The medical equipment and scientific instrument industry has turned in almost eight years of remarkably steady and predictable warranty expense reports, showing signs of neither boom nor bust.

Unlike the homebuilders or the automakers, the makers of medical equipment and scientific instruments report fairly stable sales revenue and warranty expenses. Equipment sales in the third quarter of 2010 was up by just under 4%, and warranty claims paid are actually down by just under 6% so far this year.

Typical Range

The 97 current and 46 former manufacturers tracked by Warranty Week in this industry sector since 2003 have generally paid out between $150 million and $200 million per quarter in warranty claims. In fact, the industry total has fallen within those bounds in 27 of the 31 quarters charted since 2003, as can be seen below in Figure 1.

In the first nine months of 2010, medical equipment and scientific instrument manufacturers have reported a combined $521 million in claims, down from $552 million during the same period of 2009. Their highest quarterly total came in the third quarter of 2008 ($266 million), while their lowest total came in the second quarter of 2003 ($139 million). That was their only dip below $150 million level. And the only two other quarters above the $200 million level both came in 2005.

Steady Accrual Totals

Warranty accruals have been just as steady. There have been only five ascents above the $200 million level since 2003, and only one dip below $150 million. The other 25 quarters have seen accrual totals remain between those bounds, as can be seen in Figure 2.

The massive spike in 2005, which saw accruals surpass $300 million during that one quarter, seems to have a lot to do with a quality problem tied into pacemakers and other heart monitoring equipment, which we shall explore further on an individual company basis in a few slides. The 2010 dip to $147 million, we suspect, is partly caused by a return to predictable quality and is partly caused by a dip in sales.

If anything, however, both sales and warranty expenses in this industry seem to be more tied into the calendar than to the economic cycles. In Figure 3, we're comparing the data in Figures 1 and 2 to sales data. And what jumps out is how there seems to be a cyclical pattern where claims and accrual rates jump highest in the third quarter of each year, and fall lowest in the first or second quarters.

Schools Open: Claims Rise

When we previously pointed out the existence of this seasonal pattern, in an October 8, 2009 newsletter, we couldn't pinpoint a cause. But then an astute reader nailed likely the reason immediately: the school year. Schools open, classrooms, teaching hospitals and laboratories restock, orders are placed, repairs are requested, and claims are paid.

So it's much like the pattern seen with farm equipment (spring), motorcycles (summer) and snowmobiles (winter). But it's not the weather; it's the school calendar that produces the cycle.

The five additional quarters added since that last report on the industry follow the same pattern. And, we predict, the most recent 0.9% rates seen for both claims and accruals will be the highest we'll see until next fall. And, we should also note, this year's peak is lower than the 1.0%-1.1% figures turned in during last year's peak.

Pacemaker Recalls

The highest peak of the past eight years, as we mentioned, seemed to coincide rather precisely with the news of manufacturing problems and recalls seen in pacemakers. And that problem was most acutely felt by manufacturers such as Medtronic, which doubled its claims rate and nearly tripled its accrual rate in the final quarter of its fiscal year ended April 29, 2005. And then in the summer of that year, its warranty costs went higher still. Those spikes are obvious in the data contained in Figure 4.

And there the story would end, but it happened again in the third calendar quarter of 2009 (which corresponds to the company's first fiscal quarter of the year ended April 30, 2010). Claims rose to 0.41% of revenue while accruals rose to 0.66%. But this time, there weren't as many headlines. And now, the crisis has once again subsided, and both claims and accruals are back down, to a more typical 0.16% rate.

Varian Medical Systems is best known for its X-ray and imaging equipment used for cancer therapy and radiation treatments. And after a quick look at Figure 5, it's fairly obvious that there are no surprises in the company's warranty expense reports. Both claims and accrual rates have been trending downwards for eight years, more or less. But its lowest-ever claims rate came at the end of 2006 (2.6%) while its lowest-ever accrual rate came in late 2008 (2.8%).

The most striking aspect of the data in Figure 5 is how it suggests that X-ray and radiation equipment have a much higher-than-average warranty cost. The medical and scientific industry's average, as seen in Figure 3, is closer to 0.8%. But Varian Medical Systems is closer to 3.0%. And after remaining close to that mark for eight years, we'll have to assume that it's more of an inherent characteristic of the product and less of a problem that can be fixed.

So far, recent quarters have been pretty good for the company, however. Claims and accrual rates have been just above or just below three percent for a year. And although claims rose to $17.5 million in the most recent quarter, a three percent sales rise helped keep warranty rates stable.

FDA Says No Sale

At Steris, the news has not been so good. In May 2008, the U.S. Food and Drug Administration sent out a warning letter to Steris customers, telling them that the company's System 1 sterilization equipment did not meet the FDA's specs. Steris and the FDA went back and forth for almost two years before coming to an agreement that includes rebates and refunds, and eventually replacements.

That issue was never really reflected in the company's warranty expense reports, which as can be seen in Figure 6 have been highly cyclical but largely unremarkable for most of the past eight years. But it's undoubtedly a factor behind the 26% sales decline seen in the first half of the company's current fiscal year. And when sales fall and neither claims nor accruals follow suit, the rates we calculate rise. That's just a factor of the math: claims divided by sales equals the claims rate.

The problem in Figure 6 is the most recent quarter, which ended on September 30. During that quarter, Steris reported $197 million in product sales, $10,000 in warranty claims, and $65,000 in warranty accruals. Its calculated claims rate was only 0.005% and its calculated accrual rate was 0.033%. But it made 60 cents per share in profits -- plenty to cover its 15-cent-per-share dividend.

In Figure 6, it looks like there's no data there in that most recent quarter. But there is. And it follows a quarter in which both claims and accruals hit new highs. And there's not a word in the company's latest quarterly report to explain any of it.

Smaller Players

Finally, we wanted to spotlight two of the smaller players in the medical equipment industry. With 97 companies choose from, we hardly ever get past the top ten or twenty in terms of sales or warranty expenses. And so, in Figure 7 we'll take a look at an artificial heart manufacturer, and in Figure 8 we'll look at a hearing aid manufacturer.

Thoratec has been in business since 1976, has been a public company since 1981, and has been reporting its warranty expenses since 2003. In Figure 7, the first five-and-a-half years of that warranty-reporting period featured very low claims and accrual rates, both in dollars and as a percentage of sales.

But then in 2008 sales began to rise quickly, and so did warranty expenses. In 2007, the company paid $660,000 in claims on $235 million in sales. That rose to $2.2 million on $314 million in 2008, and $3.1 million on 374 million last year.

So far in 2010, it's paid out $3.4 million on $308 million in sales during the first nine months of the year. That's a 50% increase in claims, in terms of dollars. In terms of percentages, it's almost double the 0.8% claims rate the company reported in September 2009.

The scary part, however, is the spike in accruals. As we've said many times before, claims are what happens to you; accruals are what you think will happen. Evidently, someone at Thoratec thinks setting aside three percent of current revenue to finance future warranty claims is a good idea. What do they know that they're not saying?

The only mention of the increase in the company's latest financial statement is a note that "unfavorable warranty reserves" have helped to reduce gross margin by 0.8 percentage points. In an accompanying press release, Thoratec merely mentioned that "The decrease in gross margin reflects unfavorable foreign exchange rates, pump to non-pump mix and increased warranty costs."

High Warranty Costs for Hearing Aids?

Hearing aid manufacturer Otix Global, meanwhile, is making its first and probably last appearance in Warranty Week. In September, the company announced a merger with William Demant Holding A/S. The merger is expected to be completed before the end of the year, so the third quarter financial report is likely to be its last.

Otix has had just one high quarter in the last eight years. However, as can be seen in Figure 8, the other 30 quarters are generally coming in between four and five percent. And in its final quarter as an independent company, Otix Global's claims rate once again climbed above five percent. That's not very low. Who knew that hearing aids had such a high warranty cost?

So we've learned two things about warranty costs in the medical equipment and scientific instrument industry: First, the rise and fall of the sector's warranty expense rates is closely tied to the school calendar, and second, certain products such as radiation equipment and hearing aids have higher-than-average warranty expense rates, even on a good day. And as was seen in Figures 4 and 6, and to a lesser extent, also in Figure 7, sometimes the bad news makes its way into the warranty charts.

Product Warranty Series

This is the tenth in a series of 11 industry-by-industry newsletters that examine product warranty claims and accrual trends in detail over the past eight years. Links to the others in the series are included below, in case you've missed any.

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