October 4, 2012

Homebuilding Warranty Metrics:

The builders of single-family homes were always good at shifting warranty expenses to their suppliers and subcontractors. And though their warranty expenses are down considerably, that has more to do with slow sales than with anything else.

In some industries, the suppliers do end up paying more than the OEMs.

In the homebuilding industry, if we twist the meaning of the term OEM to refer to the builders of single-family homes, the suppliers of building materials and heating/cooling systems pay the vast majority of the warranty claims.

This is very much unlike the situation in the automotive and computer industries, where the OEMs pay the most and their suppliers pay a small fraction of the claims. It's also unlike conditions in the aerospace industry, where OEMs and their suppliers more or less split the warranty costs between them.

In the homebuilding industry, however, the big difference is that both the OEMs and many of the suppliers are customer-facing. For instance, while a new home builder may purchase and install an array of major appliances and heating/cooling systems, the warranties are issued by those manufacturers. Even with roofing and window warranties, the builder will always try to push the warranty work back onto a subcontractor or a supplier. So their net warranty costs are little more than administration expenses.

This results in a situation where the actual builder ends up with relatively light net warranty costs. In addition, many of the suppliers and manufacturers are also selling upgrades and replacements through retailers and home improvement contractors, meaning that any subsequent warranty work will most definitely not go through the original builders.

OEM/Supplier Warranty Trends

In the past three newsletters, we've examined the OEM/supplier relationship in three industries. In the September 13 newsletter, we looked at automotive. In the September 27 newsletter, we looked at computers. And in the September 20 newsletter, we looked at aerospace. This week, we will follow the same template for the homebuilders.

In Figure 1, we've taken the totals for claims paid per quarter for three groups of companies: 57 current and former homebuilders; 72 current and former manufacturers of home appliances and heating, ventilation, and air conditioning systems; and 109 manufacturers of building materials such as fixtures, furniture, cabinets, carpet, paint, carpets and tiles.

It's obvious that the bulk of the claims are paid by the HVAC and appliance companies. As we shall see later, their share has remained close to 50% for the past decade.

Second, at least for now, are the building material suppliers. However, they used to be the third-largest group until the recession began to hit the homebuilders hard in 2007.

Figure 1
U.S. Homebuilding Industry
Warranty Claims Paid, 2003-2012

Figure 1

Readers should note that while no companies appear on more than one of these three lists, some of these companies are "borrowed" from other industries. For instance, we normally assign NACCO Industries Inc. to the automotive category because of its forklift manufacturing, but this week they're here because of their appliances. United Technologies Corp. is a major aerospace company, but it's also a leading HVAC supplier.

We've included them and others here in order to widen the scope as far as possible. However, that also means that this and the other half-year 2012 reports may not line up precisely with the totals and averages expressed in the annual warranty reports.

Claims Fall in 2012

In Figure 1, claims for the homebuilders and their suppliers topped $1.6 billion for the first half of 2012. However, that was actually down 7% from the same period in 2011.

The HVAC and appliance manufacturers saw their claims payments fall by 10% during the first half of 2012. The homebuilders paid out 8% less. But the building material companies actually paid out 4% more than they did in the same period during 2011.

Note also that while the overall industry and the homebuilders saw their claims payments peak in late 2006, the HVAC and appliance makers didn't peak until 2007, and the building material companies didn't see their highest quarterly claims payment total until 2010. That suggests that even after the number of brand new homes began to decline, there was still an aftermarket for replacements, improvements and upgrades of existing homes, which declined more slowly.

By the way, in this instance we're talking about product warranty claims for new homes, new appliances, new windows, etc. These are not home warranties, which are sold primarily to the sellers of existing homes in order to give peace of mind to the buyers. These are the product warranties issued to the first owner, like the buyer of a new car or a new laptop.

There's a home warranty business that's likely to be worth more than $1.6 billion in 2012. And there's also a thriving business selling extended warranties for major appliances at retail that's likely to be worth more than $1.1 billion this year. No, these are the product warranties issued by the builders and manufacturers to their customers when a new product is sold.

Declining Accruals

The counterpart of warranty claims are warranty accruals. When a new product is sold, the manufacturer decides how much to set aside to finance future claims. This is the accrual, and it's likely to be much more closely tied to sales, or lack thereof.

In Figure 2, the quarterly accrual totals peaked in 2006, though the homebuilders actually saw their biggest quarter in 2005. This, we believe, is partly due to sales and partly due to worries about mold and Chinese drywall claims to come. The HVAC, appliance and building material suppliers, meanwhile, didn't start reducing their accruals until 2007.

Figure 2
U.S. Homebuilding Industry
Warranty Accruals Made, 2003-2012

Figure 2

In the first half of 2012, the entire industry was still cutting its accruals. The total for the first two quarters was $1.56 billion, a bit less than claims and 8% less than the accrual total in the first half of 2011.

The big reason for that overall decline is the 16% decrease in accruals made paid by the HVAC and appliance companies during the first half of this year. That was more than enough to offset the 17% increase in accruals made by the homebuilders and the 8% gain for the building material companies.

Signs of a Recovery?

That's right, the homebuilders are once again increasing their accruals. After laying flat at the bottom for almost four years, the accrual totals are once again rising for the homebuilders.

Is it an early sign of a recovery? Or is it yet another sign that the builders continue to scrape along the bottom?

It's not just accruals, though. Sales revenue is also rising. Of course, not all homebuilders are publicly traded and not all of the publicly trades homebuilders report their warranty expenses. But within the group we track, sales are up almost 19% so far this year, so it's no wonder accruals are rising.

The news is less thrilling for the other two groups. The HVAC and appliance manufacturers as well as the building material companies are seeing sales down slightly so far this year. However, the latter group still found reasons to increase its accruals, while the former group cut its accruals radically.

Our third warranty metric is the balance left in the warranty reserve fund. Basically, it's accruals made minus claims paid, with additional adjustments for acquisitions, foreign exchange, and other factors. In Figure 3, the twin peaks for the industry as a whole came at the end of 2006 and 2007, though the reserve balances peaked for the suppliers years later.

Figure 3
U.S. Homebuilding Industry
Warranty Reserves Held, 2003-2012

Figure 3

More worrisome is the drop-off in warranty reserve balances that can be seen in 2012. The homebuilders are now at their lowest level ever -- $677 million as of June 30. The HVAC and appliance manufacturers are back to 2004 levels. And the building material companies are down nearly $275 million from their peak. Taken together, their combined warranty reserve balances are down below $5.3 billion for the first time since early 2004.

Warranty Costs vs. Sales Revenue

If there's any good news in the reports, it has to do with declining claims rates. We all know that sales took a tumble in recent years. But warranty costs as a percentage of sales have also fallen.

In Figure 4, we've taken the claims data from Figure 1 and compared it to sales data for the three groups. And as the chart below shows, the homebuilders are now back down to 2007 levels, while the HVAC and appliance companies are back down to 2006 levels. Even the building material companies are down below 0.6% -- something they achieved only once before the recession hit.

So in a way, their claims rates are returning to "normal," even if sales haven't. They're learning to spend less on warranty per dollar of revenue, despite the reduction in revenue.

Figure 4
U.S. Homebuilding Industry
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2012)

Figure 4

But notice also that the charts for at least two of the three groups show a heavy seasonal pattern. Admittedly, this has more to do with the building and sales cycles for homes and heating/cooling systems than it does with when claims are paid. However, the accrual rate data (not pictured) also shows the same seasonal pattern (not good) and actually hits its minimum during the worst days of the recession (also not good).

Managing Accruals?

If the builders were better at planning, their accrual rates would be flatter. If sales are good, they'd set one percent aside to pay claims. If sales are bad, they'd still set aside one percent. In previous reports, we've noted how their accrual rates seem more attuned to the bottom line than to actual expense rate predictions. In other words, sometimes they put a lot aside, and sometimes a little. But it doesn't always correlate with the quality of their product.

In our automotive report on September 13, we noted how the OEMs have been trying to shift more warranty expense back onto their suppliers. We saw that in two ways: how the OEMs have cut their warranty expenses to record low levels while the suppliers are struggling to get back to pre-recession levels, and how the suppliers' overall share of the expenses has risen from 10% to as much as 16%.

We don't see that here. In the building trades, it's the homebuilders who are struggling to get back to where they were before the recession hit, in terms of their average claims rate. And as can be seen in Figure 5, the relative share of the suppliers has not changed all that much over the years.

In Figure 5, we took the quarterly claims totals from Figure 1 and set them to equal 100%. The makers of building materials have always paid about 25% of the industry's total claims. Their ratio has gone up and down a bit over the years, but it's remained relatively close to that 25% mark.

Figure 5
U.S. Homebuilding Industry
Warranty Claims Paid, 2003-2012
(Builders' & Suppliers' Share of the Total)

Figure 5

However, there has been a bit of a shift of expenses from the builders to the HVAC and appliance makers. The latter group had accounted for about half the claims until 2007. But then their share grew towards 65% in recent years. However, that's because the homebuilders' claims cost fell due to declining sales, not because they shifted their costs to others.

It's much the same story with accruals. The makers of building materials have consistently accounted for roughly a quarter of the industry's accruals. The homebuilders also used to account for a similar share, but it began declining in 2007 to the current 10% range, while the HVAC and appliance makers grew from 50% to 65%.

Accruals Per Home Sold

That decline, however, wasn't in the amount the builders actually accrued per new home sold. From 2003 to 2007, they accrued an average of $2,682 per home sold. From 2008 until the middle of 2012, they accrued an average of $2,548 per home sold. That's a decline of only 5% per unit -- far less than the improvements seen by the automotive OEMs.

If anything, that's additional evidence of a shift away from new construction towards the home improvement and replacement market. All those people who didn't buy new homes instead bought new kitchen appliances and new heating/cooling systems.

So in a way, there has been a kind of shift under way. It's just not based around the OEMs getting more aggressive about reimbursements from their suppliers. They've always been quite successful shifting the cost of warranty work onto their suppliers and subcontractors. But fewer home sales means fewer expenses to shift.

Back in their heyday, the top ten homebuilders were selling 15,000 to 25,000 homes per month. Beginning in 2008, that rate fell under 10,000 homes per month. Now, it's under 6,500 per month, thought that's actually up a bit from a year ago.

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