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7/27/2019 araucoltdforwardintegrationorhorizontalexpansion-120123013316-phpapp01

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CASE SUMMARIES FOR STRATEGIC MANAGEMENT CLASS

Lecture 2:Corporate Strategy:- Expansion, Integration, Diversification

A) Arauco Ltd Forward integration or Horizontal expansion?In early 2004, Mr. Perez, the president of the Chilean forestry company: Arauco ltd. was about to

present his recommendations to the board of directors on a $ 1b investment in a modern pulp

plant. The plant will increase the firms capacity by 800,000 tons to 3.2 MT, thus making it the

largest pulp producer in Latin America. Two years back the board approved about US $ 150m

investment in the current plant, increasing the firms capacity to current 2.4 MT. The current

plant has a life of about 30 years.

The major sales pitch for Perez was the downward trend in pulp prices for last three years, which

worked in advantage for Arauco, as cheaper pulp prices meant that integrated makers now may

start outsourcing. In addition Arauco was a major wood products manufacturer, such as plywood

and fiber wood panels, for which pulp was a raw material. So far the % Capacity utilization

factor (CUF) for Arauco was 100%. Roughly 50% of the firms revenue came from pulp sales to

paper making firms, the other 50% went into two products: plywood, fiber boards.

90% of global pulp production as at 2004 came from wood, the other 10% from alternative raw

materials like straw bamboo, bagasse, flax, hemp and cotton. However of late concerns of global

warming resulted in stiff opposition from environmentalists on cutting down forests for pulp

making and alternative greener sources were gradually becoming popular, although they were

not that cost effective like wood based pulp. However in future, better technologies may make

pulp making from alternate sources more viable and that day was not very far away.

Given European Unions commitment to generating 20% of its energy requirements from green

sources by 2020 and replacing the current internal combustion engine with fuel cell/battery

powered vehicles, the idea of a green planet with low carbon emissions was gaining ground in

USA, CANADA and in Latin America and the opposition to cutting down forests was rising day

by day. Perezs toughest challenge was to convince the board about his commitment to increase

capacity by another 800,000 tons to become the largest producer of pulp in Latin America and

one of the largest in the world. The board, given the green concerns and declining margins was

more in favor of a strong willed forward integration into paper manufacturing.

Thus the strategic choices for a billion dollar investment were two:-

a) Move up the value chain to become an integrated paper manufacturer with a captive pulpplant like most of the current paper firms and invest in green technologies and alternate

current(2400)+800 = 3200


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materials. However this choice was fraught with unknown financial consequences, as the

paper market was highly fragmented and given the highly segmented demand for a very

large variety of paper products, economies of scale was difficult to achieve. Also the

payback period for investing in green technologies was not known, although everyone in

the back of their minds knew that the future lies there.

b) Horizontally expand into pulp production to obtain further economies of scale, thusbecome the Worlds cheapest and one of the largest manufacturers of wood based pulp.

Here the major concern was declining pulp prices in the global market, due to industry

saturation and rising capacities. However Arauco was already the cheapest pulp producer

in the world and the increase in capacity will make it even cheaper, thus making it tough

for competitors. Although the major paper makers like Kimberly Clerk were integrated

manufacturers, there were numerous small, nonintegrated paper makers in USA and Latin

America, as well as in Asia, who were Araucos main customers for 50% production.

The global pulp and paper industry

The industry can be segmented into five major activities along the value chain. The first was

forestry, followed by pulp, paper and paperboard production came next, followed by distribution

and conversion of basic paper into glossy material for packaging. The last stage had the highest

profit margins, as it was a highly creative task and customers like FMCG firms paid high prices

for creative paper designs. Most of the industry players were involved in two or more activities

in the value chain. The industry saw a number of acquisitions and mergers in 1990s, as most of

the paper and pulp makers struggled with rising costs.

The overall global demand for paper depended on economic activity and China and India were

slated to be one of the largest consumers of paper in coming years. There was a rising oppositionto paper consumption in EU, in tandem with global warming issues and all EU members were

actively campaigning against increasing paper consumption. The trend was to have paperless

offices and truly move into the digital age. In USA, almost all the major newspaper agencies

were losing market to the digital medium and they themselves were moving online gradually.

However Asia still continued to consume more and more paper. The emphasis was more on

paper recycling and in USA alone 42% of the paper came from recycled paper. However, there is

a limit to which paper can be recycled, typically ! times. After which the fiber in the paper

becomes too short for recycling and costs rise significantly with each recycling. The industry

analysts were divided in their opinion on future of paper usage. One camp felt that the whole

world will be one giant and interconnected paperless workplace by 2020. The other camp felt

that such utopian visions are far from realistic and paper consumption will increase, although not

like past and the double digit growth rates of past will not be witnessed again. The global paper

market in 2004 was 330 MT, with an annual growth rate of 4%.

As at 2004, 183 MT of pulp was produced. Out of which 142 MT was produced by integrated

paper makers like Kimberly Clerk, which was the 4th largest paper producer in the world then.


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The largest being International paper Co, which was also a US based firm. The rest 41 MT was

produced for small and nonintegrated paper makers, by firms like Arauco which operated in

open pulp market for 50% of its pulp production. At that point of time Arauco was producing 2.4

MT and was proposing to increase its capacity to 3.2 MT. the global open pulp market was

growing at the rate of 4% per annum, an identical growth rate with paper market. The global

pulp prices touched a peak of 710 US $/ton in 2000, and fell to 400 by 2002, to recover to the

present 510 as of 2004.

A brief word on Araucos internal strengths:-

The firms gross margin rose from 41% to 43% between 2000 and 2004, although the pulp prices

in this period went down and then recovered. In 2000, the gross margin was 41%, in 2002 the

firm maintained the gross margin rate, with good cost control and efficient production, although

the pulp prices fell drastically during this period. Many of the competitors retrenched people, but

Perez desisted such drastic moves and retained all his employees in 2002. In 2004, the gross

margin rose to 48% with increase in pulp prices. Good employee relations were one of the majorstrengths of the firm. The NPBT in 2004 was 30% and PBDIT was 44%.

Strategic issues:-

a) The declining prices works to the advantage of the firm, as integrated paper makers maystart outsourcing from Arauco, the cheapest pulp producer in the world. However the

declining pulp prices also reduces operating margins. As at 2004, the general outlook was

a stable pulp price in the global market for next five years.

b) As of now, Arauco is not dependent on integrated manufacturers for its income. 50% ofits revenue comes from the 41 MT global markets, and the other 50% from value addedwood products. If pulp prices fall drastically in future, and then integrated paper makers

may start outsourcing from Arauco in large scale, thus Arauco may become a B2B firm

from its current B2C business model, which may not bode well for its long term future.

On the other hand if prices remain stable, then Arauco may continue to enjoy the

excellent financial performance.

c) Increasing environmental concerns may work against wood based pulp makers in futureand then Araucos large and new 800,000 ton plant will be a major target for

environmentalists. As of now, green and alternate technologies for pulp production have

not gained ground, due to higher costs of production, but no one knows the future! A

disruptive technology in another five to seven years may surface, thus not giving Araucothe time to recover its billion dollar investment, the estimated payback for which is

around 10 years at current pulp prices.

d) On the other hand, a move into becoming an integrated paper manufacturer (when theentire global opinion is moving against paper consumption) is also fraught with risks, as

this market is highly fragmented and varied. There are five to six different types of paper

consumption, the basic being newspaper, followed by books, office stationery, legal


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documents, packaging material and pamphlets. The last two are the most lucrative

segments. The first three categories are already under onslaught from digital media and

environmentalists. Thus moving up the value chain represents a stiff task and above all

developing a NEW CORE COMPETENCE. The alternative is to develop technological

competence for green pulp manufacturing, the payback for which is once again uncertain.

HENCE THE BILLION DOLLAR QUESTION WHERE TO INVEST THE SUM AND

HOW?

Theoretical lens to examine the case

From Economies of scale and scope to Economies of collaboration and information.

Arauco should move to horizontal expansion.

The aim behind a horizontal expansion is to grow its market share for a Pulp because thhave a cost advantage.

Company needs a growth in a sector that is presently functioning.

Arauco is one of the worlds premier forestry enterprises in terms of plantation areas an

elds.Through horizontal expansion Arouco would become a market leader, it has also a

costadvantage which other havent. The market seems to be moving in its favor for now

least. Asthe result of a horizontal merger company will acheive economies of scale. The

have youngforest. One of the worlds lowest cost producers. When they become a mark

leader, they canadjust prices. They can control demand and supply of the market of pu

The group would prefer to remain a market pulp producer. Pulp is Araucos main indust

activity, generating upto 52% of EBITDA High yielding forest resources increase Arauco

competitive advantages.They will make Competitive positioning in fast growth Asian

markets.Pupl production is the core competency of the Arauco, where they have the co

advantage.They need to increase their production capacity. When they will increase the

apacity, costwill decrease over the time. Nueva Aldea Complex is the start-up process w

ill increase itscapacity. Arauco has a leading position in the volatile market pulp industry

its low cost production capabilities. They have resources and capabilities which create

ompetency, sothey have sustainable competitive advantage over others and due to this are creatingsuperior value. They have high potential for sustained growth and profitabil

Arauco hasconsistently increased its pulp production in previous years and becoming on

the top global producers of market pulp while consolidating its position as a low cost

producer.Arauco will strength its core business of pulp because they are the low cost pu

producer. Costwill also decrease when they increased their capacity. They will become

market leader after increasing capacity and after that they can control demand and sup

and prices of Pulp.

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