CHANGING TRENDS IN THE AUTO ANCILLARY INDUSTRY

Increasing Tierisation and Consolidation likely Constrained profitability due to high investment requirements and declining pricing

flexibility Declining integration levels by Vehicle Manufacturers (VM) to expand market

The Rs. 120 billion (bn) auto ancillary industry is fragmented with over 5,000 playersmanufacturing several components across different product segments with each productsegment having around three to five key players. The industry comprises the organised sectorand the unorganised sector of which the former comprises around 300 medium and large-sizedunits accounting for 75% of the industrys turnover. The unorganised sector in contrastcomprises over 5,000 small-scale units concentrating mainly on low value-added segments ofthe industry and catering to the replacement market. Their competitiveness stems from lowerpricing, enabled by lower operating costs and exemption from excise duty.

Market Segmentation

The auto ancillary industry can be broadly classified on a functional basis into engine parts,transmission and steering parts, suspension and braking components, electrical equipment andothers. The engine parts segment is the most significant contributor to the ancillary industry interms of value and accounts for around one-third of total production.

The market for auto ancillaries is classified into original equipment (OE) market, thereplacement market and exports. Approximately 40% of the demand in terms of value isderived from the OE market while exports account for 10% and the replacement marketaccounts for the balance. However, this segmentation varies across components and the size ofthe replacement market depends upon the durability of the component, the criticality of thecomponent in the performance of the vehicle, the stringency of emission norms, the availabilityof reconditioning options and the scrappage rate of vehicles in the country.

Original Equipment Manufacturers (OEM) market: The OEM market for autoancillaries is characterised by cyclicality in line with the end-user automobile industry. Thecomponent manufacturers commission capacities and undertake production in line with theproduction schedules of the Vehicle Manufacturers (VMs). Servicing the OEM marketrequires access to technology necessary to meet quality requirements, ability to meet thestringent delivery schedules of the VMs, price competitiveness and in some cases proximityto VMs.

Replacement Market: The size of the replacement market in India is significant owingprimarily to the large vehicle base approximating 40 million vehicles. The low vehiclescrappage rate in the country, also necessitate frequent replacement of parts. Thereplacement market acts as a steadying factor in the industry, and provides a partial hedgeagainst the risk of recession in the auto sector. The component manufacturers enjoy betterbargaining power in the replacement market as compared to the OE market and as a result,the margins in the replacement market are higher.

Export Market: The domestic industrys focus on exports has been recent and has beenpart of industry initiatives to counter the cyclicality in the domestic auto sector. During theperiod between 1993-94 and 1997-98, Indias ancillary exports have grown at a CAGR of19.3% to touch Rs. 12.3 bn. Growth in the export market is however constrained by poorprice-competitiveness on account of the domestic industrys uneconomic size of operations,higher defect rates of Indian products, high investments required to be made inwarehousing facilities and inadequate technological development. A significant portion ofthe industrys total exports is to the overseas replacement markets and the domesticcomponent manufacturers have limited exposure to the global OEMs.

The domestic automotive industry was traditionally characterised by high import tariffs andquantitative restrictions on imports, which led to a high level of indigenisation of vehicles builtin India. The limited range of vehicles available in the market, the relatively long life cycle ofvehicles, the well-defined and clearly demarcated end-user markets across OEM clients,together with the high levels of vertical integration of domestic vehicle manufacturers limitedthe growth of the domestic auto ancillary industry. Moreover, the licensing policy of theGovernment also acted as an entry barrier and effectively prevented competition resulting ininefficient manufacturing systems.

The entry of Maruti Udyog Limited (MUL) in 1983 initiated a new phase of development in theindustry and led to large volumes and quantum improvements in quality and infusion of newtechnology. MUL encouraged the establishment of joint ventures with Suzukis Japanesesuppliers. The establishment of several manufacturing units provided a further impetus forgrowth to the auto-components industry and an overall increase in competition levels in theindustry. The liberalisation of the Indian automobile industry followed by the entry of the majorVMs including General Motors, Ford, Honda, Hyundai, Daewoo and Fiat marked the secondphase of development in the industry. The Governments insistence on indigenisation normsprovided the domestic auto ancillary industry lead time to develop the capabilities required toservice the sophisticated end product requirements.

The strong growth in the auto sector during the period 1993-94 and 1996-97 led to largecapacity additions in the ancillary industry. However, the subsequent years (1997-98 and 1998-99) have been characterised by a slowdown in the commercial vehicles (CVs) and passengercar segments of the auto sector resulting in an over-capacity situation in the componentsmarket. While production in the ancillary industry registered a CAGR of 31% during theperiod between 1993-94 and 1996-97, growth in the industry slowed down to 6% during theperiod between 1996-97 and 1998-99. Consequently, increasing intensity of competition anddecline in the pricing flexibility of players led to a fall in the profitability of componentmanufacturers. However, the eleven-month period between April 1999 -February 2000 haswitnessed a significant recovery in the CVs and passenger car segments of the auto sectorleading to an upturn in the components industry.

Emerging Trends

Declining integration levels of VMs: In order to improve their cost-competitiveness(lower fixed costs) during periods of auto slowdown, the large VMs in India are reducingtheir levels of integration by hiving-off of certain component divisions into separatecompanies. The falling levels of integration are expected to expand the size of the domesticauto ancillary market while intensifying the competition simultaneously. By reducing in-house manufacturing and increased outsourcing, the need for investment and technicalupgradation is transferred from the VM to the auto ancillary manufacturer. Further, theincreasing competition levels in the ancillary industry and the resultant pressure oncomponent prices may also permit VMs to derive cost advantages.

Adoption of global logistics and supplier systems: In line with global trends, the Indianauto ancillary industry is currently witnessing the emergence of single-source suppliersystems which require the component manufacturers to make significant investments indedicated facilities, such as design, tooling and production for the manufacture anddelivery of the required components. Hence, component manufacturers are increasinglyexposed to the risk of model failure. Driven by the need to be cost-competitive in thescenario of increasing competition levels and declining pricing flexibility, automanufacturers are also resorting to implementation of inventory management techniques,such as Just-In-Time, which in turn has resulted in an increase in the working capitalrequirements of component manufacturers.

Increasing emphasis on quality: The entry of global vehicle manufacturers in thedomestic market is leading to the adoption of global quality control practices in thedomestic industry. Effective quality control leads to improved export competitiveness,better quality perception in the retail market and increased acceptance by global passengercar manufacturers operating in India. Self-certification is an emerging concept in theindustry, which obviates the need for a quality check to be undertaken by the vehiclemanufacturer as the components are delivered directly to the OE clients in a ready-to-usequality certified form. However, enforcement of quality control calls for increasedinvestments in technology and automation of facilities.

Declining Pricing Flexibility: As the auto ancillary industry is characterised by deriveddemand, pricing flexibility in the industry is constrained by the pricing pressures on theend-user auto sector. In the scenario of price-based competition amongst VMs, thecomponent manufacturers are faced with considerable pressure on their realisations and arefrequently required to absorb increases in the cost of production with consequent pressureon profitability. Consequently, operational efficiency and cost control initiativesincreasingly determine profitability in the industry. However, certain players in industrysegments such as fuel injection equipment and engine valves have not been significantlyimpacted, primarily on account of their strong competitive position in terms of marketpresence and operational efficiencies.

Technological Changes and Impact on Profitability: The expansion in the range ofvehicle models, particularly in the passenger car segment, has warranted significantinvestments in the design and tooling capabilities of component manufacturers. Further, theincrease in the number of variants has the effect of reducing the batch size thereby leadingto lower asset utilisation levels and an increase in the cost of production.

Tierisation: The demanding requirements from the new VMs, the need for investments innew capacity, quality improvement systems and technology upgradation are expected tolead to the emergence of tierisation in the industry. The Tier I manufacturer outsourcessub-assemblies from various Tier II players, (who buy sub-components from Tier IIIplayers), and assemble entire system modules to be used as inputs by the VM. The Tier Isupplier would be made responsible for the quality of the sub-assembly including the sub-components and would be required to make significant investments in quality control andinventory management. Players engaged in the manufacture of complete assemblies andhaving superior inventory and production management systems, quality certification fortheir product and processes and financial strength are well positioned to emerge as Tier Iplayers.

Consolidation: As witnessed in the global markets, the domestic auto ancillary industry isalso likely to increasingly witness consolidation. Additionally, it is also likely that theforeign partners would gradually try to increase their stake in the joint ventures formedwith the Indian players. Further, domestic manufacturers of components are likely toexplore mergers and acquisition possibilities to emerge as sub-assembly manufacturers.Entry of foreign players is also likely in the product segments requiring a high degree ofquality and technological support.

Future Scenario

The recovery in the CV and passenger car segments is expected to translate into a significantgrowth in demand for ancillary segments over the short to medium term. Growth in the two-wheeler segment would continue to be strong with the motorcycle segment expected to record ahigh growth. Tractors would continue to witness a moderate growth of 10% over the medium

term. Component manufacturers with exposure to the two-wheeler and tractor segments wouldtherefore continue to witness steady growth rates.

However, growth in the domestic ancillary market would also be dependent upon growth in thereplacement market. The increasing stock of vehicles in the country and the rising scrappagerates of vehicles are expected to be the key demand determinants in the replacement market.Further, the increasing share of high-value vehicles and increasing outlay for vehiclemaintenance necessitated partly by stringent governmental regulations are expected to drivevolumes growth in the replacement market. Moreover, reduced competition from theunorganised sector due to the rising complexity of the vehicle parts would also lead tosignificant growth for the organised sector.

The export earnings from certain segments of the industry, where global players havecommissioned significant capacities such as brakes, shox etc. are expected to increase as theseplayers are developing India as an export base. Existing players would continue to increasefocus on exports in order to counter downturns in the end-user auto sector.

The industrys profitability would be dependent to a large extent on the performance of theCVs segment over the short to medium term, as this segment is characterised by reasonablepricing flexibility. Companies with varied exposure across vehicle segments would also benefitas they enjoy the flexibility of cross-subsidisation, which in turn may lead to higher sales andincrease in market share. Over the short to medium term, the performance of players in thereplacement market assumes importance in order to maintain steady cash flows.

The impact of tierisation in the domestic industry is expected to increasingly relegate a numberof small and medium-sized units to servicing the replacement market over the long term. This isexpected to increase the pressure on profitability in the replacement market. Moreover, theemerging trend of single-supplier sourcing is expected to find increased acceptance resulting inlower pricing flexibility for component manufacturers unless significant volumes from thereplacement market is implied. Further, the large number of variants and models is expected toresult in lower capacity utilisation levels and a consequent decline in operating profitability.This could however be partly countered by the establishment of flexible manufacturingsystems, which would enable the manufacture of low batch volumes. Moreover, the reductionin the number of vehicle platforms would also translate into significant volumes for thecomponent manufacturer and result in lower developmental cost of components.