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Wednesday, November 29, 2006

Sony Deals Self a Cyber-Shot in the Foot

Sony announced yet another quality issue in one of their products.  This time its not laptop batteries a problem that has led to a recall of over 9 million battery packs. 

That recall started with Apple laptops and later spread after a Dell laptop caught fire at a conference, which was caught on video.  The Dell incident was followed shortly thereafter by a spectacular fire at LAX involving an IBM laptop.  Shortly after each incident, Sony increased the scope and range of their recall.

This time Sony has announced quality issues with Sony digital cameras.  They have specifically called out issues that result in liquid crystal display screens that fail to display their images correctly and compounded by images that are saved with distortion and hints of some cameras that might not take pictures in the first place.

The Cyber-shot camera line has been specifically mentioned and indications are that the problem could impact up to 8 models.  A million units of these were shipped within Japan.  More were shipped overseas, but reminiscent of the battery recall, Sony has not yet provided numbers as to how many were shipped overseas and how many went to specific countries.

Model Numbers

The BBC identified on November 24, 2006 in an article titled 'Sony recalls cameras over glitch' shortly after the Sony Press Release the following models impacted by the problems:

  1. DSC-F88
  2. DSC-M1
  3. DSC-T1
  4. DSC-T11
  5. DSC-T3
  6. DSC-T33
  7. DSC-U40
  8. DSC-U50
Not a Logistical Recall; Just Offers of Repair

As yet they are not replacing units, but only offering to repair them.  Sony has not provided any return information to address these models specifically yet.  These models had been shipped between September 2003 and January 2005 according to the BBC.  That indicates that the product line was compromised most likely from the the beginning to the end of the product life cycle, approximately a year and a half. 

This is not the first time Sony has had problems with their cameras nor is it the first time they have seen these types of problems.  Similar problems came to light a year ago in October impacting almost two dozen models.  There is no indication that Sony new of the problems with these models last year, nor any reason that identifies why the problems are surfacing almost two years after the last shipment.

The reality of the situation is that many products life cycle far out strips that as measured by the manufacture that ships the products.  The products continue to live on un-consumed in warehouses, distribution points, and retailer shelves for many months and sometimes for years after the fact.  Many companies amortize the warranty risk of products based on historical trends for those lines and utilizing conservative measurements to expense the risk off in an appropriate amount of time balancing this with the need to keep reserves on the balance sheet clean.

Anatomy of Warranty Reserves

A product that began shipping in September of 2003 and stopped shipping in January 2005 may no longer hold a warranty reserve on the Sony balance sheet.  If for example Sony amortized the warranty reserve over a 12 month period, which is typical for consumer electronic goods with a 1 year manufacturers warranty, the early shipments reserves would have been entirely consumed as of September 2004.  All of the reserves would have been exhausted by January of 2006.

If we consider that Sony may have staggered its warranty amortization to 18 months to allow 6 months for the life of the product in the channel after leaving the manufacturing line or even 24 months allowing a 12 month channel life that would still leave the reserve with only 2 months of funding remaining.

Funding Remaining on 24 month amortization

So far 1 million units have been identified for Japan.  If the total scale of this recall follows a lesser trajectory than that of the battery recall, maybe 5 million units in total will have shipped during the time period.  Thus far according to The Wall Street Journal article Sony Cameras Bring Latest Quality Problem by Arran Scott and Yoshio Takahashi only 0.4% of the products shipped have been reported to be affected by this issue.

Now that Sony has gone public with the problem, it is likely that the increased awareness will push consumers to check their devices and take action.  If that reporting rate were to increase to 5%, then Sony could receive a repair bill for (5,000,000 x 0.05) 250,000 units.

If we run some rough numbers and make the initial assumption that these cameras retailed for $200 and that Sony sold them for $132 each indicating a typical retail margin.  Sony might have planned for a return rate of say 3%, which would translate to about $19.8 million initially in reserve on unit sales of 5 million units(about $660 million total revenue).

If we straight line the sales over the 17 month period(Sep 03 to Jan 05), that would be an average of $1.16 million in reserves booked each month.  Those reserves would have been consumed by actual returns and repairs, and if those returns and repairs failed to materialize at the time, the reserve balance could have been justifiably reduced 24 months after the initial sales date, or at the rate of $1.16 million per month if no actual expenses were incurred.

Putting it a different way if we assume that absolutely no returns or repairs have ever occurred with these products, which would included retailer returns and refusals-an unlikely situation at best, this would only leave $2.3 - $3.4 million dollars in the reserve as of the Sony press release to cover these expenses.

If an average return costs Sony $100

  • $25 service and support to set up the return - Customer Service Line
  • $10 in Parts
  • $25 in labor
  • $20 in Freight
  • $20 in indirect including legal expenses, accounting and everything else resulting from a Returns Fire Drill

Then Sony's 250,000 units x $100 per unit could cost the company about $25 million less a residual reserve of $3.4 million.  The return expense will net out at only $22 million.  No large amount for Sony, initially, but definitely something that would show that their historical returns rate in this case was double their expectations.

The Real Hit to the Sony Financials

Managing these expectations is where this recall and the battery recall may impact the Sony bottom line the most.  If for example Sony has to increase their Warranty reserve 2x on outgoing shipments this year that's a 3% (using our estimated numbers) increase in product expenses and likely to be even higher for laptop batteries.

The increase in rate might also be matched by an increase in amortization time required to spend the reserves.  Sony's accountants might be forced to increase the period from 12 to 24 to 36 or even 60 months, delaying the potential bring back of profits after increasing the cost of Sales up front.  As a public company this is where Sony feels the pain the most as an increase in this type of expense makes Sony even less price competitive at retail compared to competitors that may have pegged their warranty reserve rate correctly and held quality in check at the same time.

Benefit of the Doubt - Insult to Injury

That's giving Sony a significant benefit of doubt.  If that return rate increases, if the number of models increases, if Sony can't repair for less than what they sold the units ($132 v. $100 repair) or if the reserve was exhausted a year ago, then this dynamic could change substantially.

Brand Impact

The actual recall expenses above neglect to account for the cost or true impact on the Sony brand.  It will take many months and years before the true impact on the Sony brand can be assessed in marketing studies.  But it appears that Sony, long recognized as a market leader in product quality, appears to be rapidly spending that hard earned brand capital by bringing defective products to market and failing to rapidly address the issues as they come to light.