Saturday, August 17, 2019

Forward Integration or Horizontal Expansion? Essay

In early March 2004, Alejandro Perez, president and CEO of Chilean forestry company, Arauco, was about to present his recommendations to the board of directors as to whether the company should invest US$1 billion to construct a new state-of-the-art chemical pulp plant. The plant, part of a multiphase project called Nueva Aldea, would increase Arauco’s capacity by approximately 800,000 tons to 3. 2 million tons, placing the company as the largest producer of market pulp, just ahead of Aracruz in Brazil. Two years earlier, Arauco’s board approved the first phase of the Nueva Aldea project for US$150 million, which consisted of building a sawmill, plywood mill, and energy complex. The second phase involved constructing a pulp mill following the inauguration of the new Valdivia plant on January 30, 2004. The Valdivia plant had a designed production capacity of 700,000 tons of pulp, with an operating life between 30 and 40 years and expected sales of USD $350 million per year. 1 Perez was concerned about the downward trend in market pulp prices over the last three years. In addition, major paper companies, the sole buyers of market pulp, were typically backwardintegrated into the production of pulp. Perez was confident, however, that the board would trust his judgment given Arauco’s tremendous success in recent ventures into remanufactured wood products (such as cut stock, blanks, clear rips, and decking balusters), plywood, and fiberboard panels. Perez anticipated the toughest question the board would pose: would shareholders be better served by a strong-willed forward integration move into paper manufacturing rather than the horizontal growth plan he was proposing? Furthermore, was a large resource commitment a good strategic move at this point? History of Arauco and COPEC Arauco was formed through a merger between Industrias Arauco and Celulosa Constitucion in 1979. Both companies had been created 20 years earlier by the Chilean government to develop forest resources, improve soil quality, and promote employment. In the late 1970s, the Chilean government had initiated an aggressive privatization program, which resulted in the sale of Industrias Arauco in 1977 to Compania de Petroleos de Chile (COPEC), a conglomerate involved in oil and gas, fishing, ________________________________________________________________________________________________________________ Professors Ramon Casadesus-Masanell and Jorge Tarzijan (Universidad Catolica de Chile) and Research Associate Jordan Mitchell prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright  © 2005, 2006, 2008, 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www. hbsp. harvard. edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School. 705-474 Arauco (A): Forward Integration or Horizontal Expansion? forest management, and pulp. Two years later in 1979, COPEC purchased Celulosa Constitucion, merging the two entities to create Celulosa Arauco y Constitucion SA (referred to as Arauco). Arauco began its expansion plan in the 1980s, which involved purchasing land and plantations and installing new technology equipment to improve efficiencies to compete effectively in the world market pulp arena. The expansion plan paid off as the company’s total holdings in hectares2 grew from 170,000 in 1980 to 1,200,000 hectares in 2003. 3 Throughout the 1990s, the company increased its production capacity by constructing a second line at the Arauco mill, introducing new bleaching systems, entering new product lines, and expanding energy generation at its plants. By 1996, Arauco moved across the border to Argentina to purchase the company Alto Parana, expanding the company’s overall product offerings, land holdings, and production capacity. In 2000, Arauco aggressively increased its capacity yet again by purchasing its third mill in Chile, increasing production in Argentina, and entering into the MDF (medium-density fiberboard) and HB (hardboard) markets through stakes in sawmill PANELS plants such as Cholguan and Trupan. In late 2001, the company commenced a three-year construction project of its new mill, the Valdivia mill, at an estimated cost of US$600 million. The Valdivia plant had opened in January 2004 with a total construction cost of US$1. 2 billion; US$900 million was apportioned to the purchase of the plant’s assets (a pulp plant and other assets), and US$300 million was for the creation of a 100,000 hectare forest. 4 The plant was the world’s fifth-largest bleached kraft pulp plant and the largest in Chile. By 2004, Arauco was one of the world’s premier forestry enterprises in terms of plantation areas and yields. It was also involved in the production of market kraft wood pulp, saw timber, and wood panels with forest plantations throughout Chile, Argentina and Uruguay. Arauco had sales offices in Argentina, Brazil, Mexico, Holland, Japan, and the U. S. , and distributorships in Peru, Columbia, Venezuela, Korea, Taiwan, Thailand, Malaysia, and India. (Exhibit 1 shows Arauco’s corporate structure. ) COPEC was the majority shareholder with 99. 98% ownership of Arauco’s shares. COPEC: This company was founded after the stock market crash in 1929 with the intention of guaranteeing fuel supplies in Chile. 5 As of the end of 2003, the market capitalization of COPEC was approximately US$9. 3 billion, which represented 12% of the market capitalization of all publicly traded companies in Chile. COPEC was publicly traded with the majority of shares being indirectly held by the Angelini Group (via another company, AntarChile). Anacleto Angelini, part owner of the Angelini Group, was deemed to be one of the 10 richest men in Latin America by Forbes magazine. 6 COPEC’s consolidated sales were US$2. 7 billion, with operating income at $375 million. Although 35% of COPEC’s sales7 came from forestry, COPEC’s profits were tied closely to pulp prices, since 78% of the company’s EBITDA originated from Arauco. 8 Other sales were derived from fuels (60. 4%), fishing (1. 4%), and other investments (3. 2%). Arauco’s Strategy Arauco explained its central strategy in a letter to shareholders: The central idea behind our global strategy is to strengthen our position as one of the most important forestry companies in Latin America, employing [the company’s] size to achieve the necessary economies of scale for positioning [ourselves] as a company that provides a reasonable return to its shareholders while properly meeting its responsibilities to its employees, the country and the communities where it develops its activities. In the forestry area, Arauco’s strategy is to increase the value of it forest resources, consisting of radiata and 2 Arauco (A): Forward Integration or Horizontal Expansion? 705-474 taeda pine and eucalyptus through further purchases but especially through making intensive use of the most advanced technologies in genetic improvement, forest management and pest, weed and fire protection. 9 The company felt that it could achieve its strategy through implementing a capital expenditure plan aimed at increasing capacity, efficiency, and productivity in both pulp and wood products. While the company’s current strength was in softwood through its radiata and taeda pine forests, Arauco wanted to increase its hardwood pulp production by planting eucalyptus trees. By using advanced forest techniques, the company hoped that it would improve product quality and increase margins. An analyst described Arauco’s cost advantage in comparison with its northern counterparts: Arauco has a leading business position in the volatile market pulp industry due to its lowcost production capabilities. Unlike bleached softwood market pulp producers in the Northern Hemisphere, Arauco produces bleached softwood kraft pulp for less than $300 per ton. As a result, Arauco has been able to generate positive cash flows during troughs in the market pulp cycle. Nevertheless, like all producers of market pulp, Arauco is not able to escape the impact of pricing swings on its financial performance. This is reflected in the company’s credit protection measures, which have improved over the past two years as prices have risen. 10 Perez gave his view of Arauco’s performance against its strategy, in light of difficult economic conditions in Chile: During several years, the company has been concentrated in the pulp business because we had young forests. But while they were maturing, we developed other important businesses like woods and panels that gave a bit more stability to the results. As well, investments made to improve our assets, our operational strength, and economic conditions—like the favorable exchange rate for export industries—have all helped to reduce operational costs. And, there’s a third reason that we’re different from other large Chilean companies that have a presence in Argentina. We’re oriented to exports. The crisis in Argentina has shook us like it has others, but our focus has allowed us to gain access to other markets and weather the storm. 11 An industry observer commented on Arauco’s decreasing reliance on pulp: â€Å"The firm . . . has been diversifying their business lines to minimize the impact of the volatility of pulp prices—one of their principal sources of income. The search to expand the company’s horizons have already had some repercussions to the company’s image: traditionally, they’ve been called Celulosa Arauco y Constitucion (Celarauco) or Celco, but now the company is positioning themselves more frequently with the name Arauco. †12 Product Segments Arauco had three main product segments: pulp products, such as bleached and unbleached kraft pulp; forestry products like pulpwood and sawlogs; and wood products, which included flitches, lumber, remanufactured wood products and panels. (Exhibits 2 and 3 show Arauco’s overall financials, employee base, and sales by product segment. ) Pulp Pulp was used primarily in the manufacturing of paper and paperboard products, although pulp was also employed in other products like rayon, photographic films, cellophane and explosives. 13 3 705-474 Arauco (A): Forward Integration or Horizontal Expansion? Ninety percent of the world’s pulp originated from wood and 10% was produced through alternative materials such as straw bamboo, bagasse, kenaf, flax, hemp, and cotton. 14 Processes and types There were several types of kraft pulp traded throughout the world. Pulp could either be bleached or unbleached and derived from either hardwood or softwood. Two processes existed for producing pulp: mechanical (produced by shredding logs or wood chips) and chemical (made by cooking wood chips in a solution). Chemical pulp was further subdivided into two groups: sulphite pulp and sulphate pulp (more commonly called kraft pulp, meaning â€Å"strong† in German). By 2004, the kraft process was the world’s predominant chemical pulping method accounting for 95 per cent of all chemical pulp. Kraft pulp was brown in color, and was thus bleached for most applications. For example, in the manufacturing of white paper, pulp was bleached at the end of the pulping process. In contrast, brown paper bags were manufactured from unbleached kraft paper. Arauco elected to produce all of their pulp through the kraft process. a Each region specialized in a given category: for example, northern bleached softwood kraft pulp was produced mainly in Canada, the U. S. , Russia and Scandinavia and bleached eucalyptus kraft pulp was made mostly in Latin America. Arauco’s production of pulp Over 50% of Arauco’s revenues were generated by pulp sales. As of early 2004, Arauco had five pulp mills in Chile: Arauco I, Arauco II, Constitucion, Licancel, and the newly constructed Valdivia. The company also controlled another pulp mill, which was part of the wholly owned Argentinean company Alto Parana. (Exhibit 4 provides information about each mill. ) Arauco Mills (both I and II) were located 600 kilometers south of Chile’s capital, Santiago, in what was known as the eighth region15 of Chile. The annual capacity of Arauco I was 290,000 metric tons of eucalyptus kraft pulp or 200,000 metric tons of RADIATA kraft pulp. Arauco II produced only bleached radiata pine pulp, and its annual production capacity was about 500,000 tons. Both mills were equipped to produce elementary chlorine-free pulp—a pulp that avoided the use of environmentally harmful chlorine gases. Constitucion Mill was located 360 kilometers southwest of Santiago in the seventh region of Chile, and boasted a capacity of 355,000 metric tons of unbleached pulp. Licancel made elementary chlorine-free bleached radiate and eucalyptus kraft wood pulp, which was used primarily in the production of printing, writing, hygienic, and industrial papers. Its production was about 120,000 tons annually. Based in Misiones, Argentina, Alto Parana produced approximately 350,000 tons of bleached softwood kraft wood pulp from tadea pinewood, supplied both from its own plantations and independent sources. The company’s pulp mills were not affected by seasonality and generally ran at capacity throughout the year except eight to ten days of maintenance every 12 months. Arauco was the world’s largest single producer of unbleached softwood kraft pulp, holding 15. 8% of the total market. The company actively exported around the world, with Asia as its major destination for export sales. Pulp represented US$709. 8 million or 48. 7% of Arauco’s sales in 2003. (Exhibit 5 shows Arauco’s pulp exports. ) Arauco Electricity Generation To combat against rising electricity costs in Chile in the first half of the 2000s, Arauco installed two electricity generating turbines beside its pulp production facilities at an approximate cost of $60 million. Combined, the turbines have a capacity of approximately 250 megawatts (MW) per year. Arauco’s plants used 120 MW, leaving 130MW extra electricity generation capacity. Arauco had decided to install the additional capacity (which cost roughly $20 million of the total $60 million) so that it could sell the extra electricity to the Chilean a The word â€Å"kraft† was derived from the German word â€Å"strong. † 4 Arauco (A): Forward Integration or Horizontal Expansion? 705-474 electricity grid. Arauco was the only Chilean manufacturer who engaged in energy trading of such magnitude; revenues from selling off the additional energy averaged about $100 million per year. Selling market pulp Arauco marketed all bleached pulp under the name â€Å"Arauco† and unbleached pulp under the name â€Å"Celco. † Pulp was a commodity and was marketed by pulp producers mostly on price and service to nonintegrated paper manufacturers. Arauco aimed to establish long-term relationships with nonintegrated paper manufacturers by providing competitively priced and high-quality pulp. (Arauco’s cost of producing pulp per ton is shown in Exhibit 6). Besides these costs, there were selling and administrative expenses averaging approximately 9% of yearly revenues. The asset beta of pulp production and sales was 0. 9. Arauco also tightly controlled its inventories, attempting to sell its bleached and unbleached pulp at favorable market prices. (Exhibit 7 shows Arauco’s Chilean bleached and unbleached pine pulp prices (CIF) per metric ton. ) Forests Arauco’s forestry products were classified as either sawlogs or pulpwood. Arauco was Chile’s largest radiata pine owner, with 33% of the country’s total plantations. Radiata pine was a fastgrowing conifer tree and was highly regarded for its quality of wood. Chilean climatic conditions were ideal for the growth of radiata pine, and the country was generally considered to have the richest natural resources of radiata pine in the world. Common uses for the radiata pine were decorative veneer, form work, heavy and light construction, joinery, paneling, pulp/paper products, wainscotings, packing cases, boxes, crates, and building materials. In Chile, the harvesting of pulp logs could take place 16 to 18 years after planting and high-quality saw logs could be harvested in 25 years. In contrast, pulp logs cultivated in the northern hemisphere were harvested only 18 to 45 years after plantation and sawlogs required 50 to 150 years. Radiata pine in Chile had a high yield per hectare due to the quality of soil, making it possible to plant a larger number of pines by hectare. The first seven to 12 meters of the radiata pine tree was the highest quality part and was used in sawmills and plywood mills. The next eight to 13 meters was destined to sawmills or pulp mills depending on diameter and density of knot distribution. The top section was used for pulp and medium-density fiberboard (MDF) production. (Exhibit 8 shows a diagram of a tree and its multiple uses. ) Forests management Arauco’s forest holdings were geographically split by farmlands. To control forest fires, the company operated an organization dedicated to the constant identification and extinguishing of potential hazards. (Exhibit 9 summarizes Arauco’s land and forest holdings in Chile as of year-end 2003. ) In addition to the 900,000 hectares Arauco owned in Chile, it owned 200,000 hectares in Argentina and Uruguay. Bioforest Bioforest was the only forestry science and technology research center in Chile. In its laboratories, nurseries, and greenhouses, Bioforest conducted research and evaluated the latest techniques. The company fed innovations into the rest of Arauco’s operations but did not publicize its findings to the broader research community, nor did it offer consulting services to outside companies. The total spend on research and development was spread throughout several areas of the company and therefore, exceeded the research and development costs listed in the company’s annual financial statements. With advances in genetics and pest controls, Arauco was constantly seeking to improve the quality of its plantations. Bioforest had reached important achievements including the genetic 5 705-474 Arauco (A): Forward Integration or Horizontal Expansion? replication of high-quality radiata pine trees and eucalyptus trees. The company also researched soil fertility and insects aiming to develop strategies for plague control. Among other techniques to exterminate parasites, the company used natural predators biologically designed and reproduced in its own labs. Wood Products From its plantations, Arauco provided logs to sawmills and pulp mills, and to factories for the manufacture of panels. Arauco also sold logs and a variety of wood pieces on the open market. Arauco supplemented its production of pulp logs with purchases in the Chilean market. The plantations owned by Arauco covered approximately two-thirds of the raw material needed for production. The remaining one-third was purchased from providers and forest owners. The company hired independent contractors to perform most of its forest operations (planting, maintenance, thinning, pruning, harvesting, transportation, and access road construction). In 2003, the company employed over 10,000 workers through more than 300 subcontracting deals, with many contractors having long-standing relationships with Arauco. One important activity performed by independent contractors was the transportation from the forest plantations and between mills and ports. Fifteen years earlier, Arauco had owned a complete fleet of trucks, but by 2003 the company had outsourced the majority of its transportation needs. In some situations, Arauco provided capital to truck owners in order to expand and improve services. Arauco strove to establish long-term relationships and made renewable agreements of up to three years with truck owners and operators. Sawmills: Sawmills cleaned, dried, cut, and chopped logs into sawn timber. Arauco’s sawmills varied in capacity and capability, with some designed to produce green sawn timber (wood not dried in a kiln) and others designed to handle kiln-dried wood and remanufactured wood products. Arauco strategically built its sawmills close to its plantations to cut down on transportation costs and reduce time. The company owned 11 sawmills in Chile and two in Argentina that divided their production between sawn timber (green or kiln-dried) and remanufactured wood products, with an annual production capacity of 2. 5 million cubic meters of lumber. Arauco also owned five remanufacturing facilities that produced remanufactured wood products from reprocessed sawn timber. Like its forest operations, Arauco employed independent contractors to operate all of the sawmills and remanufacturing facilities. By 2003, Arauco’s sales of sawmill products represent 27. 5% of total sales. The mills had a total capacity of 5. 4 million cubic meters of sawlogs and 2. 65 million cubic meters of lumber. The Horcones II sawmill in Chile and the Misiones sawmill in Argentina were built in the first quarter of 2000 to increase production capacity by 520,000 cubic meters of sawn timber per year. The investment cost for Arauco was approximately US$52 million. At the same time, Arauco acquired Forestal Cholguan, through which it got the Cholguan sawmill, which further increased production capacity by 300,000 cubic meters of lumber per year. Panels Arauco produced plywood and fiber panels, which represented 20. 4% of the company’s sales in 2003. Arauco had expanded capacity first by building a plywood facility in 1997 at a cost of US$44 million, which increased production capacity by 230,000 cubic meters. In 2000, it built a second production line at a cost of US$30 million, and the total production of the facility reached 340,000 cubic meters. Maderas Prensadas Cholguan S. A. also became part of Arauco when the company bought Cholguan in 2000, increasing the capacity by approximately 300,000 cubic meters of MDF and HB. During 2002, two new mills MDF were set up, one in Chile and another in Argentina at a cost of US$135 million, amounting to a combined production capacity of 500,000 cubic meters. With all of these investments, Arauco’s current capacity was larger than one million cubic meters per year, making Arauco one of South America’s largest panel producers. 6 Arauco (A): Forward Integration or Horizontal Expansion? 705-474 Log Merchandizing Arauco used a process called â€Å"log merchandizing† to determine the location of cuts on each log and the order in which each section was sent to different adjoining facilities. Log merchandizing involved the use of a computer-driven scanner, which identified the log’s diameter, the shape of the knots and the optimal points for the cuts. After a log was cut, it was automatically grouped and then sent to one of three destinations: sawmills for timber, panel production or the chip plant (for eventual pulp production). It was estimated that the log merchandizing process saved millions of dollars per year as a 10-centimeter (3. 9 inches) error variation for an optimal cut in a major batch could result in $50 million in losses. The investment to install the specific assets related to log merchandizing cost about $30 million. As an Arauco executive stated: â€Å"You have no idea of the quality of the tree and the number of knots until you cut it down. The log merchandizing process ensures that we are using the parts of the tree for the right purpose. † Alto Parana Arauco acquired Alto Parana in 1996, with the main goal of kick-starting profitable businesses in Argentina. The acquisition included a pulp mill and plantations. Alto Parana was located 1,300 kilometers northeast of Buenos Aires, in the Misiones province of Argentina. The Alto Parana plant was the biggest pulp market producer in Argentina, with a capacity of 350,000 tons per year of bleached softwood kraft pulp. Arauco obtained raw material from Alto Parana’s plantations. While the plantations spanned 173,000 hectares, only 86,000 hectares were planted. Since these plantations were not sufficient for Alto Parana’s pulp mill capacity, approximately 50% originated from third parties. Alto Parana frequently entered into negotiations with third parties negotiating on the basis of price, quality, availability, and delivery. Sometimes, price negotiation escalated to local government as the forestry industry was the lifeblood of the Misiones province. The proximity of third-party resources was another vital concern as transportation costs ate into margins. Alto Parana was located far away from the main ports in Argentina. Thus, it was neither plausible nor cost effective to transport raw material from other countries. Argentina’s main forestry zones were located in the provinces of Misiones, Corrientes, Entre Rios, Chaco, and Patagonia. Apart from Misiones, where Alto Parana was located, Corrientes was the closest at 300 kilometers from the Alto Parana facility. In 2003, Corrientes had pine and eucalyptus plantations spanning 117,000 and 71,000 hectares, respectively. Exhibit 10 shows the approximate costs of lumber transportation inside Argentina. In addition, there were loading costs associated with moving raw materials from the forest plantations to the plants. Owners of Argentinean plantations had to choose between exporting the wood to foreign nations or selling the wood to local-based enterprises. It was estimated that the following firms would require approximately 50,000 tons of market pulp each. The main Argentinean firms that needed wood as a raw material were: †¢ Celulosa Argentina S. A. , specializing in the production of bleached pulp, and located in Santa Fe, 900 kilometers from Parana, with a capacity of 95,000 tons per year. †¢ Faplac S. A. , manufacturer of PBO (particle boards), located in the province of Buenos Aires about 1,000 kilometers from Alto Parana, with a capacity of 50,000 tons per year. 7 705-474 Arauco (A): Forward Integration or Horizontal Expansion? †¢ Ledesma S. A. , manufacturer of notebooks and commercial paper, with a production facility in San Luis, 1,400 kilometers from Alto Parana. Ledesma manufactured about 85,000 tons of paper a year, although most of the raw material it needed to produce pulp came from sugar cane. †¢ Massuh S. A. , manufacturer of pulp and paper, with a production of 120,000 tons per year. Its pulp and paper plant was located in Quilmes, Buenos Aires province, more than 1,300 kilometers from Alto Parana. †¢ Papelera Jujuy, paper manufacturer, located in Jujuy, 1,100 kilometers from Alto Parana with a capacity of 50,000 tons per year. †¢ Papelera Tucuman, paper manufacturer, located in Tucuman, about 1,000 kilometers from Alto Parana, with a capacity of 50,000 tons per year. Pulp and Paper Industry The global pulp and paper industry consisted of five main activities: forestry, pulp production, paper and board production, distribution, and converting. Most of the larger players in the industry had integrated operations that involved two or more of the above activities. The industry had undergone a number of mergers and acquisitions in the 1990s as pulp and paper manufacturers struggled to enhance efficiencies, increase capacities, and lower costs. Some industry observers felt that the highly fragmented nature of the industry meant that prices were less stable. Several of the larger companies were considered to be fully integrated with the ownership and operation of forests, pulp mills, paper factories, distribution, and converting facilities. Other firms chose to focus on a particular category. The overall paper demand was determined ultimately by consumers’ willingness to purchase products such as newspapers, magazines, office paper, stationary, and a host of home products such as tissue and toilet paper. Paper and paperboard in packaging was widespread and used across most consumer and industrial applications. The overall usage of converted paper products (newspapers, magazines, tissue paper, diapers, etc. ) created the demand, which determined the prices for pulp and paper. The main consumers of paper were from North America, with an average consumption of 326. 5 kilograms of paper per person per year. Western Europe, Japan, and China consumed approximately 190 kilogram per person per year. Developing countries in Asia, Eastern Europe, and Latin America were also increasing their usage of paper products. For example, corrugated paper in China was estimated at 13 to 15 billion cubic meters a year, with growth rates projected to be 10% annually for the next 10 years. 16 The possibility of such growth had spurred several pulp, paper, and chemical companies to form joint ventures with Chinese firms. Pulp and paper prices fluctuated as producers lowered prices in times of soft demand, and moved to increase supply by building more capacity when demand was predicted to increase. Suppliers of pulp and paper controlled inventories tightly, releasing products to the marketplace at targeted times. (Exhibit 11 shows the worldwide consumption of paper. ) Environmental Considerations—Recycling and Substitutes to Paper Governments had been increasing regulations for pulp and paper companies to avoid clearcutting forests, to reduce chemical by-products such as chlorine, limit gas emissions from the operation of factories, and increase recycling. With greater environmental pressures, the three â€Å"R† slogan (reduce, reuse and recycle) was creating alternative industries and increasing global 8 Arauco (A): Forward Integration or Horizontal Expansion? 705-474 capabilities to recycle paper. For example, in the U. S. , it was estimated that approximately 42% of paper was recovered for recycling. 17 Recycled fibers from paper replaced the use of pulp in paper manufacturing. Using recycled fibers had several advantages, including lower costs to recycle paper than to produce pulp, the reduction of wood usage, lower residues released into the environment, and an overall drop in the cost of environmental treatment. The major disadvantage of using recycled fibers was that its output per comparable ton was much less than pulp. Recycled fibers could be reused between five to seven times; after seven times, the fibers became too short for papermaking. 18 Recycled fibers were experiencing modest growth, with production growing at a compound annual growth rate of approximately 6% moving from 48 million tons annually in 1980 to an estimated 150 million in 2000. Some industry observers felt that the increasing use of computers, handheld devices, and mobile phones would act as a substitute for paper. However, with more information passing through these mediums, other industry observers felt that paper usage would increase. The Paper and Paperboard Industry Over half of the material that went into making paper and paperboard was made using pulp. Other materials included recycled fiber, chemicals, and minerals. By mixing together different variations of softwood or hardwood pulp, the paper manufacturer could produce a product for a specific intent. Paper products ranged from uncoated free sheets (such as regular writing paper) to coated free sheets, tissues, newsprint, and coated and uncoated groundwood. The worldwide paper market was estimated to be greater than 330 million tons at the end of 2003. The paper market had experienced three years of soft demand with no real growth in dollar terms since 2000. As of March 2004, an analyst assessed the worldwide paper market: Global paper demand is on the mend. U. S. prices are likely to lead the way into price recovery with a meaningful positive effect on U. S. earnings in the second quarter and should gain further in the second half. The U. S. dollar sets the tone for the sentiment to invest in the paper sector. While a weaker U. S. dollar undoubtedly has negative implications for earnings in the near term the impact of a weaker U. S. dollar is dwarfed in comparison to the impact of higher prices. . . . European paper prices have bottomed in our view and it appears likely that higher prices should start to impact earnings in some early cycle segments from the third quarter onwards. Later cycle segments, such as newsprint and SC paper, should see a nice price rebound in the early stages of 2005. Prices have been on a downward trajectory since the fourth quarter of 2000 but the tide is now turning. 19 Paper and Paperboard Companies Most of the large paper companies chose to operate a completely integrated structure that included the ownership of forests, pulp mills, paper manufacturing facilities, distribution arms, and converting capabilities. However, there were a number of smaller local firms that produced paper based on the specific need of their markets. These smaller paper manufacturers typically purchased raw materials such as pulp from suppliers based on the type of pulp (bleached, unbleached, softwood, hardwood, etc. ), the cost, and the service details. Some industry insiders felt that maintaining a fully integrated structure allowed for greater negotiation leverage with the main suppliers to the industry, such as chemical providers and paper and pulp machinery manufacturers. 9 705-474 Arauco (A): Forward Integration or Horizontal Expansion? Exhibit 12 shows a list of 25 of the world’s largest paper companies. The top five producers included: 1. International Paper Co. (U. S. ) had revenues of $25. 2 billion and profits of $302 million in 2003. The company was a fully integrated enterprise producing plywood, paper, pulp, packaging, and chemical by-products from papermaking. It controlled over 10 million acres of forestlands in the U. S. , Brazil, and New Zealand. 20 2. Georgia-Pacific Corp. (U. S. ) had revenues of $20. 2 billion and profits of $254 million in 2003. Like its main rival, International Paper Co, Georgia-Pacific was a vertically integrated competitor in pulp, paper, lumber, plywood, oriented strand board, adhesives, and a number of paper consumer products. The company planned on spinning off its consumer products division but changed plans due to weak equity markets in 2002. However, it did sell majority ownership of its distribution arm, Unisource Worldwide. 21 3. Stora Enso Corp. (Finland) had revenues of $15. 2 billion and profits of $182 million. Stora Enso was involved in the manufacturing of a wide variety of products such as magazine paper, newsprint, fine papers, packaging, graphic products, office papers, wallpaper base, and sawn timber. 22

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