March 29, 2012

Aerospace Warranties:

The makers of Boeings, Cessnas and Gulfstreams haven't made much improvement in the past five years. But their suppliers continue to boost revenue, cut costs, and reduce warranty expenses as a percentage of sales. And that divergence got worse as 2011 ended.

Usually, it's the OEMs that first find ways to cut warranty costs. Then they pass on the knowledge to their suppliers. But with aerospace warranty providers, it's the suppliers who have cut costs and squeezed inefficiency out of their warranty processes, while the OEMs they supply haven't seen much improvement during the past five years.

With the help of five charts, we hope to tell the story of warranty expense in the U.S.-based aerospace industry since 2003. We've been tracking 56 current and former warranty providers whose product lines fit primarily into the aerospace industry, plus another 31 companies that are at least partially engaged as an aerospace OEM or supplier.

We track each company on a quarterly basis, but this week and in the weeks ahead we'll present that data in an annual format, for the nine years from 2003 to 2011. Next week we'll tackle the automotive industry, followed by computers and other electronics-filled industries later in April.

OEM & Supplier Split

There was some aerospace-specific claims data included in Figure 8 of the March 22 newsletter, which took a high-level look across all warranty-providing industries. Rather than repeat that here, we are going to divide the aerospace industry further, into OEMs and suppliers. So it's the same data, but this week it's segmented into those two groups.

The reason we're doing that is because warranty can be very different when your customer is an OEM rather than an end user. Unlike in the passenger car and personal computer industries, where OEMs pay the lion's share of the warranty expenses, in the aerospace industry things are more evenly split. The primary reason, we believe, is the structure of each industry's warranties.

In the passenger car and personal computer industries, the OEMs issue one comprehensive warranty, on which they pay claims and then do their best to recover some amount from their suppliers. But in the aerospace industry, the buyer deals with separately-issued warranties for the fuselage, interior, engines, avionics, and other systems. So the cost is more evenly distributed.

In Figure 1, for instance, we can see that the total for claims paid is fairly evenly split between the aerospace OEMs and the suppliers over most of the last nine years. The OEMs paid slightly more than half the total in 2003 and 2004. The suppliers paid a bit more than half from 2005 to 2007. And the OEMs have paid more than half ever since. But neither side has ever paid more than 54% or less than 46% of the total.

Figure 1
Warranty in the Aerospace Sector
Claims Paid by U.S.-based Companies
(in US$ millions, 2003-2011)

Figure 1

As can be seen in Figure 1, the aerospace industry does not seem to have suffered much of a downturn in 2008 or 2009, at least in terms of claims paid. For other warranty metrics, such as the accruals tracked in Figure 2, there is a bit of a dip in the accrual data for those two years.

But for both claims and accruals, 2011 set a new record. OEMs and their suppliers together paid $1.09 billion in claims, $60 million more than was paid during the previous top year of 2008. Aerospace companies accrued $1.08 billion in 2011, $15 million more than they did in either 2006 or 2007.

Of course, paying more claims or making more accruals is hardly a good thing. But as measures of an economic recovery after a recession, it's good to see an annual increase. And if that increase in claims is surpassed by an even larger increase in sales, then that's a really good outcome.

We should note, however, that most of the military and defense-related aerospace industry is excluded from this report. Major defense contractors such as Lockheed Martin Corp. do not accrue for warranties like their civilian peers. Instead, the cost of any warranties is passed on directly to their customers in the military. Therefore, there is no warranty data included in their annual reports, and they are not included in these industry totals.

We should also note that the data that is covered this week includes the worldwide spend by just the U.S.-based aerospace companies. It does not include any warranty spending by international aerospace companies such as Airbus S.A.S., Bombardier Inc., or Embraer S.A., or by their non-U.S.-based suppliers.

This week's report also doesn't include companies such as General Electric Co. that are only partially aerospace companies. Those companies will be covered in future newsletters under the heading of the industry that accounts for the bulk of their warranty expenses (i.e. power generation for GE).

Lag Time for Claims

Claims rise and fall on their own schedule, independently of sales. In the aerospace industry, some of the warranties can stretch to 10 years or more, so there can be a significant lag time between when a product was sold and when it comes back for warranty work. That may in part explain why the annual totals for claims paid have been so flat in this sector for the past six years.

Accruals, meanwhile, should always rise and fall at more or less the same rate as sales, unless there's been a change in product quality, average repair cost, or some other metric. So when sales go up by 10% or 11%, as they did in 2011, so should accruals.

In Figure 2, we can see that accruals also set a new record in 2011, with aerospace OEMs and their suppliers together setting aside $1.08 billion. That was a 16% gain overall from 2010 levels, but the increase was more than twice as large for the OEMs.

Figure 2
Warranty in the Aerospace Sector
Accruals Made by U.S.-based Companies
(in US$ millions, 2003-2011)

Figure 2

The reason for the big annual jump in OEM accruals can be traced to its largest constituent. Boeing Co. increased its accruals from $141 million in 2010 to $232 million in 2011. And most of that increase came in the fourth quarter of 2011, when the company effectively tripled its accrual amount, compared to the fourth quarter of 2010.

However, both Textron Inc. and General Dynamics Corp. also increased their accruals to unusually high levels in the fourth quarter of 2011. The result was a 32% annual increase for them and the other OEMs, from $421 million in 2010 to $557 million in 2011.

Predicting Increased Claims?

The increase in accruals for the aerospace suppliers was a much more modest 2.7%, from $508 million to $521 million. And, we note, those suppliers accrued far more per year during the period from 2005 to 2008. So either the OEMs see a major warranty cost item coming their way that their suppliers do not yet see, or some other factor is at work.

There's no clear answer to be found in the warranty reserve fund balances. Last year, the industry total dropped by $25 million from the end of 2010, and was also $14 million below the 2007 total. But most of the drop was on the OEM side, as can be seen from the totals listed in Figure 3. OEMs saw their reserve balance drop by $20 million, while their suppliers saw only a $5 million decrease.

Figure 3
Warranty in the Aerospace Sector
Reserves Held by U.S.-based Companies
(in US$ millions, 2003-2011)

Figure 3

Compared to both claims and accruals, however, warranty reserve levels have been relatively stable in the aerospace industry for the last five years. There was a big jump in 2006-2007, but since then the annual changes have remained below 4%, up or down. For instance, the decrease in 2011 was just under 1%. The increase in 2010 was just over 3%.

Also, notice that while claims and accruals are evenly split by the OEMs and their suppliers, this is not the case with warranty reserves. As can be seen in Figure 3, the OEMs have generally held about 60% of the overall total, while their suppliers have held the remaining 40%.

Compared to Sales Increases

Those are the raw dollar totals for claims, accruals, and reserves in the aerospace industry. Now, let's combine those metrics with some sales data, to show how warranty providers can both increase the amount and reduce their rate of spending.

Aerospace OEMs saw their product revenue climb by 9.7% in 2011. Their suppliers saw a slightly more robust 11.3% increase in product sales. The reason this is important is because the claims and accrual rates are calculated by dividing each of those warranty metrics by product sales. So when sales rise, the rates change even if the warranty metrics don't.

In Figures 1 & 2, we saw a rise in both claims and accrual amounts for both the OEMs and their suppliers. But the increases weren't uniform. Claims rose by 4.9% for the OEMs and by 12.7% for their suppliers. Accruals jumped by 32% for the OEMs, but rose by only 2.7% for their suppliers.

Some of these increases were above the rise in sales. Others were below. Therefore, the claims and accrual rates went in opposite directions.

In Figure 4, we charted the claims and accrual rates for just the OEMs, for the 36 quarters of the years 2003 to 2011. Note that during the last four years, the OEMs' claims rate has been a bit above their accrual rate. This in part explains the $20 million decrease in reserves seen in 2010-2011: money was going out faster than it was coming in. But then at the very end of 2011, the rates came together.

Figure 4
U.S.-based Aerospace OEMs
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2011)

Figure 4

The long-term trend is not so positive. After trending down for five or six years, claims and accrual rates for the aerospace OEMs have been rising for the last three or four years. The good news, however, is that the claims rate at the end of 2011 was back down to its year-end 2009 level.

Accrual rates, however, continue to rise. And as we mentioned before, accrual rates should remain about the same in the absence of a change in product quality or repair cost.

At the end of 2011, the OEM's accrual rate had risen to just over 0.9%. That's not high, especially when compared to the rates typically seen for OEMs in the auto, computer and appliance industries. But for aerospace OEMs, it's the highest accrual rate seen since late 2006.

Suppliers Keep Reducing Costs

For aerospace suppliers, there's quite a bit more good news in their claims and accrual rate trends, as shown in Figure 5. Both rates dipped below 0.7% at the end of 2011. And though they've been lower -- even within the four quarters of last year -- they've never been much lower than they are now. And clearly, rates have been much lower in 2008-2011 than they were in 2003-2006.

Figure 5
U.S.-based Aerospace Parts Suppliers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2011)

Figure 5

In other words, aerospace suppliers continue to reduce their accruals, as measured both in dollars and as a percentage of sales. And that trend is now at least nine years old. Meanwhile, their claims payments recently rose a little faster than sales, so their claims rate rose a little bit from year-end 2010 levels. But those rates were low, both before and after the increase.

For aerospace OEMs, however, things have been better. Claims and accruals as measured in dollars both set new records in 2011. And accruals grew a lot faster than sales, especially in the most recent quarter.

The trend can be seen most clearly in the red and green lines. In Figure 5, we see slow but steadily dropping rates for nine years. But in Figure 4, we see that 2011 was more or less a return to how things were in 2007.

Ninth Annual Product Warranty Reports

As we continue with our annual survey of U.S.-based warranty providers, here are the links to the online editions of all the other parts of this series:

Readers needing more detailed snapshots of individual companies in either a PowerPoint or Excel format are invited to view the list of charts and spreadsheets available on the Warranty Statistics page.

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