July 7, 2016

Asian Auto Warranty Report:

Honda sees its warranty costs soar because of air bag recalls, forcing it to set aside more money for warranty work than GM and Ford combined. Meanwhile, Toyota, Tata, and Hyundai struggle to maintain steady warranty expense rates for their nameplates.

Lately it seems like every passenger car manufacturer is going to take its turn in the doghouse, suffering from an unexpected spike in warranty costs brought on by an alleged defect that starts small but eventually grows into a headline-grabbing scandal. It happened to Toyota Motor Corp. with its sticky accelerator pedals. It happened to General Motors Co. with its faulty ignition keys. It happened to Volkswagen with its diesel emission deceptions. And now it's happening to Honda Motor Co. Ltd. with its shrapnel-spewing air bags.

This week, to round out coverage of the international automotive OEMs, we're measuring the warranty expenses of four passenger car and light truck manufacturers based in Asian countries. Under the spotlight this week are Toyota and Honda, based in Japan; Hyundai Motor Co., based in South Korea; and Tata Motors Ltd., which acquired Jaguar Land Rover Ltd. in 2008, and is based in India.

For each of these four Asian passenger car and light truck manufacturers, we gathered four essential metrics: the amount of claims paid per year, the amount of accruals made per year, annual automotive sales revenue, and the number of vehicles sold worldwide each year. By dividing the latter two into the first two, we created three ratios: claims rate (as a percent of sales), accrual rate (as a percent of sales), and accruals per vehicle sold.

Can't Do Claims Per Vehicle?

The reason we calculated the latter metric and not a figure for claims per vehicle sold is because accruals are made at the time of sale, in relation to the vehicle actually sold. Finance experts make their best estimate of the cost of the vehicle's warranty over the life of the warranty, and then set that amount aside. When we divide the accruals total by the unit sales total, we are calculating the average accrual per vehicle sold.

In contrast, most of the claims paid in one year are likely for vehicles sold in previous years, especially with longer warranties. There is always a lag time between when a warranty begins and when the warranty work is done. Also, for external observers, it is impossible to accurately calculate the number of vehicles under warranty at any given point in time, because some of those warranties expire on mileage before their time is up, and others are sold with non-transferrable warranties or wrecked by their first owner.

Still, there are good reasons to measure claims as a percentage of sales. In Figure 1 below, it's immediately apparent that Toyota had an issue with rising claims rates from fiscal 2009 to fiscal 2011. Honda is in the midst of a rise in claims rates that began in fiscal 2015. We believe the issues were unintended acceleration and defective air bags, respectively, but there could have been additional problems in the product line at the same time.

Figure 1
Honda & Toyota
Warranty Claims Rates, 2003-2016
(as a % of product sales)

Figure 1

Please note that both of these manufacturers run on a fiscal year that begins on April 1 and ends on March 31. Therefore, the figures quoted for 2016 are for the year that ended March 31, 2016, which of course included nine months of 2015. So any comparisons made with European or American OEMs that usually run on the calendar year would have to be time-shifted by one quarter.

What that means is that Toyota's problems began to manifest themselves some time after April 2008, during fiscal year 2009. And Honda's problems began to elevate its claims rate at some point within the fiscal year that began in April 2014.

The Scandals Grow Slowly

That's a bit early compared to the public timetable. Toyota announced its recall of cars affected by what it called an "an unsecured or incompatible driver's floor mat" in November 2009 and then widened the recall to include " a potential accelerator pedal issue" in January 2010. Both of those events were within the fiscal year 2010, in which Toyota's claims rate was 2.5%. Warranty Week first reported upon the cost of the recalls in a June 30, 2011 newsletter, after fiscal 2011 results were announced.

With the air bags, meanwhile, the scope of the problem began to become clear in the early days of fiscal year 2014, when in April 2013 Honda and several other OEM customers of Takata Corp. began issuing air bag recalls. And then throughout 2014 several more OEMs began issuing recalls as well. Takata announced a NHTSA defect investigation in June 2014, and Honda announced a voluntary consumer information advertising campaign in March 2015.

By May 2015, the recall had grown to become "the largest auto recall in U.S. history". In November 2015, the Department of Transportation's National Highway Traffic Safety Administration issued a $200 million fine against Takata, and required Honda and 11 other manufacturers to speed up the recalls.

For Honda, the cost of the recalls caused its claims rate to rise to 1.3% in fiscal 2015, and then to 2.0% in fiscal 2016. But the way that warranty accounting works caused its accrual rate to rise much faster, and much sooner. That's because a company that uses the accrual method is required to set aside the funds to cover an expense when the size of that expense becomes known. And then, when the bills come due later, the claims are paid. So one would expect a company in crisis to raise its accrual rate before its claims rate confirms the problem.

In Figure 2, we can see Honda's accrual rate rising to 2.5% in fiscal 2015, and then to an unprecedented 4.8% in fiscal 2016. In other words, Honda set aside 4.8% of its fiscal 2016 manufacturing revenue to cover the expected cost of claims and recalls. Its previous height was 2.0% in fiscal 2004, and as recently as fiscal 2012 it had been below one percent.

Figure 2
Honda & Toyota
Warranty Accrual Rates, 2003-2016
(as a % of product sales)

Figure 2

Honda described the scope and size of the problem in its most recent annual report, filed with the U.S. Securities and Exchange Commission on June 23:

"Honda has been conducting market-based measures in relation to airbag inflators mainly in North America and Japan. This is related to the problem where the internal pressure of the inflator rises abnormally at the time of airbag deployment on the driver's side and passenger's side, causing damage to the container and spraying metal fragments inside of the cars...

"Provisions recorded for the above warranty programs accrued during the period for the years ended March 31, 2015 and 2016 are approximately ¥120.0 billion and approximately ¥436.0 billion, respectively. These include the financial impact from the amendment of the Consent Order issued by NHTSA in November 2015, which is based on an agreement with our supplier in May 2016.

"The number of airbag inflators subject to provisions above, which were conducted in market-based measures for the year ended March 31, 2016 are approximately 11,880 thousand units for the driver's side and approximately 6,000 thousand units for the passenger's side.

At an exchange rate of 112 yen to the dollar, the size of the 2016 provision translates to almost US$3.9 billion. But Honda's total accruals, for its cars, motorcycles, generators, and other products, came to almost ¥608 billion, which comes to US$5.4 billion at current exchange rates. That's slightly more than was accrued by GM and Ford combined in calendar 2015.

Accruals Made Per Vehicle Sold

Another way to measure the pain caused by this massive increase in warranty accruals is to assess it on a per-vehicle basis. But there's at least two problems with that approach. First, the additional accruals aren't just for recently sold vehicles. The funds will also pay for new air bag inflators for older vehicles. So strictly speaking, they're not accruals made at the time a new car was sold.

Second, Honda sells not only cars but also motorcycles, ATVs, scooters, lawn mowers, snow blowers, outboard motors for boats, and even aircraft. And while the air bags are a problem for the car company, the car company is only 83% of the parent company. So assigning the correct proportion of accruals to each new car sold is not so straightforward.

Therefore, we had to construct a work-around for Honda. What we did was to take the company's average passenger car revenue per unit sold and multiply it by the company's overall accrual rate. If anything, this underestimates the accruals per unit sold, because we doubt the other product lines also had a 4.8% accrual rate. And if the motorcycles and generators had a lower accrual rate closer to the 2003-2014 baseline, then the cars must have had an even higher accrual rate per unit than we're calculating.

Figure 3 is in yen per vehicle, while the data in Figure 6 is in U.S. dollars per vehicle. The latter is calculated at that exchange rate of 112 yen to the dollar, so ¥139,000 equals $1,237. Both amounts are extraordinarily large for Honda, which used to turn in some of the lowest warranty expense rates in the business.

Figure 3
Honda & Toyota
Warranty Accruals per Vehicle, 2003-2016
(in JP¥ per vehicle per year)

Figure 3

Note that while Toyota's accrual rate per unit sold fell about four percent in fiscal 2016, Honda's more than doubled. The strengthening yen helped mitigate the pain of Honda having to pay for all those air bag replacements in U.S. vehicles, but the bills still had to be paid. In one year, it pushed up Honda's warranty costs to nearly the heights of the German luxury car manufacturers profiled in last week's newsletter.

Tata & Hyundai Remain Steady

Now, let's turn to two other Asian OEMs for which the news hasn't been as dramatic in recent years. Tata and Hyundai have very different product lines but lately have reported very similar claims rates. In Figure 4, Tata's fiscal 2015 claims rate was 1.7% while Hyundai's was a little under 1.6%. But keep in mind that For Tata, this rate was for the months of April 2014 to March 2015, while for Hyundai it was for calendar 2015. Tata doesn't file its annual reports until the end of July or the beginning of August, so we still don't have any data for the months of April 2015 to March 2016.

Figure 4
Tata & Hyundai
Warranty Claims Rates, 2003-2015
(as a % of product sales)

Figure 4

The most peculiar feature of Figure 4, which is also repeated in Figure 5, is the enormous rise in Tata's fiscal 2009 warranty expense rates. Based upon the experience of Toyota and Honda, one might suspect some manufacturing crisis took hold of the company during that time. But fortunately, all that happened was the company's acquisition of Jaguar Land Rover, which Tata acquired from Ford in June 2008, midway through its fiscal year 2009.

The Cost of Luxury

Before that acquisition, Tata was selling compact vehicles such as the Indica sedan and the Ace mini truck. It had also recently launched the Nano, a low-cost car for families on a budget. And then along came the Jaguar luxury models and the Land Rover premium all-terrain vehicles, and the warranty expenses that accompanied them. Tata's claims rate rose from 0.7% in fiscal 2008 to 3.6% in fiscal 2009, while its accrual rate rose from 0.9% to 3.4% in the same time span.

The good news is that Tata's claims rate has more or less declined ever since the acquisition, while its accrual rate, seen in Figure 5, has stabilized in a range of 2.1% to 2.4%. It will be interesting to see what happens in fiscal 2016, but the point is that it may just be more of the same: consistency and stability.

Hyundai, meanwhile, has traded on the power of its eye-catching warranties ever since 1998, when then-CEO Finbarr O'Neill made long warranties the centerpiece of the company's sales strategy. We don't have data that stretches that far back, but the accruals data in Figure 5 suggests that after getting its warranty expenses under control in the 2003-to-2009 time period, it saw rising-then-falling rates from 2009 to 2011, and then rates slowly rising again from 2012 to 2015.

Figure 5
Tata & Hyundai
Warranty Accrual Rates, 2003-2015
(as a % of product sales)

Figure 5

Hyundai still has the lowest accrual rates in the world, however, at least among the 13 automotive OEMs that we're tracking. If any of the non-reporting OEMs such as Nissan or Renault care to fill in the missing data, we'd be happy to add them into the charts. But as far as we can tell, Hyundai had the lowest accrual rates as a percentage of revenue in both 2015 and 2014. Honda held the title from 2009 to 2014, and Tata held it from 2003 to 2008. None of the American or European OEMs has ever come close.

Costs Expressed in US Dollars

We do, however, want to conclude with a translation that changes all these calculations made in Asian currencies into U.S. dollars. In Figure 6, we've taken the yen-based data from Figure 3 and converted it into U.S. dollars. And we're also including the Tata per-unit data, originally in Indian rupees, and the Hyundai per-unit data, originally in Korean won, converted into dollars.

Figure 6
Four Asian Auto OEMs
Warranty Accruals per Vehicle, 2002-2015
(in US$ per vehicle per year)

Figure 6

In fiscal 2016 (represented as the 2015 column in this chart), Honda accrued the equivalent of US$1,237 per vehicle, while Toyota accrued $652. That represented a radical rise for Honda from fiscal 2015's rate of US$571, while for Toyota it was a modest gain from US$637 in fiscal 2015.

That pushes Honda up into the high-cost end of the industry, where Tesla and the luxury Europeans already sit, and keeps Toyota in the midrange, where Fiat Chrysler and PSA Group now reside. GM and Ford, meanwhile, have once again moved down to the low-cost segment, rejoining Hyundai.

This all-dollar representation of the data shows that although we don't yet have a per-unit calculation for Tata in fiscal 2016, it's unlikely to challenge Hyundai for the title of lowest warranty cost per unit. Hyundai accrued only US$177 per unit last year, and that was actually a little above the US$155 rate seen in 2012 and 2013. But it was the lowest in the industry.

In terms of the highest warranty costs, at least among these four Asian OEMs, Honda held the title in fiscal 2016 (represented as the 2015 column in this chart), while Tata held it from fiscal 2012 to 2015. Toyota had a few bad years before that, and they were all accruing a relatively small amount of funds per vehicle sold from fiscal 2005 to 2007.

Who's Turn in the Doghouse?

If there's any conclusion to be made, it's that each OEM seems to take its turn in the doghouse, suffering from a spike in warranty and recall expenses due to some unforeseen crisis. This year it's Honda's and VW's turn. Last year it was Ford and GM. Before that, Toyota had its manufacturing excursion to deal with.

Tata and Hyundai had a different challenge. Hyundai pioneered the decade-long powertrain warranties, and then had to get its costs under control after the bills came due. Tata made a major acquisition, and had to get its costs under control as it absorbed multiple luxury brands. Both seem to have stabilized their expense rates lately, though that could change at any moment if it becomes their turn in the doghouse.

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