Arauco (A): Forward Integration or Horizontal Expansion?

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

Page 1

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

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 2

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

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 3

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.

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 4

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 

Arauco’s 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 Arauco’s 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.

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 5

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.

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 6

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.

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 7

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.

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 8

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 group’s EBITDA. Moreover, the majority of Arauco’s 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

Page 9

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

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Exhibit 2. Sales breakdown

Page 10

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

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 11

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

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 12

Arauco (A): Forward Integration or Horizontal Expansion? ber 23, 2014 Exhibit 9. Harvest time comparison region wise

Exhibit 10. Region wise sales growth

PGID: 61510267, 61010338, 61510346, 61510575, 61510663

Page 13