By Angielina Tay

Introduction

China, one of the fastest growing economies in the world, achieved a per capita GDP of $6,800 in 2005. During the 10th Five-Year Plan (2001-2005), China’s automotive industry underwent rapid growth, which catapulted it to the status of the world’s second-largest automotive producer today.

This industry has been through many ups and downs in the past 50 to 60 years. The history of the Chinese automotive industry can be traced to the 1950s, when the government founded the First Automotive Factory (now the China FAW Group Corporation, China’s largest automotive company) to manufacture the first “Made-in-China” automobile. In the 1980s, the government began approval of foreign investments in the form of joint venture relationships with local companies. Beijing Jeep, formed in 1979, was the first joint venture, followed by Shanghai Volkswagen in 1983.

For China, 2006 is expected to be a challenging year, as it is the deadline for it to open its market to foreign competition, as laid down by the World Trade Organization (WTO) entry agreement. With automotive import quotas coming to an end in 2005, and the final phase of import car tariffs reducing to as low as 25 percent during mid-2006, competition among local car manufacturers and import car dealers is expected to be fierce. Additionally, adjustment in the automotive components tariffs to as low as 10 percent will have an impact on local parts manufacturers, especially affecting industries that do not require high technical skills. However, this may not reshuffle the Chinese automotive industry, because local manufacturers are able to accommodate the needs of their customers with lower prices, hence decreasing demand for imported cars and parts.

‘Aftermarket’ is a general term referring to the Chinese automotive industry as a whole, regardless of products, unless otherwise stated, for example, the heating, ventilation, and air-conditioning (HVAC) aftermarket.  The definition does not take export figures into account.  Furthermore, minivans, light commercial trucks, buses, and trucks are not taken into account.

Chinese Automotive Aftermarket and Its Supply Chains

The Chinese automotive market still has not achieved the global ratio of 1:1.5 between the size of OEM (original equipment manufacturer) market and aftermarket. This increases the scope for expansion in the Chinese automotive aftermarket. This is also one of the important directions stated in the Chinese 11th Five-Year Plan (2006-2010).

To gain share in this potentially large market, many world-class original equipment suppliers (OESs) such as Delphi, Behr, and Visteon, have already entered the market. However, to maximize and to sustain their world-class market leadership in the Chinese market, a few challenges need to be overcome.

The Chinese automotive aftermarket is not well structured. While earning marginal profits from car sales, aftermarket sales and services made up almost 40 percent of OEMs’ core income. Therefore, they cannot afford to lose this income.

In the current market structure, two chains supply parts and services to the aftermarket. One is known as the OES chain. In this supply chain, the OESs are the major parts suppliers to both the OEMs and the aftermarket. The OEMs in China want to control this automotive market as a whole. Therefore, they structure this supply chain as follows: OESs to OEMs and their appointed distributors to 4S shops and their appointed service centers to end-users.  (4S shops are car dealers’ sales, service, spare parts, and surveying operations.  In addition to these functions, they collect feedback from customers.) This is to ensure that they have complete control of the aftermarket for their products. If anyone in this supply chain has depleted stocks, the chain is reversed to obtain stocks. This is the officially recognized supply chain. Chart 1 shows the official and the unofficial chains.

There is another unofficial supply chain, which is the non-OES chain. Suppliers in this chain do not supply the OEM market; they are either counterfeit, knock-off, or recycled manufacturers. Knock-off products are excess production by manufacturers using the original equipment (OE) technologies, and yet unauthorized by the OEMs. Counterfeit products are those that are produced by unauthorized manufacturers. Recycled products will be further explained in the following section.

These non-OES manufacturers can supply stocks to either independent distributors in the market, or any repair shop (both OEM appointed and non-OEM appointed), to reach the end users. 

The dotted lines in the chart represent the undisclosed supply chain. Automotive parts are not to be supplied through this route. Suppliers and manufacturers in the market are not to bypass the OEM to supply stocks to any OE appointed service centers or shops. In other words, OEMs should have full control over the official supply chain, which comprises the entire automotive industry.

Chinese Automotive HVAC System Aftermarket Analysis

The same supply chains also apply to the Chinese automotive HVAC aftermarket. Not many manufacturers supply complete HVAC systems to OEMs -- they usually supply HVAC components separately, and some do so only on request. OEMs usually obtain parts from different OESs to secure their upstream stock supply. Some manufacturers also provide on-site assembly guidance or instructions to OEM customers to avoid troubleshooting issues on the technical side. If any part fails, the OES takes responsibility for solving the problem.

Besides the undisclosed supply chain and the non-OES chain, two other notable supply chains supply to the HVAC components aftermarket in particular.

First is the “recycled products” supply chain. Some companies have their own factories that remanufacture or recycle unwanted old junk parts. There are two ways of collecting these unwanted parts. Firstly, the manufacturers themselves or some junk collectors collect them from the Guangzhou wharf. Tons of rubbish are shipped into China from overseas, and there are people who make a living by collecting and selling recyclable junk. Those who collect parts such as compressors, in particular, are most likely to be the suppliers to the “recycled manufacturers”. Secondly, supply is obtained by collecting thrown-away parts from repair shops.

These kinds of parts usually do not last very long. The lifespan is a maximum of two years, and the replacement rate is 25 percent. These products are also exported to countries such as Spain, Thailand, and Russia. Market demand for these products increased by 30 percent in 2005. These products might not hold a significant share of the aftermarket, but the market certainly cannot afford to overlook them because their recycling rates are unknown, and consumers are keen on such low-cost products. Non-genuine products in this market are usually 50 percent cheaper than the genuine parts obtained from OESs.

There also is an illegitimate supply chain that is undeclared by suppliers. Some OESs are reluctant to dispose of goods rejected by OEMs, which are usually second- or third-grade products. While they seek to maximize revenues and minimize resource wastage, they willingly take the risk of secretly supplying these products to the aftermarket. This is an illegitimate business between suppliers and distributors, which sometimes involves repair shops too. This might be considered a breach of OEM contracts. In this case, not only do suppliers breach the contract, the OEM-appointed repair shops are also at risk of violating their contracts with the OEM. If their wrongdoing is proved, heavy penalties might occur in various ways, such as fines, and the risk of losing the contract.

Each year, OEMs lose approximately 25 to 30 percent of the HVAC aftermarket to the undisclosed supply chains. However, market share lost to recycled products and illegitimate products is unknown.

Some OESs devise strategies to sustain their market shares, such as setting up another manufacturing line under their business, so that any rejected stock will return to their own factory to be recycled and re-labeled. This is a low-price strategy, taking advantage of the unwanted stock and existing market purchasing behavior to maximize marginal profits and sustain aftermarket shares.

Reasons behind Loss in HVAC Aftermarket Share

There are seven important parts in an HVAC system.  These are:

• Compressor
• Condenser
• Heater core
• Radiator
• Accumulator-receiver dryer
• Evaporation valve
• Evaporator

In the Chinese market, HVAC systems are seldom being replaced, unless necessitated by a serious accident. Usually, drivers will prefer to fix rather than replace a part, due to price sensitivity. The Chinese HVAC market is fairly mature. Therefore, there are minimal technical issues in the manufacturing stage. If there are any, they can be easily rectified within the warranty period when car owners take their car to 4S or appointed service shops. In such cases, the OESs are responsible for providing warranty repairs or parts exchange.

The lifespan of HVAC systems in China is estimated to be 15 years and above. Thus, in many cases, HVAC systems are not damaged until cars reach their disposable age. Major replacement occurs for two reasons: technical troubleshoots and major car accidents. Moreover, the replacement of an HVAC system is expensive. Thus, not many owners of older vehicles, aged eight years and above, are willing to replace it.

When the price for original goods is too high, consumers tend to seek substitutes. This is where the business opportunities arise.

Sales are concentrated on compact and medium sedans. Judging the current passenger car’s occupancy rate, most cars also appear to be in the medium- and low-end categories, such as Santana by Volkswagen. Chart 2 shows car sales in China in 2004 and 2005.  Most consumers are able to afford a family car, but not necessarily the expensive after-sale repairs and services from the expensive 4S and appointed shops. It is estimated that stock from non-OESs are about 40 to 50 percent cheaper than genuine stock from the OESs.

Most OEM-appointed service shops are not conveniently located. For example, these shops are located in suburban areas or industrial areas that are not easily accessible to consumers. Therefore, it becomes a habit for consumers to go to those mom-and-pop shops that are easily accessible. Another factor is that service charges in the mom-and-pop shops are lower, and usually consumers can avoid replacing parts, instead just fixing them.

Most consumers bring their cars to the appointed 4S shop or service stations during the warranty period, which is when any HVAC technical problems are easily spotted. After that, most cars are serviced at non-4S shops, as consumers are extremely price-sensitive.
Customers who are able to afford high-end cars are most likely car lovers. They are most likely to continue to service their cars at the appointed 4S shops. As they are not price-sensitive, they are less likely to purchase non-genuine products.

In summary, the major reasons for the undisclosed non-OES supply chain and any illegitimate supply chains to evolve are:

• Pricing: price sensitive Chinese consumers
• Convenience: inconvenient accessibility to 4S shops

Drivers and Restraints 

Drivers in the Chinese HVAC aftermarket are:

• There is an increasing demand for cars, with car production and car sales projected to reach levels similar to those of Japan and the United States over the next five years. HVAC production is almost equal to car production.
• With increasing living standards, and a desire for better a lifestyle, Chinese people are encouraged and able to spend beyond their necessities (for example, luxury cars). In particular, after China’s accession to the WTO, with the reduction of import tariffs and diminishing import quotas, people are moving closer to owning their own dream cars, regardless of whether these are “Made in China” or imported.

Restraints in the Chinese HVAC aftermarket are:

• Technologies are very mature in this industry, with minimal technical difficulties and barriers. Late entrants into this market are less likely to benefit from its mature state.
• The fragmented and unstructured automotive industry, with counterfeit, knock-off, and recycled products available.

Conclusions

The Chinese OE HVAC market is estimated to be almost equal to the country’s car production rate. Therefore, the Chinese HVAC aftermarket is anticipated to be 2 percent of the Chinese OE HVAC market in the next five years.

The legitimate Chinese HVAC aftermarket is expected to remain small until the availability of counterfeit products is reduced and the market structure is reorganized. It will take a while for the market to restore itself to the competitive edge. OEMs need to further reinforce their supply chains and minimize the loss of aftermarket share to illegitimate competitors, regardless of the products.

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