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Alejandro Perez, president and CEO of Celulosa Arauco, a Chilean forestry company, needed to make a strategic decision in order

to grow his company. His job is to determine whether to forward-integrate Arauco into paper manufacturing or horizontally expand its operations. He chose the horizontal growth, which would be implemented by investing US$ 1 billion to construct new state-of-the-art chemical pulp plant. The new pulp mill would increase Araucos annual pulp production capacity to 3.2 million tons, positioning it as the largest market pulp producer in the world. Before getting to the reasons that led to Perezs decision, it is important to state the difference between the two options that he is faced with. Horizontal Expansion is the expansion of a firm within an industry in which it is already active, through acquisition (i.e. its competitors) with intent to increase firms market share in a particular product or service, and/or to achieve economies of scale. Vertical Integration is an acquisition/merger of firms at different stages of production and/or distribution in the same industry. When a firm acquires its input supplier it is called backward integration, when it acquires firms in its output distribution chain it is called forward integration. Although horizontal expansion and vertical integration both represent an opportunity for expansion, their advantages and disadvantages are determined on a company-tocompany basis. In order to make the right decision, a deep analysis of the business operations and financials, combined with a review of industry and economic trends is needed. Perezs decision to grow Arauco through horizontal expansion is reflected in the cons of vertical integration and the pros of horizontal expansion, as well as the companys current industry positioning and its area of expertise. In order for Arauco to achieve its goal, of becoming one of the most important forestry companies in Latin America, it is imperative for the company to improve its economies of scale, increase capacity, efficiency and productivity, all while continuing to be responsible to its shareholders, employees, and other stakeholders. Horizontal expansion will minimize the companys risks and strengthen its core competencies. It will help it to maintain its cost leadership in the pulp sector and grow its market share through operational synergy. Forward integration move into paper manufacturing could undermine Araucos current market position. With 48.6% (case exhibit 2e) of the companys total sales revenue coming from pulp sales to paper manufacturers, the move into paper manufacturing business could create a negative ripple effect through Araucos core business. Arauco has consistently increased its production capacity through construction and acquisition of pulp plants, as well as expansion of the companys overall product offerings. The company has developed the expertise at this level of its value chain and could improve its business practices with the new pulp mill. On the contrary, the manufacturing paper activity would be a completely new experience to Arauco, and

would implicate a riskier, and potentially larger investment. Developing new core competencies would require different skills and capabilities and could compromise Araucos existing strengths. It would require a larger capital investment, and would result in increased administrative overhead costs. Additionally, paper manufacturing industry is dominated by established companies, such as International Paper Co., Georgia-Pacific Corp., and Stora Enso. If Perez had chosen to vertically integrate the company he would inevitably put pressure on paper prices and could possible instigate a price war with vertically integrated top producers, which have razor thin profit margins of less than 2% (case exhibit 12). This competition could eventually hurt Araucos core business, since the prices for paper and pulp are correlated, as well as negatively affect the companys economies of scale. Moreover, the addition of manufacturing paper activities could make Arauco compete with nonintegrated paper manufacturers that were also Araucos pulp buyers. This could deteriorate Araucos relationship with some of its customers, and go against the companys goal of establishing long-term relationships with nonintegrated paper manufacturers. Horizontal expansion would catapult Arauco toward its goal of strengthening its position as one of the most important forestry companies in Latin America, as well as make it the largest pulp producer in the world. The company would gain market share and increase its capacity to 3.2 million tons, surpassing current leader Aracruz, which is expected to produce 3 million tons by 2005. In addition to five plants that Arauco already owns, the new pulp plant would increase the companys capacity by 800,000 tons, and allow Arauco to further improve its economies of scale through state-of-the-art facility that would further decrease its average total cost and help it meet the forecasted increase in demand of pulp. Araucos production is export oriented. About 85% of its revenue is tied to foreign markets, Asia being the major destination, followed by North America and Europe. Pulp sales accounted for over fifty percent of export sales, with Asia, and specifically China with a fast growing paper market, fueling the demand for paper products. Increasing the pulp production capacity would enable Arauco to keep up with the growing demand in the Asian markets and increase its market presence there. The expected increase in production volume fueled by Chiles free trade pact with European Union in 2002, and U.S. in January of 2004, would lead to lower operating and capital costs. As paper industry starts to recover in these two major markets, the increase in demand and strengthening of U.S. dollar will benefit Arauco and help it to improve its gross profits through cost advantage. With the gross consumption of paper and paperboard (MM metric tons; case exhibit 11) in the U.S. almost 3 times of that in

China, the free trade pact sets Arauco in good position to increase its market share in the U.S. Araucos research and development business unit, Bioforest, will continue to improve companys quality of plantations. Bioforests achievement to genetically replicate high quality radiata pine trees and eucalyptus trees, which account for close to 68% of Araucos plantations, will help to supply the capacity and further improve economies of scale. The high yield per hectare in Chile and expedited log cultivation gives the company an advantage over its northern hemisphere competitors, where it takes 2 to 3 times longer to harvest plantations. Improvement on Araucos economies of scale would result in the allocation of research and development expenses, which accounted for $1.6 million in 2000, to a greater number of outputs. Therefore, it would positively impact output costs. Another advantage of opening a new plant would be the rise to economically valuable by-products. The volume of waste products could be large enough to warrant their resale, reducing the costs of producing market pulp and opening the company to new markets. Kraft pulp production residues can be utilized in agricultural purpose, in the production of molded egg cartons, and in brick-clay as an organic pore-forming agent. This step towards waste reduction could also positively impact the companys intangible assets (i.e. image/reputation), as it moves towards establishing itself as biggest pulp producer in the world and becomes environmentally aware. As cited in the case, an industry observer commented that Araucos business lines diversification had had some negative repercussions to the companys image as a pulp producer. Becoming the largest producer of market pulp would help Arauco to recoup and strengthen its image as a pulp manufacturer leader. The new plant would improve Araucos competitiveness and strengthen its position in the unbleached softwood kraft (USKP) global market, where it currently holds 15.8% market share. Since Arauco doesnt provide all the raw material necessary for its pulp production, with the rise in capacity, Arauco would have greater negotiation power over suppliers, such as third-party forest owners, and leverage its large volume production against downstream channel members. Suppliers of pulp control inventories tightly, releasing products at favorable market prices. Being placed as the largest producer of market pulp would give Arauco an increased power on the flow of pulp volume to the market, and consequently, a better control of pulp prices which would be beneficial to Arauco. Analyzing market conditions and Araucos operations and financial information it is in the best interest for the company to grow through horizontal expansion. By focusing on

its core business of pulp production the company will continue to benefit from economies of scale, as it positions itself as the upcoming industry leader with the possibility of achieving sustainable growth.

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