May 7, 2015

Telecom Equipment Warranty Report:

Some of the four very different segments of the telecom equipment industry are better at reducing their warranty costs than others. But the biggest trend over the last decade has been the contraction of the U.S.-based part of the industry, and the rise of European and Asian competitors in their place, except for the Internet/data and broadcasting/cable TV segments.

Most of the business in the telecommunications industry comes from services, which usually do not come with a warranty. But all of the hardware bought by the carriers and network operators is sold under warranty, as is much of the networking gear bought by consumers.

The problem is, there are now so many types of networks and equipment that fit into the category. There's the telephone network, the Internet, the mobile phone networks, and all the radio and TV broadcasting networks. Then there are the government communications networks, and the security systems that protect those. And it's getting more complicated all the time (e.g. Wi-Fi and RFID).

For this week's analysis, we began with a list of 203 U.S.-based companies that manufacture telecommunications equipment of one sort or another. But that's the problem: it's really multiple separate markets that we're mixing together under the wide-reaching label of "telecommunications equipment."

And just as they have different uses, they also have different users. And those users seem to have very different expectations when it comes to warranty. Consumers are the most fussy and the most costly. Businesses are demanding but predictable. And governments are easy to please, and quite willing to pay for their guarantees. Therefore, it's not just what you make, but also who buys it that determines your warranty costs.

Four Telecom Sub-Groups

So we split the group into four parts: 1) those that make data communications equipment, local-area networks, and Internet gear (64 companies); 2) those that make more traditional telephone network equipment as well as wireless and mobile phone equipment (59 companies); 3) those that make equipment used by broadcast radio and television stations as well as cable TV networks (48 companies); and 4) satellite and microwave equipment (32 companies).

Some are selling to consumers through retailers, while others are selling directly to carriers or governments. There are those that sell their gear to carriers, who rent it to consumers (e.g. cable boxes and satellite dishes). And there are probably still a few little old ladies paying a monthly charge for their rotary dial wall phone in the kitchen.

Together the 203 companies paid out $1.056 billion in claims last year, down from $1.104 billion in 2013. But as can be seen in Figure 1 below, almost three-quarters of that total came from the Internet/data companies.

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

Figure 1

It wasn't always that way. Back in 2006, the traditional telecom equipment category accounted for two-thirds of the claims while the Internet companies comprised only a quarter of the total. As recently as 2010, the traditional telecom category was still bigger than the datacomm category.

What's happened since is the collapse of the traditional domestic U.S. telecom equipment industry, through a combination of bankruptcies (e.g. Nortel) and acquisitions (e.g. Motorola), combined with the domestic growth of Internet manufacturers and the international growth of mobile phone network equipment makers. Since we're not counting the European and Asian manufacturers here (and we counted Apple as a computer vendor in the April 16 newsletter), it looks like everything but datacomm has virtually disappeared in recent years.

The Internet and data communications companies have had their three busiest years in terms of paying claims from 2012 to 2014. They're led by Cisco Systems Inc., with smaller-but-growing contributions from Netgear Inc.; Juniper Networks Inc.; and Itron Inc., among others.

In the other three categories, the leading warranty providers include Ciena Corp. and Valmont Industries Inc. in the phone category; Arris Group Inc.; SPX Corp.; Broadcom Corp.; and Polycom Inc. in the TV category; and Garmin Ltd. and Harris Corp. in the satellite/microwave category.

Warranty Accruals

The pattern is similar with warranty accruals, as can be seen in Figure 2. The overall telecom sector as well as the telephone/mobile slice peaked in 2006 and fell again last year. The peak was $2.285 billion in 2006, of which about 65% was telephone/mobile, and the valley (so far) was the total in 2014 of $1.009 billion, of which 73% was Internet/data.

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

Figure 2

Again, it's not so much that these markets are declining as it is just the U.S.-based portion of them. A decade ago, American telecom equipment manufacturers dominated world sales. Now, not so much. Cisco is still a major exporter, but many of the other once-dominant brand names have disappeared or been acquired: Motorola, Lucent, Avaya, AT&T, Western Electric, Nortel, 3Com, Tellabs, and Scientific-Atlanta. By 2014, more than half of the 188 telecom manufacturers that we started tracking in 2003 were gone, and only 15 new companies have joined the list since 2003.

Actually, hidden away in these statistics is some good news about the broadcast and cable TV equipment companies. Theirs was the only one of the four categories to show an increase in accruals last year and was one of only two to see an increase in claims from 2013 to 2014 (the other being satellite/microwave). Now we're not trying to celebrate an increase in warranty expenses, but in a declining market anything that's not declining is worth mentioning.

Warranty Reserves

In terms of warranty reserves, the year-ending balance in the warranty reserve funds of the telecom equipment companies shrank again in 2014. In fact, all four segments saw a decline, with the Internet and phone/mobile categories each contracting by more than 10%.

As with the claims and accrual totals above, the big change in the 2011-2012 phone/mobile category came from the exit of Motorola, while the big change from 2008 to 2009 was the exit of Nortel. It's just easier to see in the chart below.

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

Figure 3

For all four categories together, reserves declined in 2014 to $1.057 billion -- slightly more than in 2012 but $112 million less than in 2013. So while it's not quite a record low, it's at the very low end of the generally downward trend seen in the last 12 years. And it's about half the $2.06 billion total seen in 2003.

Warranty Expense Rates

There's no doubt that warranty expenses are declining in the U.S.-based telecom equipment sector. But so are product sales, as customers turn to European and Asian manufacturers. Which is declining faster? As with the totals listed above, the story is different for each of the four sub-segments.

The data communications equipment makers were for years able to cut their warranty expense rates by making the process more efficient and making a better product. As can be seen in Figure 4, from 2003 to 2009 they were able to reduce their warranty expense rates from around 2.4% of product sales to under 1.4%. And they were able to keep them low for another two years, until 2011.

But then the progress stopped. From 2011 to 2014 the expense rates rose again, to a range of around 1.8% or 1.9%, before suddenly taking a dive at the very end of last year. The latest reading was a claims rate of 1.5% and an accrual rate of 1.4%.

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

Figure 4

The reason for the big drop at the end of 2014 seems to be nothing but a coincidence of good fortune. Cisco, which at the end of calendar 2014 was in the first quarter of a fiscal year that ends in July, managed to cut its accrual rate to 1.5%, from an all-time high of 2.6% in the same quarter the previous year. That achievement landed Cisco the one and only spot for a telecom equipment company in the Top 100 Warranty Provider list in the March 12 newsletter.

However, Juniper and Netgear also managed to cut their warranty expense rates significantly over the long term, with the latter trimming its accrual rate from astronomical levels -- as high as 8.5% in 2008 -- to merely 4.3% by the end of 2014. Juniper had both a claims and accrual rate over seven percent in 2004. In 2014, both expense rates were under one percent.

All of these long- and short-term cost-cutting efforts converged at the end of 2014. From the third to the fourth quarter, the average claims rate dropped by 0.26% while the average accrual rate dropped by 0.47%. And that drop, in turn, put both averages back to where they were when they hit bottom back in 2009-2011.

Warranty Expense Rate Reduction

The telephone/mobile segment also saw a big drop in warranty expense rates in the past few years, though we suspect it was largely caused by the exit of Nortel and Motorola from the calculations. Still, among those left behind, Ciena cut both its claims and accrual rates in 2014, as did Preformed Line Products Co.; Zhone Technologies Inc.; and Novatel Wireless Inc.

Figure 5
All U.S.-based Telephone/Mobile Companies
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 5

The curious thing about Figure 5 is the fact that the big drop in 2013 was followed by a bounce back in 2014. The only major carrier network equipment manufacturer to see a big increase in expense rates from 2013 to 2014 was Adtran Inc., but it wasn't really a big enough change to move the averages by much. For most of the others, expense rates fell in 2013 and remained low in 2014.

Long-Term Cost-Cutting

In Figure 6 we're taking the claims and accrual totals for the broadcast equipment companies from Figures 1 and 2 and dividing them by product sales. And because product sales were up for this sub-group in 2014, they actually made some of the expense rates rise more slowly.

For instance, the Arris Group saw its claims total jump from $28.3 million in 2013 to $40.5 million in 2014. But sales were up by 47%. So the company's claims rate barely changed. Infinera Corp. saw claims jump from $9.4 million to $10.9 million. But sales were up 23%. So its claims rate actually fell a bit, from 2.0% to 1.9%.

Figure 6
All U.S.-based Broadcast/Cable TV Companies
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 6

The reason for the 2014 bounce-back in this segment's expense rates is the contribution of companies such as Broadcom, which saw claims rise from $6.0 to $17 million, while sales grew only slightly. The result was a claims rate that more than doubled (though it's still a relatively low 0.2%).

And finally, we have the 32 satellite and microwave equipment makers included in Figure 7. Some of these companies, such as Comtech Telecommunications Corp., Iridium Communications Inc., Garmin, and Harris, were also included in the aerospace equipment industry profiled in the April 2 newsletter. But that's unavoidable, especially when some of their products use satellite and microwave networks to help airplanes and helicopters communicate.

More problematic is the way that some of these companies have product lines that cross over from one telecom segment to another. For instance, Comtech also makes broadband amplifiers and wireless equipment that cross over into the phone and wireless category. The Wireless Products Group at Harris makes communications security products such as the HailStorm and StingRay mobile phone tracking systems that would seem to fit into that same category.

Further complicating is the fact that many sales are made to government buyers, where the cost of the warranty is included in the contract and is funded by the customer. Therefore, any cut in warranty cost would become a reduction in revenue, and not necessarily an increase in net income.

In Figure 7 we can see that this group has not done much to cut their warranty expense rates over the past 12 years. Two of the larger warranty providers among them, in fact, saw their claims payments skyrocket for a brief period, then fall back to normal. It happened to Garmin in 2008-2009, then it happened to Harris in 2010. And, to a lesser extent, it also happened to Loral Space & Communications in 2011. All had their crisis, then returned to their baselines before anyone noticed.

Figure 7
All U.S.-based Satellite/Microwave Companies
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2014)

Figure 7

The sum total of these manufacturing excursions is what you see in Figure 7. In the calm years, warranty expense rates are in a range of 1.0% to 1.5%. But in the chaotic years, those rates can jump up to 2.5% or higher. Then, after the problem is corrected, the calm years return.

Product Sales Totals

We should also note that one of the unseen drivers of these expense rate changes is product sales. When sales rise and expenses remain the same, the expense rates drop. And when sales fall but expenses remain the same, the expense rates rise.

According to our calculations, the data equipment companies saw a slide decline in product sales in 2014. The phone/mobile companies saw a 3.4% decline. The broadcast equipment companies, however, saw an 11% increase in product sales. And the satellite/microwave companies saw a 1.3% increase.

Therefore, changes in sales were not much of a factor in the changes in expense rates seen in Figures 4 and 7. But the changes in sales added to the increase seen in Figure 5, and they reduced the increase seen in Figure 6. So in one case, they made the increase look worse, while in another they made it look better.

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