Arauco (A): Forward Integration or Horizontal Expansion?

ber 23, 2014

ASSIGNMENT SUBMISSION FORM

Treat this as the first page of your assignment
Course Name: CDMA_A

Assignment Title: Group written case analysis #1

Case Name: Arauco (A): Forward Integration or Horizontal Expansion?
Submitted by:
(Student name or group name)

Group Member Name

Michele Bellai
Rajarshi Sahai
Manuj Kumar
Abhishek Verma
Jie li

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

PG ID
61510267
61010338
61510346
61510575
61510663

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

Aruaco was a pulp industry leader from Chile that had subsequently moved to energy, forestry and wood
products through a backward integration process. The company had shown superior results, given its cost
leadership in international market in the competitive space of pulp industries and was set to become the largest
player in the world with the addition of a new facility. While being based in Chile, the company enjoyed the
advantages of a resurgent and investment friendly economy and opening trade barriers, it was also constrained
by a highly concentrated conglomerate based ownership.
Despite being a well-managed company, the aspect of exposure to market risk, given the cyclical trend pulp
market was a major concern. The board of the company was circumspect, and wanted to explore cost
leadership advantage in a new forward integration to paper industry. However entering paper industry
would take the company away from its core competency and shift it towards an arguably receding paper
market.
To understand the dynamics of the industry we did the Porter's analysis on both the paper and pulp industries
separately. Then we considered the competitive advantages that Arauco enjoyed due to internal and external
factors using PESTEL framework. We also did a comparative study using the data presented to understand what
benefits forward integration gave as compared to backward or horizontal integration. We could conclude that
going forward Aruaco should backward integrate rather than going into the paper market.
Attractiveness of the Pulp Industry - Porter's Five Forces Analysis

Low bargaining power of suppliers: Most of companies in pulp industry were backward integrated
into forestry. Profits for suppliers in forestry industry depended on the buyers and market trends. For
example, by holding 1,200,000 hectares of plantations, Arauco enjoyed a competitive advantage by the
virtue of captive forest resources and sustainable plantations.

Medium bargaining power of buyers: Although most of paper companies, which were the only buyers
of pulp, were backward-integrated into pulp industry, the demand of market pulp was still reasonably
high. In 2003, 183 million tons of pulp was manufactured and companies vertically integrated into the

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

pulp and paper industry used 142 million tons. Just 41 million of pulp was in fact left in the market. The
expected pulp price increase was however driven by the demand from the paper companies.

Low threat of new entrants: Pulp industry was a capital-intensive industry requiring substantial time to
build pulp mills to the tune of $1 billion and three years. Further, pulp mills were specially designed for
distinct wood types and were highly inflexible to diversification. Heavy investment was required in
building a pulp production company with a rich and diversified product line.

Medium threat of substitutes: The recycling of paper and the introduction of electronic equipment as
substitutes of paper, which would mean high threat of substitutes for pulp too as paper industry was the
primary consumer of pulp.

High industry rivalry: Pulp industry was fragmented. The market share of five largest market pulp
companies was only 27%. Pulp manufactures were competing on cost by increasing efficiency in
production and backward integration.. The Nueva Aldea project-with one billion dollars in investments
in a chemical pulp plant would Arauco the largest pulp producer in the market with production capacity
of 3.2 million tons, giving it a leadership driven competitive advantage.

Porter Five forces - Pulp Industry

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

We could see that the industry was highly capital intensive and had fairly high competition. But Arauco
maintained its leadership in the market and was actually a cost leader, with difference in pulp costs as high as
$200 per metric tonne with the next competitor. Arauco clearly enjoyed a lot of benefits due to external factors
affecting its business. Nevertheless, its capabilities cannot be doubted as it clearly invested in itself by creating
its own internal competitive advantages.
Competitive advantages analysis
Benefits due to external factors are as mentioned below:

Political
Economic

Shift from socialist regime to market driven economy - liberalization

lead to privatization and public ownership of major state companies.

Prospects opening up for free trade with rest of the world, particularly

Europe and USA held promise.

Middle income, low inflation and high GDP growth country, ideal for
expanding industries

Less diversification meant pulp prices had major impact on the

industry climate.

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

Low cost of forestry operations/sourcing. (see exhibit 8 for cost

comparison for different regions)

Agro environment was ideal for fast (half the time of northern
plantations) and sturdy growth trees like Radiata. The soil fertility
helped gave higher yield per hectare. (refer Exhibit 9 time to harvest

Environmental

Legal

pine logs in different regions)

Climate allowed for year-long operation with insignificant impact of

winters.
Improving legal and institutional structures for long term stable
business prospects

Low regulatory constraints with limited focus on climate change

issues.

Sources of internally generated competitive advantages

Araucos has a leading business position in the volatile market pulp industry due to its low-cost production
capabilities (the cost per ton of bleached softwood Kraft pulp was less than $300)

Strong orientation towards exports (84.6% of sales were exports, refer exhibit 10 for regional growth
rate of Araucos sales) helped them remain highly competitive.

Favorable exchange rates for export industries allowed Arauco to bring down its operational costs and cost
of capital.

Considering the instability of the pulp market and along with the evolution of its forests, Arauco has decided
to diversify its product lines to reduce its sensitivities to market hazard.

Investing in tangible assets and using intensive advanced technologies has significantly enhanced the
production efficiency. Few highlights
-

Arauco has cut down its transportation times by implementing its sawmills closed to plantations.

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

-

Creation of Bioforest; the only forestry science and technology research centre in Chile, helped Arauco
constantly improve the quality of its plantations and develops new business opportunities. The
automated log merchandising process saved more than $50 million dollars per year.

The company decided to go further into its original activity by installing its own electricity turbines to
reduce its costs and increase its revenues by reselling its extra electricity production, the only Chilean
manufacturer engaged in important energy trading.

Not only did Arauco generate internal advantages but it also took steps to hedge against uncertainty by
diversifying its business by horizontal integration.

Diversification benefits to Arauco

Pulp sales accounted for 50% of Arauco's sales. But the prices in pulp market were highly unstable due to a
fragmented industry. Moreover, prices of pulp in the last few years had a downward trend. Arauco since year
2000, had started investing more in increasing its capacity of wood products manufacturing. Perez's horizontal
growth and diversification strategy was important in the following ways:

With prices more stable in this segment, which made up nearly 47% of Arauco's sales, Perez could
decrease the adverse effects of sudden price fluctuations in the pulp market.

As the pulp prices had remained low in the last few years and the demand nearly constant, wood
products were Arauco's engines of growth with high year on year sales growth.

Nearly 40% of the revenues from wood products segment generated inter segment sales; therefore it
helped other segments grow.

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

The strategy that Perez followed had paid off as the company continued to grow with flat pulp sales. Now with
the market showing signs of upward trend in pulp demand, it was necessary for Arauco to invest in increasing
pulp manufacturing capacity to take advantage of the growth trend.
The decision to move to paper industry was in consideration so an analysis of the paper industry revealed that
Arauco will not yield the same competitive advantage as it had in the pulp industry. Besides moving out of core
competency could not be considered as a good decision in commoditized industry with low margins.
Attractiveness of the Paper Industry - Porter's Five Forces Analysis

Bargaining power of supplier: low, Most of the industry is backwardly integrated into pulp and forestry.
Since the paper is a commodity product, companies has to adapt to market prices and cannot charge any
premium. The transportation costs hindered their bargaining power.

Industry rivalry: Medium. The industry had undergone a number of mergers and acquisitions in the 1990s
as pulp and paper manufacturers struggled to enhance profitability, increase capacity and lower costs.
However, even after this period of consolidation, the market pulp industry was still fragmented which
resulted in price volatility. 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 the coming years, therefore the growth
outlook of the industry looked attractive.

Bargaining power of buyers: High, Being a commodity, producers did not have bargaining power.
Additionally, switching costs were low.

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

Threat of new entrants: Low. Paper industry is a highly capital intensive industry and most of the larger
players are integrated backwards and are present in multiple product lines. Moreover, it was required to
invest an amount equal to depreciation to preserve plant efficiency. These factors made it very difficult for
new players to compete with the established players. Lately, governments has been increasing regulations for
paper companies to avoid clear-cutting forests, to reduce chemical by-products such as chlorine, limit gas
emissions from the operation of factories and increase recycling. This creates a further barrier to entry.

Threat of substitutes: High, Due to the increased regulation, recycling paper industry was increasingly
emerging as one of the sources of threat to the industry. Already in the US, 42% of the paper was recovered
for recycling. Paper cannot be reused; on the other hand the recycled paper could be used up to seven times.
Also, some industry observers were of the opinion that use of computers, handheld devices and mobile
phones were emerging as substitute to paper.

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

We see that the industry as such is highly competitive and with margins being driven down due to lower
entry barriers and substitutes threat. With the growth in the market also highly uncertain it was
imprudent to venture into paper industry.
However, to substantiate the claim we did a comparative study of the existing industries and considered our
existing position compared to others to find that pulp was the area to grow as it was driving our growth and
profitability.
Horizontal Expansion and Backward Integration over Forward Integration
Exhibit 1 shows the significance of the pulp business is towards the overall EBIDTA; in fact, in 2002 and
2003 the pulp division contributed to approximately 50% of the groups EBITDA. Moreover, the majority of
Araucos sales are originated by the pulp business line; hence, it would be worth exploiting this upward trend
to increase profitability. Indeed, only the forest division was able to enhance its profitability considerably, from
$29M in 2002 to $100M in 2003, see Exhibit 2.
It should mention that the net income margin rose from 2001 to 2003 although Arauco faced unfavorable price
fluctuations; more importantly, gross margin and SG&A margin stabilized. It could be inferred that Arauco
successfully managed to keep constant those ratios while increasing production, as shown in Exhibit 3.
Exhibit 4 presents a few ratios that indicate how well the company manages the available resources. It appears
that Arauco hired more employees than needed, which in turn, resulted in a drop of the ratio production volume /
No. of employees. Conversely, Arauco was able to mitigate the effects of the unfavorable market conditions in
2002, which negatively impacted the ratio sales per employee. Overall, Arauco could reorganize the allocation of
its workforce to bring back the ratio production volume to No. of employees to the level obtained in 2001. As a
result, Arauco may improve its profitability.
Exhibit 5 presents the Dupont analysis of Arauco and its five major competitors; it should be pointed out that
diversification and vertical integration, both backward and forward, do not imply increase in
profitability. In reality, such strategies drag down profit significantly; on the whole, only Aracuz generates a
PGID: 61510267, 61010338, 61510346, 61510575, 61510663

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

good profitability margin (14.8%) because it is only backward integrated and focused on its core business.
It is worthwhile to mention that the asset turnover is greater in completely vertically integrated companies
presumably because other divisions generate substantial sales, with the exception of CMPC. Furthermore,
vertically integrated companies show a high leverage compared to backward integrated firms.
Conclusion
From our perspective, Arauco should invest in the new pulp mill to further strengthen its market position.
Additionally, we believe that in the coming years a series of mergers will occur given the poor profitability of
some players, high leverage. It appears that this industry needs economy of scale to compete in this highly
intensive sector to boost profitability. Further reasons for the investment in the pulp mill are listed below:

NPV of the project amounts to $1.35bn, under the assumption that the FCFs are around $350m
per year; see Exhibit 5

The company has been able to withstand pulp prices fluctuations, maintaining a constant gross
margin and above all increasing the net income margin

Exhibit 1. EBIDTA breakdown

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Exhibit 2. Sales breakdown

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

Exhibit 3. Key Ratios

Exhibit 3. Efficiency ratios

Exhibit 4. Dupont analysis: Arauco and its 5 main competitors

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

Exhibit 6. NPV of the pulp factory

Exhibit 8. Cost Comparison of pulp cost per metric ton by competitors

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Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014

Exhibit 9. Harvest time comparison region wise

Exhibit 10. Region wise sales growth

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