Caso Arauco

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.

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



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

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