August 23, 2012

Large Vehicle Warranties:

Claims rates spiked during the recession, but returned to normal soon after. For some of the OEMs, however, rates continued to drop as warranty processes were improved. The result is some of the lowest expense rates ever in the first half of 2012.

Large vehicles seem to have proportionally smaller warranty expense rates than passenger cars. While cars tend to incur warranty claims and accrual rates close to 2.5%, trucks, buses, and other large vehicles tend to hover closer to 2.0%. Lately, they've brought those averages down even lower.

In the January 19 newsletter, we looked at on-highway truck OEMs and their suppliers. This week, we're broadening the focus to include more types of large vehicles, such as construction equipment, mining equipment, farm equipment, and recreational vehicles. And we're narrowing the focus to just the OEMs in each of these sectors.

There are some 35 U.S.-based OEMs in this group, making everything from fire engines to school buses. The leaders in terms of warranty claims paid per year are Caterpillar Inc., Deere & Co., Navistar International Corp., Textron Inc., and Paccar Inc. There are a total of 13 large vehicle OEMs within the list of the top 100 warranty providers, which we last detailed in the March 15 newsletter.

Industry Averages

In Figure 1 below, we've taken all 35 OEMs' warranty claims totals, warranty accrual totals, and product revenue totals, and calculated some percentages for their average claims rates and average accrual rates. Note that although the data extends into the second quarter of 2012, it doesn't include data from two of the mid-sized OEMs whose annual reports for fiscal years ended in June 2012 have not yet been published. Still, it's unlikely that their additional data would move the averages very much.

Figure 1
U.S.-based Large Vehicle OEMs
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2012)

Figure 1

From the look of the data, it appears that 2009 was a very bad year for warranty claims, while 2011 and 2012 are producing a series of record low claims rates. The 1.5% rate seen in the most recent quarter, in fact, was the lowest ever recorded for this group of 35 large vehicle manufacturers.

The 2009 spike, we suspect, is a product of falling sales rather than rising claims. And in a reverse sense, some of the progress seen recently has more to do with rising sales, though there is also some contribution from falling claims.

Changes in Sales Volume

The claims rate is highly sensitive to changes in sales volumes, because basically you're using this year's money to pay for repairs being made to products you sold last year. When sales are rising quickly, the claims rate plummets. And when sales fall quickly, as they did when the recession took hold in 2009, the claims rate spikes.

The metric that's more immune to changes in sales is the accrual rate, as shown by the green line in the figure above. Though it seems to rise and fall with the seasons, over the long term the accrual rate is trending downward. And it shouldn't do that unless there's been a meaningful change in product reliability and/or repair cost.

Every time a product is sold, the manufacturer sets aside a predetermined amount of money to cover the expected cost of its warranty. So if there's no sales, there are no accruals. And if sales soar, so do accruals. In other words, when there are less accruals per unit sold over time, the manufacturer is essentially announcing that their warranties are costing them less.

At least four out of the five companies that we're spotlighting in this week's newsletter show a 2009 spike in their warranty claims rate. But as suddenly as it spikes, it falls back to "normal," as sales recover.

Reducing Warranty Expenses

In several of these cases, however, the claims rate along with the accrual rate follow up the 2009 spike with a steady 2010-2012 decline that leaves them better off than they've ever been before. Take a look at Caterpillar, for instance, in Figure 2: the leader in the construction equipment sector of the large vehicle industry. The company just reported its sixth consecutive quarter with a claims rate below two percent, with its accrual rate falling below 1.5% in both early 2010 and early 2012.

Figure 2
Caterpillar Inc.
Warranty Claims & Accrual Rates, 2003-2012
(as a percentage of product revenue)

Figure 2

Caterpillar is on a multi-year warranty improvement "journey," and the results are quite apparent in the above chart. If we take two percent as the company's long-term average, it's clear that both its claims and accrual rates have been on a downward trend since the recession ended in 2009. And given that this is a company routinely spending $800 million to $1 billion a year on warranty work, any percentage decrease can involve a large amount of savings.

Seasonal Pattern

In Figure 3, we see the exception to the trend. Deere, the warranty leader in the farm equipment business, has always allowed its warranty expenses to follow the seasons. Rates go up in the cold months as sales fall and repairs rise. Then rates go down during the growing season, as sales rise and repairs fall. Note that in most years, Deere pays out the most claims in the final quarter of the calendar year, as shown by the blue columns. But then the claims rate peaks in the first quarter, as winter sales decline.

Figure 3
Deere & Co.
Warranty Claims & Accrual Rates, 2003-2012
(as a percentage of product revenue)

Figure 2

Deere breaks the trend because the long-term trend is uncertain. This year the company reported its lowest-ever claims and accrual rates, but last year its accrual rate spiked to nearly 3.5%. And as we've mentioned, accrual rates shouldn't do that unless something goes seriously wrong.

Deere also breaks the pattern in that there's no recession-related 2009 spike in rates. During those four quarters, in fact, Deere's claims and accrual rates remained closer to their long-term averages than they did in most other years. It's as if not even the business cycle could overcome the strength of the long-term seasonal pattern.

Paccar Setting the Pace

Paccar, however, fits the trend perfectly. In Figure 4, we see a company whose claims and accrual rates remain very close to two percent for six years, but then jump to unprecedented heights in 2009. And then they fall back again, with the accrual rate reverting to two percent but the claims rate falling even lower.

Figure 4
Paccar Inc.
Warranty Claims & Accrual Rates, 2003-2012
(as a percentage of product revenue)

Figure 2

We spotlighted Navistar in a newsletter only two months ago, so Paccar, as the owner of the Peterbilt, DAF and Kenworth brands, is the company we've chosen to represent the on-highway truck industry. The only disturbing thing about Paccar's data is the company's tendency -- seen three times since 2003 -- of dropping accruals to artificially low levels in quarters in which it sees claims fall to artificially low levels. The result looks a bit like missing teeth: notches in the data that interrupt an otherwise smooth trend.

Rise and Fall

Terex is a manufacturer of mining, road building and construction equipment, and through its Genie Industries subsidiary, of aerial work platforms and boom lifts. In Figure 5, the only curious feature of the data is the late 2009 spike in the claims rate to 7.3%, accompanied by a fall in the accrual rate to only 0.5%. It was, however, almost completely caused by a drop in sales during that fourth quarter of 2009.

Figure 5
Terex Corp.
Warranty Claims & Accrual Rates, 2003-2012
(as a percentage of product revenue)

Figure 2

Were it not for those curious anomalies, the Terex data would be in really good shape, with the 2003-2008 data not changing much at all, the 2009 data getting disfigured by the recession, and the 2010-2012 data taking the averages to new lows. The company's accrual rate went below one percent in 2012, and except for that curious quarter of 2009, it's never been lower. Meanwhile, its claims rate at 1.1% is now back to where it was in 2007.

Blending Two Trends

Finally, our representative of the recreational vehicle segment of the large vehicle business is Thor Industries. There's the familiar spike in claims in 2009, but the record since then has repeated much of the pre-recession pattern, which was highly seasonal. So Thor is a little like Paccar or Terex with the short-term spike, and a little like Deere with the seasonal pattern.

Figure 6
Thor Industries Inc.
Warranty Claims & Accrual Rates, 2003-2012
(as a percentage of product revenue)

Figure 2

As with Deere, the winter months see the highest claims rates, because who would buy an RV when it's too cold to sit inside? But that's an excellent time to send an RV in for some warranty work, precisely because it's so unlikely to be needed for camping.

The thing is that the spike in the winter of 2009 was higher than any other year's peak, either before or since. And as with Terex, it curiously coincided with an unusual drop in the accrual rate. Still, recessions do strange things to a company's finances, and just surviving this last one is a major accomplishment. In fact, several of the former RV market leaders didn't make it, and were liquidated.

So there they are: five representatives from five sectors of the large vehicle industry. Looking at the charts as a set, it's easy to see why the industry's long-term average seems to hover around two percent. And looking at the spikes of 2009, it's clear that falling sales had more to do with the rise in the percentages than anything warranty-related.

Permanent Expense Reduction?

The really good news is what has happened after 2009. For several of these companies, rates didn't just return to normal. They continued falling, partly because of sales gains but also because of warranty process improvements. And several makers of large vehicles and heavy equipment are now enjoying some of the lowest warranty expense rates in their history. Let's hope this trend is long-term.

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