April 26, 2018

Aerospace Warranty Report:

Unlike the automotive industry, the manufacturers of commercial airplanes do not have higher warranty expenses than their suppliers, and do not spend a larger percentage of their sales revenue on warranty claims. But just like those land-based vehicle makers, airplane and helicopter manufacturers have been cutting their warranty costs for more than a decade.

Things are different in the aerospace industry. Manufacturers of both the airframes and their suppliers spend comparable percentages of their sales revenue on warranty claims, and those suppliers actually account for two-thirds of those costs.

Since 2003, we have collected four warranty metrics from each of the aerospace manufacturers: claims paid per year, accruals made per year, warranty reserves held at the end of each year, and product sales totals. With the claims, accruals, and sales data, we have calculated two additional metrics: claims as a percentage of sales, and accruals as a percentage of sales.

We've been tracking a total of 100 manufacturers that are heavily involved in the aerospace industry. Ten of them are making planes, drones, helicopters or satellites, and 90 of them are producing parts and components for those manufacturers. However, for this week's analysis, we are expanding the definition of an aerospace manufacturer to include companies that are usually counted in other industry categories, borrowing United Technologies Corp. from the HVAC category, Garmin Ltd. from the consumer electronics category, and a bunch of satellite and microwave manufacturers from the telecom equipment category. All of the industry totals will therefore be somewhat larger than were listed in the March 22 newsletter, which assigned all manufacturers to one and only one industry category, even when they were prominent warranty providers in multiple industries.

As we did in the past few newsletters that were focused on the automotive industry, we're splitting the group into OEMs and suppliers. However, unlike in the automotive industry, the aerospace OEMs are not paying the lion's share of the warranty expenses. Nor do they always spend a higher percentage of their revenue on warranty expenses.

So in this case, the aerospace industry is different. That probably has something to do with the incredible amount of paperwork that goes into the provision of parts and components, and the constant emphasis on safety, which drives up the overhead for all, and drives down the failure rate, and therefore the need for warranty work.

Warranty Claims

Let's begin with the annual warranty claims payments. In Figure 1 we're looking at the amount of claims paid by the aerospace OEMs and suppliers for the past fifteen years. The OEMs account for only about a third of the totals in any given year. No doubt, the inclusion of United Technologies in the supplier category affects this greatly, given all the warranty claims payments they're making for HVAC systems, elevators, and other non-aerospace lines of business. But since each company reports only a single worldwide total for claims payments, we cannot separate the company's aerospace expenses from the building trades without adding some uncertain assumptions into the hard numbers.

Figure 1
Aerospace Warranties
Claims Paid by U.S.-based Companies
(in US$ millions, 2003-2017)

Figure 1

Product warranties in the aerospace industry tend to be very long, so it would be difficult to tie any one year's claims total to any single product line. But in general, as Figure 1 illustrates, claims totals have been declining gently for most of the past decade.

In 2017, the U.S.-based aerospace industry saw claims payments drop slightly to just under $1.3 billion. But the drop came entirely from the OEM side. The suppliers actually saw a $24 million increase in claims payments, while the OEMs reported a $41 million decline.

One of the biggest declines was reported by Boeing Company, which paid out $241 million past year, down by $68 million from 2016 levels. General Dynamics Corp., makers of the Gulfstream business jets, saw a $32 million increase in claims. Back in the March 15 newsletter, both of them featured in a top 10 list for the sheer magnitude of these changes.

On the supplier side, Honeywell International Inc. saw its claims payments jump by $52 million, and avionics supplier Rockwell Collins Inc. saw a $30 million increase, while avionics supplier L-3 Technologies Inc. saw a $17 million increase. United Technologies saw a $33 million decline, but as was mentioned, it is unknown whether that decline arose from its HVAC, elevator, or aerospace product lines.

Warranty Accruals

Unlike with warranty claims, warranty accruals are closely tied to a specific year's sales. In fact, warranty accruals are made precisely at the time of sale, with the amounts decided by analysts who forecast the future cost of the warranties issued alongside those sales.

Therefore, the 2012 jump in OEM accruals can be closely tied to the trouble Boeing had that year with the launch of the 787 Dreamliner. Those troubles have now subsided, and last year Boeing was able to cut its accruals by a steep $82 million. This in turn helped drive down the industry total by $171 million to just over $1.4 billion. OEMs cut their accruals by $79 million, and suppliers cut theirs by $92 million.

Figure 2
Aerospace Warranties
Accruals Made by U.S.-based Companies
(in US$ millions, 2003-2017)

Figure 2

Honeywell made one of the steepest cuts of all, reducing its warranty accrual total by $111 million last year. That earned it a place on the best top 10 list of all, Figure 3 in the March 15 newsletter. Because accruals are closely tied to sales, massive reductions in accruals, made voluntarily, are a sign that the analysts are predicting lower costs in the future. So when a company cuts its accruals by more than a third, as Honeywell did last year, it's a giant signal of success.

In contrast, United Technologies raised its accruals by $77 million and Rockwell Collins boosted its total by $25 million. Smaller increases were reported by General Dynamics, Textron Inc., Trimble Inc., and L-3 Technologies.

Warranty Expense Rates

While the annual changes in the industry's claims and accrual totals, as detailed in Figures 1 and 2, are informative in their own rite, a more revealing way to look at the data is in proportion to sales. For instance, the multi-million-dollar reductions reported by Boeing can be measured against its total sales revenue for commercial aircraft deliveries. And on that basis, its claims payments as a percent of sales declined from 0.5% in 2016 to 0.4% in 2017, and its accrual rate declined from 0.6% to 0.5%. It doesn't sound like much, but when sales topped $56.7 billion, such declines work out to multiple tens of millions of dollars.

For Figures 3 and 4, we've taken the data from Figures 1 and 2 and divided the figures by corresponding sales totals. In addition, we've widened the measurements from an annual to a quarterly format, so that instead of 15 calculations we have 60 data points per warranty metric.

In Figure 3, we've taken the claims and accrual totals of the aerospace OEMs and divided each by sales. Once again, we see the 2012 spike in accruals caused, we think, by the 787 Dreamliner's troubles. But since then, we've seen a steady decline in the industry's warranty expense rates, bottoming out in 2016 in the 0.5% range.

Figure 3
Aerospace OEMs
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2017)

Figure 3

In 2017, however, there was a slight uptick in the expense rates. This can be attributed not to Boeing, but to Gulfstream, which saw sales fall and expenses rise, producing a half a percentage point gain in the company's claims rate. That was enough to raise the industry's overall claims rate back to 0.6%, and the accrual rate to nearly 0.7%.

For aerospace suppliers, in contrast, 2016 was the year of higher expense rates, while the trend has otherwise been for relatively stable expense rates from 2012 to 2017. As can be seen in Figure 4, expense rates in 20 of the last 24 quarters have remained close to 0.7%, after undergoing a massive decline from 2003 to 2012.

Figure 4
Aerospace Suppliers
Average Warranty Claims & Accrual Rates
(as a % of product sales, 2003-2017)

Figure 4

Over the long term, the aerospace industry has seen its warranty expense rates average out to around 0.9% for both OEM and supplier, and for both claims and accruals. The standard deviation has remained close to 0.2%, which reflects the massive changes in expense rates from a decade ago until now.

However, there hasn't really been much of a gap between the expense rates of the OEMs and the suppliers, as was seen in the automotive industry. In fact, they seem to decline in parallel, except for some of the anomalous years such as 2012 and 2016.

Out of the 120 possible rate comparisons -- 60 for the claims rate and 60 for the accrual rate -- the OEMs have been higher in 49 cases and lower in 71 cases. And they've been lower in all 16 instances in both 2016 and 2017. In other words, in the aerospace industry, unlike in the automotive industry, the OEMs have reported lower warranty expense rates most of the time, and all of the time in the last two years. But the differences have generally been small.

Warranty Reserves

We have one more warranty metric to detail: the year-ending balance in the warranty reserve funds of the 100 aerospace companies in these two groups. And while suppliers have generally reported about twice as much claims and accruals as the OEMs, in terms of warranty reserves the split is much closer to 50/50. In no year have the OEMs reported a higher balance, but in 2015 they came within $40 million of doing so. In 2017, the split was 44%/56% -- close to the long-term average.

Figure 5
Aerospace Warranties
Reserves Held by U.S.-based Companies
(in US$ millions, 2003-2017)

Figure 5

Rockwell Collins was the only aerospace company to make any of the top 10 lists in the March 15 newsletter, because of its more than doubling of its warranty reserve fund balance to $186 million by the end of 2017. But this was no doubt linked to its year-ago acquisition of B/E Aerospace Inc., which itself carried a $111 million balance at the end of 2016. Notably, Rockwell Collins is expected to be acquired later this year by United Technologies, which will probably trigger an appearance by that ever-larger conglomerate on some top 10 lists a year from now.

On its own, however, United Technologies increased its warranty reserves by $125 million, but because the company is so massive, with a presence in multiple industries, that was barely a 10% rise. Proportionally, Textron saw an even larger increase, as did Rockwell Collins.

The biggest decline in reserves was reported by Boeing, which cut its balance from $1.4 billion to $1.2 billion last year. Gulfstream cut its reserve balance by $48 million, and Honeywell cut its balance by $79 million. Industry-wide, the 100 companies together reduced their year-end warranty reserve balance by $228 million. But that was almost entirely due to the reductions reported by the OEMs.

Worldwide Warranty Total

This portrait is of course incomplete, because the aviation industry is worldwide, not U.S.-only. In a future newsletter, we will examine the warranty metrics reported by all of the international commercial aircraft manufacturers such as Airbus Group N.V. and Dassault Aviation Group from Europe, Bombardier Inc. from Canada, Embraer S.A. from Brazil, and the Russian aviation conglomerate United Aircraft Corp. However, that introduces yet another variable into the mix, namely currency exchange rates, which can affect the totals and averages all on its own.

In the July 20 newsletter of last year, we sized the warranty expenses of the worldwide commercial aircraft industry at $1.14 billion in claims and $1.31 billion in accruals. Boeing, General Dynamics, and Textron accounted for around 44% of those totals in 2016. It will be interesting to see what their "market share" turns out to be in 2017.

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