Offer product guarantees? Think twice
In 2020, companies offering S&P 500 guarantees paid a total of $ 20.2 billion to cover their customers’ guarantee claims, with average guarantee payments of $ 246.1 million (according to Calcbench). The potential financial implications of warranty claims cannot be ignored. For example, in 2012 Navistar faced the risk of bankruptcy mainly due to the enormous financial burden of its warranty contracts.
In an upcoming study, my colleagues and I examined whether and how the offering of collateral and unexpected changes in collateral payments affect the value of the business. Our results offer important implications for senior executives and are relevant to performance measurement decisions.
Does the guarantee offer work effectively as a marketing tool? Previous literature offers mixed evidence as to whether warranty contracts help companies signal better product quality to potential customers. Previous studies have documented that devices sold by manufacturers that offer longer or shorter warranty terms are viewed as more reliable by customers. In contrast, in the automotive industry, manufacturers with longer warranties have been shown to receive lower quality ratings.
Consistent with the view that warranty coverage is not a reliable signal of product quality, our analysis shows that offering guarantees per se does not guarantee a higher firm value. On the contrary, companies that experience unexpected increases in guarantee payments have a lower firm value than those that do not offer guarantees.
To understand how potential investors interpret high collateral payments, we conducted an experiment with individual investors who indicated that they read companies’ annual reports before making any investments in stocks. Using actual financial statement data presented under a fictitious business name, we found that high or low guarantee payments (i.e. 6% or 1% of revenue) significantly reduce product quality assessments of potential investors as well as their likelihood of investing in equities.
Additionally, supporting the idea that warranty payments are informative signals about product quality, we have found that future discussions of quality issues in 10-K reports and analyst reports are more frequent for companies that report higher guarantee payments in the current period.
After validating collateral payments as a proxy for product quality information, we analyzed the stock return performance of all companies offering collateral traded on the US stock exchanges. Our sample covered fiscal years 2010 to 2016 and included 3,014 observations for 666 unique companies.
After controlling for changes in various relevant factors including profitability, sales, and financial leverage, we found that when companies experience unexpected increases in collateral payments (modeled on the basis of lagged collateral payments), their returns fellows are 2.5 percentage points lower on average. This corresponds to a 17.2% drop in annual stock returns for the average company in the sample.
While investors interpret the increase in collateral payments as a signal of declining product quality (‘quality losses’) and adjust their valuations accordingly, they do not respond as strongly to lower collateral payments ( “Quality gains”). Our results show no significant relationship, on average, between inventory returns and unexpected drops in warranty payments. The asymmetric reaction of investors to the rise or fall of collateral payments is consistent with the notion of loss aversion (i.e. losses are greater than gains).
What could managers do to mitigate or even eliminate the negative implication of the firm value of higher than expected collateral payments? We looked at two relevant signals – advertising and research and development spending – as possible moderating factors. Our results suggest that efforts to increase advertising, but not R&D, may help.
When companies significantly increase their ad spend, investors react less negatively to unexpected increases in guarantee payments. Managerial optimism communicated by more intensive advertising counteracts negative information conveyed by higher-than-expected guarantee payments.
Interestingly, the increase in R&D spending does not help companies avoid the backlash from investors to the increase in guarantee payments. This may be due to the fact that R&D investments involve great uncertainty and may also lead to a loss of focus on production.
Finally, although companies, on average, do not appear to derive any benefit from valuing unexpected declines in collateral payments, our additional analysis reveals that investor reaction to the good news conveyed by lower than expected collateral payments is conditioned. by recent changes in the competitive landscape of the industry.
If a company operates in an industry that has recently become more competitive (measured by industry concentration), unexpected decreases in guarantee payments are rewarded with higher stock returns. Therefore, in the face of intensifying competition, managers need to strongly communicate quality improvements to investors.
Overinvest in quality
What are the implications of our findings for performance measurement? Product quality and customer satisfaction play an important role in the long term success of a business. As implied by investor valuation decisions, collateral payments made based on customer claims are relevant in valuing these dimensions.
Guarantee payments are an objective measure, which is not subject to the potential biases involved in the survey methodology. Tracking changes in warranty payments and linking executive compensation to relevant benchmarks can help facilitate product quality improvement efforts within the company and avoid reputational damage. resulting from potential product reliability issues and recalls.
Nevertheless, we advise companies and managers to avoid investing too much in quality improvement efforts. This is for two reasons. First, better quality comes at a cost, and managers must balance the marginal cost with the benefits of quality. Second, the stock market does not unconditionally reward lower collateral payments. The reaction of investors depends on the intensity of competition between competitors in the industry.
Providing product guarantees is a double-edged sword. While customers view warranties as an insurance contract, warranties come at a significant cost. Investors do not seem to perceive collateral in general as a factor in improving value. The increase in warranty payments is an indication of potential product quality issues, setting a red flag for stock market participants.
Ahmet C. Kurt is Assistant Professor of Accounting at Bentley University.