Self-reliant AC manufacturing opportunity and its challenges

Self-reliant AC manufacturing opportunity and its challenges

Electronics permeate all sectors of the economy and the electronics industry has cross-cutting economic and strategic importance. In India, electronics manufacturing has grown rapidly during the last 4 years. However, this pales in comparison to the actual potential for growth which is curtailed by specific constraints. The government has been working to create a conducive environment for manufacturing and to offer incentives comparable with those offered in other countries to attract large investments into the manufacturing sector.

Under the Atmanirbhar Bharat program, the GoI has introduced the production-linked incentive (PLI) scheme for air conditioners and its components. It has earmarked Rs 3000 crore for room air conditioners and Rs 2000 crore for components, which include compressors, copper tubes, aluminum foil, PCB assembly of controllers, BLCD motors, service valves, and cross flow fans besides sub-assemblies. The incentive is payable on incremental sales based on the investment.

The PLI scheme may have long-term potential to boost the local component ecosystem. But the scheme has failed to impress local manufacturers who assemble finished units. Since last April, the cabinet has approved PLI for five other sectors. But unlike the previous ones, the latest scheme focuses solely on growing component manufacturing. The manufacturers will receive 4-6 percent incentive on incremental production, only if they add value by growing component production.

The selection of companies for the scheme shall be done, so as to incentivize manufacturing of components or sub-assemblies which are not manufactured in India presently with sufficient capacity. Mere assembly of finished goods shall not be incentivized.

It will help in growing the local AC manufacturing base and make India more competitive in the global market. The absence of incentives for incremental assembly will lead to the deferment of investments by local players in building capacity for finished ACs. However, toward a holistic growth of the sector, it is highly desired that the finished goods are also considered for incentivizing, in addition to its components, under the PLI scheme. Further, given the low penetration of this category, the domestic demand also needs to get a boost by making ACs more affordable.

FTA route gets quashed for AC imports

In October 2020, the government banned the import of air conditioners to boost domestic production. Currently, India imports ~1.6 million units (Rs 3500 crore) of finished RACs, which is 22 percent of total volume sold in India in FY20. In a residential AC, compressor and motor, which account for around 30 percent of the price are imported, while sheet metal, coils and other are sourced locally. The government’s move to ban imports of finished air conditioners is expected to hit small players and Chinese manufacturers.

Though the move is anticipated to help push the Aatmanirbhar Bharat movement, players which have been already manufacturing most of their product range in the country may have minimal impact on them.

The intent of the government is to put a curb on duty-free import of air conditioner units from FTA countries such as Thailand, Malaysia, and Vietnam. Earlier, if importing a fully built AC through countries like Thailand, Malaysia, and Vietnam, the duty was zero and in case of importing without refrigerant, full duty was to be paid.

Chinese manufacturers which were setting up factories in other countries in order to bring products to India directly under FTAs, will be affected by the government’s move. Under the FTAs, finished products like ACs attract zero duty but the components have to pass through an inverted duty structure. Now after notifying that gas-filled units are banned what that means is can be imported as a component. Therefore, the zero percent duty route is now no longer available.

The move also might hit some small companies which were importing either the indoor unit or outdoor unit from countries such as China and through Thailand by using FTA route with zero percent duty. As a result, several global manufactures have taken up local manufacturing of their products. However, even if smaller players can find local manufacturers, they may still not be able to sell at lower price points that had been their key sales strategy.

OEMs are also clear winners as they will have more opportunities for outsourced manufacturing. Some AC OEMs have been gaining traction with tightening of import norms. Indian AC OEMs now have a robust domestic electronics supply chain, allowing them to shorten lead times, reduce inventory holding, develop technology differentiators and most importantly, eliminates a key point of friction that has been holding the expansion of the ecosystem back.

Indian air conditioners market

The Indian room AC market has been grown at ~10 percent CAGR (in volume) over FY2010–20. According to Tech Scientific data, it is projected to grow at a CAGR of more than 17 percent, to surpass USD 11 billion by 2023. However, the air conditioning and cooling products market was adversely affected in the 1H20 due to the nationwide lockdown, with sales coming to a grinding halt during the category’s peak season. AC is a highly seasonal sales product and it sees its peak during the March-June period.

Indian AC market

In mn nos.

FY2010-20

Though the pace has been somewhat slow, during the past year, government’s initiatives like special funding of stressed projects, mainly in affordable and mid-income categories, are likely to provide impetus in the near future. Growth of e-commerce retail portals and the increasing number of organized retail formats in Tier-II and Tier-III towns will create good growth opportunity for the air conditioners category.

India has seen rapid growth in electrification even in deeper pockets. Government initiatives like metering of houses focus on reducing transmission loss of electricity and programs like Deendayal Upadhyaya Gram Jyoti Yojana (DDUGJY) are creating various opportunities in new geographies for the supply of air conditioners. Rapid urbanization and migration to cities have given rise to affordable housing.

In the air conditioners space, the government aims to reach USD 1 trillion-dollar revenue while creating 2.5-3 lakh jobs. The short-term plan is to hike customs duty on finished ACs and in a phased manner increase customs duty on components and also bring quality control orders on ACs and components. Additionally, the long-term plan is to create industrial clusters near ports, make some changes to public procurement for air conditioners and revise AC guidelines under the Bureau of Energy efficiency on frequency.

Challenges hindering growth

Price volatility. The price rise of the key raw material has been impacted by sharp commodity price inflation over the past few years. It is affected by the price volatility of certain commodities. Commodity prices, including steel, copper and ABS plastics, and ocean freight are on the rise and, therefore, companies have hiked prices between 4-6 percent with effect from January 1, 2021.

The seasonality factor. AC companies face the seasonality element of business; example, for room conditioners, demand goes up in summers while inventory stocking up begins from December onward. Thus, businesses usually see an increase in inventory levels in 4Q. The summer season is a crucial part of the air conditioners industry. The February to June period contributes to ~60 percent of the total industry’s turnover. March and April contribute 12 percent each toward sales turnover in the industry.

Supply chain disruption. India imports 45-50 percent completely built units almost worth USD 60 billion, mainly from China, apart from importing most of the components. Wuhan is a major manufacturing center for the electronics industry and companies based there are important suppliers for Indian manufacturers. Before the lockdown, in February and March-20, the appliances and consumer electronics industry was already facing a shortage of components, which are primarily imported from China, which had impacted production. Supply disruptions led to a scarcity of components or units which pushed up prices.

Other macro/industry-wide concerns. Consumer behavior and the demand are directly linked to GDP growth. A sharp fall in GDP may lead to a fall in consumer demand. Even when normalcy returns, several people may lose their purchasing power or become more conscious of making purchases. As consumers struggle with health concerns, potential job losses and pay cuts, high ticket discretionary purchases are deferring the growth. The sector suffers from highly competitive intensity and, hence, weak pricing power, low product differentiation, and threats to market share by existing competitors and new entrants. There is a need for in-house manufacturing. This could pose a challenge for margin expansion and reduce return ratios. Slower economic growth is bringing down demand for premium products and has shifted consumer preference toward value-for-money type of products. This is impacting the sale of premium products and manufacturers’ profitability, going forward.

The bottom line

The self-sufficiency hypothesis is that some of the value created by local consumption trickles down the supply chain to the domestic manufacturing ecosystem – and ultimately down into workers’ pockets. This is then recirculated into the economy through further consumption. Additionally, long-term ecosystem benefits like domestic IP creation and exports, while harder to quantify, are likely to create value in orders of magnitude greater than vanilla import substitution.

This, in brief, is the objective behind the government’s drive for self-sufficiency in low penetration segments like ACs. The objective is sound but not without its challenges it requires the perfect alignment of complex variables that will somehow result in the evolution of an ecosystem.

The import ban is likely to drive market share gains for the indigenous AC players as well as the international ones which have been manufacturing in India for years now. After the excise duty hikes on compressors and other equipment a few years ago, AC manufacturers have spent on backward integration, and should reap the benefits now. However, India is still at a nascent stage in terms of product technology and hence, the requirement to import certain components will remain for some time.

With no incentive for incremental assembly, manufacturers are now hoping that large global component makers set up shop here. Since key components that are being imported require huge investments to manufacture locally, setting up such facilities may not be a viable business proposition for entities in India. To turn such investments profitable, the kind of scale that is required does not exist in the local market.

What is interesting is that despite government’s efforts Chinese companies have succeeded in capturing market share in India amid the growing anti-China sentiment, thanks to their JVs and other strategic alliances with domestic as well as international players.

While leading Indian rivals may adapt and survive to protect their market share, mid- to small-level companies operating in the economy and mass-premium segments, face the risk of losing further market share.

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