April 28, 2016

Medical & Scientific Equipment Warranty Report:

Though product sales are down, warranty expenses are down by more. And while any equipment that uses lasers or X-rays has higher warranty expenses than units that don't, those manufacturers have cut their warranty costs significantly in the past decade.

While the makers of medical equipment and scientific instruments don't have very high warranty expense rates, they are a significant sector of the product warranty industry. And when defects creep into the field, as has happened numerous times with pacemakers and sterilization products, warranty costs can become a very big issue for the manufacturer.

In order to put together this week's industry report, we started with a list of 196 U.S.-based medical equipment and scientific instrument manufacturers and split them into two groups. There were 44 companies making equipment that used lasers or X-rays in some way. And there were 152 that did not.

The laser and X-ray group was led by manufacturers such as Coherent Inc.; Hologic Inc.; Mercury Systems Inc.; Sirona Dental Systems Inc.; and Varian Medical Systems Inc. The other group was led by companies such as Agilent Technologies Inc.; Bio-Rad Laboratories Inc.; Danaher Corp.; Illumina Inc.; and Thermo Fisher Scientific Inc. Most were predominantly involved in the medical or scientific industries, though a handful came from closely-allied industries such as semiconductors or computer equipment. A few came from the bedding or furniture industries.

The reason for the split is something that we noticed years ago in the medical and scientific fields: any equipment involving lasers or X-rays seems to naturally attract warranty costs at a much higher rate than other equipment. It showed up in last year's report as well as in the 2014 edition. And it showed up again this year.

Four Warranty Metrics

For each company, we gathered four essential metrics from all of their annual reports and quarterly financial statements: the amount of claims paid, the amount of accruals made, the amount of warranty reserves held, and the amount of product sales reported. The latter was used to calculate the percentage of revenue that went towards claims and accruals, and all four were used to calculate the capacity of the warranty reserve fund to pay claims, plotted against the accrual rate.

In Figure 1 we're charting the annual total for claims paid by the two groups. It's obvious that the laser and X-ray companies pay far less claims than the other group. In fact, their share of the total is seldom more than 15%. Last year it was 16% of a $730 million total.

Figure 1
Medical & Scientific Equipment Warranties
Claims Paid Worldwide by U.S.-based Manufacturers
(in US$ millions, 2003-2015)

Figure 1

The entire group of 196 companies saw their claims total fall by about $91 million last year. But the laser and X-ray equipment companies actually saw a slight increase overall. This was driven primarily by increases at Varian Medical Systems and Sirona Dental Systems. Most of the others paid out less in 2015 than they did the year before.

Outside of the laser and X-ray group, there were lots of claims cost reductions. Agilent paid out $26 million less, while Danaher paid out $15 million less. Roper Technologies Inc.; Invacare Corp.; and Hill-Rom Holdings Inc. each also reported multi-million-dollar claims cost reductions. Medtronic plc, enjoying their less-regulated new domicile of Dublin, declined to report any warranty expenses at all during the second half of the year, though we can hardly count that as a cost reduction as much as it is a flouting of accounting principles.

On the increase side, both Boston Scientific Corp. and Illumina saw their claims cost rise by 40% of more. Steris plc, Thermo Fisher, and Bio-Rad Laboratories each also saw multi-million-dollar increases in their claims costs. But, on balance, the group of 152 companies saw a 13% decrease in claims costs last year.

Warranty Accruals

Warranty accruals followed much the same pattern. Overall there was a $64 million decline in medical and scientific accruals, comprised of an increase for the laser and X-ray group and a decrease for the other group. Varian and Sirona led the increases, and Agilent and Danaher led the decreases.

But there were some differences. Hologic cut its claims cost by $2.6 million but raised its accrual total by $3.7 million. BioLase Inc. paid out $115,000 more in claims but raised its accruals by $1.3 million. In the first half of calendar 2015, Medtronic accrued more than it did in the entirety of 2014. Its accruals also popped in 2009 and 2013, so perhaps it's a good thing that it isn't reporting warranty expenses any more.

Figure 2
Medical & Scientific Equipment Warranties
Accruals Made Worldwide by U.S.-based Manufacturers
(in US$ millions, 2003-2015)

Figure 2

Because of the increases and decreases, last year the laser and X-ray companies comprised over 17% of the $725 million industry total for accruals -- their highest share ever. But their $126 million total in 2015 was actually lower than it was in four of the previous 12 years. And as we shall see, those totals as a percentage of revenue recently went lower than they've ever been, thanks to increasing sales.

Warranty Expense Rates

When we take the totals for claims and accruals outlined in Figures 1 and 2, and divide them by the corresponding product revenue totals, we get a pair of percentages for each group: their claims and accrual rates. These help to put the raw totals into perspective, because as companies grow, of course their expenses also grow. The question is whether expenses are growing proportionally with sales.

In Figure 3, it's clear that they have not been in constant proportion since 2003. Both pairs of expense rates are on a downward slope, which means that either sales are rising faster than warranty expenses, or expenses have been falling.

Looking back at Figures 1 and 2, it seems to be a little of both. Annual claims and accrual totals were relatively stable from 2009 to 2013 or 2014, but have been falling since. So the cause of the decreasing expense rates mush have been rising sales. In 2014 and 2015, the totals were down and so were the expense rates, so there must have been flat or declining sales totals.

In fact, sales were down last year, by -5% for the laser and X-ray group and by -4% for the other group. But still, progress has been made in the area of warranty cost-cutting. For the laser and X-ray group, the average claims rate hit a new low of just under 1.2% at the end of 2015, while their average accrual rate dipped to 1.3% in early 2015. For the other group, their average claims and accrual rates dipped below 0.5% for the first and only time in the opening quarter of 2015.

Figure 3
Medical & Scientific Equipment Warranties
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2015)

Figure 3

We should note that there seems to be a noticeable seasonal pattern to both sales and warranty expenses in the medical and scientific equipment industries. But rather than being tied to the weather, as is the case with farm equipment or snow removal machinery, it is tied to the school year. Budgets blossom in the fall, and repairs accelerate in the winter and spring. The interplay between the two causes the seasonal pattern that's noticeable in both pairs of lines in Figure 3.

Of all the medical and scientific equipment companies, only eight were among the top 100 warranty providers, and only two saw their claims or accrual rates rise or fall by a large enough proportion to make it into the March 17 newsletter. Danaher was in there for a big drop in its claims rate, and Sirona Dental Systems was in there for a large increase in both its claims and accrual rates.

But there were 20 medical and scientific companies that reported paying more than $10 million in claims past year, and among that group, there were some even larger changes in claims and accrual rates. Roper Technologies Inc., Cynosure Inc., and Hill-Rom saw their claims rates fall by a fifth or more, while both Cynosure and Invacare saw their accrual rates fall by that proportion.

In terms of increases, five companies saw big jumps in their claims rates: Boston Scientific; Sirona Dental Systems; Bio-Rad Laboratories; Agilent Technologies; and Illumina. Six saw big jumps in their accrual rates: Boston Scientific; Bruker Corp.; Hill-Rom; Sirona Dental Systems; Steris; and Varian Medical Systems.

Compared to Product Sales

Of course, increasing expense rates are bad while falling rates are good. Changes in claims rates are heavily dependent on sales, while accrual rates should remain constant unless there's been a change in product mix, quality, repair cost, or some other non-financial measure. In other words, rising accrual rates are a sign of trouble, while falling accrual rates demonstrate increasing product reliability (or at least the belief by the company that this is the case).

Agilent reported the biggest drop in annual sales, though this was almost entirely related to its spin-off of Keysight Technologies Inc. to its stockholders. Medtronic also saw a drop in sales, but it also went through a financial reorganization. Among the like-to-like comparisons, Bruker, Invacare, and Bio-Rad Laboratories saw the biggest drops in product sales, while Cynosure, Illumina, and Hill-Rom saw the biggest gains in sales.

Our fourth metric is the closing balance in the warranty reserve funds of all 196 companies at the end of each of the past 13 years. In Figure 4, it looks like the two groups more or less maintained the same relationships between their respective totals, with the laser and X-ray companies never having more than 15% of the overall total.

Figure 4
Medical & Scientific Equipment Warranties
Reserves Held Worldwide by U.S.-based Manufacturers
(in US$ millions, 2003-2015)

Figure 4

The difference is that warranty reserves actually rose in 2015 for both groups, though only very slightly. Still, it was the first increase for either group since 2012-2013, and the first overall increase since 2010-2011. As the data in Figure 4 suggests, the ending balances have been relatively flat for most of the past decade.

Warranty Reserve Capacity

The thing is, these balances on their own don't say much about a given company's ability to pay warranty claims, which after all is the main purpose of keeping a warranty reserve fund (as opposed to paying out-of-pocket as expenses arise). So what we've done is to take the balances in Figure 4, and divide them by the claims totals in Figure 1, to calculate how many months those reserves would last given the current monthly cost of claims. In other words, if a company has a warranty reserve balance of $10 million and is paying claims at the rate of $12 million per year, then its reserves would last for 10 months. If reserves rose to $12 million and claims somehow fell to $6 million a year, the reserves would last for two years, or 24 months.

In Figure 5 we've plotted this capacity to pay claims on the vertical axis, in months, while the horizontal axis is a restatement of the accrual rates in Figure 3. For each group, we've made 52 calculations for the four quarters of the past 13 years. And they show a distinctly different pattern. The laser and X-ray equipment makers generally have higher expense rates and lower reserve capacities than the others. But they all have lower-than-average capacities than manufacturers in other industries: the all-industry average is 19 months, with an average 1.3% claims rate.

Figure 5
Warranty Reserves vs. Accruals
Laser & X-ray Equipment vs. Other Medical Devices
(in months of claims & % of sales, 2003-2015)

Figure 5

Generally, the lower reserve capacities signal shorter warranties, though manufacturers are also free to underfund their liabilities, if they choose. In this case, there is a noticeable cluster around 12-to-15 months for the other medical manufacturers, while the laser and X-ray companies are generally between 9 and 12 months. But there are outlying points for both groups.

In terms of individual companies, it's easy to spot when a manufacturer is keeping a level of reserves that's thinner than its peers. For instance, Sirona keeps only 3 or 4 months of reserves on hand, given its claims payment levels. Steris keeps only 6 months of reserves on hand. Illumina and Bio-Rad ended 2015 at a level of 6 months, though they have generally been higher in the past. The same goes for Agilent and Thermo Fisher, which both ended 2015 at 7 months.

At the other extreme, Hill-Rom was keeping 18 months of reserves on hand at the end of 2015, and this was down somewhat from past years. Invacare was keeping 15 months of reserves, and this was also down from historical levels. Danaher and Varian were maintaining about a year's worth of reserves, as they have done for most of the recent past.

Boston Scientific is worth a special mention. As was previously mentioned, the company saw big jumps in both its claims and accrual rates. Its sales were flat, so most of that was rooted in product problems. At the end of 2013, it had a warranty reserve equal to 84 months. By the end of 2014, that ratio was down to 25 months. And then at the end of 2015 it dropped to 12 months. Over the same period, the balance fell from $28 million to $23 million. It's still enough to fund all the company's expected warranty claims, but it shows how quickly reserves can change from abundant to merely adequate, because of big changes in expenses.

Another Acquisition

And finally, this may be our last opportunity to mention St. Jude Medical Inc., makers of heart valves, defibrillators and pacemakers. The company has always maintained a very thick cushion in its warranty reserves, keeping the equivalent of eight or nine years' worth of funds in the account. But at the end of 2015, it allowed that reserve capacity to drop to 23 months, which is still much higher than its competitors.

Yesterday, the company agreed to be acquired by Abbott Laboratories for $25 billion in cash and stock. And since Abbott Labs stated in its annual report that "product warranties are not significant," we are not hopeful that the company will continue to report its warranty expenses in its financial statements. And with Medtronic now in Ireland, that will make it even harder for investors to spot the next warranty crisis in cardiovascular medical products.

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