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 61510663 Page 2 . the demand of market pulp was still reasonably high. To understand the dynamics of the industry we did the Porter's analysis on both the paper and pulp industries separately. Profits for suppliers in forestry industry depended on the buyers and market trends. it was also constrained by a highly concentrated conglomerate based ownership. which were the only buyers of pulp. 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. given the cyclical trend pulp market was a major concern. We could conclude that going forward Aruaco should backward integrate rather than going into the paper market. and wanted to explore cost leadership advantage in a new forward integration to paper industry. Attractiveness of the Pulp Industry . by holding 1. Then we considered the competitive advantages that Arauco enjoyed due to internal and external factors using PESTEL framework. Despite being a well-managed company. Arauco enjoyed a competitive advantage by the virtue of captive forest resources and sustainable plantations. 2014 Aruaco was a pulp industry leader from Chile that had subsequently moved to energy. forestry and wood products through a backward integration process.000 hectares of plantations. However entering paper industry would take the company away from its core competency and shift it towards an arguably receding paper market. the aspect of exposure to market risk. 183 million tons of pulp was manufactured and companies vertically integrated into the PGID: 61510267. were backward-integrated into pulp industry. While being based in Chile.Porter's Five Forces Analysis Low bargaining power of suppliers: Most of companies in pulp industry were backward integrated into forestry. In 2003. The company had shown superior results.Arauco (A): Forward Integration or Horizontal Expansion? ber 23. the company enjoyed the advantages of a resurgent and investment friendly economy and opening trade barriers. For example. We also did a comparative study using the data presented to understand what benefits forward integration gave as compared to backward or horizontal integration. 61510575. Medium bargaining power of buyers: Although most of paper companies. The board of the company was circumspect. 61010338. 61510346.200. 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. 61010338. 61510663 Page 3 . pulp mills were specially designed for distinct wood types and were highly inflexible to diversification.. which would mean high threat of substitutes for pulp too as paper industry was the primary consumer of pulp. Heavy investment was required in building a pulp production company with a rich and diversified product line. The expected pulp price increase was however driven by the demand from the paper companies. Further.2 million tons. Just 41 million of pulp was in fact left in the market.Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 2014 pulp and paper industry used 142 million tons. The market share of five largest market pulp companies was only 27%. 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. giving it a leadership driven competitive advantage. Medium threat of substitutes: The recycling of paper and the introduction of electronic equipment as substitutes of paper. High industry rivalry: Pulp industry was fragmented. Porter Five forces . 61510346. Pulp manufactures were competing on cost by increasing efficiency in production and backward integration. 61510575.Pulp Industry PGID: 61510267. Arauco clearly enjoyed a lot of benefits due to external factors affecting its business. 61510575. low inflation and high GDP growth country. Nevertheless. But Arauco maintained its leadership in the market and was actually a cost leader. particularly Europe and USA held promise. 61510346. its capabilities cannot be doubted as it clearly invested in itself by creating its own internal competitive advantages. 2014 We could see that the industry was highly capital intensive and had fairly high competition. with difference in pulp costs as high as $200 per metric tonne with the next competitor. 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. 61510663 Page 4 .Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 61010338. Middle income. ideal for expanding industries Less diversification meant pulp prices had major impact on the industry climate. PGID: 61510267. 61010338. 61510346. 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. Considering the instability of the pulp market and along with the evolution of its forests. The soil fertility helped gave higher yield per hectare. 61510663 Page 5 . (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. 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. 61510575. 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.6% of sales were exports. Few highlights – - Arauco has cut down its transportation times by implementing its’ sawmills closed to plantations. Favorable exchange rates for export industries allowed Arauco to bring down its operational costs and cost of capital. PGID: 61510267.Arauco (A): Forward Integration or Horizontal Expansion? ber 23. refer exhibit 10 – for regional growth rate of Arauco’s sales) helped them remain highly competitive. Arauco (A): Forward Integration or Horizontal Expansion? ber 23. But the prices in pulp market were highly unstable due to a fragmented industry. 61510575. Not only did Arauco generate internal advantages but it also took steps to hedge against uncertainty by diversifying its business by horizontal integration. As the pulp prices had remained low in the last few years and the demand nearly constant. 61010338. - 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. wood products were Arauco's engines of growth with high year on year sales growth. Perez's horizontal growth and diversification strategy was important in the following ways: With prices more stable in this segment. Moreover. therefore it helped other segments grow. PGID: 61510267. Arauco since year 2000. the only forestry science and technology research centre in Chile. helped Arauco constantly improve the quality of its plantations and develops new business opportunities. Perez could decrease the adverse effects of sudden price fluctuations in the pulp market. which made up nearly 47% of Arauco's sales. 2014 - Creation of Bioforest. The automated log merchandising process saved more than $50 million dollars per year. Diversification benefits to Arauco Pulp sales accounted for 50% of Arauco's sales. had started investing more in increasing its capacity of wood products manufacturing. 61510346. prices of pulp in the last few years had a downward trend. Nearly 40% of the revenues from wood products segment generated inter segment sales. 61510663 Page 6 . the only Chilean manufacturer engaged in important energy trading. switching costs were low. 61510346. The overall global demand for paper depended on economic activity. even after this period of consolidation. and China and India were slated to be one of the largest consumers of paper in the coming years. Now with the market showing signs of upward trend in pulp demand. Most of the industry is backwardly integrated into pulp and forestry. it was necessary for Arauco to invest in increasing pulp manufacturing capacity to take advantage of the growth trend.Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 61510663 Page 7 . Attractiveness of the Paper Industry . The transportation costs hindered their bargaining power. However. Industry rivalry: Medium. PGID: 61510267. Since the paper is a commodity product. Besides moving out of core competency could not be considered as a good decision in commoditized industry with low margins. increase capacity and lower costs. Being a commodity. 61510575. companies has to adapt to market prices and cannot charge any premium. 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. The industry had undergone a number of mergers and acquisitions in the 1990s as pulp and paper manufacturers struggled to enhance profitability. producers did not have bargaining power.Porter's Five Forces Analysis Bargaining power of supplier: low. the market pulp industry was still fragmented which resulted in price volatility. Additionally. Bargaining power of buyers: High. 2014 The strategy that Perez followed had paid off as the company continued to grow with flat pulp sales. 61010338. therefore the growth outlook of the industry looked attractive. Moreover. 61510575. on the other hand the recycled paper could be used up to seven times. Paper industry is a highly capital intensive industry and most of the larger players are integrated backwards and are present in multiple product lines. to reduce chemical by-products such as chlorine. limit gas emissions from the operation of factories and increase recycling. 61510346. Due to the increased regulation. Threat of substitutes: High. These factors made it very difficult for new players to compete with the established players. some industry observers were of the opinion that use of computers. 42% of the paper was recovered for recycling. 2014 Threat of new entrants: Low. Paper cannot be reused. governments has been increasing regulations for paper companies to avoid clear-cutting forests. 61010338.Arauco (A): Forward Integration or Horizontal Expansion? ber 23. recycling paper industry was increasingly emerging as one of the sources of threat to the industry. Already in the US. Also. Lately. handheld devices and mobile phones were emerging as substitute to paper. it was required to invest an amount equal to depreciation to preserve plant efficiency. 61510663 Page 8 . PGID: 61510267. This creates a further barrier to entry. gross margin and SG&A margin stabilized. which in turn. It could be inferred that Arauco successfully managed to keep constant those ratios while increasing production. In reality. Arauco could reorganize the allocation of its workforce to bring back the ratio production volume to No. only Aracuz generates a PGID: 61510267. in fact. Arauco was able to mitigate the effects of the unfavorable market conditions in 2002. 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. of employees to the level obtained in 2001. the majority of Arauco’s sales are originated by the pulp business line. Exhibit 4 presents a few ratios that indicate how well the company manages the available resources. both backward and forward. Overall. 61510663 Page 9 .Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 61510575. It should mention that the net income margin rose from 2001 to 2003 although Arauco faced unfavorable price fluctuations. which negatively impacted the ratio sales per employee. With the growth in the market also highly uncertain it was imprudent to venture into paper industry. It appears that Arauco hired more employees than needed. from $29M in 2002 to $100M in 2003. 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. As a result. Indeed. 61510346. resulted in a drop of the ratio production volume / No. Arauco may improve its profitability. see Exhibit 2. hence. of employees. in 2002 and 2003 the pulp division contributed to approximately 50% of the group’s EBITDA. 61010338. it would be worth exploiting this upward trend to increase profitability. Conversely. However. such strategies drag down profit significantly. on the whole. it should be pointed out that diversification and vertical integration. Horizontal Expansion and Backward Integration over Forward Integration Exhibit 1 shows the significance of the pulp business is towards the overall EBIDTA. Moreover. more importantly. as shown in Exhibit 3. only the forest division was able to enhance its profitability considerably. Exhibit 5 presents the Dupont analysis of Arauco and its five major competitors. do not imply increase in profitability. Further reasons for the investment in the pulp mill are listed below: NPV of the project amounts to $1. Conclusion From our perspective. 61510575. high leverage. see Exhibit 5 The company has been able to withstand pulp prices fluctuations. 61010338. Additionally. 2014 good profitability margin (14. under the assumption that the FCFs are around $350m per year. Arauco should invest in the new pulp mill to further strengthen its market position. vertically integrated companies show a high leverage compared to backward integrated firms. Furthermore.Arauco (A): Forward Integration or Horizontal Expansion? ber 23.35bn. with the exception of CMPC. 61510346. maintaining a constant gross margin and above all increasing the net income margin Exhibit 1. EBIDTA breakdown PGID: 61510267. we believe that in the coming years a series of mergers will occur given the poor profitability of some players.8%) because it is only backward integrated and focused on its core business. Sales breakdown Page 10 . It is worthwhile to mention that the asset turnover is greater in completely vertically integrated companies presumably because other divisions generate substantial sales. 61510663 Exhibit 2. It appears that this industry needs economy of scale to compete in this highly intensive sector to boost profitability. Dupont analysis: Arauco and its 5 main competitors PGID: 61510267. 61510575. Key Ratios Exhibit 3.Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 61510663 Page 11 . 61010338. 2014 Exhibit 3. Efficiency ratios Exhibit 4. 61510346. 2014 Exhibit 6. 61510346. 61510663 Page 12 .Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 61510575. Cost Comparison of pulp cost per metric ton by competitors PGID: 61510267. NPV of the pulp factory Exhibit 8. 61010338. Arauco (A): Forward Integration or Horizontal Expansion? ber 23. 61510346. Harvest time comparison region wise Exhibit 10. 61510663 Page 13 . 61010338. 2014 Exhibit 9. Region wise sales growth PGID: 61510267. 61510575.
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