October 22, 2015

Warranty Reserves & Foreign Exchange:

The rising value of the U.S. dollar is impacting revenue, profits, and even warranty expenses. For U.S. companies, it's hurting exports. And for international companies in the U.S., it's helping to reduce the cost of imports and to increase the value of warranty reserves.

It's a popular refrain being heard frequently as U.S.-based exporters announce their third quarter financial results: The relative strength of the U.S. dollar is hurting both their top lines and their bottom lines.

What we wanted to see is if it's also impacting warranty expenses. Manufacturers are supposed to disclose any adjustments they make to their warranty reserve balances, including those that account for changes in foreign exchange rates. We wanted to see in which direction those changes are trending.

The first thing we did was see how frequently warranty providers report foreign exchange adjustments to their warranty reserve funds. Many large companies don't do so, because they instead adjust the value of the individual claims they pay at the time those claims are paid. In other words, the warranty reserves are held centrally in a single currency, and the adjustments are made to the cost of the individual claims as needed.

But some companies do report foreign exchange adjustments in their warranty reserve fund balances, because they keep a local reserve in each country in which they do business, and pay claims out of that fund in the currency of the country. Then, when it's time to report their financials, the remaining balance is converted into the company's native currency, and the resulting fluctuations are recorded.

We looked at six quarters of data, from the first quarter of 2014 to the second quarter of 2015, involving some 520 U.S.-based companies and around 60 international companies. So that's roughly 3,500 quarterly reports, though once you subtract all the companies that report their warranty expenses only once a year rather than quarterly, you're left with more like 2,800 reports.

Of those 2,800 reports, we found 472 reports where a foreign exchange adjustment impacted the warranty reserve balance. So that's roughly one in six. Of those 472 instances, 128 adjustments increased the balance while 344 reduced the balance. So that's roughly one in four up and roughly three out of four down. In other words, in the last year and a half, foreign exchange fluctuations have tended to reduce warranty reserves more frequently than they were increased.

Multiple Currency Pairs

We're dealing with at least nine native currencies: the U.S. dollar, the euro, the Japanese yen, the Swedish krona, the Swiss franc, the Brazilian real, the Korean won, the Chinese yuan, and the Indian rupee. In the last 18 months, the overriding trend has seen the U.S. dollar increase in value and both the euro and yen to decrease in value. The picture for the others is mixed, depending upon which currency pair you're comparing.

In the charts below, we're tracking the dollar-euro exchange rate (as determined by Fiat in its annual reports) and the dollar-yen exchange rate (as reported by Toyota in its annual reports). The reason we use these companies' exchange rates rather than the published market rates is so that when we convert their revenue and warranty expenses from one currency to another, our figures are the same as theirs. Different companies can use different rates from different days, or averages of multiple days. But this way, by letting Fiat and Toyota do all the work, we adopt the same methodology of two of the largest manufacturers that we track, and we can blame them if the results don't flatter everybody.

Figure 1
One Euro in U.S. Dollars

The dollar-euro rate peaked in 2007 at $1.46 to the euro, while it was lowest in 2002 at $1.05 to the euro. As of the end of June 2015, it stood at $1.11 per euro, which is the lowest it's been since 2002.

Helping Europe, Hurting U.S.

This trend would work against American companies that keep their warranty reserves in Europe, denominated in euro. Although it wouldn't affect the cost of individual claims, at the end of each quarter the remaining reserves would be worth fewer dollars, and a negative adjustment would need to be made.

For European companies that have a significant business in the U.S., this trend would work in their favor. Assuming they make their accruals for U.S. product sales in dollars and keep their U.S. reserves in dollars, at the end of each financial period they would convert the remaining reserves from dollars into euro. And while a year ago each $1.33 converted into a euro, now it takes only $1.11 to get a euro. So that results in an upward adjustment to their reserve balance.

Figure 2
One Japanese Yen in U.S. Dollars

It's much the same story in the dollar-yen exchange rate. The value of the yen has been depreciating since 2012, so that hurts U.S. companies paying claims in Japan and helps Japanese companies paying claims in dollars.

Normally, the exchange rate is expressed as yen per dollar. So on that basis, the peak came in 2012, when the dollar was worth 82 yen, and the trough was once again 2002, when the dollar was worth 133 yen. As of June 2015 it was worth 122 yen.

We're also working with other currencies, however, such as Swedish krona for Atlas Copco, Electrolux, Ericsson, Sandvik, and Volvo; Indian rupees for Tata Motors; Canadian dollars for Bombardier; and even some Chinese yuan and Korean won. That could get a little messy.

So for all companies, we're going to list the size of their warranty reserves and foreign exchange adjustments in plain numerical quantities without any currency symbols, followed by a percentage. In the tables below we will separate them into two groups: Figures 3 and 5 are for manufacturers that use dollars as their native currency, and Figures 4 and 6 are for those that use another native currency. And we will do separate tables for the increases and the decreases. But we won't specify the currency.

Multiple Appearances

There's also a possibility of multiple adjustments per company making a top 20. In fact, it happened with five different U.S.-based companies, each of which saw large increases in one period and large decreases in another: Clean Diesel Technologies Inc.; Fuel Systems Solutions Inc.; Harman International Industries Inc.; ResMed Inc.; and Wabco Holdings Inc.

On the two international charts, Honda, Kubota, and Tata Motors make two appearances. Tata is included on both Figures 4 and 6, while Honda and Kubota make two appearances on Figure 4. Usually, Japanese companies report their warranty expenses only once a year, and they make those reports for fiscal years that end on March 31. So they could make different lists for both fiscal 2014 and fiscal 2015, which would have ended in the first quarters of calendar 2014 and 2015.

Meanwhile, most European and American companies follow the calendar, with fiscal years ending on December 31. So it's doubtful they filed two different annual reports within the six quarters under consideration. However, some American companies end their fiscal years on October 31. Others choose June 30 or September 30. So when we designate a report in the following tables as either 2014 or 2015, that refers to the company's fiscal year, whenever it might have ended.

Also, most American warranty providers publish their warranty expense data four times per year. Some publish data for three quarters of three months each, followed by an annual report for 12 months. Others publish data for rolling periods of three, six, nine, and then 12 months.

In the tables below, the data is labeled by the year or quarter in which it was reported. A tag of 2Q14 means the report is for the three months of the second calendar quarter of fiscal 2014. A tag of 6mo14 means the first half of that company's fiscal year 2014.

Each report contains two numbers and a percentage. As was mentioned, the numbers are amounts of money, in either millions or billions of units, depending upon the specific currency involved. The first is the beginning balance in the warranty reserve fund during the period. The second is the size of the foreign exchange adjustment. And then the percentage represents the relative size of the adjustment, as a percentage of the balance.

Dollar Currency Gains

Looking first at the American companies, we have listed the 20 largest foreign exchange gains of the last 18 months. The big winner was Oclaro Inc., a manufacturer of telecommunications equipment. In its fiscal year ending June 28, 2014, the company reported a currency translation adjustment of +$1.424 million. Given that it started the year with only $4.67 million in its warranty reserve fund, that represented better than a 30% increase. For the sake of comparison, the company paid $3.6 million in claims and made $2.2 million in accruals during the same period.

Next was the audio entertainment company Harman International, which reported a $9 million foreign exchange gain in its fiscal year ended June 30, 2014. However, while the company said the adjustment primarily represents foreign currency translations, it also includes adjustments for the addition of accrued warranties related to the acquisitions of AMX Holding Corp. and Verto Medical Solutions LLC (doing business as yurbuds).

Figure 3
Top 20 Upward Foreign Exchange Adjustments
by U.S.-based Companies
Jan. 2014 to June 2015
(as a % of reserves)

     Warranty   Foreign  Impact
    Reserve Exchange Upon
  Company   Period  Balance   Increase   Reserves 
  Oclaro Inc. 2014 4.67 +1.42 +30%
  Harman International 2014 128 +9.06 +7.1%
  Joy Global Inc. 2Q15 58.5 +2.01 +3.4%
  Cameron International 1Q14 45.6 +1.40 +3.1%
  AGCO Corp. 2Q15 253 +7.30 +2.9%
  Wabco Holdings Inc. 2Q15 41.0 +1.10 +2.7%
  Dover Corp. 1Q14 43.7 +1.14 +2.6%
  ResMed Inc. 2014 16.0 +0.372 +2.3%
  Dana Holding Corp. 2Q15 46.0 +1.00 +2.2%
  Louisiana-Pacific Corp. 2Q14 26.2 +0.500 +1.9%
  Twin Disc Inc. 2014 5.70 +0.108 +1.9%
  Preformed Line Products 6mo14 1.14 +0.020 +1.8%
  Trio-Tech International 2014 0.061 +0.001 +1.6%
  Clean Diesel Technologies 6mo14 0.453 +0.007 +1.5%
  Tecumseh Products Co. 6mo14 13.2 +0.200 +1.5%
  Powell Industries Inc. 2Q14 4.83 +0.061 +1.3%
  Rofin-Sinar Technologies 6mo14 12.3 +0.154 +1.3%
  Foster Wheeler AG 1Q14 73.5 +0.900 +1.2%
  Woodward Inc. 6mo14 15.2 +0.178 +1.2%
  Fuel Systems Solutions 2Q14 8.21 +0.094 +1.1%

    Source: Warranty Week from SEC data

Most companies, we note, separate their adjustments for acquisitions and divestitures from their adjustments for foreign exchange fluctuations. And they also separate those adjustments from those made because of changes of estimates -- basically corrections for past over- or under-accruals that are made when the actual warranty expenses don't match up to predictions.

However, some huge multinational companies based in the U.S. never reveal any of their adjustments. Instead, they reveal just their beginning and ending balances, and two figures for net claims paid and net accruals made. The accounting rules outlining what to publish are clear about the need to reveal all of these adjustments, but enforcement is poor to nonexistent.

Ironically, compliance seems to be much higher with international companies, in that while only one-in-six U.S.-based companies report foreign exchange fluctuations in their warranty reserve balances, about half of the international companies do so. Then again, far more U.S. companies report their warranty expenses than do international companies, and the international companies that do report tend to be large manufacturers that do business in multiple countries. It's entirely possible that many of the smaller U.S. companies have minimal exposure to foreign markets and international warranty expenses.

International Increases

As mentioned, roughly half the 60 international companies whose warranty expenses we track have regularly reported foreign exchange adjustments. Some have made multiple reports over the past six quarters. But most have been increases, or upward adjustments. This is the opposite of the trend for U.S. companies, where decreases or downward adjustments outnumber increases by better than three-to-one.

In other words, the currency trends identified in Figures 1 and 2 are, on balance, helping international companies increase their warranty reserves while they are hurting American companies by forcing them to reduce their reserve balances. But it all depends on where each company does most of its business, where it keeps its reserves, and how it counts them.

In the table below, we're not including any currency symbols. Instead, the goal is to measure the change on a relative basis, as in how the size of the foreign exchange adjustment compares to the beginning balance.

For instance, the largest increase we found outside the United States came in India, where Tata Motors boosted its warranty reserves by 13.4 billion rupees, which was more than 20% of the balance it reported for the beginning of fiscal year 2014. Tata, of course, now owns the Jaguar Land Rover brands, whose luxury vehicles are sold worldwide. We suspect comparatively few are sold in India, which means the company has a huge exposure to foreign exchange fluctuations, since it reports in rupees.

Thanks to Jaguar Land Rover, the company also has a large worldwide warranty cash flow. Along with accruals of almost 57 billion rupees and against claims payments of 43 billion rupees, those foreign exchange adjustments helped the company boost its warranty reserve balance by almost half last year. Or, to put it a different way, about half the increase in reserves came from foreign exchange adjustments, and about half came from accruals exceeding claims.

We also note that Atlas Copco, Ericsson, Volvo, and Electrolux are all towards the top of the chart, suggesting that Swedish manufacturers have gained significantly from the recent currency fluctuations. Then again, it's not real money. In the next 18 months, the trend could reverse, and the krona could strengthen, and then they'll be downwardly adjusting their warranty reserve balances.

Figure 4
Top 20 Upward Foreign Exchange Adjustments
by International Companies
Jan. 2014 to June 2015
(as a % of reserves)

     Warranty   Foreign  Impact
    Reserve Exchange Upon
  Company   Period  Balance   Increase   Reserves 
  Tata Motors Ltd. 2014 66.5 +13.3 +20%
  Atlas Copco AB 2014 868 +133 +15%
  Ericsson 2014 909 +103 +11%
  Sony Corp. 2014 66.8 +7.28 +11%
  Fiat S.p.A. 2014 3,656 +392 +11%
  Volvo AB 2014 9,881 +958 +9.7%
  Electrolux AB 2014 1,248 +117 +9.4%
  Makita Corp. 2014 2.36 +0.210 +8.9%
  BMW AG 2014 3,468 +304 +8.8%
  Nidec Corp. 2015 3.04 +0.252 +8.3%
  Sandvik AB 2014 510 +40.0 +7.8%
  Honda Motor Co. 2015 274 +21.2 +7.7%
  Komatsu Ltd. 2014 31.2 +2.28 +7.3%
  Hitachi Ltd. 2015 44.9 +3.15 +7.0%
  Kubota Corp. 2014 8.08 +0.525 +6.5%
  Technicolor SA 2014 16.0 +1.00 +6.3%
  Alcatel-Lucent 2014 402 +23.0 +5.7%
  Honda Motor Co. 2014 208 +11.4 +5.5%
  Metso Corp. 2014 60.0 +3.00 +5.0%
  Kubota Corp. 2015 9.61 +0.389 +4.0%

    Source: Warranty Week from SEC data

Next we turn to the U.S.-based companies that have reported downward foreign exchange adjustments to their warranty reserve balances in 2014 or the first half of 2015. As noted, these are the most numerous of all, comprising more than two out of three adjustments.

Some of these adjustments have been relatively large. For instance, in its 2014 annual report, MagnaChip Semiconductor Corp. reported $175,000 in "translation adjustments," against $7.2 million in "provisions" and $4.9 million in "usage." Those are alternate terms for foreign exchange, accruals, and claims, respectively.

The adjustment doesn't sound large compared to claims or accruals, but MagnaChip, like many semiconductor companies, prefers to keep its warranty reserve balance comparatively small. And compared to its beginning balance last year ($877,000), that adjustment represents a one-fifth contraction in size all by itself.

Figure 5
Top 20 Downward Foreign Exchange Adjustments
by U.S.-based Companies
Jan. 2014 to June 2015
(as a % of reserves)

     Warranty   Foreign  Impact
    Reserve Exchange Upon
  Company   Period  Balance   Decrease   Reserves 
  MagnaChip Semi 2014 0.877 -0.175 -20%
  Clarcor Inc. 2014 1.60 -0.273 -17%
  Advanced Energy Indus 2014 22.1 -3.66 -17%
  BorgWarner Inc. 2014 72.7 -11.4 -16%
  Harman International 2015 155 -23.5 -15%
  Visteon Corp. 6mo15 21.0 -3.00 -14%
  Harris Corp. 2014 39.9 -5.60 -14%
  Cognex Corp. 2014 3.02 -0.418 -14%
  ResMed Inc. 6mo14 11.8 -1.37 -12%
  Wabco Holdings Inc. 2014 51.6 -5.50 -11%
  Diebold Inc. 6mo15 113 -11.9 -11%
  Sirona Dental Systems 1Q15 7.30 -0.700 -9.6%
  Textron Inc. 2014 223 -20.0 -9.0%
  Clean Diesel Technologies 2014 0.453 -0.036 -7.9%
  Bruker Corp. 2014 26.7 -2.10 -7.9%
  Xerium Technologies 2014 1.63 -0.128 -7.9%
  Kadant Inc. 2014 4.57 -0.359 -7.9%
  Gentherm Inc. 2014 10.3 -0.796 -7.7%
  Hardinge Inc. 2014 3.45 -0.255 -7.4%
  Fuel Systems Solutions 2014 8.70 -0.628 -7.2%

    Source: Warranty Week from SEC data

All 322 of the downward foreign exchange adjustments reported by U.S.-based companies since the start of 2014 add up to $2.14 billion. While the table above is ranked by the percentage decrease the adjustments caused in the warranty reserve balance, only the adjustments of Harman International, Textron Inc., Diebold Inc., and BorgWarner Inc. exceeded $10 million in size.

Very Large Adjustments

If we reordered the list of the 322 downward foreign exchange adjustments reported by U.S.-based companies based on the size of the adjustment, we'd find a very different top 20, dominated by the U.S. car companies and a handful of truck and heavy equipment makers such as Paccar Inc. and Deere & Co. But since these companies maintain such huge warranty reserve balances to begin with, the percentage impact was never above seven percent.

Still, there are some huge numbers involved. For instance, General Motors Co. reported a $266 million downward adjustment in 2014. Ford Motor Co. reported a $145 million downward adjustment the same year. Fiat Chrysler Automobiles US LLC reported a $69 million downward adjustment last year. And those massive downward adjustments have continued into the first half of 2015.

Meanwhile, there have been only 22 downward foreign exchange adjustments by the 60 international companies that we track since the beginning of 2014. That's against 36 upward adjustments over the same six quarters, which for some companies covered the end of two different fiscal years. And so, in the table below, we're going to include only the top 10.

Figure 6
Top 10 Downward Foreign Exchange Adjustments
by International Companies
Jan. 2014 to June 2015
(as a % of reserves)

     Warranty   Foreign  Impact
    Reserve Exchange Upon
  Company   Period  Balance   Decrease   Reserves 
  CNH Industrial 2014 1,111 -120 -11%
  ABB Ltd. 2014 1,362 -130 -9.5%
  Tata Motors Ltd. 2015 93.2 -8.74 -9.4%
  Bombardier Inc. 2014 863 -65.0 -7.5%
  Autoliv Inc. 2014 36.4 -2.10 -5.8%
  Nidec Corp. 2014 2.20 -0.106 -4.8%
  Qiagen NV 2014 4.94 -0.224 -4.5%
  ReneSola Ltd 2014 20.6 -0.560 -2.7%
  Embraer S.A. 2014 104 -2.80 -2.7%
  Hyundai Motor Co. 2014 5,871 -39.7 -0.7%

    Source: Warranty Week from SEC data

A few of these decreases fall into the massive category. For instance, CNH Industrial N.V. had to adjust its reserves down by $120 million in 2014, which represented almost 11% of the beginning balance in its warranty reserve fund. However, despite being based in Amsterdam with its headquarters about an hour's drive east of London, the company uses the U.S. dollar as its reporting currency. So it shares the pain felt by the companies in Figure 5.

The same goes for ABB Ltd., which despite being based in Zurich is reporting its revenue and warranty expenses in U.S. dollars. So in that respect, its $130 million downward adjustment is only an accounting entry, not a real decline. The same goes for Bombardier Inc., Embraer S.A., Autoliv Inc., and all of the other international companies that are reporting in dollars for the convenience of their U.S.-based investors.

Few Downward Non-Dollar Adjustments

In other words, were it not for the fact that some international companies use U.S. dollars in their financial statements, we might not have been able to make even a top ten list of downward foreign exchange adjustments. That's because very few currencies have appreciated against the U.S. dollar since the beginning of 2014, so very few international companies were impacted by the change.

The currency fluctuations are, however, becoming a real issue for some of the U.S.-based companies. As the financial reports for the third quarter of 2015 continue to be filed, companies are blaming both their revenue declines and net income disappointments on foreign exchange trends. Warranty is only a small part of that, but as these charts demonstrate, it's not insubstantial.

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