April 23, 2015

Computer Supplier Warranty Report:

Data storage system manufacturers have been steadily reducing their warranty costs for more than a decade. But the cost reductions seem to have slowed down in recent years. Meanwhile, for peripheral manufacturers, warranty expense rates are now almost back to normal, following years of elevated costs.

Suppliers within the computer industry are in a unique spot. Dell, Hewlett-Packard and the others that make the actual computers are among their best customers. But they also typically sell their disk drives, monitors, keyboards and other components to consumers through retailers.

In warranty terms, this is significant, because even in the automotive industry we find that those who sell parts to end user customers have much higher expense rates than those who sell just to the OEMs. But in the computer industry, it's a blending of consumer-facing vendors and OEM-facing suppliers, so one would expect there to be much less of a difference between their respective expense rates.

We began this analysis with a list of 25 computer OEMs, 44 makers of data storage systems, and 89 computer peripheral manufacturers. But then we split it in half, focusing on the computer OEMs in last week's newsletter and holding the data storage and peripherals analysis until this week.

The Xbox Effect

What we've found is that while the data storage manufacturers are among the best warranty cost-cutters, the peripheral makers as a group are not. But that observation may be tainted by our inclusion of Microsoft Corp. as a peripheral maker, particularly during the years the company was selling the problem-plagued Xbox 360 gaming console. The manufacturing defects in that product cost the company well over a $1.5 billion dollars to fix.

You can see the Xbox effect in Figure 1, which tracks claims paid by the data storage and peripherals makers from 2003 to 2014. There is a very clear bulge in the peripheral category during the years 2007 to 2009, in which the Xbox repair bills added more than half-a-billion dollars to the claims total during each of those three consecutive years.

Figure 1
Worldwide Warranty Claims
of U.S.-based Computer Suppliers
(claims paid in US$ millions, 2003-2014)

Figure 1

By 2010, things were almost back to normal, and by 2014, the peripheral category's claims total was contracting noticeably. That was caused by a combination of factors. First, after the end of the Xbox crisis, Microsoft stopped reporting its warranty expenses. Second, big peripheral makers such as Lexmark International reduced their warranty claims payments partly by making a more reliable product, and partly by selling fewer units than they did a decade ago.

Then again, there are others who have maintained their warranty expense levels throughout the dozen years we've been measuring them. Harman International Industries has always paid out $50 or $60 million per year in warranty claims. NCR Corp. and Xerox Corp. have always been around $30 or $40 million.

Some have even grown to join the ranks of the top 100 U.S.-based warranty providers. For instance, a decade ago, Diebold Inc., a manufacturer of ATM machines, voting machines, safes, vaults, and other self-service and security machinery, had product sales of $1.1 billion and was paying about $17 million in claims per year. Now, its product sales have grown to $1.4 billion and it's paying $50 million or more in claims per year.

Of course, that also means that warranty expenses are now a more important consideration for the company, because they're consuming a higher percentage of product sales revenue than before. Back in 2003 or 2004, warranty claims payments equaled 1.5% or 2.0% of product sales. Now they consume 4% to 5% of sales.

Meanwhile, on the data storage side, things have been comparatively quiet. EMC Corp., Seagate and Western Digital continue to be the largest warranty providers in the category, and their warranty expenses haven't changed all that much. NetApp Inc. and SanDisk Corp. are the new guys, while Maxtor Corp. and Storage Technology Corp. are the old guys, acquired years ago by Seagate and Sun Microsystems (later Oracle), respectively.

While the peripherals companies are paying out a lot less in claims than they did years ago, the data storage companies are just a little below the all-time record they set for claims payments in 2013 ($785 million). But as we shall see in a later chart, revenue has been growing even faster, so claims payments as a percentage of revenue has declined over time.

The top companies, however, have not all followed the same script. EMC has seen claims rise, from $159 million in 2012 to $229 million in 2014. But both Seagate and Western Digital have seen claims fall over the same period. Seagate is down from $310 million in 2012 to $209 million in 2014. Western Digital is down from $223 million in 2012 to $194 million in 2014.

The new guys, meanwhile, have also followed different paths. SanDisk was paying out roughly $25 to $35 million per year from 2009 to 2013. But its claims total fell to $20 million in 2014, and it dropped out of the top 100 warranty providers. NetApp, meanwhile, paid out $78 million in 2013 and $70 million in 2014 -- almost three times as much as it paid out per year from 2008 to 2010.

Warranty Accruals

The 12-year track record for warranty accruals is much the same. Notice in Figure 2 that the accruals for computer peripherals soar in 2007 but are back to normal by 2009. That's because Microsoft set aside a huge pot of money in the middle of 2007 for the Xbox, and then gradually spent it over the next two years. So the spike in accruals is sudden while the bulge in claims is multi-year.

Notice also that the multi-year plateau in warranty accruals is also present in 2012-2014 for the data storage companies. However, the 2014 drop-off is a little more noticeable, with 2013 at $701 million and 2014 at $592 million. Then again, the annual accrual total has been remarkably stable, with almost every year between 2004 and 2014 coming in between $550 and $700 million.

Figure 2
Worldwide Warranty Accruals
of U.S.-based Computer Suppliers
(accruals made in US$ millions, 2003-2014)

Figure 2

For individual companies, the same trends are in effect for accruals as well. Lexmark set aside $200 million or more in accruals from 2003 to 2008, and set aside less than $100 million in every year since. Seagate's accruals have dropped from $246 million in 2009 to $161 million in 2014. But EMC is at about the same level as it was in 2009, and Western Digital is about the same as it was in 2010.

The big difference is in timing. As we saw with Microsoft, companies tend to set aside the money when the problem is discovered, and then they spend it gradually as the claims come in. And so, for the data storage companies, their peak accrual years are all over the place, depending upon when they discovered they had a problem. Seagate's accruals peaked in 2008. EMC peaked in 2013. NetApp peaked in 2012. SanDisk peaked in 2013. Western Digital's accruals are actually at their highest point now.

Warranty Reserves

The Xbox effect also left its mark in the warranty reserves chart, seen below in Figure 3. In fiscal 2007, Microsoft's warranty reserve balance soared from $10 million to $850 million, and grew a bit more to $861 million by the end of calendar 2007, which helped drive up the total for the peripherals category to a record-setting level of $1.6 billion that year. But all that extra money was spent by 2010, and the peripherals' reserve balance returned to normal levels once the crisis passed.

And again with the data storage companies, they seem to have chosen a range of $900 million to $1 billion and stuck with it over most of the past dozen years. They actually went a little above $1 billion in 2012, but were more than $120 million below that level in 2014.

Among the individual companies, Seagate and EMC are now far below their peak levels of warranty reserves, but Western Digital and SanDisk experienced their highest-ever warranty reserve balances right at the end of 2014. Meanwhile, NetApp is down below $100 million once again after spending 2012 and 2013 above that level.

Figure 3
Worldwide Warranty Reserves
of U.S.-based Computer Suppliers
(reserves held in US$ millions, 2003-2014)

Figure 3

Mathematically, if you take the beginning balance in the warranty reserve funds, add in the new accruals, and subtract the claims payments, you should have the closing balance. But there are a few additional adjustments that companies frequently make: for acquisitions, foreign exchange fluctuations, and to make up for past expense estimates that were either too high or too low.

In 2014, Seagate, Western Digital and SanDisk made minor adjustments for acquisitions. Harman International Industries made frequent adjustments for international sales of its audio equipment. And then Seagate, Western Digital, and Lexmark made numerous changes of estimate, mostly to cover for past shortfalls.

In fiscal year ended June 27, 2014, Western Digital added $28 million to its warranty reserves to correct for past under-accruals. And it made significant additional adjustments in the next two fiscal quarters as well. Seagate added only $1 million to its reserves in its fiscal year ended June 27, but then it added $15 million in the quarter ended January 2, 2015 (which we've mapped to the fourth calendar quarter of 2014). And Lexmark added $2.8 million in additional accruals in 2014.

Warranty Expense Rates

To calculate the warranty expense rates in Figures 4 and 5, we took the claims and accrual totals of the 25 computer OEMs, the 44 makers of data storage systems, and the 89 manufacturers of computer peripherals, and added them all together. Then we took the corresponding product sales totals for these 158 companies over the past 48 quarters, and divided the expense totals by the sales total to create a pair of percentages for each group.

Product sales revenue was up by about 3.4% for the data storage companies, but was down by about 0.3% for the peripheral makers. This has an enormous effect on the claims rate, because if expenses rise and sales fall, or if expenses rise faster than sales, it will artificially boost the percentages, making it look like the product line is becoming less reliable.

Xerox, NetApp, NCR, and Western Digital were among the companies to see sales declines at the end of calendar 2014.

At the other extreme, rapidly rising sales can artificially depress the claims rate, because there's always a lag time between when a product is sold and when it needs repairs. Among our top storage and peripheral warranty providers, some of the fastest-growing companies were Zebra Technologies Corp., Harman International, Diebold, and Daktronics Inc.

Lexmark saw a slight gain in sales, but its claims payments dropped too. The result was a claims rate that fell under nine percent for the first time since 2010. And while 2010 was a comparatively good year, way back in 2008 Lexmark's claims rate almost hit 15%. That was a bad year.

The problem is that almost 80% of the company's revenue comes from non-warranted sources such as printer ink and other consumables. So the actual printer hardware it sells accounts for only about 21% of total revenue, which makes those small claims payments look much larger. Fortunately, though, its claims payments get smaller every year.

In Figure 4, we're comparing the computer OEMs to the data storage companies. The two pair of lines seem to run in parallel, with around 1.2% to 1.4% of distance between them. It's not exactly equivalent to the relationship between the automotive OEMs and their suppliers, but it's close enough. It helps to prove the theory that it's the consumer-facing OEMs that end up paying the greatest share of a given industry's warranty expenses, in both absolute dollar terms and in relative percent-of-sales terms.

Figure 4
All U.S.-based Computer & Data Storage Companies
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 4

Notice however that the gap between the corresponding pairs seems to be diverging in the last few years. That's no optical illusion. The data storage expense rates seem to have stopped declining, and the OEM expense rates are beginning to rise. But the distance between the pairs of red and orange claims rate lines have dropped below one percent. And the distance between the dark and light green pair of accrual lines has widened beyond 1.5%. Basically, what the chart is telling us is that the OEMs expect their expense rates to continue rising while the data storage companies expect their expense rates to resume falling.

In Figure 5, we've taken the same computer OEM data and compared it against the expense rates of the computer peripheral companies. Once again, the Xbox effect can be seen. In fact, the years 2007 to 2009 represent the only time that the pairs of lines ever cross.

Figure 4
All U.S.-based Computer & Peripheral Companies
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 5

Once again, as with the data storage companies, the warranty expense rates peripheral manufacturers have stopped declining in the past few years. The average has settled just above one percent, although a seasonal pattern can be seen (tied to the school- and holiday-driven interplay between warranty expenses and sales rates).

Ten of the data storage and peripheral companies are among the 100 largest U.S.-based warranty providers. But only four of them saw large enough changes to either their claims or accrual rates to land them a spot on one of the top 10 lists detailed in the March 12 newsletter. And all four were on a "good" list, meaning their expense rates fell noticeably.

Seagate saw its claims rate fall from 1.7% to 1.2%, while Diebold saw its claims rate fall from 4.7% to 3.6%. NetApp reduced its accrual rate from 1.5% to 0.9%, while EMC saw its accrual rate fall from 1.4% to 1.1%. These changes may not sound like much, but they were among the biggest changes seen across the top 100 warranty providers.

Others that just missed out on the "most improved" lists included Western Digital and Harman International on the claims rate side, and Seagate and Lexmark on the accrual rate side. All of these companies are improving their warranty management, cutting their warranty expense rates, and reducing the cost of warranty for their employers. And that, in turn, is the reason that the averages are now down around one percent for both the data storage and the peripheral manufacturers.

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