE brands are made by computer or telecom companies. Ironically, one of the largest CE-only domestic brands is Microsoft. And they're not spending much on warranty any more.

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