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Brewing Product Warranties

May 3, 2012

Recently Green Mountain Coffee Roasters (GMCR) was in the news when the great analytical investor David Einhorn shorted the stock of the company.  His presentation on the reasons for shorting the stock is a must read for investors with an analytical bent of mind.  Investors fall into two major categories – the analytical type and the momentum type.  Momentum based investors might look successful for a period of time before  they come to a sorry end.  Many investors who fancy themselves as analytical investors are in reality momentum players going along with ebbs and flows of popular opinion in the investing world.  In contrast, David Einhorn is probably the best exemplar of analytical investing (at least at present).

The point of this note is not to sing paeans to David Einhorn.  It is for reinforcing the importance of product warranties in the world of credit analysis, something which we highlighted in an earlier piece Product Warranties and Credit Analysis (See   https://crediteye.wordpress.com/2011/11/22/product-warranties-and-credit-analysis/)

Between the first quarter of 2010 and the first quarter of 2011, GMCR’s sales of coffee brewers went up by 50%.  But thanks to a spate of product returns, the company had to increase its warranty reserve by 10 times.  Amongst the many dubious things that companies facing earnings pressure resort to, one of the dirtiest tricks is cutting costs, not through productivity enhancement but through cutting corners.  This inevitably results in product returns and increased costs later.  In effect, a company is booking costs of a particular time period at a future time period when the product warranties come home to roost.    Investors must flee at the first sign of a company underbooking costs, either by cutting corners or by not adequately provisioning for product returns.

A more insidious form of warranty is the extended warranty, which covers defects beyond the normal warranty period.   This extended warranty is usually sold at the point of sale of the good and results in instantaneous cash flow to the manufacturer.  If the extended warranty is mispriced and profits from the extended warranty are booked upfront, an analyst will not be able to spot problems until much later when the extended warranty gets into force.  While extended warranty is not important for players like GMCR, it is vital for producers of heavy-duty capital goods such as gas turbines for power generation.  Long term creditors and shareholders of companies manufacturing high-end capital goods must ensure that they have a clear understanding of the contingent liabilities emanating from these product warranties and extended product warranties.  They need to convince themselves that these liabilities have been priced in an actuarially sound fashion.      

 

 

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