November 1, 2012

Most Improved Warranty Metrics, Part 3:

While the short-term changes in warranty expense rates have a lot to do with the recession, the comparisons with 2003 and 2006 data have also identified numerous warranty cost-cutters.

Year after year, many American manufacturers have reduced the percentage of sales revenue they spend on warranty, as product reliability rises and both the cost and frequency of repairs declines.

It's a trend that gets lost in the rhetoric, but is plain to see in the industry data: American manufacturers are spending a smaller share of their revenue than ever before on warranty. In the quarter ended in June 2012, their warranty costs averaged only about 1.3% of sales, down from roughly 1.5% to 1.6% in 2006 and about 1.8% in 2003.

As can be seen in the chart below, the cost of paying claims, as a percentage of sales, soared during the recession. But that had more to do with falling sales than with rising claims. The proof is in the fact that accrual rates, which are largely unaffected by sales fluctuations, continued to fall throughout the 2008-2010 period.

Figure 1
All U.S.-based Manufacturers
Average Warranty Claims & Accrual Rates
January 2003 to June 2012
(as a % of revenue)

Figure 1

In the October 11 newsletter, we tracked the one-year changes in the claims and accrual rates of major American manufacturers. In the October 25 newsletter, we expanded that to include a look at three-year trends, comparing June 2009 data to June 2012.

Long-Term Data

Now, we're going even further back, comparing both June 2006 and June 2003 data to the same June 2012 data. The idea is to see if the short-term improvements in warranty expenses seen in those comparisons are fleeting, or if they're part of a long-term trend.

The methodology is the same. We started by collecting the latest warranty expense data from each company's latest financial statements. We also collected product sales data, and calculated the percentage of revenue spent on warranty costs by dividing one into the other.

We can't compare one company to another. There are just too many differences between companies and between industries as to what is and isn't considered to be a true warranty cost. But we can compare one company against itself, by taking those latest rates and comparing them to a point in the past.

What we're showing are the largest warranty expense rate improvements among a group of 225 U.S.-based manufacturers that paid $4 million or more in claims during calendar 2011. In other words, we're comparing the comparisons, and ranking the most improved in the bunch. And this year, we're doing it for the six-year period from the middle of 2006 to 2012, and for the nine-year period from the middle of 2003 to 2012.

Let's start with the six-year claims rate improvements. In the chart below, we're listing the name of the company, its claims rate in mid-2006, its claims rate in mid-2012, and the net change. Since all the data is computer-rounded, some of the math may appear to be a little off. For instance, Waters Corp. went from 2.0% to 0.64%, which should round off to be a 1.4% change. But the 2006 figure was actually 1.981%, and the 2012 figure is 0.635%, so the difference actually is 1.346%, which rounds off to 1.3%.

Cutting Expenses by Half or More

The amazing thing is that 20 companies cut their claims rate by more than half over the past six years. They had to cut their claims rate by two-thirds or better to get onto a top 10 list. In Figure 2, the top claims rate reduction was reported by Cymer Inc., which reduced its claims rate from 4.0% in 2006 to under 0.8% in 2012. That's more than a 4/5th reduction.

Figure 2
U.S.-based Warranty Providers:
Top Ten Claims Rate Reductions,
June 2012 vs. June 2006
(claims as a % of revenue)

   Claims   Claims  Claims
  Rate Rate Rate
  Company  June 2006   June 2012   Reduction 
  Cymer Inc. 4.0% 0.77% -3.2%
  Nvidia Corp. 1.5% 0.33% -1.2%
  Woodward Inc. 0.56% 0.17% -0.39%
  Waters Corp. 2.0% 0.64% -1.3%
  Raytheon Co. 0.81% 0.27% -0.54%
  Harris Corp. 1.4% 0.48% -1.0%
  Newport Corp. 1.6% 0.56% -1.1%
  Juniper Networks 2.5% 1.0% -1.6%
  Medtronic Inc. 0.43% 0.17% -0.26%
  Valspar Corp. 0.69% 0.27% -0.42%

    Source: Warranty Week from SEC data

We won't get too deep into the reasons for these rate reductions, but basically they boil down to either that 1) things were bad back then, 2) things are great right now, 3) it's a little of both, or 4) none of the above.

Nvidia, for instance, definitely falls into the first group, reducing its claims rate from 5.8% back then to only 0.33% now. For a printed circuit board manufacturer in the computer industry, 0.33% is normal and 5.8% is a clear sign of manufacturing problems.

For an automotive supplier such as Valspar Corp., however, an 0.69% claims rate is more or less normal for its industry and 0.27% is really, really good. Same story for Medtronic Inc. in the pacemaker industry. They're both having really good years, in terms of claims costs.

A Question of Timing

For most companies, it's a little of both. But then there are all the companies that fall into the fourth category. Perhaps because of the unfortunate timing of a past claims payment or the fortunate arrival of a reimbursement from a supplier, the claims rate was artificially too high or too low for reasons that had nothing to do with repair costs. One company laid off some warranty clerks, and then congratulated itself when claims fell. But then it found out why: the claims processing was all backed up because of the labor shortage.

However, that's why we're looking at one-, three-, six-, and nine-year trends. They can't always be lucky (or unlucky). A company can disconnect its phones and cut its claims rate to zero, but not for long. They can cut their warranties to 90 days or 90 minutes. In the long run, that's going to hurt more than it helps.

The bigger danger in relying on the claims rate, however, is two-fold. First, there is a lag time between when the product revenue is earned and when the repair cost is incurred. So we might be comparing one year's sales to another year's repair cost. Also, in a time of generally rising sales volumes, such as 2012, that lag time artificially depresses the recent percentages and makes the improvement look better.

Those factors are not present with accrual data. In every case, we compare current accruals to current sales, with no lag time. And since accruals are set aside as each unit is sold, the percentage rates should stay the same as sales and accruals rise and fall together.

If there is a massive decrease in accrual rates, it could mean one of four things: 1) product quality was really bad back then, 2) product quality is really good now, 3) a little of both, or 4) none of the above.

Wrong Estimates

In this case, the none of the above contingent is a little larger, because accrual rates are even more susceptible to artificial manipulation. A company's chief financial officer is free to make the absurd claim that every product made in a given quarter is perfect, and therefore accruals are not necessary. If time proves that boast to be incorrect. it can be fixed with a change of estimate. But it's an estimate, and an estimate can only be proven wrong over time.

In Figure 3, there are no 0% accrual rates, but Lear Corp. set aside only $200,000 in claims to cover $7.3 billion in sales during the first half of 2012. That's only a 0.003% accrual rate, and that's going to look good no matter what year it's compared with.

Turns out, it's by far the biggest improvement in accrual rates, whether you're looking at one-, three-, six-, or nine-year trends. But it's not because Lear has suddenly begun making nearly flawless products. It's more of an accounting anomaly that won't be repeated.

Figure 3
U.S.-based Warranty Providers:
Top Ten Accrual Rate Reductions,
June 2012 vs. June 2006
(claims as a % of revenue)

   Accrual   Accrual  Accrual
  Rate Rate Rate
  Company  June 2006   June 2012   Reduction 
  Lear Corp. 0.10% 0.003% -0.096%
  Nvidia Corp. 1.7% 0.18% -1.5%
  MTS Systems 2.3% 0.33% -2.0%
  Harris Corp. 2.2% 0.42% -1.8%
  FLIR Systems 2.0% 0.38% -1.6%
  Franklin Electric 3.4% 0.67% -2.8%
  Raytheon Co. 1.3% 0.27% -1.1%
  Broadcom Corp. 0.25% 0.05% -0.20%
  Waters Corp. 2.1% 0.47% -1.7%
  SunPower Corp. 2.5% 0.65% -1.8%

    Source: Warranty Week from SEC data

Still, there is a small group of companies that are appearing again and again on our top 10 lists. Four companies are on the lists of both Figure 2 and Figure 3: Nvidia Corp.; Waters Corp.; Raytheon Co.; and Harris Corp. Two of those companies are also in the Figure 5 list.

A total of only 23 companies are represented in the four lists in this week's newsletter. There are 15 companies that made two or more lists this week. Two more made one list this week and one more in either the October 11 or October 25 newsletters. And then six more companies made only one appearance this week.

Most Frequently Improved

Meanwhile, there are only 40 companies on any of the eight top 10 lists spread across three newsletters, and half of those make only one appearance. In other words, only 20 companies account for 60 of the 80 top 10 slots.

It's not quite a new 80-20 rule, but it's close. Here are the 20 companies that make two or more appearances on this entire collection of top 10 lists. As of the middle of 2012, by virtue of their repeat appearances, they are the most improved warranty providers of all: Axcelis Technologies Inc.; Boston Scientific Corp.; Broadcom Corp.; Cymer Inc.; Harris Corp.; Hologic Inc.; Juniper Networks Inc.; Lear Corp.; LSI Corp.; MTS Systems Corp.; Newport Corp.; Nvidia Corp.; Raytheon Co.; Rofin-Sinar Technologies Inc.; SanDisk Corp.; St. Jude Medical Inc.; SunPower Corp.; Valspar Corp.; Waters Corp.; and Woodward Inc.

With two warranty metrics and four time periods, the most times a company could be on a top 10 list would be eight. None achieved that, but Harris and Lear each made five out of the eight lists.

What's amazing is the number of companies that reduced their claims and/or accrual rates, but not by enough to make a top 10 list. As mentioned, we started with a list of 225 large and medium-sized warranty providers. An incredible 78 companies reduced both their claims and accrual rates from 2003 to 2012 and from 2006 to 2012. Of those, 32 also reduced both their claims and accrual rates from 2009 to 2012 and from 2011 to 2012.

Since 2003, a total of 43 companies have reduced their claims rate by half or more. The same number of companies reduced their accrual rates by half or more since 2003. But only 31 did both at the same time. And three companies -- Rofin-Sinar Technologies Inc.; Hologic Inc.; and Axcelis Technologies Inc. -- achieved both 50% reductions and made both top 10 lists. In other words, they are the most improved since 2003.

In Figure 4, the top 10 long-term claims reduction champions are listed. Rofin-Sinar leads the list, thanks to its massive claims rate reduction, from 3.9% in 2003 to under 0.47% in 2012. But that has more to do with the high rates in 2003 than with the most recent rates. The same goes for Hologic, and most obviously, Axcelis. They were having a really bad year in 2003 and returned to normal in 2012.

Figure 4
U.S.-based Warranty Providers:
Top Ten Claims Rate Reductions,
June 2012 vs. June 2003
(claims as a % of revenue)

   Claims   Claims  Claims
  Rate Rate Rate
  Company  June 2003   June 2012   Reduction 
  Rofin-Sinar 3.9% 0.47% -3.4%
  Cymer Inc. 6.3% 0.77% -5.5%
  Hologic Inc. 3.0% 0.44% -2.6%
  Axcelis 12% 1.9% -10%
  JDS Uniphase 2.7% 0.47% -2.2%
  Valspar Corp. 1.4% 0.27% -1.2%
  Juniper Networks 5.0% 1.0% -4.0%
  Newport Corp. 2.9% 0.56% -2.3%
  Trinity Industries 0.89% 0.18% -0.71%
  Woodward Inc. 0.81% 0.17% -0.64%

    Source: Warranty Week from SEC data

Our final chart in this series compared accrual rates in 2003 and 2012. To make this long-term list, a company had to reduce its accrual rate by three-quarters or better. And unfortunately, that leaves out 23 companies that reduced their accrual rates by a mere one-half to three-quarters.

The Top Long-Term Cost-Cutters

We love lists and don't want to slight anyone, so here are the 23 companies, in addition to the top ten in the Figure 5 list, which cut their accrual rates by half or more since 2003: Atmel Corp.; Carlisle Cos. Inc.; Cavco Industries Inc.; Cohu Inc.; Dell Inc.; EMC Corp.; FEI Co.; Franklin Electric Co. Inc.; KB Home; KLA-Tencor Corp.; L-3 Communications Corp.; Modine Manufacturing Co.; Newport Corp.; OSI Systems Inc.; Rockwell Collins Inc.; Ryland Group Inc.; Select Comfort Corp.; St. Jude Medical Inc.; Thermo Fisher Scientific Inc.; United Technologies Corp.; Valspar Corp.; Westinghouse Air Brake Technologies Corp.; and Woodward Inc.

Figure 5
U.S.-based Warranty Providers:
Top Ten Accrual Rate Reductions,
June 2012 vs. June 2003
(claims as a % of revenue)

   Accrual   Accrual  Accrual
  Rate Rate Rate
  Company  June 2003   June 2012   Reduction 
  Lear Corp. 0.08% 0.003% -0.07%
  Rofin-Sinar 3.8% 0.38% -3.4%
  Tellabs Inc. 3.3% 0.42% -2.9%
  Axcelis 12% 1.7% -10%
  Broadcom Corp. 0.35% 0.05% -0.29%
  Waters Corp. 2.8% 0.47% -2.3%
  Hologic Inc. 2.7% 0.48% -2.2%
  Harris Corp. 2.2% 0.42% -1.8%
  MTS Systems 1.7% 0.33% -1.4%
  SanDisk Corp. 1.5% 0.38% -1.1%

    Source: Warranty Week from SEC data

Again, what we're doing here is comparing each company to itself over time, and then ranking the comparisons from the biggest reduction on down. And some of these companies are successfully cutting costs on a consistent basis.

Out of the 33 companies that reduced their accrual rates by half or more since 2003, 24 were also down by half or more since 2006. Of those 24, only nine were also down by half or more since 2009. And of those nine, only Lear and Broadcom were down by half or more since a year ago.

Top Warranty Cost-Cutters

We've already mentioned how freakishly small Lear's accruals have been in 2012. However, there doesn't seem to be anything freakish about Broadcom's cost-cutting. The company accrued $2 million in the first half of 2012 -- slightly less than it did in 2003. But in the intervening nine years, product sales have grown more than five-fold, with no proportional increase in warranty expenses. And that's the sign of a true cost-cutting champion.

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