CORPORATE STRATEGY

RSM 5002
Session 2
EMBA 37
Prof. Beatrix Dart
University of Toronto
 Today’s Agenda

• Arauco Case Presentations

• Insights from the Arauco case

• Firm structure and boundaries: when to vertically

integrate

2
Our Corporate Strategy Course Road Map

Corporate Vertical Growth Strategies;

Strategy and Alliances and Disruptive
Integration Innovation
Diversification Acquisitions

• Corporate • Vertical • Growth • Managing

Strategy Integration strategies Disruptive
Innovation
• Diversification • JVs • Alliances
• Strategic
• The case of GE • Acquisitions
Innovation in
Practice
 Arauco’s competitive advantages

• Cost advantage: cost of wood (climate conditions = fast growing forest, higher yield), cost of labour
Time to Produce Time to Produce
Pulplogs Sawlogs Cost

Arauco 17 years 25 years $294

Northern Producers 31.5 years 75 years $385
Ratio 1/2 1/3 3/4

• Research and Development (Bioforest, better quality trees) help to keep the cost advantage
• Economies of scale, scope and sequence
• Economical environment in Chile (stable rules, access to capital)
• Corporate advantage: integration into saw mills, location of its forests, integration and use of R&D
discoveries
Competitive Advantages & Corporate Advantages
+ Quality + Price of Wood
of Wood & Production
Fast
+ Growing
Trees
+
CHILE
+ Low +
Good Margins
Distance to + & EBITDA
Wood & Ports
+
Costs
+
+
+ + Good Access
New Cash to Cap. Mkt
Eff. Mills Generation
Economies of
+ + Scale/Scope/Seq +
+
+ +
R&D Stable
(Bioforest) CAPEX
+ Rules
Program +
Source: graphic provided by Arauco
 Strategy of Arauco
“Maximize the commercial value of our plantations by pursuing sustainable
growth opportunities in our core businesses and expanding into new markets
and products”

Always reinforcing our competitive advantages of being a low cost producer

by:
• Focusing in businesses that produce us economies of scale and scope
• Investing in R&D
• Maintaining a low cost culture

Source: slide provided by Arauco’s CFO

 Threats to Arauco
1. Substitution threat: alternatives to pulp (bamboo, hemp, cotton etc.)
and recycled materials going into pulp

2. Imitation threat: Barriers to imitation are investments into the business

of market pulp, such as capacity additions, equipment, R&D, distribution
centers. Cost advantage through the central resource, the Chilean forest.

3. Holdup threat: trees as the critical resource need to be backward

integrated to avoid holdup threat from suppliers and to keep up plant
utilization. Also, see semi-integrated ports to avoid work-stoppages.
 Arauco’s Industrial Complex

Forest
Panels Mill

Log Merchandising

Products
Sawmill Pulp
Pulp Lgs Panels
& Sawn Timber
Chips Energy
Energy
Steam

Steam Energy Waste Waste

Chips Materials Materials
Pulp Mill
Energy
Energy
Plant Energy
Wood Products
Waste
Materials Steam

Source: graphic provided by Arauco

 Arauco´s Value Chain
Log Log
R&D Forest
Transportation Optimizing

Remanufacturing
Energy
Domestic
Sawn Distribution
Timber
Pulp
Clients
Inland Sea
Panels Ports
Transportation Transportation
Wood Products
Pulp Distribution
Integrated
Pulp Wood Semi Integrated
( 30%) De-Integrated

Source: graphic provided by Arauco

 Assessing Arauco’s integration
• Vertically integrated into forests, R&D, sawmills, energy
production
• Not integrated into transportation (and some pulp
wood)

What is the rationale?

 Nueva Aldea Project

 Will it increase economies of scale, scope and sequence?

 Will it help to protect competitive cost advantage?
 Is the discounted payback positive?
 Does it increase or decrease threats?
 What are the alternatives? Should Arauco invest into the paper business?
 And what happened at Arauco?
• They went ahead with the investment into Nueva Aldea, which was build for $840 mil.
Significantly increased revenues and net income.
• In 2004, they were charged of environmental pollution (toxic waste went from the
Valdivia plant into the Rio Cruces, killing almost the total population of black-necked
swans and other water birds)
• CEO resigned in 2005, plant had to temporarily close
• Re-opened with updated technology, and was allowed to produce only at limited
capacity
• At tribunal hearing in 2007, the company was accused of falsifying reports on
environmental impact, and agreed to pay a lump-sum of 614 mil Chilean Pesos to the
tourism industry as well as an annual penalty fee to avoid closure. Legal dispute is still
ongoing
• In May 2009 Arauco and the Finnish company Stora Ensa announced a US$ 2.2 bn deal
into a pulp mill in Uruguay (opened in 2014)
Vertical Integration in the academic literature
Two main motives for Vertical Integration (VI):

Strategic Considerations Governance Considerations

“Win the power play against competitors”
• Foreclose input and output markets
• Cross-subsidize one stage of value
chain to squeeze out more focused
competitor
• Increase barriers to entry
• Retain control over IP
“Make the firm as cost-efficient as possible”
• Transaction cost economics (see next slide)
• Agency theory (measurement problems:
partners’ contribution might be difficult to
judge, performance might be difficult to
monitor, etc.)
 Transaction cost economics
Challenges related to:
– Frequency of transaction
– Lack of coordination (capacity planning, reliability of information)
– Uncertainty of transaction (demand, price)
– Specificity of the assets involved in the transaction (quality, complexity of task/ product)
– Identifying a partner, negotiation, adapting, monitoring, and enforcing a contractual agreement
– Protection of technology/knowledge/IP (recognition, disclosure)
 this is called “degree of difficulty of writing contracts”

And finally: How critical is the management of the asset (and related activities), which
impacts costs of opportunism, such as hold-ups?
 In Summary

If the importance is high and it is difficult to write the asset

contract for the transaction, you should vertically integrate

In other words, if high relationship-specific investments are

required and you need to share intangible, knowledge-
intensive resources, you better vertically integrate
 Critique of Vertical Integration
• ~“Companies should stick to their knitting and outsource anything else.”

• ~”VI is considered ineffectual and obsolete.”

• ~ “A company’s value chain has become too complex (with various economic and
technological circumstances), it will overwhelm managerial capabilities. “

• ~”With information being readily available via the Internet or via online tools, transaction
costs are greatly reduced. You can now separate the physical good/asset and its associated
information, allowing to further expand the scope of business.”

• ~” More uncertainty and more complexity also means higher performance risk associated
with VI. In a fast-changing environment, VI may present a premature commitment that could
turn out to be costly, especially in the presence of high exit barriers.”
 A more practical view of Vertical
Integration

Value Migration Integrated Solutions

• In many industries, value-added has • Suppliers are asked to provide “integrated

migrated downstream (i.e.
maintenance and servicing of
products)
• Forward-integration allows to capture
the additional value
solutions”, i.e. expand their activities into
product innovation and assembly
• Demand for full project services, such as in
construction or engineering, including
financing and facilities management

Deep Customer understanding helps to create more opportunities and synergies

The relevant question for firms today is:

Do the current vertical boundaries enable the effective

acquisition, development and processing of knowledge?
 Joint Venture as an alternative structure
In a situation with high fixed cost and uncertain demand, a JV can be the best solution.

• You can monitor quality, retain control of IP, limit capital investment, and benefit from the
expertise of a partner
• JV partner might also have strong customer relationships
• Ideally, you negotiate an option to increase your stake if the product does really well
• Possibility to even acquire your JV partner
• Ultimate solution in flexibility and in creating strategic options

Challenge: finding the right partner

Let’s check on your understanding
Vertical Integration Kahoot!
 The ownership spectrum
for vertical structure

Arm’s-length Medium- or long- Alliances and Joint Ventures Ownership

market exchanges term contracts* equity stakes

* Also includes: Licensing, Franchise, Royalties

 For the 3rd class session: Disney/Pixar case
• What are the pros and cons of merger from Disney’s perspective?

• What are the pros and cons of merger from Pixar’s perspective?

• What are potential alternatives to the merger for both firms?

• What would be your recommendation?

Submit 8-10 powerpoint slides per team to e-DropBox by August 9th, 10 am!
Case analysis counts 20% towards final grade. 4 teams will be selected to
present. Other teams will be required to submit written critique by August
14th.