Arauco ltd – forward integration or horizontal expansion

1. 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 firm’s 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 firm’s capacity to current 2.4 MT. The current
plant has a life of about 30 years. current(2400)+800 = 3200
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 firm’s 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 Union’s 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. Perez’s 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 pulp
plant like most of the current paper firms and invest in green technologies and alternate

2. 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, thus
become the World’s 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 Arauco’s 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 opposition
to 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.

3. 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 Arauco’s internal strengths:-
The firm’s 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 major
strengths 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 may
start 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% of
its revenue comes from the 41 MT global markets, and the other 50% from value added
wood 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 future
and then Arauco’s 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 Arauco
the 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 the
entire 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

4. 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 they
have a cost advantage.
Company needs a growth in a sector that is presently functioning.
Arauco is one of the worldʼs premier forestry enterprises in terms of plantation areas and
yields.Through horizontal expansion Arouco would become a market leader, it has also a low
costadvantage which other havenʼt. The market seems to be moving in its favor for now, at
least. Asthe result of a horizontal merger company will acheive economies of scale. They
have youngforest. One of the worldʼs lowest cost producers. When they become a market
leader, they canadjust prices. They can control demand and supply of the market of pulp.
The group would prefer to remain a market pulp producer. Pulp is Araucoʼs main industrial
activity, generating upto 52% of EBITDA High yielding forest resources increase Araucoʼs
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 cost
advantage.They need to increase their production capacity. When they will increase their
capacity, costwill decrease over the time. Nueva Aldea Complex is the start-up process which
will increase itscapacity. Arauco has a leading position in the volatile market pulp industry due
to its low cost production capabilities. They have resources and capabilities which create core
competency, sothey have sustainable competitive advantage over others and due to this they
are creatingsuperior value. They have high potential for sustained growth and profitability.
Arauco hasconsistently increased its pulp production in previous years and becoming one of
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 pulp
producer. Costwill also decrease when they increased their capacity. They will become a
market leader after increasing capacity and after that they can control demand and supply
and prices of Pulp.