Air-conditioning & Refrigeration Industry Pre - Budget Memorandum 2003-04 RAMA 13 December 2002, New Delhi.

Air-conditioning & Refrigeration Industry

Pre - Budget Memorandum 2003-04

RAMA

13 December 2002, New Delhi

2

RAMASUMMARY OF KEY MESSAGES- AIR-CONDITIONERS, 1

• The Indian AC market size is Rs 2,790 crore comprising the household and commercial segments. The market is currently at a nascent stage and shows tremendous promise to grow. However, despite the reasonable growth in the last few years, the growth potential has not been entirely captured.

• The key bottleneck to growth is the low affordability of ACs. This is clearly evidenced in the Chinese market where substantially low price points (less than 50% of Indian retail prices) have driven penetration of ACs.

• In order to capture the growth potential, a substantial reduction in price is required. The primary cause for the high prices is the high incidence of indirect taxes, excise duties and import duties on the product category : accounting for close to 45% of the MRP. In particular, the abnormally high excise duty of 32% is a major deterrent to growth.

• With government support in duty and tax rationalization, the AC market can grow very rapidly over the next 5 years to as much as Rs. 14,000 crores by 2007. Reducing excise duties, indirect taxes and import duties is a win-win-win solution for the government, players and consumers.

• The specific short term proposals include:

– A reduction in excise duty from 32% to 16% with 40% abatement beginning March ‘03

– Excise exemption in certain states such as Jammu, North East to be repealed as they destroy value for government, players and consumers and confer none of the intended benefits to the system

– A reduction of import duty to 25% for finished goods and 15% for components beginning Mar-03

3

RAMASUMMARY OF KEY MESSAGES - COLD CHAIN, 2

• Agriculture has been recognised by government as a focus area

• Cold chains (84.18) are a vital part of the agricultural chain

• There is a huge unrealised potential for– Preserving food and dairy products– Improving food distribution– Reducing cost of food to the common man

• Cold chain enjoy excise exemption. however, CENVAT credit on inputs is not available

• To maintain the spirit of exemption from incidence of taxes, replace exemption to cold chain by refund/ subsidy

4

RAMATHE INDIAN AIR-CONDITIONING INDUSTRY IS A Rs 2,790 CRORE MARKET

Source: Francis Kanoi; Industry estimates

Segment Value Volume Applications

1 Window ACs Rs 1200 crore

540k nos Homes, SOHO

2 Mini Split ACs Rs 730 crore

220k nos Homes, offices, shops, showrooms

3 Ducted Split and Packaged AC

Rs 400 crore

216k tons Commercial establishments

4 Chillers and Central Plant

Rs 460 crore

272k tons Industrial, institutional and large commercial

Rs 2,790 crore

Major players

• Amtrex Hitachi• Blue Star• Carrier Aircon• Daikan Shriram• LG• Samsung• Voltas• Whirlpool• O’General• Matsushita

Industry investment in line with potential resulting in surplus capacity leading to oversupply and price wars

5

RAMATHE RESIDENTIAL SEGMENT IS FAST OVERTAKING THE COMMERCIAL SEGMENT IN RAC WHILE THE PACKAGED AC HAS WITNESSED LIVELY GROWTH IN RECENT PAST

Source: Francis Kanoi; Industry estimates

Increasing share of domestic segment in RAC

• Growth of residential segment driven by higher affordability and disposable income, changing lifestyle in perceiving AC as need rather than luxury

• Residential segment expected to drive growth of RAC & eventually will increase share >80% as in the most markets

Packaged AC displays, thrice the growth of GDP

‘000 TonsEstimates

Actual

Commercial

Residential

215

185

165

141

123110

'97-98 '98-99 '99-00 '00-01 '01-02 '02-03

14%

• Easy Availability of comprehensive range of ducted splits and ductless flexible PAC system & improved affordability will drive future growth on the back of high growth in IT, healthcare, retail, telecom, financial services, entertainment, leisure & tourism and other services sectors.

6

RAMA

TREMENDOUS POTENTIAL FOR HOUSEHOLD AIR CONDITIONER MARKET TO GROW, GIVEN LOW PENETRATION

Very low penetration Leading to huge untapped potential of 83 mn*

Per cent of all households

Million

Taiwan

Hong Kong

Korea

Malaysia

Thailand

China

Indonesia

India

38

144

182 0.11.7

180

3

61

5

2883

Total HH

HH with refrigerators

Untapped potential

Unelect-rified

Below poverty line

Untapped potential

Small towns and Rural

Urban

1.8

144

36

64

33

55

28

Multiple ownership

Source: Francis Kanoi; NCAER

*After removing households below poverty line and in uncertified areas

+

7

RAMAHOWEVER GROWTH IS LOWER THAN POTENTIAL AS AC IS VERY EXPENSIVE PURCHASE EVEN FOR HIGH INCOME CLASS (1/2)

Price income multiple for ACs in China**

Income class P/I multiple Penetration

Per cent of all HH

Bottom 40%

Next 20%

Next 20%

Next 10%

Top 10%

Sizable population in India finds ACs expensive

Income class Penetration

Price/Monthly income multiple

Untappedpotential*

Up to 12,000

12,000 – 16,000

> 16,000

@ price ofRs.21,000

# HH mnPer cent

*After removing households below poverty line and in unelectrified areas**Based on Urban population***Monthly household income

Source: Francis Kanoi; IMRB; NCAER

MHI***

8

RAMA

HOWEVER GROWTH IS LOWER THAN POTENTIAL AS AC IS VERY EXPENSIVE PURCHASE EVEN FOR HIGH INCOME CLASS (2/2)

Source: Francis Kanoi, ORG-GFK

Growth has been lively in household air conditioner market but less than potential

Value

Rs. Crores

Volume

‘000 units

1995 1998 2000 2001 2002

25% 9% 31% 30%

1995 1998 2000 2001 2002

18% 17% 26% 31%

9

RAMATHE HUGE DIFFERENCE IN RETAIL PRICES BETWEEN INDIAN AND CHINESE ACs EXPLAINS THE LOW PENETRATION, DEMAND

Chinese retail prices are more than 60% lower than Indian retail prices

Type of AC Indian price Chinese price

US$ US$

• 1 Ton window 360 136

• 1.5 Ton window

420 185

• 1 Ton split 555 199

• 1.5 Ton split 635 280

This explains difference between Indian and Chinese statistics

Domestic market

• India : 0.3 mn units• China : 14 mn units

Penetration

• India : 1%• China : 20%

GDP

• RAC’s contribution to GDP in China is 4 times that of India

Exports

• India : Insignificant • China : 5.9 mn units

10

RAMA

. . . AND CHINA EMERGED AS LARGEST MANUFACTURER, EXPORTER OF RACs ON BACK OF LARGEST DOMESTIC MARKET

Source: Appliance Magazine

Historical similarities with India: Large rural population, lack of basic infrastructure& low penetration (till 80’s)

6201520

2750

3800

4800

58006500

7800

10000

12000

14000

620130 200 280 350 360 405 470 544 615

115

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

China

India

• In the last decade the Chinese RAC market has grown from 6 to 23 times the Indian RAC market, despite Per Capita PPP differential of only 1.7 times

• Today China is the largest manufacturer & exporter in the world with a CAGR of 46% in last 11 years

• China leading due to– Economic reforms,

localisation of ancillaries, dominance of domestic brands and entry of MNCs

– Lower Prices leading to increased affordability; single VAT of 17%.

– Export competitiveness due to large Scale operations for domestic market itself

11

RAMATHE HIGH INCIDENCE OF INDIRECT TAXES AND DUTIES IS THE PRIMARY CAUSE FOR THE HIGH PRICE POINTS Effect of

government policyTypical 1.5 ton window AC

Rs

Keyassumptions

Manufacturing cost

Manufacturing margin

Freight, warranty

Sales tax, octroi

Excise duty

Channelmargin

Consumer price

Discount MRP

8115

21051000

10003395

4215

1170

22000100021000

• High import duty 30% for key components

• Weighted average range of 12%-21%

• Octroi/entry tax of 3%

• 32% with 40% abatement

• AC is still perceived as luxury

Duty effect

Source: McKinsey Analysis & Interview of Players

46% - Rs 9,715

54% - Rs 11,285

12

RAMATHE LOW ABATEMENT IS NOT IN LINE WITH THE HIGH POST MANUFACTURING COST NOR IS THE EXCISE DUTY ON PAR WITH OTHER WHITE GOODS

• Highest rate of ED and sales tax amongst white goods

– ACs: 32% ED on 60% of MRP; sales tax of 21%

– Refrigerator : 16% ED– Driven by perception of AC as a

luxury – today, AC is a need especially in a tropical country like India

– Further, amendment in the CST Act, almost all AC sales subject to LST which is higher than refrigerators

• Abatement of 40% not in line with high post manufacturing costs

– Post manufacturing costs of AC is 52.7% of MRP leaving a gap of 12.7% (given abatement of 40%) on which no abatement

Head Base Value Remark

MRP 100.00

Excise Duty 19.20@32% with 40% abatement

Octroi/Entry or TO Tax

1.00Weighted Average (Range 0 - 5.5%)

Sales Tax 15.00Weighted Average (Range 12 - 21%)

Primary Freight 2.00Avg. Freight including Insurance

Secondary Freight 1.00

Dealer Margin on MRP

12.00

Warranty Pay-out 2.50

Total Post-Mfg. Cost 52.70Abatement allowed 40%, gap-12.7%

Source: Industry Sources

13

RAMATHROUGH CONTINUED EFFORTS BY PLAYERS BACKED BY GOVERNMENT SUPPORT SUPPORT, THE INITIAL PRICE OF AN AC CAN BE BROUGHT DOWN DRAMATICALLY

Typical 1.5 ton window AC

Rs

Keyassumptions

Current price

Cost reduction effort by players thru design, scale & anciliarisa-tion

Reduce excise duty to 16%

Rationalise indirect tax and import duty structure

Final possible price

• Single VAT of 15%

• Single import duty of 10% across value chain

21000

4600

23003100 11000

Source: McKinsey Analysis & Interview of Players

14

RAMAREDUCING EXCISE DUTY ON ACs FROM 32% TO 16% WILL BE TAX POSITIVE FOR THE GOVERNMENT

Current tax rev. (ST+ excise = 35%)

Total loss due to decrease in tax rate at current volume

Offset due to increase in demand at reduced price

Net loss due to lowering excise duty to 16%

Tax revenue potential (intermediate)

Gain due to increased compliance

Reduced costs due to scale leading to reduced prices and increased demand at new duty levels

Total revenue potential

Current tax revenue indexed to 100

20,000

22,000

24,000

26,000

28,000

30,000

100 150 200 250 300 350

Price elasticity for ACs

X

Price (Rs)

Volume (’000 unit)

Price elasticity of ~3, meaning a 30% drop in price will result in 100% increase in volumes

Source: McKinsey Analysis & Interview of Players

15

RAMAFURTHER, MOVING TO SINGLE VAT AND IMPORT DUTY WILL NOT AFFECT TAX COLLECTION ADVERSELY

Change in tax revenues

Current total tax revenue indexed to 100

Current tax rev

ST+ Excise -25%

C.Duty – 24%

Loss due to lowering VAT to 15%

Loss due to lowering duty to 10%

Tax revenue after reduct-ion in rates

Indirect Tax gain due to increas-ed sales

Direct Tax gain due to increas-ed sales

Gain due to increas-ed compl-iance

Gain in duty revenue due to higher consum-ption

Total

Rev. poten-tial

Company driven actions to lower prices, hence improve demand and tax collections

Reve-nue poten-tial

Gains in tax

revenue

Gains in duty

revenue

Source:CII-McKinsey Study on “Learning from China to Unlock India’s Manufacturing Potential”

0

100

200

300

400

500

600

700

0.00 0.50 1.00

Price elasticity for manufactured goods

Price/Income

Refrigerators

Color TVs

16

RAMA

THE FINAL OUTCOME WILL BE A WIN-WIN-WIN SITUATION FOR PLAYERS, GOVERNMENT AND CONSUMERS

•Domestic AC market can be a huge market by 2007

• Size of domestic market Rs 6280 crore and 4.3 million units with further growth possible

• Increased standard of living for consumer

– AC will become a need and productivity enhancer

•Growth in exports will earn foreign exchange for country

• Scale in domestic market will drive competitiveness in exports (e.g., Chinese exports of 5.9 million units driven of domestic volume of 14 million units)

• Household AC exports can be Rs 700 crore

17

RAMAON THE OTHER HAND, NOT IMPLEMENTING INITIATIVES WILL CONTINUE TO HAMPER INDUSTRY PROFITS AND A MAJOR OPPORTUNITY WOULD BE LOST

0

20

40

60

80

100

120

1998 1999 2000 2001 2002

Price (Index 1998 to 100)

Total variable cost(Indexed 1998 to 100)

• Further price reduction very difficult at current costs

• Current costs difficult to reduce at current volumes

• Industry deadlock

Price cost squeeze adversely affects players’ profitability

Source: Analysis

18

RAMAPROPOSALS TO GOVERNMENT - EXCISE DUTY, 1

1 Excise duty rates and exemptions

Excise duty rates - Air-conditioners (84.15)• Excise duty and abatement to be brought on par with white goods (16% excise duty

and 40% abatement) effective March 2003

Excise duty exemption• Excise duty exemption to SSI to be withdrawn as it has outlived its purpose & large

gap between the duty payable and the input duty is a potential threat for leakage in revenue

• Locational exemptions for manufacturing in North-East and Jammu for air-conditioners to be repealed as this has led to creation of finishing, packing & invoicing hubs, adding to fragmentation of manufacturing and inability to capture scale economics

– This exemption destroys value for government, players and consumers and confer none of the intended benefits to the system

– The exemption is financially attractive due to large gap between duty payable at 32% and all inputs at 16% with no requirement of value addition or minimum employment. In fact air-

conditioner is the exception and not covered in the negative list

• If existing notification can’t be repealed, amend the notification by adding – condition for value addition– criteria for investment/employment

19

RAMA

PROPOSALS TO GOVERNMENT - EXCISE DUTY, 2

2 Excise exemption for Cold Chain (84.18)

• Cold chain enjoys excise exemption under General Exemption No 66 in List 44

• However, CENVAT credit on inputs is not available

• To maintain the spirit of exemption from incidence of taxes

–cold chain may be covered under payment of excise duty at 16%

–grant refund of Terminal Excise Duty (TED) to manufacturer or ; –grant additional subsidy, equivalent to excise duty, to user

20

RAMA

PROPOSALS TO GOVERNMENT- CUSTOMS DUTY, 1

1 Customs duty

Broadly in agreement with the recommendations of Kelkar Committee:

•2003-04 : –25% on finished goods and –15% on raw material, inputs and intermediate goods

•By 2004-05 : 2 tier structure with –20% on final goods and –10% on raw material

•By 2006-07 : single 10% import duty across value chain

Recommend equal reduction of 10% in rate of custom duty to meet the target rates.

Thank You