April 3, 2014

Aerospace Warranty Report:

The makers of the actual planes and helicopters haven't done much to reduce their warranty expenses but their suppliers have done a remarkable job with their cost-cutting efforts. In this week's report, we look at both groups together and separately.

Now that the 2013 product warranty expense data has all been collected from the annual reports, it's time to make some sense out of the trends, one industry at a time. In aerospace, it's been a very different decade for the OEMs who make the actual planes and helicopters, and their suppliers, who make everything from the jet engines to the in-flight entertainment systems. While the OEMs haven't made much progress in terms of warranty cost-cutting, their suppliers are enjoying the results of more than a decade of incremental progress.

We began with a list of 96 U.S.-based companies that have a significant manufacturing presence in the aerospace industry. Nine are primarily OEMs, such as Boeing Co., Textron Inc., General Dynamics Corp., and Raytheon Co., and 87 are suppliers to those OEMs, such as United Technologies Corp., Honeywell International Inc., L-3 Communications Corp., and Rockwell Collins Inc.

Some, we should note, would otherwise be listed in another industry sector, such as United Technologies in the HVAC category or Garmin Ltd. in the consumer electronics category. But they're here this week because a good portion of their manufacturing revenue and warranty expenses are generated from the aerospace industry. And we wanted this week's list to reflect all the companies in the aerospace industry -- not just those who are exclusively in this one industry.

Wider List of Companies

Because of the use of this wider definition of what it means to be an aerospace company, however, the totals and averages for this somewhat larger group are going to be different than what was seen in the totals and averages from last week's newsletter. In that tally, for instance, claims payments within the aerospace industry were seen rising from $1.126 billion in 2012 to $1.323 billion in 2013. In the chart below, however, the totals for the OEMs and suppliers together are $400 million higher. It's the inclusion of United Technologies and about 35 other part-time aerospace companies that accounts for the change.

In Figure 1 we see the total claims payments for the OEMs and suppliers together being up in 2012-2013, after being down in 2011-2012. Claims payments by the OEMs were up 26% last year, thanks to the continued increases of Boeing and others, while their suppliers were up only 3%.

In fact, while the OEMs have been up year-over-year for most of the past decade, the suppliers are up and down from one year to the next. And that's a very important difference. It's not just that expenses are up because sales are up. One group has actively cut its costs while the other group hasn't done much at all.

Figure 1
Warranty in the Aerospace Sector
Claims Paid by U.S.-based Companies
(in US$ millions, 2003-2013)

Figure 1

That combination, of the uneven record of the OEMs and the consistent cost-cutting of their suppliers, drove the overall industry claims total to its second-highest level last year: slightly above 2009's level but not quite yet past the 2008 peak. However, the two groups are pulling in opposite directions. While the suppliers are actually now at a low point, the OEMs are at a new record high.

Also, while the split between them in 2008-2009 was around 70/30, it's now closing in on 50/50. The OEMs used to pay less than a third of the entire industry's total claims. Now they pay almost half.

In other words, the suppliers are cutting their claims costs while the OEMs aren't. We shall see that trend again, in terms of warranty expenses as a percentage of sales, in a few more charts. But first, we'll look at the warranty accrual and warranty reserve totals.

Accruals Keep Rising for OEMs

The split in warranty accruals, as can be seen in Figure 2, has actually been in the OEM's favor for the past two years. But again, that's a change in the pattern seen earlier in the decade. From 2004 until 2010, the ratio was vaguely three-to-one in favor of the suppliers. But then in 2011 it dropped to only two-to-one, and in 2012 and 2013 it flipped over, with more than half in the OEM column. Again, the trend has been for the OEMs to increase their expense or at least to remain the same, while their suppliers have been cutting and improving.

Figure 2
Warranty in the Aerospace Sector
Accruals Made by U.S.-based Companies
(in US$ millions, 2003-2013)

Figure 2

There was a slight change in trend last year, however. Warranty accruals made by the OEMs did actually drop, ever so slightly, from $1.048 billion to $1.035 billion, while the accruals made by the suppliers were also down a bit. And that led to a slight one-percent drop in the overall accrual total, down from the record $1.985 billion they set aside to fund their warranty expenses in calendar 2012.

However, after accruals made by the OEMs nearly doubled from 2011 to 2012, this latest decline, even if it's small, is still most welcome. As we outlined almost a year ago in our last Aerospace Warranty Report, that sudden jump in accruals was mainly a function of the Boeing 787 Dreamliner being grounded in early 2013, although Textron and General Dynamics also increased their accrual totals that year.

This year, Textron and General Dynamics were both up again, but Boeing cut its warranty accruals by $83 million in 2013. The net effect or all these increases and decreases was a $13 million decline in OEM accruals, which is the first decline they've seen since 2009-2010. It's a small change, but we think it represents a decline from the peak. So in that regard, it's a small step in the right direction.

For the aerospace suppliers, meanwhile, 2013 saw the least amount of warranty accruals ever. Their total came in $3 million below 2012's total, and was even $15 million below 2003's total. However, here the pattern seemed to be big cuts in accruals by a handful of big companies such as United Technologies and L-3 Communications, and small increases by most of the others. So perhaps not everyone is so successful at cutting warranty costs?

Warranty Reserves at the Peak?

In Figure 3, we've tracked the ending balance in the warranty reserve funds of these 96 companies from 2003 until 2013. Note that the balance is not always a mathematical addition and subtraction of the claims and accruals, because there are additional adjustments made for changes in foreign currency exchange rates, acquisitions, divestitures, and other events. But it's usually pretty close. More or less, the end-of-year warranty reserve balance is the beginning-of-year balance plus the year's accruals, minus the claims payments.

Here too there is a closing of the gap between the OEMs and their suppliers. From 2003 until 2011, the OEMs held about 40% of the total while the remainder belonged to their suppliers. So for instance, in 2008 the OEMs had a balance of $1.6 billion and the suppliers were at $2.4 billion. That means the OEMs held 40% of the $4 billion total while their suppliers held the remaining 60%.

But then in 2012, the ratio got awfully close to 50/50, thanks to a big jump in the OEMs' reserves. And it remained close to a 50/50 split in 2013, because neither group's balance changed by much.

Figure 3
Warranty in the Aerospace Sector
Reserves Held by U.S.-based Companies
(in US$ millions, 2003-2013)

Figure 3

The overall total was down marginally in 2013, with the OEMs down a bit and their suppliers up a bit from 2012 levels. But once again, with this warranty metric, it looks like 2012 was the peak. That's usually a good thing as long as product sales are growing while warranty expenses are not.

And indeed, that seems to be the case here. Warranted product sales by these companies were up around 6.6% in 2013, with slightly stronger sales growth among the OEMs than among the suppliers. But some companies did even better than that. General Dynamics saw commercial aerospace sales climb 20%. FMC Technologies saw sales rise 16%. B/E Aerospace was up 15%. And United Technologies Corp. saw product sales rise 11%.

In terms of warranty reserves, however, across the aerospace industry the overall trend is a bit unclear. For every OEM with big declines in reserves, such as Boeing, there are OEMs with big increases, such as General Dynamics. Within the suppliers, the reserve balance of government communications company Harris Corp. is up significantly while the balance of the instrumentation company Ametek Inc. is down significantly. And as can be seen in Figure 3, there hasn't been much change in the totals since 2012.

Expenses Compared to Product Sales

The thing is, the numerical totals in Figures 1 through 3 are more meaningful when compared to sales data. With a company such as General Dynamics, for instance, it's one thing to report big jumps in warranty claims and accruals. It's another to note that those jumps were accompanied by a big increase in sales of Gulfstream business jets.

So yes, claims were up and accruals were up. But so were sales. So the company's warranty expense rates as a percentage of sales were about the same in 2013 as they were in 2011 and 2012, and they're also significantly below where they were back in 2003 and 2004. That's when the company was having quality problems. Now, it's just selling more and spending more.

In Figures 4 and 5, we've taken the data from Figures 1 and 2 and divided it by the corresponding warranted product sales figures for all of the companies involved. Figure 4 shows the resulting percentages for the nine OEMs, while Figure 5 shows the calculations for the 87 suppliers.

The chart in Figure 4 is not so impressive, with accrual rates hitting a new high in late 2012 and almost returning there in 2013, and claims rates hitting heights not seen in more than nine years. But there aren't that many large aerospace OEMs, and the problems of any one of them can drive up the averages significantly. Back in 2003-2004, it was Gulfstream. In 2012-2013, it's Boeing.

Figure 4
U.S.-based Aerospace OEMs
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2013)

Figure 4

The thing to note is the shape of the curve over the past decade. It's high in 2003 and 2004, drops to an all-time low in 2005, and then gradually rises for the next eight years. Except for the data from 2003 and 2004, that's more or less the same pattern seen in Figures 1 and 2. In other words, complacency and inattention to warranty have crept into the aerospace OEM sector over the past few years. It's only one percent of revenue -- so what if it goes to 1.3%? It's still only a minor worry.

Textbook Warranty Cost Reduction

If that sounds harsh, compare and contrast it to the record of the 87 suppliers in Figure 5. The chart below illustrates textbook warranty cost reduction. The companies start out in 2003 averaging around 1.1% to 1.5% of revenue spent on warranty, but by 2009 they're under one percent and by 2013 they're under 0.7%.

Figure 5
U.S.-based Aerospace Parts Suppliers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2013)

Figure 5

Now, go back to Figures 1 and 2, and you can see why claims and accrual totals have kept shrinking. The companies are paying less and putting less aside because they're making better products with lower repair costs. Sales are up but expenses are down. And so, the expense rate is down.

Top Warranty Cost-Cutters

Therefore, aerospace suppliers such as United Technologies, FMC Technologies and Rockwell Collins are among the top warranty cost-cutters of 2013, as we detailed in the March 20 newsletter. And the category in which we count their warranty expenses is at a record low, while the OEMs they supply are threatening to set a new record high.

Unlike in the automotive industry, which we shall get to in the next few weeks, the aerospace industry is one in which the suppliers have gotten far ahead of their customers in terms of boosting product quality and reducing product warranty expenses.

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