Arauco ltd – forward integration or horizontal expansion
CASE SUMMARIES – FOR STRATEGIC MANAGEMENT CLASSLecture 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 topresent his recommendations to the board of directors on a $ 1b investment in a modern pulpplant. The plant will increase the firm’s capacity by 800,000 tons to 3.2 MT, thus making it thelargest pulp producer in Latin America. Two years back the board approved about US $ 150minvestment in the current plant, increasing the firm’s capacity to current 2.4 MT. The currentplant has a life of about 30 years. current(2400)+800 = 3200The major sales pitch for Perez was the downward trend in pulp prices for last three years, whichworked in advantage for Arauco, as cheaper pulp prices meant that integrated makers now maystart outsourcing. In addition Arauco was a major wood products manufacturer, such as plywoodand fiber wood panels, for which pulp was a raw material. So far the % Capacity utilizationfactor (CUF) for Arauco was 100%. Roughly 50% of the firm’s revenue came from pulp sales topaper 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 rawmaterials like straw bamboo, bagasse, flax, hemp and cotton. However of late concerns of globalwarming resulted in stiff opposition from environmentalists on cutting down forests for pulpmaking and alternative greener sources were gradually becoming popular, although they werenot that cost effective like wood based pulp. However in future, better technologies may makepulp 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 greensources by 2020 and replacing the current internal combustion engine with fuel cell/batterypowered vehicles, the idea of a green planet with low carbon emissions was gaining ground inUSA, CANADA and in Latin America and the opposition to cutting down forests was rising dayby day. Perez’s toughest challenge was to convince the board about his commitment to increasecapacity by another 800,000 tons to become the largest producer of pulp in Latin America andone of the largest in the world. The board, given the green concerns and declining margins wasmore 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
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 industryThe industry can be segmented into five major activities along the value chain. The first wasforestry, followed by pulp, paper and paperboard production came next, followed by distributionand conversion of basic paper into glossy material for packaging. The last stage had the highestprofit margins, as it was a highly creative task and customers like FMCG firms paid high pricesfor creative paper designs. Most of the industry players were involved in two or more activitiesin the value chain. The industry saw a number of acquisitions and mergers in 1990s, as most ofthe paper and pulp makers struggled with rising costs.The overall global demand for paper depended on economic activity and China and India wereslated 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 wereactively campaigning against increasing paper consumption. The trend was to have paperlessoffices and truly move into the digital age. In USA, almost all the major newspaper agencieswere 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 onpaper recycling and in USA alone 42% of the paper came from recycled paper. However, there isa limit to which paper can be recycled, typically ! times. After which the fiber in the paperbecomes too short for recycling and costs rise significantly with each recycling. The industryanalysts were divided in their opinion on future of paper usage. One camp felt that the wholeworld will be one giant and interconnected paperless workplace by 2020. The other camp feltthat such utopian visions are far from realistic and paper consumption will increase, although notlike past and the double digit growth rates of past will not be witnessed again. The global papermarket 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 integratedpaper makers like Kimberly Clerk, which was the 4th largest paper producer in the world then.
The largest being International paper Co, which was also a US based firm. The rest 41 MT wasproduced for small and nonintegrated paper makers, by firms like Arauco which operated inopen pulp market for 50% of its pulp production. At that point of time Arauco was producing 2.4MT and was proposing to increase its capacity to 3.2 MT. the global open pulp market wasgrowing at the rate of 4% per annum, an identical growth rate with paper market. The globalpulp prices touched a peak of 710 US $/ton in 2000, and fell to 400 by 2002, to recover to thepresent 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 pricesin this period went down and then recovered. In 2000, the gross margin was 41%, in 2002 thefirm maintained the gross margin rate, with good cost control and efficient production, althoughthe pulp prices fell drastically during this period. Many of the competitors retrenched people, butPerez desisted such drastic moves and retained all his employees in 2002. In 2004, the grossmargin 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 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
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 andyields.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 theircapacity, costwill decrease over the time. Nueva Aldea Complex is the start-up process whichwill increase itscapacity. Arauco has a leading position in the volatile market pulp industry dueto its low cost production capabilities. They have resources and capabilities which create corecompetency, 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.