September 4, 2014

Computer OEM & Supplier Warranties:

Are the computer OEMs paying a growing or shrinking percentage of the warranty costs of their industry? Are the warranty costs of their suppliers rising or falling as a result of their efforts to make them split the bill?

There are two ways for an original equipment manufacturer to reduce its warranty expenses. One is to cut the amount the OEM pays to its customers and the repair organizations that perform the warranty work. The other is to increase the size of the reimbursements coming in from the OEM's suppliers, for defects and failures found to be at least partially their fault.

Accounting regulations make all U.S.-based manufacturers disclose their net warranty expenses, which means the amounts going out the front door minus the reimbursements coming in the back door. Therefore, from a financial point of view, getting your supplier to pay a claim has the same effect as there not being a claim to begin with (though the latter is preferable from a customer relations point of view).

In the automotive business, as we found in the August 21 newsletter, the OEMs became very good at recovering an increasing share of warranty expenses from their suppliers from 2008 to 2012. But then, for various reasons, they recently let the ratio slip back a bit to where it was in 2007.

In the aerospace business, there never really was much of a gap between the OEMs and their suppliers in terms of warranty expense rates. As detailed in the August 28 newsletter, both groups pay about the same percentage of revenue in warranty costs. However, because the suppliers' revenue is larger, that means they end up paying more than 60% of the overall industry total. But in recent years, the OEMs' share of the total has been climbing.

Computer Industry Supplier Recovery

In the computer industry, we've found no evidence that the OEMs are getting any better at recovering more warranty expenses from their suppliers. In fact, they're recovering less. But that may have more to do with a shift in the product mix towards smartphones than it has to do with any change in relations between the OEMs and their suppliers.

As in the previous two special reports, we began this week with a list of all U.S.-based manufacturers that have reported warranty claims payments at some point between 2003 and the middle of 2014. And then we screened out all the companies that did not make computer products.

That left us with 367 companies, of which 25 were computer OEMs, and 342 were their suppliers. Among those suppliers, 44 made data storage systems and components; 64 made data communications equipment; 89 made computer peripherals such as monitors or printers; and 145 made semiconductors and/or printed circuit boards.

The leading computer OEMs still reporting their warranty expenses include Apple Inc.; Hewlett-Packard Co.; and IBM Corp. Those that have been acquired or gone private over the past decade include Dell Inc.; Sun Microsystems Inc.; Gateway Inc.; and Palm Inc.

The leading warranty providers in the data storage segment include Seagate Technology plc; Western Digital Corp.; and EMC Corp. The top three companies in the datacomm category are Cisco Systems Inc.; Netgear Inc.; and Extreme Networks Inc. Some of the top peripheral makers include Lexmark International Inc.; Harman International Industries Inc.; Planar Systems Inc.; and Microsoft Corp.

We gathered the warranty claims and accrual expense reports of these 367 companies for every quarter between the start of 2003 and the middle of 2014. And we gathered their corresponding product sales figures for the same period.

Paying the Warranty Claims

In Figure 1, we totaled the warranty claims payments of the 25 computer OEMs and 342 of their suppliers and set it equal to 100%. As the chart shows, in most quarters the OEMs accounted for between 60% and 75% of the total.

The long-term average shares are very close to 2-to-1 in size. The OEMs pay around 67% of the bills while their suppliers pay around 33%. However, in recent years, it's been closer to 3-to-1, as the OEMs' share has risen and the suppliers' share has fallen.

Figure 1
Computer Industry Product Warranties
Claims Paid by U.S.-based Companies
(as a percent of the total, 2003-2014)

Figure 1

In all of 2013, for instance, these companies paid out more than $10.1 billion to settle warranty claims. Of that total, $7.6 billion came from the OEMs and $2.5 billion came from the suppliers. So far in the first half of 2014, the OEMs have paid out $3.4 billion and the suppliers have paid out $1.2 billion.

Special Notes

We should note that because Dell went private in October 2013, and because Dell is the second-largest U.S.-based computer OEM (after HP), we had to make some changes to the warranty data. For the fourth quarter of 2013, and for the first and second quarters of 2014, we added in a figure of $250 million per quarter to account for Dell's warranty claims payments.

In other words, we don't know exactly how much Dell paid out in claims during the past nine months, because as a private company it no longer reports those figures. So we took the amount they paid out in the third calendar quarter of 2013, and added it to the OEM totals for the three quarters afterwards.

We should also note that by including all of Apple's warranty expenses, we aren't strictly counting computers. There are some iPhone warranty costs included in the OEM category as well. In fact, we suspect that's the primary reason why the OEM's share has continued to climb for the past few years.

Also, there is of course no data from the international computer OEMs nor from their suppliers. But we don't know how much of Sony's and Panasonic's warranty expenses (see July newsletter) comes from their computer product lines, and we have no data from Lenovo, Toshiba, Acer, Asus, or Samsung.

It would be conjecture on our part if we were to somehow try to manufacture warranty expenses for those missing brands, or to try and include a portion of Sony's and Panasonic's total s. Dell is the only theoretical component of the data in these charts, and that's done only because it was such a major part of the OEM data for the first 43 quarters of the timeline.

Also, some of the companies we're counting as suppliers also have thriving retail distribution channels and make direct-to-consumer sales as well. So they're sometimes like OEMs themselves, facing the customer and paying relatively higher warranty costs as a result.

But then again, in the automotive industry some of the truck suppliers also face the end user customers directly, as is the case in the aerospace industry with components such as avionics and jet engines. So in none of these industries is it strictly true that the suppliers always face the OEMs and the OEMs alone face the end user customers when it comes to paying warranty expenses.

Making the Warranty Accruals

In Figure 2, we're looking at the same companies in the same categories as in Figure 1, but instead of claims payments we're looking at the amounts they set aside as warranty accruals. Once again, we've added in theoretical data for Dell during the past three quarters, so that it doesn't seem as if the OEMs' share has suddenly fallen.

The biggest difference between Figures 1 and 2 is that notch you see in the 2007 data below. That's caused by Microsoft, which set aside $974 million in accruals at the end of its fiscal year in June 2007, in advance of the repair costs it expected from the Xbox 360 product line.

Figure 2
Computer Industry Product Warranties
Accruals Made by U.S.-based Companies
(as a percent of the total, 2003-2014)

Figure 2

Without that notch in the data, accruals would also stay close to the 2-to-1 long-term ratio seen with claims. However, in recent years the OEMs' share has drifted above 75%. In fact, during the first quarters of 2013 and 2014, as well as during the fourth quarter of 2013, the OEMs' share of all the accruals briefly climbed above 80%.

Again, we suspect it's a function of the iPhone, and the tremendous amount of money Apple is setting aside in warranty accruals. In calendar 2013, Apple set aside $5.75 billion in warranty accruals, more than Ford and General Motors combined.

Thanks to the cost of recent recalls that's no longer true in the first half of 2014, but Apple is still setting aside more than twice as much as HP and almost seven times as much as Cisco. In fact, Apple alone now accounts for 44% of the accruals of the entire U.S.-based computer industry.

If we reclassify smartphones as small computers, we're all set. But even then, Microsoft is not yet reporting any warranty expenses for the product line it acquired from Nokia, and neither Google nor Samsung are reporting either. So there are problems with that approach as well.

Warranty Expenses vs. Product Revenue

Next we took the claims and accrual totals from Figures 1 and 2 and divided them by product revenue to calculate claims and accrual rates. For instance, if the OEMs in a given quarter paid out $2 billion in claims on $78 billion in sales revenue, their claims rate would be a little over 2.5%. If they reported $1.5 billion in claims on $54 billion in sales their claims rate would be 2.7%.

In Figure 3, we have plotted two pair of lines over 46 quarters -- one pair for the 25 OEMs and one pair for the 342 suppliers. Claims rates are in red and orange, and accrual rates are in dark and light green.

Figure 3
U.S.-based Computer Manufacturers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 3

Notice that in every quarter, there is a gap between the expense rates of the OEMs and their suppliers. In this respect, it resembles the automotive industry, where the customer-facing OEMs seem to pay the most as well as to pay the highest rate.

However, there are some important differences. In Figures 1 and 2, we've seen a relative shift of expenses towards the OEMs over time, while in the automotive industry there was a shift towards the suppliers for multiple years, and a recent reversal of that trend. And in Figure 3, while the gap between the two pairs of lines is shrinking, it's doing so because both pairs are falling at different rates, not because one group is shifting expenses to the other.

Measuring the Gap

Back in 2003, the computer OEMs saw warranty expense rates as high as four percent. Their suppliers were around 1.4% to 1.5% most of that year, so the gap between them was around 2.0% to 2.5%.

In the recessionary year of 2009, the OEMs were at three percent. By 2012 they were briefly under two percent. Their suppliers were generally around 1.1% to 1.3%, so the gap between them was generally around 1.6%.

In the most recent quarter, the OEMs saw a claims rate of 2.7% and an accrual rate of 2.4%. Their suppliers had a claims rate of 1.2% and an accrual rate of 1.1%. So, depending on the metric, the gap was either 1.3% or 1.5%.

In order to make it easier to follow, in Figure 4 we've charted just the gap between the two pairs of lines. And once again, we can see the effect of Microsoft's massive accrual spike in 2007. But we can also see the way the gap has fallen from 2.0% to 2.5% in 2003 to 1.5% to 2.0% in 2009, and then briefly below one percent in 2012.

Figure 4
U.S.-based Computer Manufacturers
Gap Between OEM & Supplier Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 4

The gap is widening once again in recent quarters. In fact, in 2013 the gap in accrual rates grew to a difference it hasn't seen since 2006. Once again, we're going to blame Apple and the iPhone. Anything that's both complex and handheld is going to have relatively higher warranty expense rates than a larger and more stationary desktop computer.

What we're not seeing in any of this data is evidence of a meaningful shift of warranty expenses from the computer OEMs to their suppliers. If anything, it's the opposite. But then again, many of the iPhone's suppliers aren't included here. So there's no supplier increases to offset the Apple increases that we are measuring.

Supplier Recovery Efforts

The conclusion we draw, however, is that while there is ample evidence of a shift of expenses from OEM to supplier in the automotive industry, there's no evidence of that happening in the aerospace or computer industries. And while in all three industries the OEMs' shares have recently increased, they're doing so for different reasons.

  • In the automotive industry it's a combination of increased recall expenses and a loosening of the grip the OEMs have had on their suppliers since 2008.

  • In the aerospace industry, the OEMs are also having trouble with recalls. But their biggest problem is they never learned how to cut their warranty costs like companies such as United Technologies Corp. did.

  • And in the computer industry, the OEMs are spending more because one OEM is selling more smartphones than ever before. And many of their smartphone component suppliers fall outside the list of U.S.-based companies that we're tracking here. So the increase is confined to the OEM side only.

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