20-F 1 d20f.htm FORM 20-F Form 20-F
Table of Contents

As filed with the Securities and Exchange Commission on June 26, 2008

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 20-F

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR

15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2007

Commission File Number: 33-99720

CELULOSA ARAUCO Y CONSTITUCIÓN S.A.

(Exact name of Registrant as specified in its charter)

Arauco and Constitution Pulp Inc.

(Translation of Registrant’s name into English)

Republic of Chile

(Jurisdiction of incorporation or organization)

Avenida El Golf 150

14th Floor

Las Condes, Santiago

Chile

(Address of principal executive offices)

Gianfranco Truffello

Tel.: 56-2-4617221 • E-mail: gtruffello@arauco.cl

Avenida El Golf 150

14th Floor

Las Condes, Santiago

Chile

(Name, telephone, e-mail and/or facsimile number and address of company contact person)

 

 

Securities registered or to be registered pursuant to Section 12(b) of the Act:

None

Securities registered or to be registered pursuant to Section 12(g) of the Act:

None

Securities for which there is a reporting obligation pursuant to Section 15(d) of the Act:

Title of each class:

7.20% Notes due 2009

8.625% Notes due 2010

7.75% Notes due 2011

5.125% Notes due 2013

5.6% Notes due 2015

7.50% Notes due 2017

6.375% due 2017

Indicate the number of outstanding shares of each of the issuer’s classes of capital or common stock as of the close of the period covered by the annual report:    Shares of Common Stock, without par value: 113,152,446

If this report is an annual or transition report, indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.    Yes  ¨    No  x

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.

Large accelerated filer  ¨    Accelerated filer  ¨    Non-accelerated filer  x

Indicate by check mark which basis of accounting the registrant has used to prepare the financial statement included in this filing:

U.S. GAAP  x    IFRS  ¨    Other  ¨

Indicate by check mark which financial statement item the registrant has elected to follow:    Item 17  ¨    Item 18  x

If this is an annual report, indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

 

 


Table of Contents

TABLE OF CONTENTS

 

          Page
PART I   

ITEM 1.

   Identity of Directors, Senior Management and Advisers    1

ITEM 2.

   Offer Statistics and Expected Timetable    1

ITEM 3.

   Key Information    1

ITEM 4.

   Information on the Company    12

ITEM 5.

   Operating and Financial Review and Prospects    38

ITEM 6.

   Directors, Senior Management and Employees    59

ITEM 7.

   Major Shareholders and Related Party Transactions    64

ITEM 8.

   Financial Information    66

ITEM 9.

   The Offer and Listing    69

ITEM 10.

   Additional Information    69

ITEM 11.

   Quantitative and Qualitative Disclosures About Market Risk    78

ITEM 12.

   Description of Securities Other Than Equity Securities    79
PART II   

ITEM 13.

   Defaults, Dividend Arrearages and Delinquencies    80

ITEM 14.

   Material Modifications to the Rights of Security Holders and the Use of Proceeds    80

ITEM 15.

   Controls and Procedures    80

ITEM 16A.

   Audit Committee Financial Expert    81

ITEM 16B.

   Code of Ethics    81

ITEM 16C.

   Principal Accountant Fees and Services    81

ITEM 16D.

   Exemptions From the Listing Standards for Audit Committees    82

ITEM 16E.

   Purchases of Equity Securities by the Issuer and Affiliated Purchasers    82
PART III   

ITEM 17.

   Financial Statements    83

ITEM 18.

   Financial Statements    83

ITEM 19.

   Exhibits    83

 

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Celulosa Arauco y Constitución S.A. is a corporation (sociedad anónima) organized under the laws of the Republic of Chile, and subject to the rules of the Chilean public corporations (sociedades anónimas abiertas). Except where otherwise specified or the context otherwise requires, when we refer to the “Company,” “Arauco” or “we,” in this annual report, we mean Celulosa Arauco y Constitución S.A. and its consolidated subsidiaries. When we refer to “Chile,” we mean the Republic of Chile; when we refer to “Argentina,” we mean the Argentine Republic; when we refer to “Brazil,” we mean the Federative Republic of Brazil; and when we refer to “Uruguay,” we mean the Oriental Republic of Uruguay. All references to “tons” are to metric tons (1,000 kilograms), which equal 2,204.7 pounds. One “hectare” equals 10,000 square meters or 2.471 acres. Discrepancies in any table between totals and the sums of the amounts listed are due to rounding.

Unless otherwise specified, all references to “$”, “U.S.$”, “U.S. dollars” or “dollars” are to United States dollars; references to “Chilean pesos” or “Ch$” are to Chilean pesos; references to “Argentine pesos” or “Ar$” are to Argentine pesos; references to “Brazilian reals” or “R$” are to Brazilian reals; references to “€” or “euro” are to the euro, the single European currency established pursuant to the European Economic and Monetary Union; and references to “UF” are to Unidades de Fomento. The UF is a unit of account that is linked to, and adjusted daily to reflect changes in, the Chilean consumer price index reported by the Chilean National Institute of Statistics (Instituto Nacional de Estadísticas). At December 31, 2007, one UF equaled U.S.$39.45 and Ch$19,622.66.

Item 18 of this annual report includes our audited consolidated financial statements as of December 31, 2006 and 2007 and for the years ended December 31, 2005, 2006 and 2007, including the notes thereto, which have been prepared in accordance with generally accepted accounting principles in the United States, or U.S. GAAP.

For your convenience, we have included translations of certain amounts into dollars at a specified rate. Unless otherwise indicated, the U.S. dollar equivalent for information in Chilean pesos is based on the observed exchange rate (dólar observado) reported by the Central Bank of Chile (Banco Central de Chile), which we refer to as the Central Bank, for December 31, 2007, which was Ch$496.89 to U.S.$1.00. The observed exchange rate is, for any date, the average exchange rate at which transactions are actually carried out in the Formal Exchange Market (Mercado Cambiario Formal) on the previous day, as certified by the Central Bank on the following business day. You should not construe these translations as representations that the Chilean peso amounts actually represent such dollar amounts or could be converted into dollars at the rates indicated or at any other rate. On June 24, 2008, the observed exchange rate was Ch$505.11 to U.S.$1.00. For information regarding historical rates of exchange in Chile from January 1, 2003 see “Item 3. Key Information—Exchange Rates.”

The Federal Reserve Bank of New York does not report a noon buying rate for Chilean pesos.

Unless otherwise specified, references to the devaluation or the appreciation of the Chilean peso against the U.S. dollar are in nominal terms (without adjusting for inflation), based on the observed exchange rates for the relevant period.

 

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PART I

 

Item 1. Identity of Directors, Senior Management and Advisers

Not applicable.

 

Item 2. Offer Statistics and Expected Timetable

Not applicable.

 

Item 3. Key Information

SELECTED FINANCIAL DATA

The selected financial information presented below is prepared in accordance with U.S. GAAP as of and for the years ended December 31, 2003, 2004, 2005, 2006 and 2007. The selected U.S. GAAP financial information should be read in conjunction with, and is qualified in its entirety by reference to, our audited consolidated financial statements, prepared in accordance with U.S. GAAP, included in Item 18.

The selected U.S. GAAP financial information as of December 31, 2006 and 2007 and for the years ended December 31, 2005, 2006 and 2007 is derived from our audited consolidated financial statements provided in Item 18.

For all periods, the financial data in the following table are expressed in U.S. dollars, the currency in which we publish our audited consolidated financial statements. See Note 1 to our audited consolidated financial statements.

 

    As of and for the year ended December 31,  
    2003     2004     2005     2006     2007  
    (in thousands of U.S.$, except ratios and per share data)  

Income Statement Data

         

Sales revenue

  U.S.$  1,458,220     U.S.$ 2,075,052     U.S.$ 2,373,907     U.S.$ 2,850,012     U.S.$ 3,576,719  

Cost of sales, exclusive of depreciation

    (782,793 )     (1,041,590 )     (1,388,322 )     (1,626,038 )     (2,108,730 )

Depreciation

    (112,636 )     (141,329 )     (170,291 )     (186,995 )     (240,299 )

Selling and administrative expenses

    (105,897 )     (124,784 )     (180,355 )     (229,220 )     (279,868 )
                                       

Income from operations

    456,894       767,349       634,939       807,759       947,822  

Interest income

    30,051       25,431       34,487       40,899       47,735  

Other income (expense)

    1,570       (4,990 )     (2,225 )     (344 )     10,820  

Foreign exchange gains (losses)

    52,353       16,227       (6,249 )     10,510       (1,942 )

Interest expenses

    (46,629 )     (78,109 )     (109,886 )     (82,460 )     (136,595 )

Income before taxes, minority interest and equity from earnings of unconsolidated affiliates

         
                                       
    494,239       725,908       551,066       776,364       867,840  

Provision for income taxes

    (80,574 )     (139,899 )     (113,328 )     (161,958 )     (178,924 )

Minority interest in consolidated subsidiaries

    (199 )     (321 )     (72 )     100       (1,079 )

Equity in earnings of unconsolidated affiliates

    6,001       6,473       6,682       7,926       9,520  
                                       

Net income

    419,467       592,161       444,348       622,432       697,357  

Dividends paid

    133,906       175,387       207,724       194,691       284,343  

(table continues on following page)

 

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     As of and for the year ended December 31,  
     2003     2004     2005     2006     2007  
     (in thousands of U.S.$, except ratios and per share data)  

Balance Sheet Data(1)

          

Property, plant and equipment (less forests), net

   2,176,701     2,524,428     3,087,900     3,447,037     3,562,250  

Forests

   1,243,638     1,412,488     1,549,903     2,016,637     2,241,737  

Total assets

   4,736,027     5,273,866     6,114,019     7,068,952     7,700,376  

Total long-term liabilities

   2,026,365     1,919,979     2,434,810     2,501,850     2,838,585  

Total shareholders’ equity

   2,421,001     2,787,267     3,090,118     3,430,559     3,840,349  

Other Financial Data

          

Capital expenditures (2)

   512,939     757,320     618,337     1,090,450     462,837  

Depreciation

   112,636     141,329     170,291     186,995     240,299  

Number of shares

   113,152,446     113,152,446     113,152,446     113,152,446     113,152,446  

Net income per share

   3.71     5.23     3.93     5.50     6.16  

Dividends per share (in US$)

   1.18     1.55     1.84     1.72     2.51  

Dividends per share (in Ch$)(3)

   893.2     1,098.9     1,128.9     957.4     1,329.1  

Cash Flow Data

          

Total operating cash flow

   346,513     870,523     750,952     1,013,829     900,715  

Total cash flow arising from financing activities

   193,388     (127,636 )   115,661     71,871     (217,053 )

Total cash flow arising from investment activities

   (561,773 )   (745,679 )   (865,138 )   (1,089,478 )   (668,335 )

 

(1)

In 2006, we adopted the SEC Staff Accounting Bulletin No. 108 with respect to quantifying misstatements in financial statements. See Note 1(u) to our audited consolidated financial statements.

(2)

Accrued for the period. Capital expenditures do not include acquisitions of other companies. See Note 13 to our audited consolidated financial statements.

(3)

In constant Chilean pesos as of December 31, 2007.

 

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EXCHANGE RATES

The following table sets forth, for the periods and dates indicated, certain information concerning the observed exchange rate reported by the Central Bank. No representation is made that the Chilean peso or U.S. dollar amounts referred to in this annual report could have been or could be converted into U.S. dollars or Chilean pesos, as the case may be, at the rates indicated or at any other rate. The Federal Reserve Bank of New York does not report a noon buying rate for Chilean pesos. See “Item 10. Additional Information—Exchange Controls.”

 

     Daily Observed Exchange Rate

Year Ended December 31,

   High    Low    Average(1)    Period-End
     Ch$ per U.S.$

2003

   758.21    593.10    686.89    593.80

2004

   649.45    557.40    611.11    557.40

2005

   592.75    509.70    558.06    512.50

2006

   549.63    511.44    529.64    532.39

2007

   548.67    493.14    521.06    496.89

2007

           

December

   506.79    495.49    498.83    496.89

2008

           

January

   498.05    463.58    479.46    465.34

February

   476.44    453.95    466.67    453.95

March

   454.94    431.22    442.13    437.71

April

   461.49    433.98    447.51    461.49

May

   479.66    464.83    471.00    479.54

 

Source: Central Bank of Chile

 

(1)

For each year, the average of the month-end exchange rates for the relevant year. For each month, the average daily exchange rate for the relevant month.

On June 24, 2008, the observed exchange rate was Ch$505.11 to U.S.$1.00.

 

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RISK FACTORS

We are subject to various changing economic, political, social and competitive conditions, particularly in our principal markets. Any of the following risks, if they actually occur, could materially and adversely affect our business, results of operations, prospects and financial condition.

Risks Relating to Arauco and the Forestry Industry

Environmental concerns led us to temporarily suspend our operations at the Valdivia Mill, which adversely affected, and in the future may continue to adversely affect, our business, financial condition and results of operations

Our operations at the Valdivia Mill, an industrial development in the Province of Valdivia in the newly created Fourteenth Region of Chile (which was previously part of the Tenth Region of Chile), have been subject to continued environmental scrutiny by Chilean environmental regulators and the Chilean public since the mill began its operations in 2004. A variety of concerns and claims have been raised regarding potential environmental impacts in the area. Primarily, it has been alleged that the mill’s operations impacted the nearby Carlos Anwandter Nature Sanctuary and contributed to the migration and death of black-neck swans living in the area. In connection with an environmental administrative proceeding, environmental regulators required us to temporarily suspend operations at the Valdivia Mill for approximately one month in January 2005. We resumed operations at the mill on February 18, 2005. See “Item 8. Financial Information—Legal Proceedings.”

On June 8, 2005, we voluntarily suspended operations at the Valdivia Mill, until certain technical and legal conditions could be clarified with the applicable regulatory authorities. We estimate this voluntary suspension resulted in a loss of sales of approximately U.S.$1.0 million per day and a loss of profits of approximately U.S.$250,000 per day. Pursuant to the decision of our board of directors, based on certain clarifications provided by the Environmental Regional Commission (Comisión Regional del Medio Ambiente), or COREMA, of the Tenth Region of Chile, the mill resumed operations on August 12, 2005 at 80% of its authorized production capacity, after 64 days of suspended operations. In order to achieve the full production capacity authorized by applicable permits, the mill had to fulfill certain new requirements established by the COREMA. On January 18, 2008, the COREMA authorized the Valdivia Mill to return to its annual authorized production capacity of 550,000 metric tons. The mill gradually increased its production over a four-month period starting in March 2008 and reached full capacity in June 2008. The suspension of operations at the Valdivia Mill adversely affected our business, financial condition and results of operations. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants can be expected to have similar adverse effects. We offer no assurance that the Valdivia Mill will be able to operate without further interruption. See “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Valdivia Mill.”

We submitted to the COREMA of the Tenth Region of Chile an environmental impact study for the implementation of substantial technological improvements on the quality of the effluents generated by the Valdivia Mill. As of the date of this annual report, we have not been notified of the resolution that would conclude the environmental evaluation process by the COREMA. By March 31, 2009, we must also submit an environmental impact study for the construction of a pipeline to discharge the Valdivia Mill’s wastewater in a body of water other than the Cruces River or the Carlos Anwandter Nature Sanctuary or their sources. We will have to construct and put into operation this pipeline no later than 15 months from the date in which the COREMA approves the environmental impact study in its final form. The COREMA has also appointed a consulting firm to analyze and prepare a report on different feasible alternatives for discharge of the Valdivia Mill effluents. Approval by the COREMA of our environmental impact studies regarding the pipeline and the improvement of the quality of the effluents and the construction and operation of such a pipeline are each subject to many environmental, regulatory, engineering and political uncertainties at this time. As a result, we cannot give you any assurance that such projects will ever be approved or completed. If either our environmental study or the installation of the pipeline is delayed for reasons that COREMA attributes to us, we may face sanctions that include warnings, fines or the revocation of the Valdivia Mill’s environmental permit of operation. Alternatively, if COREMA determines that such delays are beyond our control, we believe that COREMA should extend the applicable deadlines. However, we can offer no assurances that any of such deadline extensions will be granted, even if we comply with all the requirements set forth by COREMA. See “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Valdivia Mill.”

 

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Environmental concerns led us to suspend our operations at the Licancel Mill, which adversely affected our business, financial condition and results of operations

Since June 2007, our operations at the Licancel Mill, a pulp mill located in the Seventh Region of Chile, have been subject to environmental scrutiny by Chilean environmental regulators and the public. On June 5, 2007, in connection with the death of fish in the Mataquito River, approximately 15 kilometers downstream of the mill, we decided to voluntarily suspend our operations in the Licancel Mill as a preventive measure. In addition, Chilean authorities, including the health authorities and the Superintendencia de Servicios Sanitarios (Sanitary Services Superintendency), required that we suspend activities at the Licancel Mill and that we suspend any further discharges into the river. We also commenced independent investigations relating to the cause of the death of the fish. On June 18, 2007, as a result of a pipe leakage in the water treatment system currently in place at the Licancel Mill, an estimated 50 cubic meters of effluents reached the Mataquito River. On that same date, we decided to close the mill indefinitely and informed the Sanitary Services Superintendency of the incident. On October 3, 2007, we requested to the health authority (Autoridad Sanitaria) of the Seventh Region of Chile that it remove the suspension of activities at the Licancel Mill. On October 22, 2007, the health authority of the Seventh Region of Chile removed the suspension and imposed certain conditions relating to our activities in the mill consisting primarily of the implementation of certain emergency detection and control programs and systems, with which we have complied. Furthermore, on November 12, 2007 the Sanitary Services Superintendency removed the suspension regarding the release of discharges by the Licancel Mill. The mill resumed operations during January 2008.

Several administrative and judicial proceedings have been commenced regarding the events at the Licancel Mill, including the death of fish at the Mataquito River. The proceedings and the related sanctions are described in Note 12 to our audited consolidated financial statements. We estimate that the suspension of operations at the Licancel Mill resulted in a loss of profits of approximately U.S.$4 million per month. We can offer no assurance that the Licancel Mill will be able to operate without further interruptions. Any future suspension of operations at the Licancel Mill may adversely affect our business, financial condition and results of operations. See “Item 8. Financial Information—Legal Proceedings” and “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Licancel Mill.”

We are subject to legal proceedings related to our mills, which could adversely affect our business, financial condition and results of operations

On April 27, 2005, the National Defense Council (Consejo de Defensa del Estado), the Chilean national agency that institutes legal proceedings on behalf of the Chilean government, instituted a civil lawsuit seeking reparations, damages and indemnification from us for environmental harm allegedly caused by the Valdivia Mill. If the results of this lawsuit are unfavorable to us, we may be required to invest funds or take other action to repair any environmental harm a court determines we have caused, which could materially and adversely affect our business, financial condition and results of operations. We cannot predict the outcome or impact of this lawsuit or when it may be resolved. See “Item 8. Financial Information—Legal Proceedings.”

Since the end of 2004, various criminal proceedings relating to alleged violations of several environmental laws have been instituted in Chile in which some of our mills may be affected. We cannot predict the outcome or impact of these proceedings or when they may be resolved. While Chilean law provides that only individuals can be convicted in criminal actions, as a consequence of these proceedings, certain measures may be taken that could materially and adversely affect our business, financial conditions and results of operations. See “Item 8. Financial Information—Legal Proceedings.”

We are also subject to certain other proceedings described in “Item 8. Financial Information—Legal Proceedings.” We cannot assure you that, as a result of such proceedings, our mills will be able to operate without interruption. Any such interruption could have a material and adverse effect on our business, financial condition and results of operations.

 

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The application of environmental regulations could adversely affect our ability to accomplish our development goals and adversely affect our results of operations

In each country where we have operations, we are subject to numerous national and local environmental laws concerning, among other matters, health, the handling and disposal of waste and discharges into the air, soil and water. We have made and expect to continue to make substantial expenditures to manage our existing operations in accordance with environmental requirements. The application of environmental laws in the countries where we have operations may affect our business strategy and our development goals, which may have an adverse effect on our business, financial condition and results of operations.

Environmental requirements are a factor in the development and operation of new projects. Chilean environmental regulations have become increasingly stringent in recent years, particularly in connection with the approval of new projects, and this trend is likely to continue. The implementation of these environmental policies in Chile will affect various aspects of our operations, but the effect on our operations and the outcome of any regulatory review or proceedings is uncertain. Environmental concerns and enforcement matters also attract public interest and, therefore, may be subject to political considerations that are beyond our control.

Since 2004, we have been subject to a number of environmental administrative and judicial proceedings in Chile, including proceedings related to the Valdivia Mill, the Arauco Mill, the Nueva Aldea Complex, a forestry-industrial complex in the Eighth Region of Chile, and the Licancel Mill. As a result of these proceedings, we have been subject to fines and sanctions, and we may be subject to fines, injunctions or other sanctions in the future. Additional proceedings, enforcement actions or claims related to environmental requirements or impacts may also be brought against us. Any such proceedings or claims may have an adverse effect on our business, financial condition and results of operations. See “Item 4. Information on the Company—Description of the Business—Pulp—Chile,” “Item 8. Financial Information—Legal Proceedings.”

In the future, the addition of new or more stringent environmental requirements or changes in the application, interpretation or enforcement of existing requirements, in any country where we have operations, could result in substantially increased capital, operating or compliance costs, impose conditions that restrict or limit our operations or otherwise adversely affect our business, financial condition and results of operations. These changes could limit the availability of our funds for other purposes, which could adversely affect our business, financial condition and results of operations.

Fluctuations in market price for our products could adversely affect our financial condition and results of operations

Prices for pulp, forestry and wood products can fluctuate significantly. The average price, on an annual basis, for Norscan bleached softwood kraft market pulp (pulp produced in Canada and Northern Europe sold to manufacturers of paper products delivered in Northern Europe, or NBSK), which is the benchmark for softwood bleached pulp, ranged from U.S.$526.43 in 2003 to U.S.$674.59 in 2006. In 2007, the price of NBSK ranged from a minimum of U.S.$730.0 to a maximum of U.S.$869.30. Our business, financial condition and results of operations could be materially and adversely affected if the price of pulp or other forestry products were to decline significantly from current levels. The prices that we are able to obtain for pulp products and, to a lesser extent, other forestry products depend on the following:

 

   

prevailing world prices, which historically have been subject to significant fluctuations over relatively short periods of time, depending on worldwide demand;

 

   

world production capacity;

 

   

the business strategies adopted by major integrated forestry, pulp and paper producers and other major producers; and

 

   

the availability of substitutes.

Each of these factors is beyond our control.

 

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Worldwide competition in the markets for our products could adversely affect our business and results of operations

We experience substantial worldwide competition in each of our geographical markets and in each of our product lines. Several of our competitors are larger than we are and have greater financial and other resources, which they could use to take steps that could adversely affect our financial and competitive position. The market pulp industry is sensitive to changes in industry capacity and producer inventories, as well as to cyclical changes in the world’s economies, all of which may significantly affect selling prices and, thereby, our profitability. Increased competition could materially and adversely affect our business, financial condition and results of operations.

The subprime crisis in the United States could adversely affect our business and results of operations

Export sales to the United States market accounted for approximately 12.0% of our sales revenues in 2007 as compared to 14.1% in 2006. During 2007, the decrease in demand of sawn timber products due primarily to the subprime crisis and the continued downturn in the real estate market in the United States resulted in our decision to close the La Araucana sawmill and temporarily close the Lomas Coloradas remanufacturing mill. In March 2008, we temporarily closed the Arapoti sawmill. We have also reduced shifts at the Horcones remanufacturing mill. As of December 31, 2007, the book value of the La Araucana sawmill, the Lomas Coloradas remanufacturing mill and the Arapoti sawmill was U.S.$0.9 million, U.S.$7.0 million and U.S.$14.0 million, respectively. In addition, we placed a significant quantity of our sawn timber products in other markets, especially Asia and the Middle East, in order to avoid additional staffing adjustments in the facilities and to mitigate the economic impact of these events in our sawn timber division. Our business, financial condition and results of operations could be materially and adversely affected if the subprime crisis in the United States continues to deteriorate, and if we are unable to re-allocate our sawn timber products to other markets on equally beneficial terms.

We depend on free international trade as well as economic and other conditions in our principal export markets

In 2007, export sales accounted for approximately 76.9% of our total sales revenues. During this period, 42.2% of our export sales were to customers in Asia, 24.5% to customers in North America, 20.7% to customers in Europe and 9.6% to customers in Central and South America. As a result, our results of operations depend, to a significant degree, on economic, political and regulatory conditions in our principal export markets. Our ability to compete effectively in our export markets could be materially and adversely affected by a number of factors beyond our control, including deterioration in macroeconomic conditions, exchange rate volatility, government subsidies, and the imposition of increased tariffs or other trade barriers. If our ability to sell our products competitively in one or more of our principal export markets were impaired by any of these developments, it might be difficult to re-allocate our products to other markets on equally favorable terms and our business, financial condition and results of operations might be adversely affected.

Disease or fire could affect our forests and manufacturing processes and, in turn, adversely affect our financial condition and results of operations

Our operations are subject to various risks affecting our forests and manufacturing facilities, including disease and fire. Although, in the past, certain pests and diseases afflicting radiata or taeda pine plantations in other parts of the world have not significantly affected the forestry industries in Chile, Argentina, Brazil and Uruguay, these pests or diseases may appear in Chile, Argentina, Brazil or Uruguay in the future. Although, in the past, forest fires have not significantly affected our plantations partly due to the broad geographic extension of our plantations and the varied ages and climatic conditions of our plantations, forest fires may affect our plantations in the future. Our operations and, as a result, our financial condition and results of operations could be adversely affected if any of these risks were realized.

Risks Relating to Chile

Chilean political and economic conditions directly impact our business and the market price of our securities

At December 31, 2007, 76.4% of our property, plant and equipment and forest assets were located in Chile, and in 2007, approximately 82.0% of our net sales were attributable to our Chilean operations. Accordingly, our

 

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business, financial condition and results of operations depend, to a considerable extent, upon economic conditions in Chile. Future developments in the Chilean economy could adversely affect our financial condition or results of operations and may impair our ability to proceed with our strategic plan of business. In addition, such developments may impact the market price of our securities.

The Chilean government has exercised and continues to exercise a substantial influence over many aspects of the private sector and has changed monetary, fiscal, tax and other policies to influence the Chilean economy. We have no control over and cannot predict how government intervention and policies will affect the Chilean economy or, directly and indirectly, our operations and revenues. Our operations and financial condition and the market price of our securities may be adversely affected by changes in policies involving exchange controls, taxation and other matters. In addition, our operations and financial condition and the market price of our securities may be adversely affected by factors such as:

 

   

fluctuations in exchange rates;

 

   

base interest rate fluctuations; and

 

   

other political, diplomatic, social and economic developments in or affecting Chile.

Chile’s rates of inflation, which were 2.6% in 2006 and 7.8% in 2007, as measured by changes in the Chilean consumer price index, may adversely affect our operations and financial condition and the market price of our securities.

Risks Relating to Argentina

The economic crisis in Argentina may adversely affect our financial condition and results of operations

At December 31, 2007, approximately 13.1% of our property, plant and equipment and forest assets were located in Argentina, and in 2007, approximately 11.7% of our net sales were attributable to our Argentine operations. On October 31, 2005, through our subsidiary Industrias Forestales S.A., we acquired from Louis Dreyfus S.A.S. 100% of the stock of Ecoboard S.A.I.F. and Ecoresin S.A. (formerly Louis Dreyfus S.A.I.F.) in Argentina and, indirectly as a result of that purchase, 100% of the stock of CAIF S.A. and Faplac S.A. (formerly LD Manufacturing S.A.) and 60% of the stock of Flooring S.A. The financial condition and results of our Argentine operations, including the ability of Alto Paraná S.A., or Alto Paraná, our Argentine subsidiary, to raise capital, depend, to a certain extent, upon political and economic conditions prevailing in Argentina. See “Item 4. Information on the Company—Description of Business—History.”

From 1998 to 2002, the Argentine economy experienced an economic recession marked by reduced levels of consumption and investment and an elevated unemployment rate. The Argentine gross domestic product decreased by 0.8% in 2000, 4.04% in 2001 and 10.9% in 2002. Since 2003, economic indicators have showed some signs of recovery, and the Argentine gross domestic product increased by 8.8% in 2003, by 9.0% in 2004, by 9.2% in 2005, by 8.5% in 2006 and by 8.7% in 2007. However, the Argentine economy may not continue to recover, and future economic, social and political developments in Argentina, over which we have no control, could adversely affect our business, financial condition and results of operations.

In addition, the Argentine government has exercised and continues to exercise a significant influence over many aspects of the Argentine economy. Accordingly, the Argentine government’s actions, including actions with respect to inflation, price controls, interest rates, foreign exchange controls, organized labor and taxes, have had and may continue to have a material adverse effect on private sector entities, including our operations in Argentina.

Argentine Central Bank restrictions may impair Alto Paraná’s ability to meet its obligations and transfer money abroad

We guarantee a portion of Alto Paraná’s debt. We may be required to fulfill our obligation under our guarantees if the Argentine government were to restrict Alto Paraná’s ability to transfer funds abroad. For a description of Alto Paraná’s debt which we guarantee see “Item 5. Operating and Financial Review and Prospects—Liquidity and Capital Resources.”

 

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Since 2001, the Argentine government has imposed a number of monetary and currency exchange control measures, which have included the obligation to repatriate foreign currency earned abroad and tight restrictions on transferring funds abroad, with certain exceptions for authorized transactions. Although current restrictions have not materially affected Alto Paraná’s financial condition and results of operations, there can be no assurance that the Central Bank of Argentina will not reverse its position and again restrict payments, which could impose material obstacles to Alto Paraná’s ability to transfer money abroad and negatively affect its financial condition and results of operations.

Risks Relating to Brazil

Economic conditions in Brazil may have a direct impact on our financial condition and results of operations

At December 31, 2007, approximately 10.6% of our property, plant and equipment and forest assets were located in Brazil, and in 2007, approximately 6.3% of our net sales were attributable to our Brazilian operations. During the first quarter of 2005, we acquired all of the shares of capital stock of LD Forest Products S.A. and of Placas do Paraná S.A. in Brazil, as well as 50% of the shares of capital stock of Dynea Brasil S.A. in Brazil. On September 27, 2007 Arauco entered into an agreement for the joint ownership of land with Stora Enso Oyj, a Finnish-Swedish multinational corporation. Pursuant to the agreement, Arauco acquired 80% of the shares in Stora Enso Arapoti Empreendimentos Agrícolas S.A., which owns 50,000 hectares of land, including 25,000 hectares of pine and 5,000 hectares of eucalyptus plantations; 20% of the shares in Stora Enso Arapoti Indústria de Papel S.A., which owns a paper mill with an annual production capacity of 205,000 tons of light weight coated paper; and 100% of the shares of Stora Enso Arapoti Serraria Ltda. which owns a sawmill with an annual production capacity of 150,000 cubic meters per year. Consequently, to a certain extent, our financial condition and results of operations will be dependent on economic conditions in Brazil. See “Item 4. Information on the Company—Description of Business—History.”

The Brazilian government has exercised, and continues to exercise, significant influence over the Brazilian economy. Brazilian political and economic conditions have a direct impact on our business

The Brazilian government frequently intervenes in the Brazilian economy and, occasionally, makes drastic changes in policy and regulations. The Brazilian government’s actions to control inflation and other policies and regulations have often involved, among other measures, wage and price controls, currency devaluations, capital controls and limits on imports. The business, financial condition and results of operations of our recently acquired Brazilian subsidiaries may be adversely affected by changes in policy or regulation involving tariffs and exchange controls, as well as by factors such as:

 

   

currency fluctuations;

 

   

inflation;

 

   

social instability;

 

   

price instability;

 

   

interest rates;

 

   

liquidity of domestic capital and lending markets;

 

   

tax policy; and

 

   

other political, diplomatic, social and economic developments in or affecting Brazil.

 

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Inflation and efforts by the Brazilian government to combat inflation may contribute significantly to economic uncertainty in Brazil and could harm the business of our Brazilian subsidiaries

Brazil has, in the past, experienced extremely high rates of inflation. More recently, Brazil’s rates of inflation were 7.6% in 2004, 5.7% in 2005, 3.1% in 2006 and 4.5% in 2007, as measured by the Brazilian consumer price index (Índice de Preços ao Consumidor-Amplo, or IPCA). In the past, inflation, governmental measures to combat inflation and public speculation about possible future actions have had significant negative effects on the Brazilian economy. Future measures taken by the Brazilian government, including interest rate increases, intervention in the foreign exchange market and actions to adjust or fix the value of the real may trigger increases in inflation, and consequently, have adverse economic impacts on our business. If Brazil experiences high inflation in the future, the business, financial condition and results of operations of our recently acquired Brazilian subsidiaries could suffer.

Fluctuations in the value of Brazil’s currency against the value of the U.S. dollar may result in uncertainty in the Brazilian economy and the Brazilian securities market, which may adversely affect the financial condition and results of operations of our recently acquired Brazilian subsidiaries

The Brazilian real has historically suffered frequent devaluation. In the past, the Brazilian government has implemented various economic plans and exchange rate policies, including sudden devaluations, periodic mini-devaluations during which the frequency of adjustments has ranged from daily to monthly, floating exchange rate systems, exchange controls and dual exchange rate markets. Although over long periods depreciation of the real generally is correlated with the differential in the inflation rate in Brazil versus the inflation rate in the U.S., depreciation over shorter periods has resulted in significant fluctuations in the exchange rate between the real and the U.S. dollar and other currencies.

The real appreciated by 20.7% against the U.S. dollar in 2007, and appreciated by 8.7% during the first five months of 2008. The exchange rate between the real and the U.S. dollar may continue to fluctuate and may rise or decline substantially from current levels.

Devaluation of the Brazilian real and currency instability could adversely affect the ability of our Brazilian subsidiaries to meet their foreign currency obligations in the future and could result in a monetary loss relating to this indebtedness.

Risks Relating to Other Markets

Our business, earnings and prospects may be adversely affected by developments in other countries that are beyond our control

Our business and results of operations depend, to a large extent, on the level of economic activity, government and foreign exchange policies and political and economic developments in our principal export markets. In 2007, approximately 93.9% of our total pulp sales and approximately 65.8% of our total sales of forestry, wood and panel products were attributable to exports, principally to customers in Asia, the Americas and Western Europe. Our business, earnings and prospects, as well as our financial condition, results of operations and the market price of our securities, may be materially and adversely affected by developments in these export markets relating to inflation, interest rates, currency fluctuations, protectionism, government subsidies, price and wage controls, exchange control regulations, taxation, expropriation, social instability or other political, economic or diplomatic developments. We have no control over these conditions and developments, which could adversely affect our business, financial condition and results of operations.

Developments in other emerging markets may adversely affect the market price of our securities and our ability to raise additional capital

The market price of our securities may be adversely affected by declines in the international financial markets and world economic conditions. Chilean securities markets are, to varying degrees, influenced by economic and market conditions in other emerging market countries, especially those in Latin America. Although economic conditions are different in each country, investors’ reactions to developments in one country can affect the securities

 

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markets and the securities of issuers in other countries, including Chile. Negative developments in the international financial markets in the future could adversely affect the market price of our securities and impair our ability to raise additional capital.

Risks Relating to Our Securities

The non-payment of funds by our subsidiaries could have a material and adverse effect on our business, financial condition, results of operations and ability to service our debt, including our securities

Our cash flow and our ability to service debt is dependent, in part, on the cash flow and earnings of our subsidiaries and the payment of funds by those subsidiaries to us, in the form of loans, interest, dividends or otherwise. Our subsidiaries are separate and distinct legal entities and have no obligation, contingent or otherwise, to pay any amounts due under the terms of our securities or to make any funds available for such purpose. Furthermore, claims of creditors of our subsidiaries, including trade creditors, will have priority over our creditors, including holders of our securities, with respect to the assets and cash flow of the subsidiaries. Our right to receive assets of any of our subsidiaries upon their liquidation or reorganization (and the consequent right of the holders of our securities to participate in those assets) will be effectively subordinated to the claims of that subsidiary’s creditors.

Changes in Chilean tax laws could lead us to redeem our securities

Under current Chilean law and regulations, payments of interest to holders of debt securities that are not residents of Chile for purposes of Chilean taxation will, generally, be subject to Chilean withholding tax at a rate of 4.0%. Subject to certain exceptions, we will pay additional amounts (as described in “Item 10. Additional Information—Taxation”) so that the amount received by the holder of securities after Chilean withholding tax will equal the amount that would have been received if no such taxes had been applicable. In the event of certain changes in Chilean tax laws requiring that we pay additional amounts that are in excess of the additional amounts that we would owe if payments of interest on our securities were subject only to a 4.0% withholding tax, we will have the right to redeem our securities.

FORWARD-LOOKING STATEMENTS

This annual report on Form 20-F contains words such as “believe,” “expect,” “anticipate” and similar expressions that identify forward-looking statements, which reflect our views about future events and financial performance. Statements that are not historical facts, including statements about our beliefs and expectations, are forward-looking statements.

Forward-looking statements involve inherent risks and uncertainties. These forward-looking statements are based on current plans, estimates and projections; therefore, readers should not place undue reliance on them. Actual results could differ materially from those projected in such forward-looking statements because of various factors that may be beyond our control, including but not limited to our ability to service our debt, fund our working capital requirements, comply with financial covenants in certain of our debt instruments, fund and implement our capital expenditure programs and maintain our relationships with customers, as well as a change in control, the effects on us from competition, future demand for forestry, panels and wood products in the Chilean, Argentine, Brazilian, Uruguayan and export markets, international prices for forestry and wood products, the state of the Chilean and world economies and manufacturing industries, the relative value of the Chilean peso compared to other currencies, inflation, increases in interest rates and changes in our regulatory environment. Forward-looking statements in this annual report speak only as of their dates, and we do not undertake any obligation to update or revise any of them, whether as a result of new information, future events or otherwise.

 

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Item 4. Information on the Company

DESCRIPTION OF BUSINESS

We believe that, as of December 31, 2007, we were Latin America’s largest forest plantation owner, and that we are Chile’s largest exporter of forestry and wood products in terms of sales revenue. We have industrial operations in Chile, Argentina and Brazil. As of December 31, 2007, we had approximately 931,721 hectares of plantations in Chile, Argentina, Brazil and Uruguay. During 2007, we harvested 15.3 million cubic meters of sawlogs and pulplogs and sold 4,964,138 cubic meters of wood products, including sawn timber (green and kiln-dried lumber) and remanufactured wood products, and panels (plywood, medium density fiber board, or MDF, particle board, or PBO, and high density fiber board, or HB).

Based on information published by Resource Information Systems, Inc., an independent research company for the pulp and paper industry, at December 31, 2007, we were one of the world’s largest producers of bleached and unbleached softwood kraft market pulp in terms of volume of pulp produced in 2007, with an estimated 6.2% share of the total world production of bleached softwood kraft market pulp and a 14.0% share of the total world production of softwood kraft market unbleached pulp. “Market pulp” is pulp sold to manufacturers of paper products, as opposed to pulp produced by an integrated paper producer for use in its paper production facilities. “Kraft pulp” is pulp produced using a chemical process.

Based on information published by Resource Information Systems, Inc., we were also one of the world’s lowest-cost producers of softwood kraft market pulp. We believe that we are able to produce our products at a lower cost than our competitors because of the high growth rate and short harvest cycle of radiata pine compared to other commercial softwoods, the advanced genetic and silviculture techniques we apply in our forest management, our competitive labor costs, our modern mill facilities and the proximity of our operations to Pacific coast ports.

History

Celulosa Arauco y Constitución S.A. is a corporation (sociedad anónima) organized under the laws of Chile, and subject to the rules of the Chilean public corporations (sociedades anónimas abiertas). Our principal executive offices are located at Avenida El Golf 150, 14th Floor, Las Condes, Santiago, Chile, and our telephone number is +56-2-461-7200.

We were formed on September 14, 1979 in a merger between Industrias de Celulosa Arauco S.A., or Industrias Arauco, and Celulosa Constitución S.A., or Celulosa Constitución. Our two predecessor companies were created in the late 1960s and early 1970s by Corporación de Fomento de la Producción, or Corfo, a Chilean government development corporation, to develop forest resources, improve soil quality in former farming areas and promote employment. As part of the Chilean government’s privatization program, Corfo sold Industrias Arauco to Compañía de Petróleos de Chile S.A., or Copec, in 1977 and Celulosa Constitución to Copec in 1979. In October 2003, Copec transferred all of its gasoline- and fuel-related business assets to a new subsidiary, and changed its legal name to Empresas Copec S.A., or Empresas Copec. See “Item 7. Major Shareholders and Related Party Transactions—Major Shareholders.”

In 1990, we founded Investigaciones Forestales Bioforest S.A., or Bioforest, to conduct applied research in genetic improvement, site productivity, pest and disease control and wood quality, with the goal of increasing the productivity of our forest resources. In 1990, we also began the construction of a second production line at the Arauco Mill, Arauco II, which was completed in 1991. The construction of Arauco II cost approximately U.S.$600 million, which was, at that time, the largest investment in our history.

In 1996, we acquired Alto Paraná S.A., an Argentine company, which, at that time, owned plantations and other land in Argentina and manufactured and sold bleached softwood kraft pulp. With this acquisition, we expanded our market opportunities outside of Chile.

In 2000, we acquired 98% of the shares of Forestal Cholguán S.A., or Cholguán, and 50% of Trupán S.A., or Trupán, which permitted us to enter the MDF and HB markets, and in 2002, we began operations at two new MDF mills, one in Chile and one in Argentina.

 

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During 2003, we began construction of the first phase of the Nueva Aldea Project, a new forestry-industrial complex in the Eighth Region of Chile, which was completed during 2004.

During 2004, we completed construction of the Valdivia Mill.

During 2004, we also commenced construction of the second phase of the Nueva Aldea Project, which included the development of a new pulp mill with installed annual production capacity of 856,000 tons of bleached pulp, consisting of softwood pulp and eucalyptus pulp. We completed the construction and started production in August 2006 and in May 2007 the mill reached full capacity. Total capital expenditures related to the construction of the pulp mill in the Nueva Aldea Project as of December 31, 2007 amounted to approximately U.S.$841.3 million. See “Item 4. Information on the Company—Description of the Business—Pulp—Pulp mills—Chile.”

On January 6, 2005, through Forestal Valdivia S.A., we acquired 80% of Forestal Los Lagos S.A., which represented an investment of U.S.$21.4 million and included 9,234 hectares of land planted with eucalyptus in what is now the Fourteenth Region of Chile.

On March 9, 2005, we acquired from Louis Dreyfus S.A.S. 100% of the stock of LD Forest Products S.A., a forest company located in the Brazilian state of Paraná that owned 43,000 hectares of land, of which 25,800 hectares were forest plantations, and, indirectly as a result of that purchase, 100% of the stock of Placas do Paraná S.A., an industrial company that owns an MDF mill and a particleboard mill in Paraná, and 50% of the stock of Dynea Brasil S.A., which owns a mill that produces impregnated paper and a formaldehyde and resin plant in Paraná. We paid an aggregate purchase price for these acquisitions of approximately U.S.$168.0 million. With these acquisitions, we acquired an MDF mill in Brazil with installed annual production capacity of approximately 250,000 cubic meters, a particleboard mill with installed annual production capacity of approximately 320,000 cubic meters, an impregnated paper mill, a formaldehyde and resin plant and 25,800 hectares of plantations.

On October 31, 2005, we acquired from Louis Dreyfus S.A.S., 100% of the stock of two holding companies in Argentina, Ecoboard S.A.I.F. and Louis Dreyfus S.A.I.F., and, indirectly as a result of that purchase, 100% of the stock of Caif S.A., a holding company that owns LD Manufacturing S.A. and 60% of the stock of Flooring S.A. As a result of these acquisitions, we own a particleboard mill with installed annual production capacity of approximately 230,000 cubic meters, a chemical plant that produces resins used for the production of wood panels, an MDF and particleboard-based wood floor mill with installed annual production capacity of approximately two million square meters, and an additional 8,000 hectares of plantations in Argentina. We paid an aggregate purchase price of approximately U.S.$55.0 million for this acquisition.

On June 30, 2006, through Aserraderos Arauco S.A., Forestal Celco S.A., Bosques Arauco S.A. and Forestal Valdivia S.A., we acquired the forestry assets of Cementos Bío-Bío S.A. The acquisition represented an investment of approximately U.S.$133.3 million. The acquired assets consisted of 21,000 hectares of pine plantations, one sawmill with an annual production capacity of approximately 250,000 cubic meters per year and a remanufacturing facility.

During the last quarter of 2006, we commenced construction of a second plywood line at the Nueva Aldea Complex, with a capacity of 225,000 cubic meters. In October 2007, we commenced the ramp-up process of the plywood line and we expect that it will reach full capacity in the last quarter of 2008. The construction of the second plywood line represented an investment of U.S.$50 million.

In January 2007, through its subsidiary Bosques Arauco S.A., Arauco acquired 5,105 hectares of radiata pine plantations from Forestal Anchile Ltda. This acquisition represented an investment of approximately U.S.$43.6 million.

On September 27, 2007 Arauco entered into an agreement for the joint ownership of land with Stora Enso Oyj, a Finnish-Swedish multinational corporation. Pursuant to the agreement, Arauco acquired 80% of the shares in Stora Enso Arapoti Emprendimentos Agrícolas S.A., which owns 50,000 hectares of land, including 25,000 hectares of pine and 5,000 hectares of eucalyptus plantations; 20% of the shares in Stora Enso Arapoti Industria de Papel S.A., which owns a paper mill with an annual production capacity of 205,000 tons of light weight coated paper; and 100% of the shares of Stora Enso Arapoti Serraria Ltda. which owns a sawmill with an annual production capacity of 150,000 cubic meters per year. This alliance represented an investment of U.S.$ 208.4 million, which was financed with Arauco’s resources and commercial bank loans.

 

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Corporate Structure

We are substantially wholly owned by Empresas Copec S.A., a public company listed on the Santiago Stock Exchange, the Valparaíso Stock Exchange and the Chilean Electronic Stock Exchange. Empresas Copec is a holding company, the principal interests of which are in Arauco, gasoline distribution, retailing, electricity, gas distribution and fishing. See “Item 7. Major Shareholders and Related Party Transactions—Major Shareholders.”

 

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The following table sets forth our ownership interests in our subsidiaries as of December 31, 2007.

 

     Country of
incorporation
   Total stock held  

Agenciamiento y Servicios Profesionales S.A.

   Mexico    99.9985 %

Alto Paraná S.A.

   Argentina    99.9762  

Arauco Denmark ApS

   Denmark    99.9990  

Arauco Distribución S.A.

   Chile    99.9992  

Arauco Ecuador S.A.

   Ecuador    99.9985  

Arauco Florestal Arapoti

   Brazil    79.9989  

Arauco Forest Brasil S.A. (Ex LD Forest Products)

   Brazil    99.9989  

Arauco Forest Products B.V.

   The Netherlands    99.9999  

Arauco Generación S.A.

   Chile    99.9985  

Arauco Honduras S. de R.L. de C.V.

   Honduras    99.9985  

Arauco Internacional S.A.

   Chile    99.9985  

Araucomex S.A. de C.V.

   Mexico    99.9985  

Arauco Perú S.A.

   Peru    99.9985  

Arauco Wood Products, Inc.

   U.S.A.    99.9985  

Aserraderos Arauco S.A.

   Chile    99.9992  

Bosques Arauco S.A.

   Chile    99.9256  

Caif S.A.

   Argentina    99.9987  

Controladora de Plagas Forestales S.A.

   Chile    61.1715  

Ecoboard S.A.

   Argentina    99.9987  

Ecoresin S.A.

   Argentina    99.9987  

Faplac S.A.

   Argentina    99.9987  

Flooring S.A.

   Argentina    99.9987  

Forestal Arauco S.A.

   Chile    99.9248  

Forestal Arauco Costa Rica S.A.

   Costa Rica    99.9986  

Forestal Arauco Guatemala S.A.

   Guatemala    99.9985  

Forestal Celco S.A.

   Chile    99.9256  

Forestal Cholguán S.A.

   Chile    97.4281  

Forestal Concepción S.A.

   Panama    99.9985  

Forestal Conosur S.A.

   Uruguay    99.9986  

Forestal Los Lagos S.A.

   Chile    79.9404  

Forestal Misiones S.A.

   Argentina    99.9861  

Forestal Valdivia S.A.

   Chile    99.9256  

Industrias Forestales S.A.

   Argentina    99.9987  

Inversiones Celco S.L.

   Spain    99.9990  

Investigaciones Forestales Bioforest S.A.

   Chile    99.9256  

Forestal Nuestra Señora del Carmen S.A.

   Argentina    99.9987  

Molduras Trupán S.A.

   Chile    99.9992  

Paneles Arauco S.A.

   Chile    99.9992  

Placas do Paraná S.A.

   Brazil    99.9987  

Servicios Logísticos Arauco S.A.

   Chile    99.9995  

Southwoods Arauco Lumber LLC

   U.S.A.    99.6110  

Trupán Argentina S.A.

   Argentina    99.9999  

 

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Business Strategy

Our business strategy is to maximize the commercial value of our plantations by pursuing sustainable growth opportunities in our core businesses and expanding into new markets and products. We are implementing our business strategy through the following initiatives:

 

   

We are executing a capital expenditure plan designed to increase production capacity for pulp and forestry and wood products and to improve efficiency and productivity;

 

   

We are improving the growth rate and quality of our plantations and increasing production of higher margin clear wood through advanced forest management techniques;

 

   

We are expanding our product line to enter into new markets by, among other activities, planting eucalyptus trees to provide hardwood pulp; and

 

   

We continue to develop our state-of-the-art transportation, shipping, storage and product distribution network that allow us to reach over 70 countries worldwide.

Domestic and Export Sales

The following table sets forth our sales revenue derived from exports and domestic sales for the years indicated.

 

     Year ended December 31,
     2005    2006    2007
     (in millions of U.S.$)

Export Sales

        

Bleached pulp

   $ 757    $ 982    $ 1,424

Unbleached pulp

     160      184      200

Sawlogs

     —        0      2

Sawn timber

     359      413      463

Remanufactured wood products

     208      219      207

Plywood and fiber panels

     350      391      451

Posts

     22      8      1

Other

     1      1      0
                    

Total export sales revenue

   $ 1,857    $ 2,198    $ 2,748
                    

Domestic Sales

        

Bleached pulp

     72      89      102

Unbleached pulp

     2      2      3

Sawlogs

     51      56      68

Pulplogs

     7      8      4

Sawn timber

     75      82      87

Remanufactured wood products

     8      13      13

Chips

     7      8      9

Electric power

     39      34      104

Plywood and fiber panels

     238      330      404

Other

     18      30      35
                    

Total domestic sales revenue

   $ 517    $ 652    $ 829
                    

Total sales revenue

   $ 2,374    $ 2,850    $ 3,577
                    

 

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The following table sets forth a geographic market breakdown of our export sales revenue for the years indicated.

 

     Year ended December 31,
     2005    2006    2007
     (in millions of U.S. dollars)

North America

   $ 631    $ 703    $ 673

Central and South America

     130      202      264

Asia

     596      730      1,161

Europe

     357      420      568

Other

     143      143      82
                    

Total

   $ 1,857    $ 2,198    $ 2,748
                    

Forestry Activity

Radiata pine grows at the fastest rates within a narrow band of latitude and under certain climatic conditions. One of Chile’s principal advantages in the forestry products industry lies in the short growing cycle of our radiata pine plantations. The faster rate of growth of radiata pine trees in Chile allows harvesting of pulplogs and sawlogs 16 to 18 years after planting and of high quality sawlogs 25 years after planting. For most temperate softwood forests in the Northern Hemisphere this range is 18 to 45 years for pulplogs and 50 to 150 years for high quality sawn timber. Consequently, the Chilean forestry industry is a relatively low cost producer, since a Chilean producer generally requires less time and a smaller area to produce the same volume of pine as its North American or European competitors, who face lower forest growth rates and higher transportation and investment costs as a result of the larger tracts of forests necessary to produce equivalent yields of softwood. Accordingly, since the mid-1970s, we have focused our forest management toward the application of advanced genetic and silviculture techniques to increase productivity and the quality of our plantations.

Eucalyptus, which we started planting in 1989, grows well in the forest regions of Chile. Once planted, eucalyptus trees require no further forest management (other than fire control and reduction of weeds) until harvest. The average harvest cycle of eucalyptus plantations is approximately 12 years. Once cut, eucalyptus regrows and it is only after two additional harvest rotations of approximately 12 years each that it becomes necessary to replant.

We have adopted environmentally sensitive policies towards our holdings of native forests. In selected areas, we thin native forests in compliance with applicable laws and regulations, but we do not permit clear cutting of native forests in areas surrounding rivers and streams, areas of notable environmental interest or areas with particularly fragile soil conditions. See “—Government Regulation.”

Our forestry activities have obtained ISO 14001 certification through 2007 from the International Standards Organization, or ISO. Additionally, during 2003, we obtained certification in Chile from the National Standard for Sustainable Forest Management (Estándar Nacional de Certificación Forestal Sustentable), or CERTFOR, and in 2004, CERTFOR performed its first audit of our operations and confirmed that we complied with CERTFOR requirements. In 2004, CERTFOR obtained its membership in the Pan European Forest Certification, the forestry certification that covers the largest segment of the world forestry market. We also have obtained ISO 14001 certification for our forestry activities in Argentina. In November 2005, we obtained OHSAS certification for our forestry activities in Argentina.

Forest Plantations

At December 31, 2007, our planted forests consisted of 83.5% radiata and taeda pine, and the balance primarily consisted of eucalyptus. Radiata and taeda pine have a rapid growth rate and a short harvest cycle compared to other commercial softwoods. Radiata and taeda pine are sufficiently versatile for both the production of forestry and wood products and the production of long fiber pulp for sale to manufacturers of paper and packaging.

We seek to manage our forestry resources in a way that ensures that the annual growth of our forest is equal to or greater than the volume of resources harvested each year. In 2007, we planted 41,638 hectares and harvested 36,072 hectares in Chile, Argentina, Brazil and Uruguay. We believe that we will reach a long-term sustainable equilibrium in the latter part of this decade, with annual harvests and plantations of approximately 40,000 hectares.

 

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The majority of our radiata pine is less than 16 years old. Our planted radiata pine forests are located in central and southern Chile, and most are located in close proximity to our major production facilities and to port facilities.

At December 31, 2007, our aggregate radiata pine holdings comprised approximately 40.0% of all Chilean radiata pine plantations, making us the country’s largest radiata pine plantation owner according to the Chilean Forestry Institute.

At December 31, 2007, we owned 246,068 hectares of forest and other land in Argentina, 117,907 hectares of forest and other land in Brazil and 37,498 hectares of forest and other land in Uruguay. Approximately 182,367 hectares of this land is planted with taeda pine and elliotti pine, a species of softwood that has a growth rate similar to that of radiata pine. The balance includes plantations of other species of trees, land to be planted, protected areas and natural forests.

The following table sets forth the number of hectares and types of uses of our land holdings and rights, as of December 31, 2007.

 

     At December 31, 2007  
     Total    Distribution  
     (in hectares)    (percentage)  

Pine plantations(1)

     

0-5 years

   213,193    14.4 %

6-10 years

   198,703    13.4  

11-15 years

   150,504    10.3  

16-20 years

   133,445    9.0  

21+ years

   82,256    5.6  
           

Subtotal(2)

   778,101    52.7  

Eucalyptus plantations(3)

   134,678    9.1  

Plantation of other species

   18,942    1.2  

Subtotal

   931,721    63.0  

Land for plantations

   37,856    2.6  

Land for other uses(4)

   508,175    34.4  
           

Total

   1,477,752    100.0 %
           

 

(1)

All years are calculated from the date of planting.

(2)

These figures include 27,982 hectares as to which we have the right to harvest but which we do not own.

(3)

Approximately 77.2% of our eucalyptus plantations are less than 10 years old.

(4)

Includes roads, firebreaks, native forests and yards.

Land Acquisition and Afforestation

Our total land assets have increased from fewer than 170,000 hectares in 1980 to 1,477,752 hectares at December 31, 2007. That number includes 27,982 hectares owned by third parties (but not including the assets owned by Forestal Río Grande S.A.) as to which we have harvesting rights. Although we have acquired afforested land, the bulk of the increase in our forest plantations has been through the acquisition of bare land that is, subsequently, planted with trees. In the five years ending December 31, 2007, we purchased 76,135 hectares of bare land for plantations and other uses and 58,408 hectares of forested land in Chile. We have also significantly increased our land assets in Argentina, Uruguay and Brazil.

We expect to acquire additional land in Chile, Argentina, Uruguay and Brazil if we are presented with the opportunity to do so at a desired price or location. There can be no assurance that we would be able to acquire land at the desired price or location.

We plan to continue our policy of supplementing our pulplog production with purchases from domestic third parties. We believe that this policy is efficient, given the significant quantities of pulpwood available from

 

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third parties and our increasing proportion of sawlogs yielded from our plantations. We believe that the aggregate of our existing plantations, land currently held by us that we intend to afforest and the third-party purchases we make in the ordinary course of our business will be sufficient to satisfy our anticipated future demand for sawlogs and pulplogs.

Chile

In December 2003, we acquired a controlling interest in Forestal Celsur S.A. by purchasing 83.05% of its shares, and we acquired an additional 16.95% of the shares in January 2004. As a result of the purchase, we acquired 13,590 hectares of land.

In May 2004, our forestry affiliates entered into an agreement with affiliates of Empresas CMPC S.A., or CMPC, to exchange forestry land held by the CMPC affiliates for land held by our forestry affiliates and made a cash payment to the CMPC affiliates. Pursuant to the agreement, our forestry affiliates acquired approximately 26,000 hectares of forestry land from the CMPC affiliates and transferred approximately 9,000 hectares of forestry land.

In December 2004, we acquired from Terranova S.A. 21,800 hectares of forestry land located in the Seventh Region of Chile. Approximately 12,300 hectares of this land is planted with radiata pine.

On January 6, 2005, through Forestal Valdivia S.A., we acquired 80% of Forestal Los Lagos S.A., which represented an investment of U.S.$21.4 million and included 9,234 hectares of land planted with eucalyptus in what is now the Fourteenth Region of Chile.

On June 30, 2006, through our subsidiaries Aserraderos Arauco S.A., Forestal Celco S.A., Bosques Arauco S.A. and Forestal Valdivia S.A., we acquired the forestry assets of Cementos Bío-Bío S.A. The acquisition represented an investment of approximately U.S.$133.3 million. The acquired assets consist of 21,000 hectares of pine plantations, one sawmill with an annual production capacity of approximately 250,000 cubic meters per year and a remanufacturing facility.

On October 11, 2006, the Bío Bío Investment Fund, a Chilean fund in which a group of Chilean insurance companies and other private investors participate, acquired the assets of Forestal Bío-Bío S.A. for U.S.$346 million, which include approximately 40,000 hectares of plantations. On that same date, Arauco entered into certain agreements with the Bío Bío Investment Fund pursuant to which Arauco became the administrator and exclusive buyer of these forestry assets. Arauco will receive an annual fee for the administration of the forests. Arauco’s obligations under these agreements include the purchase of the fund’s forestry assets over a seven-year term beginning in 2006 and the purchase of the fund’s supply of timber during the same period. Arauco will pay a total of U.S.$461.6 million for the purchase of the fund’s forestry assets and timber supply over such seven-year term.

In January 2007, the Bío Bío Investment Fund transferred all of its assets and financial debt to Forestal Río Grande S.A., its newly created subsidiary. At the same time, the Bío Bío Investment Fund assigned all the administration and supply agreements it had entered into with Arauco to Forestal Río Grande S.A. Arauco has determined that Forestal Río Grande S.A. is a variable interest entity of which Arauco is the primary beneficiary. As a result, commencing on October 11, 2006, Arauco consolidates the assets and liabilities of Forestal Río Grande S.A. The indebtedness of Forestal Río Grande S.A. is neither secured by Arauco nor is Arauco liable for such indebtedness. See Note (c) to our audited consolidated financial statements.

In January 2007, through its subsidiary Bosques Arauco S.A., Arauco acquired 5,105 hectares of radiata pine plantation (excluding land) from Forestal Anchile Ltda. This acquisition represented an investment of approximately U.S.$43.6 million.

Argentina

In October 2005, through our Brazilian subsidiary Arauco do Brasil Ltda., we acquired from Louis Dreyfus S.A.S. 100% of the stock of Ecoboard S.A.I.F. and Louis Dreyfus S.A.I.F. in Argentina and, indirectly as a result of that purchase, 100% of the stock of Caif S.A. and LD Manufacturing S.A. and 60% of the stock of Flooring S.A. As a result of these acquisitions, we own an additional 8,000 hectares of plantations in Argentina.

 

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On November 10, 2006, through its subsidiary Arauco Internacional S.A., Arauco acquired La Señora del Milagro S.R.L., an Argentine forestry company, which owns approximately 4,000 hectares of land in Argentina, for U.S. $5.4 million.

Brazil

In March 2005, we acquired from Louis Dreyfus S.A.S. 100% of the stock of LD Forest Products S.A. in Brazil and, indirectly as a result of that purchase, 100% of the stock of Placas do Paraná S.A. and 50% of the stock of Dynea Brasil S.A. As a result of these acquisitions, we acquired 25,800 hectares of plantations in Brazil.

In August 2006, through our subsidiary Arauco Forest Brasil S.A., we acquired from the Marchiori Group certain forestry land in Brazil. This investment of U.S.$39.6 million includes 14,715 hectares of land and plantations, mostly consisting of elliotti pine. This acquisition is expected to increase our supply capacity for medium-density fiberboard (MDF) by 305,000 cubic meters per year and particleboard (PBO) mills by 300,000 cubic meters per year in Brazil.

On September 27, 2007 Arauco entered into an agreement for the joint ownership of land with Stora Enso Oyj, a Finnish-Swedish multinational corporation. Pursuant to the agreement, Arauco acquired 80% of the shares in Stora Enso Arapoti Emprendimentos Agrícolas S.A., now Arauco Florestal Arapoti S.A., which owns 50,000 hectares of land, including 25,000 hectares of pine and 5,000 hectares of eucalyptus plantations; 20% of the shares in Stora Enso Arapoti Indústria de Papel S.A., which owns a paper mill with an annual production capacity of 205,000 tons of light weight coated paper; and 100% of the shares of Stora Enso Arapoti Serraria Ltda., which owns a sawmill with an annual production capacity of 150,000 cubic meters per year. This alliance represented an investment of U.S.$ 208.4 million, which was financed with Arauco’s resources and commercial bank loans.

Forest Management

For our pine plantations, our forestry management activities seek to increase sawlogs through advanced genetic techniques, planting and site preparation procedures, thinning and pruning. Managed forests can produce trees of larger diameter and, if pruned, a higher proportion of clear wood, which generally commands a higher price than knotted wood. Although some land is not suitable for the production of pruned logs, at December 31, 2007, over 39.0% of our pine forests in Chile were actively managed for clear wood production.

For our eucalyptus plantations, our forestry management activities seek to increase the amount of fiber production per hectare through advanced genetic techniques and planting and site preparation procedures. Eucalyptus is more expensive to plant than pine; however, after planting, eucalyptus requires minimal forest management, yields more fiber per hectare and has a shorter growth cycle and greater wood density than pine, resulting in a greater amount of pulp production per hectare.

As of December 31, 2007, we had eight nurseries in Chile, Argentina and Brazil, in which we grow seedlings using seeds and using cuttings from genetically selected trees. To achieve higher quality trees and an increased growth rate, we apply strict selection criteria to the trees from which seedlings are produced. Then, we plant the seedlings manually. Depending upon the species of tree to be planted and the nutrient and physical characteristics of the soil, we may also undertake a certain amount of ground preparation before planting.

Our other principal forest activities are thinning, pruning and harvesting.

Thinning, or culling inferior trees from the plantation, occurs in the following two stages:

 

   

Thinning to waste. Some thinned trees are chipped and used in pulp production. Thinning to waste occurs after four to six years and results in an average reduction of the number of trees per hectare from 1,250 to approximately 700.

 

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Commercial thinning. Thinned trees are used in pulp production or, depending on the quality of the particular land, as sawlogs. Commercial thinning occurs at 10 to 12 years and results in an average reduction of the number of trees per hectare from 700 to approximately 450.

This high level of culling is economical for the following reasons:

 

   

the cost of planting is relatively low,

 

   

the higher number of young trees provide each other with natural protection from the elements, and

 

   

the high degree of selection that thinning makes possible leaves only the highest quality trees to be harvested.

Pruning involves removing branches, the source of knots, which are the main defect in sawn timber. Pruning results in a high-quality clearwood sawlog of 5.3 meters from each tree, and is conducted three times:

 

   

at the time of the first thinning,

 

   

two years later, when trees are six to eight years old, and

 

   

one year later, when trees are seven to nine years old.

Our eucalyptus plantations are neither thinned nor pruned.

Harvesting timber involves felling trees, removing branches from the logs, cutting the logs into appropriate sections and loading the logs onto trucks for transport to sawmills, panel mills, pulp mills or ports for direct export. We use the lower section of the radiata pine, comprising the first seven to 12 meters, in sawmills and plywood mills or it is exported as sawlogs. We use the mid-section of the radiata pine, comprising, on average, the next eight to 13 meters, in either sawmills or pulp mills, depending on the diameter and quality of the pine. We use the top section of the tree for pulp and MDF production.

We keep apprised of product demand and our current inventory levels, and we match harvests from sections of our plantations that will provide the optimal yield given our product requirements. This process involves the use of sophisticated operations research models and close communication between our different operating areas to ensure that the correct amounts of timber of the required characteristics are supplied. We replant as soon as practicable after harvesting, with an average period between harvesting and replanting of one year.

The following table illustrates, on a hectare basis, the extent of our thinning, pruning and harvesting activities during the periods indicated.

 

     Year ended December 31,
     2005    2006    2007
     (in hectares)

Thinning

   23,219    22,773    28,759

Pruning

   38,477    45,945    45,797

Harvesting

   30,971    32,988    36,072

We manage our forest activities, but we hire independent contractors to perform the bulk of our operations, including planting, maintenance, thinning, pruning, harvesting, transportation and access road construction. As of December 31, 2007, we had arrangements with more than 325 independent contractors, which employed over 13,683 workers. Many of these contractors have long-standing relationships with us, but we award many contracts based on competitive bids. We believe that our arrangements with independent contractors provide greater flexibility and efficiency than performing these activities directly.

 

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Since areas of farmland and native forests geographically separate our forest holdings, our plantations are naturally protected against the spread of certain diseases. In addition, our subsidiary Bioforest has developed techniques to protect our forests from pests and diseases. The most prevalent pest is the European pine shoot moth, which may damage the tips of the radiata pine, resulting in deformations to the tree. We control this moth with biological methods. Specifically, we introduced the Orgilus Obscurator, a parasitic wasp that attacks only the European pine shoot moth. Other methods we use to control pests include the mechanical removal of affected tips and the use of low toxicity chemical products. Other potential diseases and pests include a fungus called Dothistroma, a fungus that reduces a tree’s growth rate, and the Sirex insect, which attacks decaying trees and results in a thinned forest.

We operate an extensive fire control organization that interacts with the fire control organizations of other forestry companies to ensure that any fire damage to our forests is minimal. The operation primarily consists of a system of spotter towers, manned 24 hours a day during the summer months, from which spotters report the direction of any fire observed to a central command post, where the fire’s exact location is determined and an appropriate ground and/or aerial response is formulated. Over the last five years, this system has limited fire damage to our forests to an average of 0.2% of the plantations per year.

Forest Production

We harvested 15.3 million cubic meters of logs during the year ended December 31, 2007, consisting of 9.4 million cubic meters of sawlogs, 5.0 million cubic meters of radiata pine pulplogs and 0.9 million cubic meters of eucalyptus pulplogs and other logs. We did not export any pulplogs during 2007 because substantially all of the pulplogs from our forests were used in our pulp mills. During 2007, our sawmills and panel mills used 7,736,989 cubic meters of sawlogs, and no sawlogs were exported. We also sold 1,521,633 cubic meters of sawlogs to unaffiliated domestic sawmills during 2007.

A log merchandising facility located at the same site as our Horcones I and Horcones II Sawmills optimizes, cuts and classifies wood destined for our plywood facility, sawmills or pulp mills with an annual processing capacity of 1.7 million cubic meters of logs per year. The Nueva Aldea Complex also includes a log merchandising facility, with an annual processing capacity of 1.4 million cubic meters of logs per year.

Pulp

We believe that we were Chile’s largest producer of bleached and unbleached softwood market pulp in terms of production in 2007. For the year ended December 31, 2007, pulp sales were U.S.$1,729.6 million, representing 48.4% of our total sales revenue for the period.

Pulp obtained from wood fibers is used in the manufacture of printing and writing paper, hygienic and sanitary paper, board and packaging. Whether a specific kind of pulp is suitable for a particular end use depends not only on the type of wood but also on the process used to transform the wood into pulp. Pulp made from softwoods, such as radiata pine, has long fibers and is used to provide durability and strength to paper products. Bleached pulp is used primarily for printing and writing papers and for tissue. Unbleached pulp is used primarily for linerboard (a packaging material). Pulp made from hardwoods, such as eucalyptus, has short fibers and is used in combination with long fiber in manufacturing paper products.

We use a chemical process, known as the kraft process, in our pulp mills in Chile and Argentina. The raw wood is in the form of pulplogs and chips, which are combined in the production process to produce pulp. The pulplogs are first debarked and chipped. The chips are then screened, mixed and cooked with chemicals to separate the bulk of the lignin from the wood fibers. After the material is screened and washed, it is then passed to high-density tanks. For bleached pulp, the next step is a five-stage bleaching process using chemicals, primarily chlorine dioxide. At all of our pulp mills, the bleaching process is preceded by an oxygen delignification stage. Then, the fibers are subjected to a final stage where the sheets are formed and subsequently dried and baled for transport to customers. The lignin and bark produced during this process is used to fuel the boilers that produce steam, providing heat and generating electricity for the mill. Our bleached pulp is bleached to a 90+ brightness level, as measured by the ISO test procedure, which is one of the industry’s measurement methods.

 

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Pulp Mills

At December 31, 2007, we owned and operated five pulp mills in Chile and one in Argentina, with an aggregate installed annual production capacity of approximately 3,041,000 metric tons. Our six pulp mills produced 2,293,786 metric tons of bleached pulp and 331,388 metric tons of unbleached pulp in 2007.

All of our pulp mills in Chile except for the Nueva Aldea Mill are ISO 9001:2000 and ISO14001:2004 certified. We expect that the Nueva Aldea Mill will be certified ISO 9001:2000 by 2010 and ISO 14001:2004 by 2009. The Alto Paraná Mill in Argentina is certified under ISO 9001:2000 and ISO14001:2004. No seasonal factors affect plant utilization, and the pulp mills generally run at full capacity throughout the year, with eight to ten days of maintenance scheduled every 12 months.

The following table sets out bleached and unbleached kraft pulp production by plant for each of the years indicated.

 

     Year ended December 31,
     2003    2004    2005    2006    2007
     (in thousands of metric tons)
Chile               

Arauco Mill (bleached)

              

Arauco I

   252    260    263    295    279

Arauco II

   494    508    494    494    475

Valdivia Mill (bleached)(1)

   —      430    351    440    436

Constitución Mill (unbleached)

   357    355    353    338    331

Nueva Aldea Mill (bleached)(2)

   —      —      —      123    715

Licancel Mill (bleached)

   134    141    145    141    53
                        

Subtotal

   1,237    1,694    1,606    1,831    2,289
                        
Argentina               

Alto Paraná Mill (bleached)

   345    349    331    348    336

Total

   1,582    2,043    1,937    2,179    2,625
                        

 

(1)

Operations at the Valdivia Mill commenced in February 2004, were temporarily suspended for approximately one month during January and February of 2005 and for approximately two months during June, July, and August of 2005.

(2)

Operations at the Licancel Mill were temporarily suspended for approximately six months from June 2007 until January 2008.

Chile

Arauco I. Arauco I, which was completed in 1972, is located at the Arauco Mill in the heart of a group of our radiata pine plantations in the Eighth Region of Chile. Arauco I produces elementary chlorine-free pulp, which does not use chlorine gas. Elementary chlorine-free pulp is also produced by a significant portion of our competitors in each of the world’s major pulp producing regions. The installed annual production capacity of Arauco I is approximately 290,000 metric tons of eucalyptus and pine bleached kraft pulp.

Arauco II. Also located at the Arauco Mill, Arauco II was completed in 1991. Arauco II’s pulping process is fundamentally the same as that of Arauco I, but it includes technological improvements in its production process and environmental design. Arauco II is also equipped to produce elementary chlorine-free pulp. The installed annual production capacity of Arauco II is approximately 500,000 metric tons of pine bleached kraft pulp.

Constitución Mill. The Constitución Mill is located in the heart of a group of our radiata pine forests in the Seventh Region of Chile. As of December 31, 2007, the Constitución Mill was the largest unbleached softwood market pulp mill in the world, with an installed annual production capacity of approximately 355,000 metric tons. In February 2006, the COREMA of the Seventh Region of Chile approved an environmental impact study for the construction of a new pipeline for the Constitución Mill, which commenced operations in February 2007.

 

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Licancel Mill. We acquired the Licancel Mill in September 1999. It is located in Licantén, which is 250 kilometers south of Santiago. The mill has an installed annual production capacity of approximately 140,000 metric tons of eucalyptus kraft pulp and pine bleached kraft pulp. The Licancel Mill is equipped to produce elementary chlorine-free pulp.

Since June 2007, our operations at the Licancel Mill, a pulp mill located in the Seventh Region of Chile, have been subject to environmental scrutiny by Chilean environmental regulators and the public. On June 5, 2007, in connection with the death of fish in the Mataquito River, approximately 15 kilometers downstream of the mill, we decided to voluntarily suspend our operations in the Licancel Mill as a preventive measure. In addition, Chilean authorities, including the health authorities and the Superintendencia de Servicios Sanitarios (Sanitary Services Superintendency), required that we suspend activities at the Licancel Mill and that we suspend any further discharges into the river. We also commenced independent investigations relating to the cause of the death of the fish. On June 18, 2007, as a result of a pipe leakage in the water treatment system currently in place at the Licancel Mill, an estimated 50 cubic meters of effluents reached the Mataquito River. On that same date, we decided to close the mill indefinitely and informed the Sanitary Services Superintendency of the incident. On October 3, 2007, we requested to the health authority (Autoridad Sanitaria) of the Seventh Region of Chile that it remove the suspension of activities at the Licancel Mill. On October 22, 2007, the health authority of the Seventh Region of Chile removed the suspension and imposed certain conditions relating to our activities in the mill consisting primarily of the implementation of certain emergency detection and control programs and systems, with which we have complied. Furthermore, on November 12, 2007 the Sanitary Services Superintendency removed the suspension regarding the release of discharges by the Licancel Mill. The mill resumed operations during January 2008.

We estimate that the suspension of operations at the Licancel Mill resulted in a loss of profits of approximately U.S.$4 million per month. The proceedings and the related sanctions are included in detail in Note 12 to our audited consolidated financial statements. Several administrative and judicial proceedings have been commenced regarding the events at the Licancel Mill, including the death of fish at the Mataquito River. We can offer no assurance that the Licancel Mill will be able to operate without further interruptions. Any future suspension of operations at the Licancel Mill may adversely affect our business, financial condition and results of operations. See “Item 8. Financial Information- Legal Proceedings” and “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Licancel Mill.”

Valdivia Mill. We completed construction of the Valdivia Mill during the first quarter of 2004 and commenced operations in February 2004. The Valdivia Mill is located in the newly created Fourteenth Region of Chile (which was previously part of the Tenth Region of Chile), an area with significant radiata pine and eucalyptus plantations. The Valdivia Mill has an installed potential annual production capacity of approximately 550,000 metric tons of bleached pulp, consisting of softwood pulp and eucalyptus pulp.

The Valdivia Mill has been subject to legal and administrative proceedings by the Chilean environmental regulators. Primarily, it has been alleged that the Valdivia Mill’s operations impacted the nearby Carlos Anwandter Nature Sanctuary and contributed to the migration and death of black-neck swans in an area downstream from the mill on the Cruces River. In connection with an environmental administrative proceeding, environmental regulators required us to temporarily suspend operations at the Valdivia Mill for approximately one month in January 2005. We resumed operations at the mill on February 18, 2005. On June 8, 2005, we voluntarily suspended operations at the Valdivia Mill, which we estimate resulted in a loss of sales of approximately U.S.$1.0 million per day and a loss of profits of approximately U.S.$250,000 per day. Pursuant to the decision of our board of directors based on certain clarifications provided by the COREMA of the Tenth Region of Chile, the mill resumed operations on August 12, 2005 at a reduced annual production of 440,000 metric tons or 80% of its authorized production capacity, after 64 days of suspended operations. In order to achieve the full production capacity authorized by applicable permits (equal to 550,000 metric tons of wood pulp per year), the pulp mill had to comply with certain new requirements established by the COREMA of the Tenth Region of Chile including modifications to the effluents’ parameters (including, among others, aluminum, sulfate, nitrogen and chlorate). In March 2006, Knight Piesold, an independent environmental auditing firm appointed by the COREMA of the Tenth Region of Chile, officially determined that the Valdivia Mill had complied with the applicable requirements. On January 18, 2008, the COREMA authorized the Valdivia Mill to return to its authorized production capacity of 550,000 metric tons. The mill gradually increased its production over a four-month period starting in March 2008 and reached full capacity in June 2008. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—Environmental concerns led us to temporarily suspend our operations at the Valdivia Mill, which

 

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adversely affected, and in the future may continue to adversely affect, our business, financial condition and results of operations”, “Item 4. Information on the Company—Government Regulation—Environment” and “Item 8. Financial Information—Legal Proceedings.”

In connection with our decision to suspend operations at the Valdivia Mill, our President and Chief Executive Officer resigned from his positions. For more information about our executive officers, see “Item 6. Directors, Senior Management and Employees—Directors and Executive Officers.”

The National Defense Council has instituted a reparation action for environmental damage seeking reparations, damages and indemnification from us for environmental harm allegedly caused by the Valdivia Mill. In addition, since the end of 2004, various criminal proceedings relating to alleged violations of several environmental laws have been instituted in Chile in which some of our mills may be involved. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—We are subject to legal proceedings related to our mills, which could adversely affect our business, financial condition and results of operations.”

In 2005, the COREMA instructed us to present by March 31, 2006, an environmental impact study for the construction of a pipeline to discharge the Mill’s wastewater in a body of water other than the Cruces River or the Carlos Anwandter Nature Sanctuary or their sources. The COREMA also instructed us to construct and put into operation the pipeline no later than 15 months from the date COREMA approves the environmental impact study in final form. COREMA initially extended the deadline for the presentation of this environmental impact study to April 2007 and, prior to the expiration of the April 2007 deadline, extended it again to March 31, 2009. When it approved the new deadline, COREMA required us to present an additional environmental impact study for the implementation of substantial technological improvements on the quality of the effluents generated by the Valdivia Mill. We submitted this study on June 13, 2007. As of the date of this annual report, we have not been notified of the resolution that would conclude the environmental evaluation process by the COREMA.

The COREMA of the Tenth Region of Chile has appointed a Canadian consulting company, Ecometrix, to analyze and prepare a report on different feasible alternatives for discharge of the Valdivia Mill effluents. Approval by the COREMA of Arauco’s environmental impact study regarding a pipeline, the construction and operation of such a pipeline and also the approval of the environmental impact study regarding the improvement of the quality of the effluents are each subject to many environmental, regulatory, engineering and political uncertainties at this time. As a result, we cannot give you any assurance that such projects will ever be approved or completed. If either our environmental study or the installation of the pipeline is delayed for reasons that COREMA attributes to us, we may face sanctions that include warnings, fines or the revocation of the Valdivia Mill’s environmental permit of operation. Alternatively, if COREMA considers that such delays are beyond our control, we believe that COREMA should extend the applicable deadlines. However, we can offer no assurances that any deadline extension will be granted, even if we comply with all the requirements set forth by COREMA.

As a result, we offer no assurance that the Valdivia Mill will be able to operate without further interruption. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants would likely have a material adverse effect on our business, financial condition and results of operations.

As part of the environmental resolution that modified the Valdivia Mill environmental permit, the COREMA of the Tenth Region of Chile asked the National Forestry Corporation (CONAF) to elaborate an Integral Environmental Management Plan for the wetland, which was completed in 2006. The plan concluded that there was a need to develop a Conceptual Ecosystem Model for the wetland. CONAF selected the Science Faculty of the University of Chile to conduct this study.

The study indicated in its second progress report that the disappearance of the “luchecillo,” a water weed that was an important food source of black-necked swans, was likely related to natural causes. Specifically, the study proposed that the disappearance of the “luchecillo” was caused by the convergence of three factors in May 2004: (i) low levels of precipitation, (ii) low levels of water flow in the rivers and the wetland and (iii) three instances in which temperatures reached zero degrees Celsius or lower. According to the study, the simultaneous occurrence of these factors was likely responsible for the disappearance of the “luchecillo” which, in turn, lead to the death and migration of the swans.

 

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Nueva Aldea Mill. During 2004, we commenced construction of the second phase of the Nueva Aldea Project, which includes the development of a new pulp mill with authorized annual production capacity of 856,000 tons of bleached pulp, consisting of softwood pulp and eucalyptus pulp. In August 2006, we commenced the start-up process of the Nueva Aldea Pulp Mill, and production capacity reached designed capacity in May 2007. The second phase of the Nueva Aldea Project has been subject to significant environmental challenges, and construction of the pulp mill was temporarily suspended between January 12 and March 10, 2005. See “Item 4. Information on the Company—Government Regulation—Environment” and “Item 8. Financial Information—Legal Proceedings.”

On February 20, 2006, the COREMA of the Eighth Region of Chile approved the environmental impact study for the construction and operation of the Nueva Aldea Mill Pipeline, which will permit the mill to discharge certain liquid effluents into the ocean. We anticipate the Nueva Aldea Mill Pipeline will commence operations in the last quarter of 2008, subject the satisfaction of certain conditions, including the receipt of certain public approvals.

Argentina

Alto Paraná Mill. Alto Paraná’s softwood pulp mill is located in the Province of Misiones, a region whose soil and climate are favorable for the rapid growth of pine trees. The Alto Paraná Mill is the only bleached softwood kraft market pulp facility in Argentina. The mill has installed annual production capacity of approximately 350,000 tons of pulp, which includes approximately 250,000 metric tons of bleached softwood pulp, currently representing almost all of the total bleached softwood pulp production capacity in Argentina, and approximately 100,000 metric tons of fluff pulp.

Production Costs

Based on information published by Resource Information Systems, Inc., our cash costs for softwood pulp production are significantly lower than the average costs of market pulp producers in Canada, the United States and Scandinavia, particularly with respect to timber and labor costs. While our modern facilities result in depreciation exceeding some of such Northern Hemisphere producers, our costs are still significantly lower than the average costs of our Northern Hemisphere competitors, on a total delivered cost basis. The following table compares our costs for the production of bleached softwood kraft market pulp to the average costs of market pulp producers in selected regions in the Northern Hemisphere for the year ended December 31, 2007.

 

     Bleached Softwood Kraft Pulp Producers’ Cost
     Arauco    British
Columbia
Coast
   British
Columbia
Interior
   United
States
South
   Sweden    Finland
     (in U.S.$ per metric ton for the year ended December 31, 2007)

Wood

   132    243    193    151    319    339

Total chemicals

   48    67    73    66    61    59

Labor

   47    73    68    41    45    49

Others(1)

   49    199    176    139    86    66
                             

Total cash cost

   276    582    510    397    511    513

Depreciation

   69    55    32    63    42    56
                             

Total mill cost

   345    637    542    460    553    569

Transportation(2)

   70    68    111    65    34    41
                             

Total delivered cost

   415    705    653    525    587    610
                             

 

(1)

Includes energy, materials and other production costs.

(2)

Delivered in Northern Europe.

Source: Resource Information Systems, Inc. World Pulp Annual Historical Data, December 2007, except Arauco information, which is furnished by Arauco.

Sales

The world market for bleached kraft market pulp during the year ended December 31, 2007 was approximately 46.3 million metric tons. Based on information published by Resource Information Systems, Inc., we believe that our production represented 9.4% of this market in 2007. During the year ended December 31, 2007, we

 

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sold approximately 93.3% of our bleached pulp abroad, principally to customers in Asia and Western Europe. Since the domestic market in Chile is dominated by a single integrated pulp and paper manufacturer, the Chilean market for bleached market pulp is relatively small.

Integrated manufacturers dominate the world production of unbleached softwood pulp, which leaves non-integrated companies that sell market pulp, like us, with only a small percentage of total production. “Market pulp” is pulp sold to manufacturers of paper products, as opposed to pulp produced by an integrated paper producer for use in its paper production facilities. With a total world production of unbleached softwood kraft pulp of 35.2 million metric tons for 2007, according to Resource Information Systems, Inc., our Constitución Mill was the world’s largest single producer of unbleached softwood market pulp, with 14.0% of the total market in 2007. During the year ended December 31, 2007, approximately 98.4% of our total unbleached market pulp sales consisted of export sales. While for the last five years Asia has been our principal export market for unbleached market pulp, we continually seek niche markets for our products in Western Europe and the United States. Historically, our sales in the Chilean market have been less than 5% of our total unbleached pulp sales revenue.

The following table sets forth, by region, the sales volumes of bleached and unbleached pulp for the years indicated.

 

     Year ended December 31,
     2005    2006    2007
     (in metric tons)

Bleached Pulp

        

North and South America

   276,496    357,592    359,386

Europe

   538,306    592,842    703,693

Asia

   793,631    854,125    1,187,040

Other

   30,872    44,801    36,801
              

Total

   1,639,305    1,849,360    2,286,920
              

Unbleached Pulp

        

North and South America

   50,963    58,838    62,964

Europe

   19,928    21,421    23,846

Asia

   284,455    275,405    237,195

Other

   —      —      146
              

Total

   355,346    355,664    324,151
              

While there are many grades and varieties, pulp is a commodity that is marketed primarily on the basis of price and service. In marketing our pulp, we seek to establish long-term relationships with non-integrated end users of pulp by providing a competitively priced, high-quality, consistent product and excellent service. The consistency of our pulp derives from our state-of-the-art mills and our use of a single species of tree, in contrast to pulp producers in some of the world’s major softwood pulp producing regions that mix different species, depending on availability and seasonality. Our bleached pulp is marketed under the brand names “Arauco” and “Alto Paraná,” and our unbleached pulp is marketed under the brand name “Celco.”

Prices for bleached softwood kraft market pulp produced from radiata pine generally fluctuate depending on prevailing world prices, which historically have been cyclical. The fluctuations generally depend on worldwide demand, world production capacity, business strategies adopted by major forestry, pulp and paper producers and the availability of substitutes. See “Item 5. Operating and Financial Review and Prospects—Management’s Discussion and Analysis of Financial Conditions and Results of Operations—Overview” and “—Prices.”

 

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The following table sets forth our average bleached and unbleached pine pulp prices per metric ton at the indicated dates, for the years indicated.

 

     2005    2006    2007
     (U.S.$ per metric ton)

Bleached Pulp

        

March 31

   540    532    640

June 30

   490    573    659

September 30

   495    620    682

December 31

   497    631    710

Unbleached Pulp

        

March 31

   470    484    621

June 30

   456    505    654

September 30

   462    559    637

December 31

   456    587    592

In accordance with customary pulp market practice, we do not have long-term sales contracts with our customers; rather we maintain long-standing relationships with our customers pursuant to which we periodically reach agreements on specific volumes and prices. We have a diversified customer base located throughout the world and totaling, as of December 31, 2007, more than 339 clients. As of December 31, 2007, we employ more than 12 sales agents to represent us in more than 43 countries. We manage this worldwide sales network from our headquarters in Chile.

Wood Products

Our wood products consist of sawn timber (green, kiln-dried lumber and flitches) and remanufactured wood products. For the year ended December 31, 2007, revenue from sales of wood products was U.S.$770.1 million, representing 21.5% of our total sales revenues for the period.

The following table sets forth, by category, our wood products sales to unaffiliated third parties for each of the periods indicated:

 

     Year ended December 31,
     2003    2004    2005    2006    2007
     (in thousands of cubic meters)

Sawn timber

   1,665    1,968    2,425    2,512    2,650

Remanufactured wood products

   299    344    360    430    389

As of December 31, 2007, we own 15 sawmills, 12 in Chile, two in Argentina and one in Brazil, with aggregate installed annual processing capacity of approximately 6,772,200 cubic meters of sawlogs and an aggregate installed annual production capacity of approximately 3,640,000 cubic meters of lumber. Contractors that are not related to us or to each other operate our 12 sawmills in Chile. We operate our sawmills in coordination with our forestry and sales operations, since our sawn timber is generally produced in accordance with customer specifications. All of the sawmills are located near our pine plantations. However, on March 31, 2008, we closed our sawmill in Brazil, which had an installed annual production capacity of approximately 150,000 cubic meters of lumber due to the appreciation of the Brazilian real against the U.S. dollar and the housing market crisis in the United States, which has negatively affected the wood division.

As of December 31, 2007, we also own five remanufacturing facilities, four in Chile and one in Argentina, that reprocess sawn timber into remanufactured wood products, such as moldings, jams and pre-cut pieces that end users require for doors, furniture and door and window frames. These facilities produced 401,000 cubic meters of remanufactured wood products in 2007. During 2007, the decrease in demand of sawn timber products due primarily to the subprime crisis and the continued downturn in the real estate market in the United States resulted in our decision to close the La Araucana sawmill and to temporarily close the Lomas Coloradas remanufacturing mill.

 

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On March 31, 2008, we temporarily closed the Arapoti sawmill due to the appreciation of the Brazilian real against the U.S. dollar and the housing market crisis in the United States, which has negatively affected the wood division. We have also reduced shifts at the Horcones remanufacturing mill.

Aserraderos Arauco S.A. was established in 1993 to centralize management and control production in our sawmill and remanufacturing operations. Our sawmills and remanufacturing facilities in Chile are currently operated by independent contractors that are paid sawing service fees calculated on a fixed and variable basis depending on productivity, with price renegotiations in the event of material changes in costs or productivity. Each of our 18 independent contractors operates exclusively for us and only with respect to one sawmill or remanufacturing facility. We believe that our arrangements with independent contractors provide us with greater flexibility and efficiency than performing such activities on our own. We operate our sawmills and remanufacturing facilities in Argentina.

The following is a brief description of our sawmills and remanufacturing facilities and their production capacity, as of December 31, 2007. Processing capacity measures a facility’s input, while production capacity measures its output. Typically, a facility’s production capacity is 50% to 60% less than its processing capacity.

Chile

Cholguán Sawmill. This sawmill was acquired in March 2000 and has installed annual production capacity of approximately 300,000 cubic meters of lumber, as well as drying kiln facilities and two remanufacturing facilities with installed annual production capacity of approximately 70,000 cubic meters of remanufactured wood products. The Cholguán sawmill also has a special facility for making laminating beams with installed annual production capacity of approximately 11,200 cubic meters and drying facilities with installed annual production capacity of approximately 260,000 cubic meters.

Coelemu Sawmill. This sawmill has installed annual production capacity of approximately 80,000 cubic meters of lumber. Much of the mill’s production is sold into the Japanese market for thin and narrow sawn timber.

Colorado Sawmill. This sawmill has installed annual production capacity of approximately 320,000 cubic meters of lumber and produces “green” sawn timber (or sawn timber that is not kiln dried) for the Chilean, Japanese and Middle Eastern markets. It also has drying facilities with installed annual production capacity of approximately 190,000 cubic meters.

Coronel Sawmill. This sawmill was acquired from Forestal Bío-Bío S.A. in October 2006. It has installed annual production capacity of approximately 160,000 cubic meters of sawn timber. It is also equipped with drying kilns with installed annual production capacity of approximately 75,000 cubic meters.

El Cruce Sawmill. This sawmill has installed annual production capacity of approximately 85,000 cubic meters of lumber.

Horcones I Sawmill. This sawmill has installed annual production capacity of approximately 360,000 cubic meters of lumber. It also has drying kilns with installed annual production capacity of approximately 420,000 cubic meters and a remanufacturing facility with installed annual production capacity of approximately 136,000 cubic meters of remanufactured wood products.

Horcones II Sawmill. This sawmill has installed annual production capacity of approximately 225,000 cubic meters of lumber, as well as drying kiln facilities with installed annual production capacity of approximately 200,000 cubic meters.

La Araucana Sawmill. This sawmill processes logs to produce sawn timber, including high-grade sawn timber for remanufacturing and flitches. It has installed annual production capacity of approximately 140,000 cubic meters of lumber. This sawmill closed permanently on October 30, 2007 as a result of the negative impact that the housing market crisis in the United States had on our wood division.

 

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Lomas Coloradas Sawmill. This sawmill was acquired from Cementos Bío-Bío S.A. in June 2006. This sawmill has installed annual production capacity of approximately 250,000 cubic meters of sawn timber. It is also equipped with drying kilns with installed annual production capacity of approximately 48,000 cubic meters. The remanufacturing facility with a capacity of 40,000 cubic meters per year was temporarily closed in 2008 as a result of the negative impact that the housing market crisis in the United States had on our wood division.

Mutrún Sawmill. This sawmill has installed annual production capacity of approximately 130,000 cubic meters of lumber. It is also equipped with drying kilns with installed annual production capacity of approximately 95,000 cubic meters.

Nueva Aldea Sawmill. This sawmill has installed annual production capacity of approximately 430,000 cubic meters of sawn timber. It is also equipped with drying kilns with installed annual production capacity of approximately 365,000 cubic meters.

Valdivia Sawmill. This sawmill has installed annual production capacity of approximately 340,000 cubic meters of lumber. It also has drying facilities with installed annual production capacity of approximately 295,000 cubic meters of remanufactured wood products and a remanufacturing facility with installed annual production capacity of approximately 72,000 cubic meters of remanufactured wood products.

Viñales Sawmill. This sawmill has installed annual production capacity of approximately 240,000 cubic meters of lumber. It is also equipped with drying kilns with installed annual production capacity of approximately 210,000 cubic meters and a remanufacturing facility with installed annual production capacity of approximately 120,000 cubic meters of remanufactured wood products.

Argentina

Bosetti Sawmill. Alto Paraná S.A. acquired this sawmill in 2004 as part of its purchase of the forestry assets of Pecom Energía S.A. in Argentina. This mill has installed annual production capacity of approximately 250,000 cubic meters of lumber. It also has drying facilities with installed annual production capacity of approximately 180,000 cubic meters.

Piray Sawmill. This sawmill, previously known as the Misiones Sawmill, was completed in 2000. It has installed annual production capacity of approximately 320,000 cubic meters of lumber. It is also equipped with drying kilns with installed annual production capacity of approximately 320,000 cubic meters and a remanufacturing facility with installed annual production capacity of approximately 65,000 cubic meters of remanufactured wood products.

Brazil

Arapoti Sawmill. We acquired this sawmill as part of the agreement with Stora Enso on September 27, 2007. This sawmill has an installed annual capacity of production of approximately 150,000 cubic meters of lumber. It was temporarily closed on March 31, 2008 due to the appreciation of the Brazilian real against the U.S. dollar and the housing market crisis in the United States, which has negatively affected the wood division.

Plywood and Fiberboard Panels

Our panel products consist of plywood and fiber panels. At December 31, 2007, we owned two plywood mills, one HB mill and two MDF mills in Chile, one MDF mill and one PBO mill in Argentina, and one MDF mill and one PBO mill in Brazil. For the year ended December 31, 2007, sales of panels were U.S.$854.3 million, representing 23.9% of our total sales revenues.

 

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The following table sets forth, by category, our plywood and fiberboard panel sales to unaffiliated third parties for each of the years indicated.

 

     Year ended December 31,
     2003    2004    2005    2006    2007
     (in thousands of cubic meters)

Total plywood and fiberboard panels

   1,059    1,107    2,046    2,397    2,455

The total annual production capacity of these nine mills is approximately 2,555,000 cubic meters of plywood and fiberboard panels, placing us among the principal wood panel companies in Latin America. The total installed annual production capacity of our two plywood mills is approximately 805,000 cubic meters of plywood. During 2007, they produced an aggregate of 546,073 cubic meters of plywood. Our HB mill has installed annual production capacity of approximately 60,000 cubic meters per year, and produced 59,957 cubic meters of panels in 2007. Our MDF mills have an installed annual production capacity of approximately 1,130,000 cubic meters, and in 2007 they produced an aggregate of 1,165,719 cubic meters of panels. Our PBO mills in Brazil and Argentina (acquired in March 2005 and October 2005, respectively) have an installed annual production capacity of approximately 560,000 cubic meters, and produced an aggregate of 494,165 cubic meters of panels in 2007.

On March 9, 2005, we acquired from Louis Dreyfus S.A.S. 100% of the stock of LD Forest Products S.A. in Brazil and, indirectly as a result of that purchase, 100% of the stock of Placas do Paraná S.A. and 50% of the stock of Dynea Brasil S.A. We paid an aggregate purchase price for these acquisitions of approximately U.S.$168.0 million. With these acquisitions, we acquired an MDF mill with installed annual production capacity of approximately 250,000 cubic meters, a particleboard mill with installed annual production capacity of approximately 320,000 cubic meters, an impregnated paper mill and a formaldehyde and resin plant.

On October 31, 2005, we acquired from Louis Dreyfus S.A.S. 100% of the stock of Ecoboard S.A.I.F. and Louis Dreyfus S.A.I.F. in Argentina and, indirectly as a result of that purchase, 100% of the stock of CAIF S.A. and LD Manufacturing S.A. and 60% of the stock of Flooring S.A. As a result of these acquisitions, we own a particleboard mill with installed annual production capacity of approximately 230,000 cubic meters, a chemical plant that produces resins used for the production of wood panels, and an MDF and particleboard-based wood floor mill with installed annual production capacity of approximately two million square meters. We paid an aggregate purchase price of approximately U.S.$55.0 million for this acquisition.

Exports, which include sales to countries other than Chile, Argentina and Brazil, accounted for 52.7% of our total sales revenues of plywood and fiberboard panels for the year ended December 31, 2007. We sell plywood and fiberboard panels primarily to customers in North America, Europe, Brazil, Chile and Argentina.

 

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Forestry Products

Our forestry products are sawlogs, pulplogs, posts and chips. As a result of our forest management policies and the increasing maturity of our plantations, our plantations are yielding increasing volumes of forestry products, particularly clear wood. As the volume of clear wood has grown, we have broadened our range of forestry products. For the year ended December 31, 2007, sales of forestry products were U.S.$83.7 million, representing 2.3% of our sales revenues for such year.

The following table sets forth, by category, forestry product sales to unaffiliated third parties for each of the years indicated.

 

     Year ended December 31,
     2003    2004    2005    2006    2007
     (in thousands of cubic meters)

Sawlogs

   516    941    1,457    1,474    1,562

Pulplogs

   256    177    254    239    149

Posts

   54    101    88    34    4

Chips

   30    2    109    178    150

Sustainable Development

As part of Arauco’s efforts to reduce greenhouse gas emissions, in June 2007, Arauco registered three electricity co-generation power plants as projects of the Clean Development Mechanism within the Kyoto Protocol. The three power plants, located in Trupán, Nueva Aldea (first phase) and Nueva Aldea (second phase), generate electricity through forestry biomass, which is a renewable resource, and replace fossil fuel energy from the electricity grid. In connection with the Clean Development Mechanism, in June 2007, Arauco sold 482,129 Certified Emission Reductions (CERs or “carbon credits”). The CERs were issued to Tokyo Electric Power Company (TEPCO), a Japanese company. With this issuance, Arauco became the first Chilean forestry company to issue CERs through the Clean Development Mechanism of the Kyoto Protocol.

In May 2008, Arauco approved the construction of a new biomass cogeneration plant with a capacity of 25 Megawatts per year and a power boiler with a capacity of 210 tons per hour of steam in the Horcones complex. We anticipate the plant and boiler will commence operations in the second half of 2009. This operation will represent an investment of approximately U.S.$70 million. We expect that this operation will generate a surplus of energy of 24 Megawatts per year to be contributed to the Central Interconnected System, which distributes electrical power throughout the Central and Southern Regions of Chile. We also expect to apply for the registration of the operation as a project of the Clean Development Mechanism under the Kyoto Protocol.

Competition

We experience substantial worldwide competition in each of our geographical markets and in each of our product lines. Several of our competitors are larger than we are and may have greater financial and other resources than we have.

Pulp

We face competition in our pulp sales from one other major Chilean producer, CMPC Celulosa S.A., and from pulp producers in other regions, particularly Canada, the United States, New Zealand and the Scandinavian countries for soft wood bleached market pulp, Brazil and Indonesia for hardwood bleached market pulp and South Africa, the United States, Portugal and New Zealand for unbleached market pulp.

Plywood and fiberboard panels

Arauco competes in the plywood and fiberboard panels markets mainly with North American, European and Latin American companies principally based in Brazil, Argentina and Chile. Arauco is recognized in the

 

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worldwide market as an attractive supplier for customers with diversified demands of panels, due to the quality, variety, and wide range of its products. These clients also value our capacity to provide them a constant and growing product line for the construction, furniture, decoration and molding industries.

Wood and forestry products

Arauco’s principal competitors in the forestry and wood products markets are the major European, North American, New Zealand and Chilean forestry companies. Arauco believes that its relatively low cost of wood, its operating efficiencies, such as in transportation, its ability to customize orders, its domestic and offshore sales and marketing organizations, and the versatility of radiata pine allow it to compete effectively in the world market for forestry and wood products.

Transportation, Storage and Distribution

To remain competitive with pulp suppliers elsewhere in the world, we ship our products to various distribution centers around the world from which final delivery to the customer is made. Historically, Arauco and other Chilean pulp and forestry products producers have coordinated their transportation requirements to achieve larger lots to fill specially designed pulp, forestry products and log ships and thus obtain competitive freight rates.

The following are the principal Chilean ports that we use:

 

   

Coronel. A private port located between Concepción and the Arauco Mill, which we constructed as a member of a consortium with five other companies and in which we have an equity interest of 50.0%. We shipped approximately 29.1% of our aggregate export volume through this port in 2007;

 

   

Lirquén. A private port in Concepción in which we have an equity interest of 20.1% and through which we shipped approximately 33.7% of our aggregate export volume during 2007; and

 

   

San Vicente and Talcahuano. Both are state-owned ports near the city of Concepción through which we shipped approximately 37.0% of our aggregate export volume during 2007.

The ports we use in Chile are approximately 55 kilometers from the Arauco Mill, 330 kilometers from the Constitución Mill, 370 kilometers from the Licancel Mill, 100 kilometers from the Nueva Aldea Mill, and 410 kilometers from the Valdivia Mill. We do not own pulp storage warehouses in any of these ports.

We ship pulp to various ports in Europe, North and South America and Asia and, as is customary in the pulp industry, we store some stock in those ports. We use 13 foreign ports that have warehouse facilities available, and standard storage terms provide that we are entitled to a certain period of storage free of charge. We seek to ensure that it does not exceed the free storage period for each shipment. At December 31, 2007, we had approximately 64,197 metric tons in storage in warehouses at foreign ports.

We believe that our shipping costs are comparable to those of our international competitors, notwithstanding Chile’s greater distance from Europe, because of the proximity of our plantations and mills to the Pacific coast and the economies of scale we achieve through our coordinated shipments with other Chilean producers.

In Argentina, timely and economical delivery of finished products to our customers is an important factor in our ability to compete effectively, and we ship most orders either by truck or railway almost immediately after they are produced.

Description of Property

Our principal properties consist of land and production plants and facilities, the majority of which are located in Chile. At December 31, 2007, we owned approximately 1,076,278 hectares of land in Chile, over 721,799 hectares of which consist of forest plantations, and 401,473 hectares of land in Argentina, Brazil and Uruguay, of which 209,922 consist of forest plantations. In addition, at December 31, 2007, we owned various

 

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plants and facilities, including five pulp mills, five panel mills, 12 sawmills and four remanufacturing facilities in Chile; one pulp mill, two sawmills, one MDF mill, one PBO mill and one remanufacturing facility in Argentina; and one MDF mill, one PBO mill and one sawmill in Brazil. However, the Arapoti sawmill in Brazil was closed on March 31, 2008.

Insurance

Consistent with industry practice, we maintain fire insurance coverage for all our Chilean forest holdings and nurseries but do not insure against pests or disease. Depending on the age of the trees affected, our insurance covers timber loss, either at replacement cost or commercial value. Our Argentine operations do not maintain fire insurance for their timber assets because we believe that the risk of damage from fire is low because Argentina receives significant amounts of rainfall, particularly during the summer months. We do not carry fire insurance for our forests in Brazil because the risk of damage from fire does not justify the costs of carrying insurance.

We also carry insurance, consistent with industry practice, covering our production plants, facilities and equipment. This insurance provides coverage, in the event of fire, explosion, machinery breakdown or natural disaster, for 12 months of business interruptions (18 months in the case of a boiler explosion in our pulp mills). All of our insurance policies covering our forest holdings and production plants, facilities and equipment in Chile are carried by the Royal & Sun Alliance insurance group, La Chilena Consolidada (part of the Zürich Group) and La Interamericana (part of AIG). The forestry insurance is carried by Penta Security Compañía de Seguros SA. Our insurance policies for facilities and equipment in Argentina are carried by the Royal & Sun Alliance and the Zürich Group, and these policies cover damage resulting from fire. Our MDF and particleboard mills in Brazil are insured by Itaú XL Seguros Corporativos, and these policies cover fire, explosions, electrical damage, equipment damage and loss of profit.

CAPITAL EXPENDITURES

To utilize our increasing volume of forest production, we have continually added to, expanded and modernized our processing facilities. We have planned capital expenditures of approximately U.S.$463.0 million for the year ending December 31, 2008, which principally include U.S.$119.8 million in acquisitions of plantations, U.S.$93.5 million in the ordinary maintenance of mills, U.S.$76.6 million in the construction of a new biomass cogeneration plant in the Horcones Complex and U.S.$18.5 million in the construction of the Nueva Aldea pipeline.

In 2007, aggregate capital expenditures were U.S.$462.8 million, consisting primarily of U.S.$229.5 million in investments in the forestry business, principally related to maintenance capital expenditures and U.S.$43.6 million related to the acquisition of pine plantations from Forestal Anchile in January 2007. Capital expenditures for 2007 also included U.S.$144.4 million in the pulp business, principally U.S.$43.0 million relating to the construction of the Nueva Aldea pipeline. Finally, capital expenditures for 2007 included U.S.$61.5 million related to the construction of the second line of the Nueva Aldea Plywood mill.

These capital expenditures represent amounts accrued for purposes of our audited consolidated financial statements and do not necessarily represent the cash cost of capital expenditures in 2007.

GOVERNMENT REGULATION

Environment

In each country where we have operations, we are subject to numerous national and local environmental laws, regulations, decrees and municipal ordinances concerning, among other things, health, the handling and disposal of solid and hazardous waste, discharges into the air, soil and water and other environmental impacts. Some of these laws require us to conduct environmental impact studies of future projects or activities (or major modifications thereto). Under these laws, our operations may be subject to specific approvals, consents and regulatory requirements, and emissions and discharges may be required to meet specific standards and limitations. We have made and will continue to make substantial expenditures to comply with such environmental laws, regulations, decrees and ordinances.

 

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Chile

The Chilean legislation to which we are subject includes the Chilean Environmental Law (Ley Sobre Bases Generales del Medio Ambiente) and related regulations. The Chilean Environmental Law created the National Environmental Commission (Comisión Nacional del Medio Ambiente), or CONAMA, which includes under its organization the various Regional Environmental Commissions (the COREMAs). CONAMA is a public agency under the supervision of the President of Chile through the Environmental Ministry (Ministro Presidente de la Comisión Nacional del Medio Ambiente). These commissions are responsible for, among other things, coordinating existing environmental regulations and evaluating environmental impact studies or declarations of environmental impact. Under the Chilean Environmental Law, we are required to conduct environmental impact studies or declarations of environmental impact of any future projects or activities (or their significant modifications) that may affect the environment. These and other regulations also establish procedures for private citizens to object to the plans or studies submitted by project owners.

CONAMA, the COREMA, and other governmental agencies may also participate in the oversight of the implementation of projects in accordance with their environmental impact studies or declarations of environmental impact. Under the Chilean Environmental Law and other regulations, affected private citizens, public agencies and local authorities can sue to enforce environmental compliance. Enforcement remedies include temporary or permanent closure of facilities and fines. The application of these environmental laws and remedies may adversely affect the manner in which we seek to implement our business strategy and our ability to realize our strategy.

We recently faced, and continue to face, certain environmental administrative proceedings in connection with certain of our pulp mills. In connection with these proceedings and based on Administrative Proceedings Law No. 19,880, the COREMA for the Tenth Region of Chile, ordered the suspension of production at the Valdivia Mill as an interim preventive measure in January 2005. The mill reopened in February 2005, after the COREMA for the Tenth Region of Chile determined that the mill could continue operations subject to a number of conditions.

On June 6, 2005, the COREMA for the Tenth Region of Chile modified our permit for the Valdivia Mill by, among other requirements, reducing the annual production capacity of the mill to 440,000 metric tons until we comply with certain conditions, which include additional monitoring of some aspects of our emissions. In addition, the modifications set new emission limits for several pollutants and require us to conduct a new environmental impact study for an alternative system for the discharge of wastewater, which we were directed to submit to the COREMA for the Tenth Region of Chile for approval no later than March 31, 2006. On February 1, 2006, the COREMA for the Tenth Region of Chile extended this deadline to March 31, 2007. We must construct and implement the alternative system, which cannot involve the discharge of effluents into the Cruces River, the Carlos Anwandter Sanctuary or their effluents, within 15 months of approval of the environmental impact study in final form. The COREMA initially extended the deadline for the presentation of this environmental impact study to April 2007 and, prior to the expiration of the April 2007 deadline, extended it again to March 31, 2009. At the time of approving the new deadline, the COREMA required us to present an additional environmental impact study for the implementation of substantial technological improvements on the quality of the effluents generated by the Valdivia Mill. We submitted this environmental impact study on June 13, 2007. As of the date of this annual report, we have not been notified of the resolution that would conclude the environmental evaluation process by the COREMA.

On June 8, 2005, we voluntarily suspended operations at the Valdivia Mill, which we estimate resulted in a loss of sales of approximately U.S.$1.0 million per day and a loss of profits of approximately U.S.$250,000 per day. Pursuant to the decision of our board of directors based on certain clarifications provided by the COREMA for the Tenth Region of Chile, the mill resumed operations on August 12, 2005 at a reduced annual production of 440,000 metric tons, or 80% of its authorized production capacity, after 64 days of suspended operations. In order to achieve the full production capacity authorized by applicable permits (equal to 550,000 metric tons of wood pulp per year), the pulp mill had to comply with certain new requirements established by the COREMA for the Tenth Region of Chile, including modifications to the effluents’ parameters (including, among others, aluminum, sulfate, nitrogen and chlorate). In March 2006, Knight Piesold, an independent environmental auditing firm appointed by the COREMA for the Tenth Region of Chile, officially determined that the Valdivia Mill had complied with the applicable requirements. On January 18, 2008, the COREMA of the Fourteenth Region of Chile authorized the Valdivia Mill to return to its annual authorized production capacity of 550,000 metric tons. The mill gradually increased its production over a four-month period starting in March 2008 and reached full capacity in June 2008.

 

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The suspension of operations at the Valdivia Mill adversely affected our business, financial condition and results of operations. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants can be expected to have similar adverse effects. We offer no assurance that the Valdivia Mill will be able to operate without further interruption. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—Environmental concerns led us to temporarily suspend our operations at the Valdivia Mill, which adversely affected, and in the future may continue to adversely affect, our business, financial condition and results of operations” and “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Valdivia Mill.”

As part of the environmental resolution that modified the Valdivia Mill environmental permit, the COREMA of the Tenth Region asked CONAF to elaborate an Integral Environmental Management Plan for the wetland, which was completed in 2006. The plan concluded that there was a need to develop a Conceptual Ecosystem Model for the wetland. CONAF selected the Science Faculty of the University of Chile to conduct this study.

The study indicated in its second progress report that the disappearance of the “luchecillo,” a water weed that was an important food source of the black-necked swans, was likely related to natural causes. Specifically, the study proposed that the disappearance of the “luchecillo” was caused by the convergence of three factors in May 2004: (i) low levels of precipitation, (ii) low levels of water flow in the rivers and the wetland and (iii) three instances in which temperatures reached zero degrees Celsius or lower. According to the study, the simultaneous occurrence of these factors was likely responsible for the disappearance of the “luchecillo” which, in turn, lead to the death and migration of the swans.

The COREMA for the Tenth Region of Chile has appointed a Canadian consulting company, Ecometrix, to analyze and prepare a report on different feasible alternatives for discharge of the Valdivia Mill effluents. Approval by the COREMA of our environmental impact study regarding a pipeline, the construction and operation of such a pipeline and also the approval of the environmental impact study regarding the improvement of the quality of the effluents are each subject to many environmental, regulatory, engineering and political uncertainties at this time. As a result, we cannot give you any assurance that such projects will ever be approved or completed. If either our environmental study or the installation of the pipeline is delayed for reasons that COREMA attributes to us, we may face sanctions that include warnings, fines or the revocation of the Valdivia Mill’s environmental permit of operation. Alternatively, if COREMA considers that such delays are beyond our control, we believe that COREMA should extend the applicable deadlines. However, we can offer no assurances that any deadline extension will be granted, even if we comply with all the requirements set forth by COREMA. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants can be expected to have similar adverse effects. We offer no assurance that the Valdivia Mill will be able to operate without further interruption.

The National Defense Council has instituted an action seeking reparations, damages and indemnification from us for environmental harm allegedly caused by the Valdivia Mill and the Licancel Mill. In addition, since the end of 2004, various criminal proceedings relating to alleged violations of several environmental laws have been instituted in Chile in which some of our mills may be involved. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—We are subject to legal proceedings related to our mills, which could adversely affect our business, financial condition and results of operations” and “Item 8. Financial Information—Legal Proceedings.”

We also faced environmental proceedings in connection with the pulp mill at the Nueva Aldea Project while it was under construction. As a result, the COREMA for the Eighth Region of Chile required us to suspend construction at the Nueva Aldea Project for approximately two months in January 2005. We resumed the construction of the pulp mill in March 2005, after complying with the conditions set by the COREMA for the Eighth Region of Chile. On August 30, 2006, the Nueva Aldea pulp mill initiated its production, and production capacity reached designed capacity in May 2007. There can be no assurance that the pulp mills will continue to operate without further interruption. See “Item 8. Financial Information—Legal Proceedings.”

 

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Argentina

Our operations in Argentina are subject to Argentine environmental legislation, including regulation by municipal, provincial and federal governmental authorities. Argentine environmental legislation includes the requirement that water used or recovered in the production process be treated and purified before being returned to the Alto Paraná River at the proper temperature. All gaseous emissions must be scrubbed to ensure satisfactory levels of waste particle recovery and odor removal. Regular testing of river and air quality is used to monitor the ultimate impact of the mill on the environment.

We believe that we are currently in material compliance with all applicable local and national environmental regulations governing our operations in Argentina.

Brazil

Our Brazilian operations are subject to environmental legislation, including municipal, regional and federal governmental laws, regulations and licensing requirements. Law No. 6,938 establishes strict liability for environmental damage, mechanisms for enforcement of environmental standards and licensing requirements for activities that are damaging or potentially damaging to the environment. A violation of environmental laws and regulations may result in

 

   

fines,

 

   

partial or total suspension of activities,

 

   

forfeiture or restriction of tax incentives or benefits, or

 

   

forfeiture or suspension of participation in credit lines with official credit establishments.

As a result, we may become liable for environmental damages caused by management of our materials, including damages caused during the transportation, treatment and disposal of our industrial waste, even where third parties manage such activities on our behalf.

Law No. 9,605 provides that individuals or entities whose conduct or activities cause harm to the environment are subject to criminal and administrative sanctions and are liable for any costs to repair the damages resulting from such harm. For individuals who commit environmental crimes, criminal sanctions range from fines to imprisonment; for legal entities, criminal sanctions may include fines, partial or total suspension of activities, restrictions on participation in government contracts and, in cases of bad faith, dissolution. In addition, Law No. 9,605 also establishes that the corporate structure of a company may be disregarded if the structure impedes the recovery for harm caused to the environment. We are not aware of any successful assertion of claims against shareholders under this provision of Law No. 9,605.

We believe we are currently in material compliance with all applicable local and national environmental regulations governing our operations in Brazil.

Forestry Regulation

Chile

The management and exploitation of forests in Chile is regulated by the Forests Law of 1931, as amended, and Decree-Law No. 701 of 1974, as amended. The Forests Law and Decree-Law No. 701 impose a variety of restrictions on the management and exploitation of forests. Forestry activities, including thinning, on land that is designated as preferably suited for forests or that has natural or planted forests, are subject to management plans that require the approval of the National Forestry Corporation (Corporación Nacional Forestal). In addition, the Forests Law and Decree-Law No. 701 impose certain standards for the prevention of forest fires, as well as fines for the harvesting or destruction of trees and shrubs in violation of the terms of a forest management plan. We believe that we are in material compliance with the Forests Law and Decree-Law No. 701.

 

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In June 2008, the Executive Office of the President of Chile presented to the Chilean Congress a bill that would create a Ministry of the Environment, a Superintendency of the Environment and a Service of Environmental Evaluation and would include substantial modifications to the Chilean Environmental Law. The bill is currently under review by the Chilean Congress.

In December 2007, the Chilean Congress approved a bill that provides for the management and conservation of native tree forests and forest development, which is currently under review by the Constitutional Court. This bill would establish a fund for the conservation and sustainable management of native forests. Owners of native forests would be able to participate so long as they had a management plan approved by the National Forestry Corporation. Depending on the owner’s approved plan, as well as other factors, the subsidy provided by the fund would be between U.S.$200 and U.S.$400 per hectare. The bill would prohibit the harvesting of native trees in certain areas and under certain conditions. The possible effect of this bill on our business, if any, cannot be quantified, but management believes it will not have a material effect. Currently, we do not perform clear cutting of native forest or any cutting in areas surrounding rivers and streams, areas of notable environmental interest or areas with particularly fragile soil conditions.

All of our forest activities are ISO 14001 certified. During 2003, we obtained the certification in Chile from CERTFOR, and in 2004, CERTFOR undertook its first audit of our operations and confirmed that we complied with CERTFOR requirements. See “Item 4. Information on the Company—Description of Business—Forestry Activity.”

In 2005, CERTFOR certified the chain of custody of the Arauco, Constitución, Licancel and Valdivia pulp mills and Arauco and Nueva Aldea plywood mills, pursuant to the Sustainable Forestry Management practices, which require that sources used for production are not endangered or that their use is not otherwise prohibited. The National Regulatory Institute (Instituto Nacional de Normalización) also accredited the effluent laboratories of the Constitución and Arauco wood mills in accordance with the strict requirements of Chilean environmental standards.

Argentina

The management and exploitation of forests in Argentina is regulated by National Law 13,273, National Law 25,080, National Decree 710, Provincial Law No. 854, Provincial Law No. 3,426 and other regulations promulgated thereunder, which collectively constitute the regulatory framework. The regulatory framework imposes a variety of restrictions on the management and exploitation of forests in Argentina. The regulatory framework regulates the replanting of land after harvesting. We believe that our Argentine operations are in material compliance with the regulatory framework.

Brazil

Environmental laws and regulations relating to the management and exploitation of forests and the protection of Brazilian plant and wildlife govern our Brazilian forestry operations. Under this regulatory framework Brazilian authorities establish forest preservation areas and regulate replanting of forests after harvesting. We believe that our Brazilian operations are in material compliance with the regulatory framework.

 

Item 5. Operating and Financial Review and Prospects

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL

CONDITION AND RESULTS OF OPERATIONS

The following discussion is based on and should be read in conjunction with our audited consolidated financial statements and the notes thereto, included elsewhere in this annual report. Our consolidated financial statements are prepared in U.S. dollars in accordance with U.S. GAAP.

Overview

We derive our sales revenue from the sale of bleached and unbleached pulp, forestry products, such as sawlogs and pulplogs, plywood and fiberboard panels and wood products, such as sawn timber and remanufactured

 

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wood products. For the year ended December 31, 2007, export sales constituted approximately 76.9% of our total sales revenue. Sales of pulp constitute the single largest component of our sales revenue. As with many commodities, pulp is subject to significant cyclical price fluctuations determined by global supply and demand. Accordingly, our sales revenue is subject to cyclical fluctuations. World prices for forestry and wood products, which are also generally viewed as commodities, fluctuate significantly.

Although prices tend to have the most significant effect on our results of operations, sales volume and product mix, costs and exchange rate fluctuations also can have a substantial impact on our results.

Our business and results of operations depend, to a large extent, on the level of economic activity, on government and foreign exchange policies and on political and economic developments in our principal export markets. In 2007, we exported our products to Asia, to North, Central and South America, to Europe and, to a lesser extent, to Africa and the Middle East. In 2007, approximately 93.9% of our total pulp sales and approximately 65.8% of our total forestry, wood products and panel product sales were attributable to exports, principally to customers in the Americas, Asia and Western Europe. Our business, earnings and prospects may be materially and adversely affected by developments in these export markets with respect to inflation, interest rates, currency fluctuations, protectionism, government subsidies, price and wage controls, exchange control regulations, taxation, expropriation or social instability, as well as by political, economic or diplomatic developments.

At December 31, 2007, approximately 76.4% of our property, plant, equipment and forest assets were located in Chile, approximately 13.1% were located in Argentina and approximately 10.6% were located in Brazil. In 2007, approximately 82.0% of our consolidated sales revenue was derived from our operations in Chile, approximately 11.7% of our consolidated sales revenue was derived from our operations in Argentina, and approximately 6.3% of our consolidated sales revenue was derived from our operations in Brazil. Accordingly, our financial condition and results of operations depend, to a significant degree, upon economic conditions in Chile, Argentina and Brazil.

Despite growth in the 1980s and 1990s, the Chilean economy has remained smaller than the economies of certain other Latin American countries. In 2000, the Chilean gross domestic product grew 4.5%, but growth slowed to 3.4% in 2001, 2.2% in 2002 and 3.9% in 2003. In 2004, GDP growth was stronger than previous years, reaching 6.2%. Unemployment was high, averaging 9.2% in 2001, 9.0% in 2002, 8.5% in 2003, 8.8% in 2004, 8.1% in 2005. GDP grew 4.0% in 2006 and unemployment began to decline, reaching 6.0%. GDP grew 5.1% in 2007 and unemployment was 7.1%.

From late 1998 to 2002, the Argentine economy went through an economic recession marked by reduced levels of consumption and investment and an elevated unemployment rate. Argentine GDP decreased by 3.4% in 1999, 0.8% in 2000, 4.0% in 2001 and 10.9% in 2002. In December 2001, amid public demonstrations and the resignation of the Argentine president, Argentina declared a suspension on payment of its foreign debt. In early 2002, the government released the Argentine peso from its one-to-one peg to the dollar and allowed the exchange rate to float, resulting in a 49.6% devaluation of the Argentine peso from January 1, 2002 to December 31, 2002. From 2003 to 2006, economic indicators showed some signs of recovery, and the Argentine gross domestic product increased by 8.8% in 2003, 9.0% in 2004, 9.2% in 2005, 8.7% in 2006 and 9.1% in 2007. In June 2005, Argentina restructured a significant portion of its sovereign bonds outstanding. The Argentine economy may not continue to recover and future economic, social and political developments in Argentina, over which we have no control, could impair Alto Paraná’s business, financial condition or results of operations.

Brazil’s GDP grew by an estimated 5.4% in real terms in 2007, compared to a growth rate of 3.7% in 2006 and 2.9% in 2005. However, in recent years, the Brazilian economy has experienced turbulence. In 2000, GDP grew 4.4%, but in 2001 and 2002, due to the international crisis in Latin and North America and the electric energy rationing in Brazil, GDP grew only 1.3% and 1.9%, respectively. GDP decreased 0.5% in 2003, mainly due to uncertainty regarding the election process and new economic policies to be implemented by the newly elected government of President Luis Ignacio Lula da Silva. The Brazilian real/U.S. dollar exchange rate also experienced turbulence in that period. During 2001, the Brazilian real declined in value by 18.7% against the U.S. dollar, and in 2002, it further devalued by 52.3%, closing at R$3.5333/U.S.$1.00 on December 31, 2002. These changes were attributable primarily to uncertainties regarding the ongoing presidential election process. Those concerns dissipated during 2003, resulting in an appreciation of the Brazilian real by 18.2% against the U.S. dollar in that year. During 2004, the Brazilian real continued to recover against the U.S. dollar, with an 8.8% appreciation. The Brazilian real appreciated 9.5% during 2006 and 20.7% in 2007.

 

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Future developments in the Chilean, Argentine and Brazilian economies may impair our ability to proceed with our strategic plan or our business, financial condition or results of operations. Our financial condition and results of operations could also be materially and adversely affected by changes in political, economic, regulatory or other policies of the Chilean, Argentine and Brazilian governments, which have exercised and continue to exercise substantial influence over many aspects of the private sector in these countries, or other political or economic developments in Chile, Argentina and Brazil, as well as regulatory changes or administrative practices of Chilean authorities, over which we have no control.

Valdivia Mill Closure

Our operations at the Valdivia Mill have been subject to continued environmental scrutiny by Chilean environmental regulators and the Chilean public since the mill began its operations in 2004. In connection with an environmental administrative proceeding, environmental regulators required us to temporarily suspend operations at the Valdivia Mill for approximately one month in January 2005. We resumed operations at the mill on February 18, 2005. On June 8, 2005, we voluntarily suspended operations at the Valdivia Mill which we estimate resulted in a loss of sales of approximately U.S.$1.0 million per day and a loss of profits of approximately U.S.$250,000 per day. Pursuant to the decision of our board of directors based on certain clarifications provided by the COREMA for the Tenth Region of Chile, the mill resumed operations on August 12, 2005 at a reduced annual production of 440,000 metric tons or 80% of its authorized production capacity, after 64 days of suspended operations. In order to achieve the full production capacity authorized by applicable permits (equal to 550,000 metric tons of wood pulp per year), the pulp mill had to comply with certain new requirements established by the COREMA, including modifications to the effluents’ parameters (including, among others, aluminum, sulfate, nitrogen and chlorate). In March 2006, Knight Piesold, an independent environmental auditing firm appointed by the COREMA, officially determined that the Valdivia Mill had complied with the applicable requirements. On January 18, 2008, the COREMA authorized the Valdivia Mill to return to its annual authorized production capacity of 550,000 metric tons. The mill gradually increased its production over a four-month period starting in March 2008 and reached full capacity in June 2008. We expect that the mill will gradually increase its production over a four-month period starting in March 2008. The suspension of operations at the Valdivia Mill adversely affected our business, financial condition and results of operations. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants can be expected to have similar adverse effects. We offer no assurance that the Valdivia Mill will be able to operate without further interruption or that it will resume operations at full capacity notwithstanding our compliance with the new requirements imposed by the COREMA are fulfilled.

In 2005, the COREMA instructed us to present by March 31, 2006, an environmental impact study for the construction of a pipeline to discharge the Mill’s wastewater in a body of water other than the Cruces River or the Carlos Anwandter Nature Sanctuary or their sources. The COREMA also instructed us to construct and put into operation the pipeline no later than 15 months from the date COREMA approves the environmental impact study in final form. COREMA initially extended the deadline for the presentation of this environmental impact study to April 2007 and, prior to the expiration of the April 2007 deadline, extended it again to March 31, 2009. When it approved the new deadline, COREMA required us to present an additional environmental impact study for the implementation of substantial technological improvements on the quality of the effluents generated by the Valdivia Mill. We submitted this study on June 13, 2007. As of the date of this annual report, we have not been notified of the resolution that would conclude the environmental evaluation process by the COREMA.

The COREMA for the Tenth Region of Chile has appointed a Canadian consulting company, Ecometrix, to analyze and prepare a report on different feasible alternatives for discharge of the Valdivia Mill effluents. Approval by the COREMA of Arauco’s environmental impact study regarding a pipeline, the construction and operation of such a pipeline and also the approval of the environmental impact study regarding the improvement of the quality of the effluents are each subject to many environmental, regulatory, engineering and political uncertainties at this time. As a result, we cannot give you any assurance that such projects will ever be approved or completed. If either our environmental study or the installation of the pipeline is delayed for reasons that COREMA attributes to us, we may face sanctions that include warnings, fines or the revocation of the Valdivia Mill’s environmental permit of operation. Alternatively, if COREMA considers that such delays are beyond our control, we believe that COREMA

 

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should extend the applicable deadlines. However, we can offer no assurances that any deadline extension will be granted, even if we comply with all the requirements set forth by COREMA. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—Environmental concerns led us to temporarily suspend our operations at the Valdivia Mill, which will adversely affected, and in the future may continue to adversely affect, our business, financial condition and results of operations”, “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Valdivia Mill” and “Item 8. Financial Information—Legal Proceedings.”

As a result, we offer no assurance that the Valdivia Mill will be able to operate without further interruption. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants would likely have a material adverse effect on our business, financial condition and results of operations.

At the time of suspension, the Valdivia Mill represented approximately 25% of our total pulp capacity. Currently, it represents 18.1% of our total pulp capacity. As a result, the suspension of operations at the Valdivia Mill adversely affected our business, financial condition and results of operations.

In connection with our decision to suspend operations at the Valdivia Mill, our President and Chief Executive Officer resigned from his positions. For more information about our executive officers, see “Item 6. Directors, Senior Management and Employees—Directors and Executive Officers.”

As part of the environmental resolution that modified the Valdivia Mill environmental permit, the COREMA of the Tenth Region asked CONAF to elaborate an Integral Environmental Management Plan for the wetland, which was completed in 2006. The plan concluded that there was a need to develop a Conceptual Ecosystem Model for the wetland. CONAF selected the Science Faculty of the University of Chile to conduct this study.

The study indicated in its second progress report that the disappearance of the “luchecillo,” a water weed that was an important food source of the black-necked swans, was likely related to natural causes. Specifically, the study proposed that the disappearance of the “luchecillo” was caused by the convergence of three factors in May 2004: (i) low levels of precipitation, (ii) low levels of water flow in the rivers and the wetland and (iii) three instances in which temperatures reached zero degrees Celsius or lower. According to the study, the simultaneous occurrence of these factors was likely responsible for the disappearance of the “luchecillo” which, in turn, lead to the death and migration of the swans.

Licancel Mill Closure

Since June 2007, our operations at the Licancel Mill, a pulp mill located in the Seventh Region of Chile, have been subject to environmental scrutiny by Chilean environmental regulators and the public. On June 5, 2007, in connection with the death of fish in the Mataquito River, approximately 15 kilometers downstream of the mill, we decided to voluntarily suspend our operations in the Licancel Mill as a preventive measure. In addition, Chilean authorities, including the health authorities and the Superintendencia de Servicios Sanitarios (Sanitary Services Superintendency), required that we suspend activities at the Licancel Mill and that we suspend any further discharges into the river. We also commenced independent investigations relating to the cause of the death of the fish. On June 18, 2007, as a result of a pipe leakage in the water treatment system currently in place at the Licancel Mill, an estimated 50 cubic meters of effluents reached the Mataquito River. On that same date, we decided to close the mill indefinitely and informed the Sanitary Services Superintendency of the incident. On October 3, 2007, Arauco requested to the health authority (Autoridad Sanitaria) of the Seventh Region of Chile that it remove the suspension of activities at the Licancel mill. On October 22, 2007, the health authority of the Seventh Region of Chile removed the suspension and imposed certain conditions, consisting primarily of the implementation of certain emergency detection and control programs and systems, which Arauco has complied with. Furthermore, on November 12, 2007 the Sanitary Services Superintendency removed the suspension regarding the release of discharges by the Licancel mill. The mill resumed operations during January 2008.

Several administrative and judicial proceedings have been commenced regarding the events at the Licancel Mill, including the death of fish at the Mataquito River. The proceedings and the related sanctions are included in detail in Note 12 to our audited consolidated financial statements. We estimate that the suspension of operations at

 

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the Licancel Mill resulted in a loss of profits of approximately U.S.$4 million per month. Consequently, the suspension of operations at the Licancel Mill adversely affected our business, financial condition and results of operations. We offer no assurance that the Licancel Mill will be able to operate without further interruptions. Any future suspension of operations at the Licancel Mill may adversely affect our business, financial condition and results of operations. See “Item 8. Financial Information—Legal Proceedings.” See also “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Licancel Mill.”

Prices

In recent years, our sales revenue has been affected by price level volatility in the export market. The prices for each of our pulp products and forestry and wood products depend on the markets in which they are sold. While prices are generally similar for a given product on a global basis, regionalized market conditions affect prices in markets such as Asia, Europe and the United States.

The following table sets forth, for the periods indicated, average unit sales prices for our products.

 

     Year ended December 31,(1)

Product(2)

   2005    2006    2007
     (U.S.$ per metric ton)(3)
Pulp         

Bleached pulp

   505.9    579.4    667.3

Unbleached pulp

   455.6    523.5    628.1
     (U.S.$ per cubic meter)(3)
Wood Products         

Sawn timber

   178.7    197.1    207.6

Remanufactured wood products

   600.3    537.6    564.7
Panels         

Plywood and fiberboard panels

   287.5    300.8    347.9
Forestry Products         

Sawlogs

   35.2    38.3    45.1

Pulplogs

   28.7    33.1    23.3

Posts

   248.7    230.4    106.7

 

(1)

Calculated as average unit prices for the year based on our internally collected data.

(2)

Each category of product contains different grades and types and the shipping terms vary with the product, as well as the customer.

(3)

We generally quote our prices in U.S. dollars for export sales and in Chilean pesos, Argentine pesos or Brazilian reals for domestic sales.

Pulp Prices

The prices that we are able to obtain for our pulp products depend on prevailing world prices as well as regional market conditions. Historically, world pulp prices are cyclical; prices are subject to significant fluctuations over relatively short periods of time, depending on worldwide demand, world production capacity, the business strategies adopted by major integrated forestry, pulp and paper producers and other major producers and the availability of substitutes. All of these factors are beyond our control.

Over the last five years, the average price, on an annual basis, for Norscan bleached softwood kraft market pulp, or NBSK, which is the benchmark for softwood bleached pulp, has ranged from a low of U.S.$526.40 per ton in 2003 to a high of U.S.$793.40 per ton in 2007. The price for NBSK was U.S.$560 per ton at December 31, 2003, a 27.3% increase over December 31, 2002, and U.S.$621 per ton at December 31, 2004, and 10.9% increase as compared to December 31, 2003. Although the price for NBSK increased during the fourth quarter of 2005 due to the strong market demand and mill closures in North America, the price of U.S.$599 per ton recorded at December 31, 2005 represented a decrease of 3.5% as compared to December 31, 2004. Although the price for NBSK increased during the fourth quarter of 2005 due to the strong market demand and mill closures in North America, the price of U.S.$599 per ton recorded at December 31, 2005 represented a decrease of 3.5% as compared to December 31, 2004. The price of U.S.$730.0 per ton recorded at December 31, 2006 represented an increase of 21.9% as compared to December 31, 2005. The price for NBSK was U.S.$869.30 at December 31, 2007, which represented an increase of 19.1% when compared to December 31, 2006.

 

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Prices for bleached grades of pulp, including eucalyptus, generally follow the same pattern as prices for NBSK. However, each grade follows its own cycle based on market demand and production capacity. During the last five years, the majority of the new capacity developed has been for hardwood pulp, particularly eucalyptus pulp. This has led to a greater spread between the prices for hardwood and for softwood. The price for eucalyptus kraft pulp delivered in Northern Europe, or BEKP, was U.S.$450 per ton at January 1, 2003, U.S.$10 per ton above the price for NBSK, and was U.S.$500 per ton at December 31, 2003, U.S.$60 per ton below the price for NBSK. During 2002 the market price for BEKP rose 6.8%, to U.S.$453 per ton at December 31, 2002. The market price for BEKP was U.S.$500 per ton at December 31, 2003, an increase of 8.0% over the price of December 2002, and U.S.$520 per ton at December 31, 2004, a 4% increase over the price of December 2003. At December 31, 2005, the price for BEKP was U.S.$589 per ton, an increase of 13.3% over the price of December 2004. At December 31, 2006, the price for BEKP was U.S.$671.6 per ton, an increase of 14.0% over the price at December 2005. The price for BEKP at December 31,2007 reached U.S.$775.20, an increase of 15.4% when compared to the price at December 2006.

Prices for unbleached softwood market pulp also follow cyclical patterns related to worldwide demand. Unbleached softwood market pulp represents about 14% of the total wood pulp market. The majority of such pulp is sold in Asia, and its price does not necessarily follow the cycle of prices for NSBK.

During the first half of 2003 the market price for UKP rose, and then fluctuated during the second half of the year, rising 23.3% overall, to U.S.$530 per ton at December 31, 2003. During 2004, UKP prices consistently rose, reaching U.S.$575 per ton by December 31, an increase of 8.5% with respect to December 31, 2003. In 2005, prices fluctuated throughout the year reaching U.S.$460 per ton by December 31, 2005, a decrease of 20% as compared to the price of December 31, 2004. In 2006, UKP prices increased reaching U.S.$586.9 per ton by December 31, 2006, an increase of 27.5% as compared to the price of December 31, 2005. The price for UKP at December 31, 2007 reached U.S.$598.5, an increase of 19.8% when compared to December 31, 2006.

Forestry, Wood Product, Plywood and Fiberboard Prices

Over the last five years, the average prices for our forestry and wood products have fluctuated significantly, reflecting the effect on demand of global economic developments. The economic downturn in the aftermath of the terrorist attacks in the United States on September 11, 2001 led to considerable declines in prices for wood products across North America. Japan’s poor economic performance at that time led to prices that were at their lowest levels in 15 years. In China, on the other hand, prices were unaffected by developments in other markets.

The downward trend in prices continued during the first half of 2003. Plywood and remanufactured products producers were affected by the closing of various plywood mills in the United States. Latin America maintained relatively higher prices for forestry and wood products. Prices in the Middle East remained high, despite the conflict in Iraq, and prices also remained high in Asia. During the second half of 2003, forestry and wood product prices increased, reflecting mill closures, a general improvement in the world economy, low inventory levels, increased transportation costs and the depreciation of the U.S. dollar against several foreign currencies.

In early 2004, strong worldwide economic growth outpaced the supply of wood products in all of our primary markets, leading to particularly great demand in the U.S. and China. The weakness of the U.S. dollar also contributed to substantial price increases for panel and lumber products during the year. Ocean freight availability was scarce and freight rates for breakbulk and container line services escalated to high levels, putting further pressure on prices. Though economic growth continued through the end of 2004, prices in the U.S. decreased slightly due to excess inventories of panel, lumber and molding products at distributors.

In spite of strong international growth and demand for wood products, the decline in prices in the U.S. continued during the first three quarters of 2005 due to excess inventories of panel and remanufactured wood products at distributors. This trend affected the average prices for wood products during 2005. By the end of 2005, the average prices for wood products demonstrated signs of recovery. However, the continued weakening of the construction sector in the United States caused a decrease in the price and demand for wood, particularly moldings, during 2006.

 

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The continued weakening of the construction sector in the United States throughout 2006 caused a decrease in the price and demand for wood, especially in moldings in that market. Along with the markets in Asia, the Middle East and Central America have been strengthening and Europe registered strong demand and prices for wood throughout 2006. The prices of plywood in the United States and Canada slightly decreased during 2006, while the other markets maintained levels comparable to those for 2005. The demand for products directed at furniture markets in Latin America remained strong during the year, and sales of medium-density fiberboard (MDF) panels also experimented important improvements due to the high demand in all the markets in which Arauco participates, which are concentrated in North, Central and South America.

The complications related to the United States construction and real estate markets have continued throughout 2007. The construction sector has continued to be affected by a significant stock of unsold houses, which has caused construction to fall 30% in the United States during 2007. This has negatively affected the sales volume of wood. The future outlook does not look favorable and we expect this situation to continue through the end of 2008. Prices of moldings and wood have continued to decrease. From a commercial point of view, 2007 was marked by an increase in the demand in virtually all markets for panels. In Europe, consumer trends favoring products with a sustainable forestry management certification increased demand for the entire range of Arauco’s panels. In the United States, the strong contraction of the real estate sector adversely affected the sale of MDF moldings. This was offset, however, by the strong increase in the demand for MDF boards in Latin America. In the case of Arauco’s plywood panels, the demand benefited from a decrease in the supply from other manufacturers and by the highly diversified applications of these products unrelated to the construction sector.

Prices for our pulp, forestry and wood products may decline in the future. Our results of operations may be materially adversely affected if the prices of our products were to decline from current levels.

Costs

Our major costs of sales are the following:

 

   

costs related to harvesting (forestry works),

 

   

the cost of timber,

 

   

the cost of mill processing,

 

   

the cost of freight,

 

   

depreciation and

 

   

maintenance costs.

Our major administrative and selling expenses are wages and salaries, insurance expenses and commissions.

Our cost of timber consists of the cost of growing our own trees, the cost of timber purchased from third parties and the cost of purchasing the right to harvest plantations owned by third parties, known as “stumpage.” The cost of our own trees consists of the cost of planting, capitalized direct and indirect interest, cost of forest development and the cost of forestry management activities (planting and site preparation procedures, thinning and pruning, protection and maintenance) performed in each plantation during the harvest cycle before harvesting.

We account for the accumulated cost of our own trees on a plantation-by-plantation basis as long-term forest assets. The cost of each plantation differs depending on the types of forest management activities performed (e.g., pruning and extensive thinning for plantations managed for a high proportion of clear wood production and application of fertilizer in areas of relatively poor soil quality), as well as the plantation’s accessibility, so that total inventory cost depends on the mix of plantations designated for harvest. Such costs are charged to cost of sales at the time of sale.

 

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Our property, plant and equipment are depreciated on a straight-line basis over the remaining useful lives of the underlying assets. However, the amount of such depreciation that relates to our fixed production assets, such as pulp mills and sawmills, is allocated to finished goods held as inventories and accumulates until charged to cost of sales when the finished goods are sold. Forests and land are not depreciated.

Our transportation costs are accounted for as cost of sales and include port costs and freight and other transportation costs. Port costs are those costs arising from the transportation of products from one of our site storage facilities into the hold of the ship. Freight is the cost of shipping the product to the port of destination. Other transportation costs are incurred primarily in the transportation of products from the forest to one of our facilities and between such facilities. Selling expenses consist primarily of per ton fees we paid to our selling agents.

During 2005, fleet growth outpaced the demand for ocean transportation in the dry cargo segment due in part to a decrease in port congestion in certain areas. Container freight rates remained stable throughout most of 2005, but showed some signs of increase toward the end of the year due to increases in fuel costs, the risks of which are borne by the shipper under most of our long-term ocean freight contracts.

During 2005 cost of lumber and maintenance costs increased principally due to higher market prices for lumber and a strong appreciation of the Chilean peso relative to the U.S. dollar. The appreciation of the Chilean peso negatively affected most of our costs, which are incurred in Chilean pesos and translated to U.S. dollars.

During 2006, costs increased principally due to an increase in depreciation resulting from the commencement of the start-up operations at the Nueva Aldea pulp mill, an increase in transportation costs due to an increase in the average price of petroleum and an appreciation of the Chilean peso relative to the U.S. dollar.

During 2007, cost of lumber and maintenance costs increased principally due to higher market prices for lumber and a strong appreciation of the Chilean peso against the U.S. dollar. The appreciation of the Chilean peso negatively affected most of our costs, which are incurred in Chilean pesos and translated to U.S. dollars.

Exchange Rate Fluctuations

The Chilean peso has been subject to devaluation in the past and could be subject to significant fluctuations in the future. In the period from December 31, 2000 to December 31, 2007 the value of the Chilean peso relative to the U.S. dollar increased approximately 15.4% in nominal terms and increased 44.6% in real terms, as compared to a 3.2% increase in value in real terms in the period from December 31, 1995 to December 31, 1998. During 2007, the value of the Chilean peso relative to the U.S. dollar increased approximately 7.1% in nominal terms and approximately 15.5% in real terms, based on the observed exchange rates on December 31, 2006 and December 31, 2007. The observed exchange rate on June 24, 2008 was Ch$505.11 to U.S.$1.00. For information regarding historical rates of exchange in Chile from January 1, 2002 see “Item 3. Key Information—Exchange Rates.”

We generally price our exports in U.S. dollars and domestic sales in Chilean pesos. To the extent that the Chilean peso depreciates against the U.S. dollar, our domestic sales revenues may be adversely affected when expressed in U.S. dollars. Conversely, appreciation of the Chilean peso may have a positive effect on domestic sales revenue when expressed in U.S. dollars. The effect of exchange rate fluctuations is partially offset by the fact that certain of our operating expenses are denominated in U.S. dollars (such as our freight costs and selling expenses in the form of commissions paid to our sales agents abroad) and a significant part of our indebtedness is denominated in U.S. dollars. As of December 31, 2007, our U.S. dollar-denominated indebtedness was U.S.$2.7 billion. In addition, as the U.S. dollar appreciates against the local currency in any of our export markets, we must from time to time price our sales in that local currency to compete effectively.

 

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Critical Accounting Policies

A summary of our significant accounting policies is included in Note 1 to our audited consolidated financial statements. We believe that the consistent application of these policies enables us to provide readers of our audited consolidated financial statements with more useful and reliable information about our operating results and financial condition. The following policies are the accounting policies that we believe are the most important to the portrayal of our financial condition and results of operations and require management’s most difficult, subjective or complex judgments.

Property, Plant and Equipment

The key judgments management must make under the property, plant and equipment policy include the estimation of the useful lives of our various asset types, the election to utilize primarily the straight-line method for recording depreciation, management’s judgment regarding appropriate capitalization or expensing of costs related to fixed assets and management’s determination that no impairment exists.

Property, plant and equipment costs are stated on our balance sheet at cost less accumulated depreciation. Depreciation of buildings, equipment and other depreciable assets is determined using primarily the straight-line method. The estimation of useful lives for fixed assets impacts the level of annual depreciation expense recorded. Utilization of the straight-line method for recording depreciation or any of the other acceptable methods for depreciating assets will result in the same amount of depreciation over the life of an asset; however, the amount of annual depreciation expense and the resulting carrying amount of net property, plant and equipment can vary significantly, depending on the method elected.

Property, plant and equipment assets are evaluated for possible impairment on a specific asset basis or in groups of similar assets, as applicable. This process requires management’s estimate of future cash flows generated by each asset or group of assets. For any instance where this evaluation process indicates impairment, the appropriate asset’s carrying values are written down to net realizable value and the amount of the write-down is charged against the results of continuing operations. If we overestimated our future cash flows by 10%, the reported value of our property, plant and equipment would not be materially affected as of December 31, 2007.

Expenditures that substantially improve and/or increase the useful life of facilities or equipment are capitalized. Maintenance and repair costs are expensed as incurred. Our evaluation of whether an expenditure related to property, plant and equipment substantially improves and/or increases the useful life of an asset and should be capitalized as an addition to the asset’s cost basis or is expensed as normal maintenance and repair expense can significantly affect results of operations for a given period, as well as our financial position.

Forests

Forest costs are stated at cost of development less the cost of forest harvested. Forest costs consist primarily of purchased timber, planting, maintenance, protection and other direct costs related to the plantation of the forest. Direct and indirect interest costs of developing forests are capitalized until the forest is deemed to have reached an exploitable stage. These capitalized interest costs are included in the historical cost of the forest. Forests do not include any estimated future reforestation costs. The cost of forest harvested is based on the volume of forest harvested in relation to the estimated volume of forest recoverable. Our estimated volume of forest recoverable is based on statistical information and data obtained from physical measurements and other information gathering techniques. This information gathered and data used requires, to a certain extent, estimates and judgments in determining the amount of forest recoverable.

Depletion

Depletion, or the costs attributed to timber harvested, is determined according to each identifiable farm block that is in the harvesting stage, based on the relationship between unamortized timber costs and the estimated volume of recoverable timber multiplied by the amount of timber cut. We review our depletion rate estimates on a recurring basis. Our statistical data indicates that, during 2007, our depletion rates were overstated by less than 4.36%. If our estimated volume of timber harvested at December 31, 2007 were overestimated by 4.36%, our reported cost of sales for the year ended December 31, 2007 would not be materially affected.

 

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Inventories

Inventories of raw materials, work-in-process and spare parts are stated at the lower of cost or market, using primarily the average cost method. Finished goods are stated at the lower of average production costs for the period, or market. Inventory costs include materials, labor, transportation, depreciation of fixed assets and production overhead, as appropriate. The determination of the net realizable value of each component of inventory is based on the current invoice price. Work-in-process inventories require an estimation of the future cost per unit to complete manufacturing from each stage of processing, using historical manufacturing costs. These estimates can affect the carrying value for inventories, and any required inventory write-down can affect results of operations in both current and future periods.

At December 31, 2007, our inventory reserves amounted to U.S.$0.6 million, which represented 0.1% of our total inventory. Additionally for the year ended December 31, 2007, our inventory write-downs represented 0.0% of our cost of sales. If our inventory reserves and write-downs were underestimated by 10%, our reported cost of sales for the year ended December 31, 2007 would not be materially affected.

Goodwill

Goodwill is the excess of acquisition cost of a business over the fair value of identifiable net assets acquired. Goodwill is deemed to have an indefinite life and is not amortized. We test these assets for impairment by applying a fair-value based test on an annual basis; we also test these assets when we determine that indicators of impairment exist. We must exercise judgment in assessing goodwill for impairment. Generally, we review the recorded value of our goodwill annually, but we will review it sooner if changes in circumstances indicate that the carrying amount may exceed fair value. Recoverability of the carrying value of the asset is determined by comparing it to net book value, including goodwill and the estimated future net cash flows of the relevant assets.

Deferred Income Tax

We use the asset and liability method of accounting for income taxes. Under this method, the provision for income taxes includes amounts currently payable and amounts deferred as tax assets and liabilities, based on differences between the financial statement carrying amounts and the tax bases of existing assets and liabilities, and is measured using the current tax rates, which we assume will be in effect when the differences reverse. Deferred tax assets are reduced by a valuation allowance, which is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In making the determination of the valuation allowance, we consider both positive and negative evidence and make certain assumptions, including projections of taxable income. Changes in these assumptions may have a material impact on results.

We consider both positive and negative evidence and make certain assumptions, including projections of taxable income. Changes in these assumptions may have a material impact on results. If we overestimated taxable income by 10%, our reported valuation allowance at December 31, 2007 would not be materially affected.

Allowance for Doubtful Accounts

We provide an allowance for doubtful accounts based on a review of the specific receivable. A 100% provision is applied for those customers for whom collectability is in doubt. Management must make certain judgments and estimates in determining accounts that are considered to be in doubt. At December 31, 2007, our allowance for doubtful accounts amounted to U.S.$12.6 million, which represented 2.1% of our total trade accounts receivable. Additionally for the year ended December 31, 2007, our receivables write-downs represented 0.0% of our total operating costs and expenses. If our allowance for trade accounts receivable and write-downs were underestimated by 10%, our reported total operating costs and expenses for the year ended December 31, 2007 would not be materially affected.

 

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Changes in Accounting Standards

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements; rather, it applies to other accounting pronouncements that require or permit fair value measurements. The provisions of this statement are to be applied prospectively as of the beginning of the fiscal year in which this statement is initially applied, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. The provisions of SFAS No. 157 are effective for the fiscal years beginning after November 15, 2007 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually); therefore, we anticipate adopting this standard as of January 1, 2008. We have not determined the effect, if any, the adoption of this statement will have on our financial condition or results of operations.

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (Statement 159). Statement 159 allows entities the option to measure eligible financial instruments at fair value as of specified dates. Such election, which may be applied on an instrument by instrument basis, is typically irrevocable once elected. Statement 159 is effective for fiscal years beginning after November 15, 2007, and early application is allowed under certain circumstances. We anticipate adopting this standard as of January 1, 2008. We have not determined the effect, if any, the adoption of this statement will have on our financial condition or results of operations.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”), an Amendment to ARB No. 51. SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity.

The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains it controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. We do not expect the adoption of SFAS 160 to have an effect on our consolidated financial statements.

In December 2007, the FASB issued FASB Statements No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). In this statement, the FASB retained the fundamental requirements of Statement No. 141 to account for all business combinations using the acquisition method (formerly the purchase method) and for an acquiring entity to be identified in all business combinations. However, the fair value principles in the revised Statement are a major change from Statement No. 141’s cost allocation process, together with other revisions from past practice. Among other changes, SFAS 141R requires the acquiring entity in a business combination to:

 

   

Recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions.

 

   

Recognize and measure the goodwill acquired in the business combination or a gain from a bargain purchase.

 

   

Expense acquisition-related costs, such as legal and due diligence costs, when incurred.

 

   

Recognize any restructuring costs that the acquiring entity expects to incur with respect to the acquired business as an expense, rather than capitalize as part of the acquisition.

 

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Disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination.

 

   

Recognize changes in the amount of deferred tax benefits that are recognizable because of a business combination either in income from continuing operations in the period of the combination or directly in contributed capital, depending on the circumstances.

SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. We do not expect the adoption of SFAS 141R to have an effect on our consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161 “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. We are in the process of evaluating the financial impact of adopting SFAS 161.

 

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Results of Operations

The following table provides a breakdown of our sales revenue and volumes, cost of sales and administration and selling expenses for the last three years.

 

     Year ended December 31,
     2005    2006    2007
     Sales     Volume    Sales     Volume    Sales     Volume
     (in millions of U.S.$, except where indicated)

Sales Revenue

              
Pulp               

Bleached pulp(1)

   U.S.$ 829.2     1,639    U.S.$ 1,071.6     1,849    U.S.$ 1,526.0     2,287

Unbleached pulp(1)

     161.9     356      186.2     356      203.6     324

Total

     991.2     1,995      1,257.8     2,205      1,729.6     2,611
Wood Products               

Sawn timber(2)

     433.4     2,425      495.0     2,512      550.2     2,650

Remanufactured wood products(2)

     215.9     360      231.2     430      219.9     390

Total

     649.3     2,785      726.2     2,942      770.1     3,040
Plywood and Fiberboard panels               

Plywood and Fiberboard panels

     588.3     2,046      721.2     2,397      853.4     2,455

Other

     —            —            0.9    

Total

     588.3          721.2          854.3    
Forestry Products               

Sawlogs (net)(2)

     51.3     1,457      56.5     1,474      69.6     1,544

Pulplogs(2)

     7.3     254      7.9     239      3.5     149

Posts

     21.8     88      7.8     34      0.9     4

Chips

     7.1     109      7.7     178      9.0     150

Other

               0.7    

Total

     87.5     1,908      79.9     1,925      83.7     1,847
Other      57.7     —        65.0     —        139.0     —  

Total sales revenue

   U.S.$ 2,373.9        U.S.$ 2,850.0        U.S.$ 3,576.7    

Cost of Sales, exclusive of depreciation

              

Forestry labor costs

     199.3          248.9          317.5    

Timber

     339.2          412.9          559.4    

Port costs

     17.3          22.4          29.6    

Freight and other transportation costs

     311.5          330.4          354.2    

Other costs of sales

     521.0          611.4          848.0    
                                

Total cost of sales

   $ 1,388.3        $ 1,626.0        $ 2,108.7    

Gross margins

     41.5 %        42.9 %        41.2 %  

Depreciation

     170.3          187.0          240.3    

Administration and Selling Expenses

              

Wages and salaries

     57.0          71.0          77.7    

Other administration and selling expenses

     123.3          158.2          202.2    
                                

Total selling and administrative expenses

   $ 180.4        $ 229.2        $ 279.9    
                                

Total operating costs and expenses

   $ 1,739.0        $ 2,042.3        $ 2,628.9    

Operating margin

     26.7 %        28.3 %        26.5 %  

 

(1)

Volumes measured in thousands of metric tons.

(2)

Volumes measured in thousands of cubic meters.

 

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Year Ended December 31, 2006 Compared to Year Ended December 31, 2007

Net Sales

Net sales increased 25.5 %, from U.S.$2,850.0 million in 2006 to U.S.$3,576.7 million in 2007 principally as a result of a strong increase in pulp sales due to higher sales volume coming from the Nueva Aldea Pulp Mill. Increases in the market prices for pulp also affected the increase in our net sales in 2007.

Pulp Sales

Sales revenue of bleached and unbleached pulp increased 37.5%, from U.S.$1,257.8 million in 2006 to U.S.$1,729.6 million in 2007, reflecting a 18.4% increase in sales volume and a 16.1% increase in average prices. Sales of bleached pulp increased by 42.4% due principally to higher sales volume coming from the Nueva Aldea Pulp Mill, which reached full capacity in May 2007. Sales of unbleached pulp increased by 9.4% principally due to a 20.0% increase in prices, partially offset by a 8.9% decrease in sales volume.

Wood Products Sales

Sales of wood products, including sawn timber and remanufactured products increased 6.0%, from U.S.$726.2 million in 2006 to U.S.$770.1 million in 2007, reflecting a 3.3% increase in sales volume and a 2.6% increase in average prices. Sawn timber sales revenue increased 11.2%, from U.S.$495.0 million in 2006 to U.S.$550.2 million in 2007 due to a 5.3% increase in average prices and a 5.5% increase in sales volume. Sales of remanufactured wood products decreased 4.9% from U.S.$231.2 million in 2006 to U.S.$219.9 million in 2007 due to a 9.5% decrease in sales volume, partially offset by a 5.1% increase in average prices. The decrease in sales volumes was caused by the continued weakening of the construction sector in the United States throughout 2007.

Plywood and Fiberboard Panels Sales

Sales of plywood and fiberboard panels increased 18.5%, from U.S.$721.2 million in 2006 to U.S.$854.3 million in 2007. This increase was primarily due to a 15.7% increase in average prices and a 2.4% increase in sales volume.

Forestry Sales

Sales revenue from forestry products increased 5.0%, from U.S.$79.9 million in 2006 to U.S.$83.9 million in 2007. This increase is mainly attributable to a 7.6% increase in prices partially offset by a 4.1% decrease in sales volume. The decrease in sales volume is due to an 88.5% decrease in sales volume of posts due principally to a reduction in demand for posts in Arauco’s principal market (the Mexican Telecommunications Industry) as a result of a change in the technology used for telecommunications which requires a lower consumption of posts. Sales revenue of sawlogs increased by 23.3%, primarily due to a 17.7% increase in average prices and a 4.7% increase in sales volume. Our sales of sawlogs and pulplogs are primarily in the local market.

Cost of Sales

Cost of sales increased 29.7% from U.S.$1,626.0 million for 2006 to U.S.$2,108.7 million for 2007 primarily due to an 18.4% increase in sales volume of pulp and an increase in the cost of timber, forestry works and maintenance costs. The higher cost of timber was due mainly to an increase in the market price of timber and the appreciation of the Chilean peso with respect to the U.S. dollar.

Gross Margins

Gross margins decreased from 42.9 % for 2006 to 41.2% for 2007 primarily due to an increase in the unit cost of sales which was partially offset by an increase in average sales prices.

 

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Depreciation

Depreciation increased 28.5% from U.S.$187.0 million for 2006 to U.S.$240.3 million for 2007 due primarily to a 36.4% increase in pulp industry depreciation expense from U.S.$124.9 million in 2006 to U.S.$170.3 million in 2007 and to a 15.3% increase in the plywood and fiberboard panels industry depreciation expense from U.S.$32.0 million in 2006 to U.S.$36.9 million in 2007. These increases were attributable to the operation of the Nueva Aldea Pulp Mill and the commencement of operations of the second line of the Nueva Aldea Plywood Mill.

Selling and Administrative Expenses

Selling and administrative expenses increased 22.0% from U.S.$229.2 million in 2006 to U.S.$279.9 million in 2007, primarily as a result of a 52.7% increase in other administrative expenses explained by an increase in sales volume, an increase in expenses on technical advice and contributions to foundations. As a percentage of sales revenue, selling and administrative expenses decreased from 8.0% during 2006 to 7.8% during 2007.

Income from Operations

Income from operations increased 17.4% from U.S.$807.8 million in 2006 to U.S.$947.8 million in 2007, primarily as a result of a 28.4% increase in sales revenues that resulted from an increase in sales volume and average price of pulp, partially offset by a 26.2% increase in cost of sales and a 22.0% increase in administration and selling expenses.

Non-Operating Income (Expense)

We recorded a total non-operating expense of U.S.$79.9 million in 2007 compared to an expense of U.S.$31.4 million in 2006, primarily due to higher interest expenses of 65.7%, which grew because of a lower interest expense capitalization as a consequence of the end of construction of the Nueva Aldea Pulp Mill, partially offset by an increase of other non operating income due to the sale of carbon credits, or CERs in 2007.

Interest Income

Interest income increased 16.7% from U.S.$40.9 million in 2006 to U.S.$47.7 million in 2007, primarily due to primarily due to a higher average cash balance and short-term investment position in 2007 as compared to 2006 partially offset by a decrease in the average nominal interest rate for our cash balance, time deposits and short-term investment positions during 2007.

Other Income (Expense)

We recorded other income of U.S.$10.8 million in 2007 compared to an expense of U.S.$0.3 million in 2006, due primarily to the sale of carbon credits, or CERs.

Foreign Exchange Gains (Losses)

We recorded foreign exchange losses of U.S.$1.9 million in 2007 compared to a gain of U.S.$10.5 million in 2006, primarily due to the decrease in the value of our Chilean peso-denominated current assets expressed in U.S. dollars.

Interest Expense

Interest expenses increased 65.7%, from U.S.$82.5 million in 2006 to U.S.$136.6 million in 2007, primarily due to a lower interest expense capitalization as a consequence of the end of construction of the Nueva Aldea Pulp Mill.

 

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Income Taxes

In 2007, we recorded a tax expense of U.S.$178.9 million, compared to an expense of U.S.$162.0 million in 2006. This increase was principally due to an increase in pretax income earned in 2007. Our effective tax rate was 20.6% in 2007 compared to 20.9% in 2006. In accordance with Chilean law, we and each of our subsidiaries compute and pay tax on a separate basis and not on a consolidated basis.

At December 31, 2007, our consolidated subsidiaries had an aggregate tax loss carryforwards of U.S.$136.7 million.

Net Income

Our net income increased by 12.1% from U.S.$622.4 million in 2006 to U.S.$697.4 million in 2007. This increase was primarily due to a higher operating income, partially offset by higher interest expenses due to a lower capitalization of interests.

Year Ended December 31, 2005 Compared to Year Ended December 31, 2006

Net Sales

Net sales increased 20.1%, from U.S.$2,373.9 million in 2005 to U.S.$2,850.0 million in 2006 principally as a result of a 26.9% increase in sales of pulp, a 22.6% increase in sales of plywood and fiberboard panels and a 11.8% increase in sales of wood products.

These increases were partially offset by an 8.7% decrease in sales of forestry products, reflecting a decrease of 9.5% decrease in sales prices.

Pulp Sales

Sales revenue of bleached and unbleached pulp increased 26.9%, from U.S.$991.2 million in 2005 to U.S.$1,257.8 million in 2006, reflecting a 10.5% increase in sales volume and a 14.8% increase in average prices. Sales of bleached pulp increased by 29.2% due principally to an increase of 14.5% in average prices and higher sales volume of 12.8% in 2006 compared to 2005. The increase in sales volume in 2006 reflects primarily the commencement of start-up operations of the Nueva Aldea Pulp Mill in August 2006 and a full year of production in the Valdivia Mill, which had been shut down for approximately three months during 2005. Sales of unbleached pulp increased by 15.0% principally due to a 14.9% increase in average prices and a 0.1% increase in sales volume.

Wood Products Sales

Sales of wood products, including sawn timber and remanufactured products increased 11.8%, from U.S.$649.3 million in 2005 to U.S.$726.2 million in 2006, reflecting a 5.6% increase in sales volume and a 5.9% increase in average prices. Sawn timber sales revenue increased 14.2%, from U.S.$433.4 million in 2005 to U.S.$495.0 million in 2006 due to a 10.3% increase in average prices and a 3.6% increase in sales volume. Sales of remanufactured wood products increased 7.1% from U.S.$215.9 million in 2005 to U.S.$231.2 million in 2006 due to a 19.6% increase in sales volume, partially offset by a 10.5% decrease in average prices due to the continued weakening of the construction sector in the United States throughout 2006.

Plywood and Fiberboard Panels Sales

Sales of plywood and fiberboard panels increased 22.6%, from U.S.$588.3 million in 2005 to U.S.$721.2 million in 2006. This increase was primarily due to a 17.2% increase in sales volume reflecting the consolidation of the acquisition of Placas do Paraná S.A. in Brazil and Faplac S.A. in Argentina in March 2005 and October 2005, respectively, and the consolidation of the operations of Arauco’s Nueva Aldea plywood mill in Chile which commenced in the last quarter of 2004. The increase in sales was also attributable to a 4.6% increase in average prices resulting from increasing prices for medium-density fiberboard (MDF), particleboard (PBO) and hardboard (HB).

 

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Forestry Sales

Sales revenue from forestry products decreased 8.7%, from U.S.$87.5 million in 2005 to U.S.$79.9 million in 2006. This decrease is mainly attributable to 63.9% decrease in sales revenue from posts reflecting a 61.0% decrease in sales volume, which in turn is due principally to a reduction in demand for posts in Arauco’s principal market (the Mexican Telecommunications Industry) as a result of a change in the technology used for telecommunications which requires a lower consumption of posts. This decrease in demand was also reflected in a 7.4% decrease in average nominal prices. The decrease in sales of posts was partially offset by higher sales of sawlogs. Sales revenue of sawlogs increased by 8.0%, primarily due to an 8.8% increase in average prices and a 1.2% increase in sales volume. Our sales of sawlogs and pulplogs are primarily in the Chilean market.

Cost of Sales

Cost of sales increased 17.1% from U.S.$1,388.3 million for 2005 to U.S.$1,626.0 million for 2006 primarily due to due to an increase in other cost of sales, primarily due to an increase in maintenance cost and chemical costs and to a higher cost of timber that negatively affected the unit cost of pulp, wood products, plywood and fiber panels and forestry products. The higher cost of timber was due mainly to an increase in the market price of timber bought from third parties. Cost of sales were also affected by a 10.5% increase in sales volumes of pulp, a 17.2% increase in sales volume of plywood and fiberboard panels and a 5.6% increase in sales volumes of wood products.

Gross Margins

Gross margins increased from 41.5% for 2005 to 42.9 % for 2006 primarily due to a 20.1% increase in sales revenue. This increase was partially offset by a 17.1% increase in cost of sales.

Depreciation

Depreciation increased 9.8% from U.S.$170.3 million for 2005 to U.S.$187.0 million for 2006 due primarily to a 7.8% increase in pulp industry depreciation expense from U.S.$115.6 million in 2005 to U.S.$124.9 million in 2006 and to a 18.7% increase in the plywood and fiberboard panels industry depreciation expense from U.S.$27.0 million in 2005 to U.S.$32.0 million in 2006. These increases were principally to the commencement of operations of the Nueva Aldea Pulp Mill and the consolidation of the acquisitions of Placas do Paraná. S.A. in Brazil and Faplac S.A. in Argentina in March 2005 and October 2005, respectively.

Selling and Administrative Expenses

Selling and administrative expenses increased 27.1% from U.S.$180.4 million in 2005 to U.S.$229.2 million in 2006, primarily as a result of primarily as a result of a 28.3% increase in other administrative and selling expenses and a 24.6% increase in wages and salaries, which was, in turn, due largely to an increase in the number of employees associated with the commencement of operations of the Nueva Aldea Pulp Mill. As a percentage of sales revenue, selling and administrative expenses increased from 7.6% during 2005 to 8.0% during 2006.

Income from Operations

Income from operations increased 27.2% from U.S.$634.9 million in 2005 to U.S.$807.8 million in 2006, primarily as a result of a 20.1% increase in sales revenues that resulted from an increase in sales volume and average price of pulp and wood products and an increase in sales volume of plywood and fiber panels, partially offset by a 17.1% increase in cost of sales and a 27.1% increase in administration and selling expenses.

Non-Operating Income (Expense)

We recorded a total non-operating expense of U.S.$31.4 million in 2006 compared to an expense of U.S.$83.9 million in 2005, primarily due to a 25.0% decrease in interest expense and a 268.2% increase in foreign exchange gain.

 

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Interest Income

Interest income increased from U.S.$34.5 million in 2005 to U.S.$40.9 million in 2006, primarily due to an increase during 2006 in the average nominal interest rate for our cash balance, time deposits and short-term investment positions.

Other Income (Expense)

We recorded other expense of U.S.$0.3 million in 2006 compared to an expense of U.S.$2.2 million in 2005.

Foreign Exchange Gains (Losses)

We recorded foreign exchange gains of U.S.$10.5 million in 2006 compared to a loss of U.S.$6.2 million in 2005, primarily due to an increase in the value of Arauco’s Euro denominated investments expressed in U.S. dollars, attributable to the revaluation of the euro against the U.S. dollar in 2006.

Interest Expense

Interest expenses decreased 25.0%, from U.S.$109.9 million in 2005 to U.S.$82.5 million in 2005, primarily due to an increase in capitalized interest expense related to the Nueva Aldea Pulp Mill project.

Income Taxes

In 2006, we recorded a tax expense of U.S.$162.0 million, compared to an expense of U.S.$113.3 million in 2005. This increase was principally due to a 40.9% increase in pre-tax earnings in 2006, attributable to an increase in income from operations in 2006. Our effective tax rate was 20.9% in 2006 compared to 20.6% in 2005, primarily due to our acquisitions in Argentina and Brazil, where income tax rates are higher relative to Chilean tax rates.

Our effective tax rate was 20.9% in 2006 compared to 20.6% in 2005, primarily due to our acquisitions in Argentina and Brazil, where income tax rates are higher relative to Chilean tax rates.

In accordance with Chilean law, we and each of our subsidiaries compute and pay tax on a separate basis and not on a consolidated basis.

At December 31, 2006, our consolidated subsidiaries had an aggregate tax loss carryforwards of U.S.$141.8 million.

Net Income

Our net income increased by 40.1% from U.S.$444.3 million in 2005 to U.S.$622.4 million in 2006. This increase was primarily due to an increase in prices of pulp and wood products and an increase in sales volume of pulp, plywood and fiberboard panels and wood products, resulting in higher operating income, partially offset by the increase in cost of sales, non-operating expense and tax expense.

LIQUIDITY AND CAPITAL RESOURCES

Our primary sources of liquidity are funds from operations, domestic and international borrowings from commercial and investment banks and debt offerings in the domestic and international capital markets.

Our net cash flow provided by operating activities was U.S.$900.7 million during the year ended December 31, 2007, U.S.$1,013.8 during the year ended December 31, 2006 and U.S.$751.0 million during the year ended December 31, 2005. The decrease in cash flow from operating activities in 2007 as compared to 2006 was principally due to an increase in investments in trading securities as well as an increase in receivables and inventory in 2007. The increase in cash flow from operating activities in 2006 as compared to 2005 was principally due to a

 

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27.2% increase in operating income, 224.4% increase in other liabilities resulting from the Bío Bío Investment Fund transaction, and a 145.8% increase in investments and proceeds in trading securities, which was partially offset by a 709.8% increase in receivables due to the increase in sales attributable to the commencement of operations of the Nueva Aldea pulp mill.

In accordance with customary practice in the pulp industry, we do not have long-term sales contracts with our customers; rather, we maintain relationships with our customers pursuant to which we reach agreements from time to time on specific volumes and prices.

We expect our principal capital expenditures for 2008 to include investments in the construction of a new biomass cogeneration plant in the Horcones Complex investments in forestry activities and ordinary maintenance of the mills, and the construction of the Nueva Aldea pipeline. See “Item 4. Information on the Company—Capital Expenditures.” For subsequent years, our capital expenditures will depend on the state of the economy in each country where we have operations, as well as market conditions.

We believe that cash flow generated by operations, cash balances, borrowings from commercial banks, export credit agencies and multilateral lending agencies and debt offerings in the domestic and international capital markets, will be sufficient to meet our working capital, debt service and capital expenditure requirements for the foreseeable future.

The following table sets forth certain contractual obligations as of December 31, 2007, and the period in which the contractual obligations come due.

 

     Payments Due by Period
     Total    Less than 1
year
   1-3 years    3-5 years    More than 5
years
     (in millions of U.S. dollars)

Contractual obligation (1)

              

Long-term debt obligations (2)

   $ 3,511.7    $ 446.4    $ 887.1    $ 709.0    $ 1,469.2

Capital (finance) lease obligations

     3.4      1.9      1.5      —        —  

Operating lease obligations

     —        —        —        —        —  

Purchase obligations (3)

     42.0      42.0      —        —        —  

Registrant’s balance sheet under GAAP

     —        —        —        —        —  

Total

   $ 3,557.1    $ 490.3    $ 888.6    $ 709.0    $ 1,469.2
                                  

 

(1)

Excludes obligations to purchase wood, plantations and land from Forestal Río Grande S.A. Arauco began consolidating Forestal Río Grande S.A. in 2006. Therefore, the assets that we are obligated to purchase from Forestal Río Grande S.A. are already included in our consolidated financial statements. Includes the accrued future interest of bank loans and bonds.

(2)

Includes estimated interest payments related to long-term debt obligations.

(3)

Excludes contracts entered into with independent contractors to perform operations on our behalf. Our payment obligations under such contracts are not pre-determined, but rather depend on the performance of certain variables. Accordingly, we cannot quantify our contractual obligations under such contracts.

At December 31, 2007, our short-term bank borrowings were U.S.$168.4 million. At December 31, 2006, our short-term bank borrowings were U.S.$203.5 million. At December 31, 2005, our short-term bank borrowings were U.S.$113.4 million.

Our total long-term bank, export credit agency and multilateral lending agency debt (including the current portion of such debt) was U.S.$706.7 million at December 31, 2007, of which 99.6% was U.S. dollar-denominated. At December 31, 2007, we also had total capital markets borrowings of U.S.$1,818.1 million, 100% of which was U.S. dollar-denominated. At December 31, 2007, the weighted average maturity of our foreign currency-denominated debt was 5.0 years. The interest rate on our variable rate debt is determined principally by reference to the London inter-bank offered rate (LIBOR), and at December 31, 2007 the average interest rate for our foreign currency-denominated floating rate debt over LIBOR was 0.3%. The average interest rate for our foreign currency-denominated fixed rate debt was 6.8%. These average rates do not reflect the effect of swap agreements and subsequent unwinds effective as of December 31, 2007.

 

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The following are our principal financing activities during 2007:

 

   

On June 11, 2007, Alto Paraná S.A. issued U.S.$270 million of 6.375% Notes due 2017 in the form of Rule 144A/Regulation S notes sold in the international debt and debt capital markets, which were fully and unconditionally guaranteed by Arauco. The proceeds of the offering were used to refinance U.S.$200 million of existing notes and to finance capital expenditures in the ordinary course of business.

 

   

On September 27, 2007, we entered into two loan agreements with Banco Bilbao Viscaya Argentaria S.A. for a principal amount of U.S.$ 150 million and U.S.$90 million, respectively. Each of the loans mature on March 27, 2016 and bear interest at a rate of LIBOR plus 0.2%. Interest is payable semi-annually.

The instruments and agreements governing our bank loans set limits on our incurrence of debt and liabilities through the use of financial covenants. The principal financial covenants contained in these agreements are as follows:

 

   

Our debt to equity ratio must not exceed 1.2:1;

 

   

Our interest coverage ratio must not be less than 2:1; and

 

   

We are required to maintain a minimum consolidated net worth of U.S.$2.5 billion, as measured in accordance with generally accepted accounting principles in Chile, or Chilean GAAP.

We were in compliance with these covenants as of December 31, 2007.

Substantially all of our borrowings are denominated in dollars. See “Item 11. Quantitative and Qualitative Disclosures about Market Risk—Foreign Currency Risk.”

OFF-BALANCE SHEET ARRANGEMENTS

We do not have any off-balance sheet arrangements.

 

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TREASURY MANAGEMENT

We manage the treasury activities of all of our Chilean subsidiaries on a centralized basis. Our subsidiaries borrow from or lend money to us in accordance with their daily cash requirements or surplus, maintaining their cash balance close to zero. Our policy is not to allow our Chilean subsidiaries to invest in financial instruments and other transactions. We make decisions regarding short-term loans, short-term investments, currency transactions and other transactions on a consolidated basis. Treasury activities are governed by our cash and deposits policy, which is approved by the board of directors.

Our Argentine subsidiaries and our Brazilian subsidiaries manage their treasury activities independently from us. Their activities are governed by cash and deposit policies that are approved by their chief executive officers. These policies are based on the same principles of our cash and deposits policy.

HEDGING

We periodically review our exposure to risks arising from fluctuations in foreign exchange rates and interest rates and make a determination, on a case-by-case basis, at our senior management level whether or not to hedge such risks. As a result, from time to time we enter into currency and interest rate swaps with respect to a portion of our borrowings. See Note 1(k) to our audited consolidated financial statements.

We have entered into two offsetting interest rate swap agreements, each in a notional amount of U.S.$130 million, to reduce the interest rate on our 7.75% Notes due 2011. These interest rate swaps settle semi-annually and terminate in 2011. The net effect of our interest rate swap agreements is that we pay fixed interest at a rate of 5.506% and receive fixed interest at a rate of 7.75%. See Note 8 to our audited consolidated financial statements.

The Bío Bío Investment Fund entered into one interest rate swap agreement, in an initial notional amount of U.S.$240 million with amortizations during the life of the swap in the same amount and dates of the amortizations of the credit agreement the Bío Bío Investment Fund obtained on October 6, 2006, with interest rate settled quarterly and with a final maturity in October 2013. The net effect of this interest rate swap agreement is that the Bío Bío Investment Fund pays fixed interest rate at a rate of 5.256% and receives a floating rate at 3 months LIBOR. In January 2007, the Bío Bío Investment Fund transferred all of its assets and financial debt to Forestal Río Grande S.A.

We have also analyzed our exposure to risks associated with fluctuations in prices of commodities, including pulp, but have, thus far, not entered into any material hedging transactions with respect to such risks. See “Item 11. Quantitative and Qualitative Disclosures About Market Risk.”

RESEARCH AND DEVELOPMENT

We spent U.S.$3.4 million in 2005, U.S.$3.2 million in 2006 and U.S.$3.2 million in 2007 on research and development. We conduct our principal research and development programs through Bioforest S.A., which concentrates its efforts on applying and implementing the advanced technology available in the market to the specific characteristics of our forests and mills.

We are continuously researching and attempting to develop different strains of long-fiber pine trees to improve their quality and to shorten the average harvest cycle. Additionally, we maintain close relations with international research institutes, equipment suppliers and the scientific and engineering community involved with our industry.

 

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Item 6. Directors, Senior Management and Employees

DIRECTORS AND EXECUTIVE OFFICERS

Directors

A board of directors manages our business. Our by-laws (estatutos) require that the board of directors consist of nine directors. Our directors cannot also be our executives. The entire board is elected every three years and can be re-elected for any number of periods. The current board was elected in April 2008, and their terms will expire in 2011. The board may appoint replacements to fill any vacancies that occur during periods between elections; however, at the annual shareholders’ meeting following any such replacement, an election of the entire board must take place. Scheduled meetings of the board of directors are, generally, held once a month. Extraordinary board meetings are called when summoned by the Chairman or when requested by at least two directors.

We do not have an audit committee or compensation committee.

Our current directors are listed below.

 

Name

   Years as
Director
  

Position

   Age

José Tomás Guzmán

   22    Chairman    79

Roberto Angelini

   22    First Vice-Chairman    59

Manuel Bezanilla

   22    Second Vice-Chairman    63

Jorge Andueza

   14    Director    59

Jorge Bunster

   14    Director    55

Carlos Croxatto

   22    Director    93

Alberto Etchegaray

   14    Director    58

Eduardo Navarro

      Director    43

Timothy C. Purcell

   3    Director    48

Included below are brief biographical descriptions of each of our directors.

José Tomás Guzmán became a Director on April 30, 1986 and became Chairman of the board of directors on May 4, 2007. He served as Chairman of the board of directors from April 18, 1991 to January 4, 2005, when he voluntarily resigned, and as First Vice-Chairman of the board of directors from January 27, 2005 to May 4, 2007. He is a partner of the law firm Portaluppi, Guzmán y Bezanilla, is a Vice-Chairman of COPEC, Empresas Copec, Compañía de Seguros de Vida Cruz del Sur S.A., AntarChile and Empresa Pesquera Eperva S.A., is Chairman of the board of directors of Forestal Arauco and Inversiones Siemel S.A., and serves as a member of the boards of directors of Industrias Forestales S.A., Sigma S.A., Servicios Corporativos Sercor S.A., Corpesca S.A. and Astilleros Arica S.A. Mr. Guzmán holds a law degree from the Catholic University of Chile.

Roberto Angelini became a Director on April 30, 1986 and became First Vice-Chairman of the board of directors on May 4, 2007. He served as Vice-Chairman of the board of directors from April 18, 1991 to January 4, 2005, when he voluntarily resigned, and as Second Vice-Chairman of the board of directors from January 27, 2005 to May 4, 2007. He serves as Chairman of the board of directors of Empresas Copec, COPEC, AntarChile, Corpesca S.A., SouthPacific Korp S.A., Pesquera Iquique-Guanaye S.A., Astilleros Arica S.A. and Servicios Corporativos Sercor S.A. He also serves as a member of the boards of directors of Forestal Arauco, Industrias Forestales S.A., Empresa Pesquera Eperva S.A., Inversiones Siemel S.A. and Sigma S.A. Mr. Angelini holds a degree in civil engineering from the Catholic University of Chile.

Manuel Bezanilla became a Director on April 30, 1986. He was appointed as Second Vice-Chairman of the board of directors on May 4, 2007. He is also a partner of the law firm Portaluppi, Guzmán y Bezanilla and serves as a member of the boards of directors of Forestal Arauco, Pesquera Iquique-Guanaye S.A., Antarchile and Inversiones Siemel S.A. Mr. Bezanilla holds a law degree from the Catholic University of Chile.

 

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Jorge Andueza became a Director on April 11, 1994. He is also the Chief Executive Officer of AntarChile and serves as a member of the boards of directors of COPEC, Empresa Pesquera Eperva S.A., Corpesca S.A., Compañía de Seguros de Vida Cruz del Sur S.A., Inversiones Siemel S.A., Astilleros Arica S.A., Pesquera Iquique-Guanaye S.A., SouthPacific Korp S.A. and Servicios Corporativos Sercor S.A. Mr. Andueza holds a degree in electronic civil engineering from Federico Santa María Technical University.

Jorge Bunster became a Director on April 11, 1994. He is also the Chief Executive Officer of COPEC, is the Chairman of the board of directors of Abastecedora de Combustibles S.A., and serves as a member of the boards of directors of Metrogas S.A., Empresa Eléctrica Guacolda S.A., Gasmar S.A. and Sociedad Nacional de Oleoductos S.A. Mr. Bunster holds degrees in commercial engineering and economics from the Catholic University of Chile and a master’s degree in business administration from Navarra University.

Carlos Croxatto became a Director on April 30, 1986. He also serves as a member of the boards of directors of Empresas Copec, COPEC, Forestal Arauco, Industrias Forestales S.A. and Servicios Corporativos Sercor S.A. Mr. Croxatto holds a degree in civil engineering from the University of Chile.

Alberto Etchegaray became a Director on April 11, 1994 and served as Chairman of the board of directors from January 4, 2005 to May 4, 2007, when he voluntarily resigned. He is also a partner of Domet Ltda., the Chairman of the board of directors of Invesco Internacional S.A., Salfacorp S.A., Isapre Consalud S.A and Habitaria S.A.. He served as the Chilean Minister of Housing for four years. Mr. Etchegaray holds a degree in civil engineering from the Catholic University of Chile.

Eduardo Navarro became a Director on September 25, 2007. He is also the Chief Executive Officer of Empresas Copec S.A., the Chief Executive Officer of Pesquera Iquique-Guanaye S.A., and serves as a member of the boards of directors of COPEC, Abastecedora de Combustibles S.A., Sociedad Nacional de Oleoductos S.A., Empresa Eléctrica Guacolda S.A., Corpesca S.A., South Pacific Korp S.A., Compañia Minera Can-Can S.A. and Colbún S.A. Mr. Navarro holds degrees in commercial engineering and economics, and a master’s degree in economics, all from the Catholic University of Chile.

Timothy C. Purcell became a director on April 26, 2005. He is also Managing Partner of Linzor Capital Partners, LP. Mr. Purcell currently serves as a member of the boards of directors of Compañía de Seguros de Vida Cruz del Sur S.A., Cruz del Sur Administradora General de Fondos S.A., Isapre Cruz Blanca S.A., BOPP Holdings, and Parque Arauco S.A. He is also a Trustee of International House in New York. Mr. Purcell received an undergraduate degree with distinction in Economics from Cornell University, as well as a Masters Degree in International Studies from the University of Pennsylvania and a master’s degree in business (MBA) from Wharton Business School.

 

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Executive Officers

Our executive officers are appointed by the board of directors and hold office at its discretion. Our current principal executive officers and the directors of each area or department are listed below.

 

Name

   Years with
Arauco
  

Position

   Age

Matías Domeyko(1)

   19    President and Chief Executive Officer    46

Gianfranco Truffello

   13    Chief Financial Officer    40

Robinson Tajmuch

   17    Chief Accounting Officer    51

Hernán Arriagada

   17    Engineering and Construction Director    60

Franco Bozzalla

   18    Panels Area Managing Director    45

Jorge Garnham

   31    Woodpulp Area Managing Director    54

Cristián Infante

   13    Argentina and Brazil Managing Director    41

Charles Kimber

   22    Corporate Affairs & Marketing Director    46

Antonio Luque

   16    Sawn Timber Area Managing Director    51

Alvaro Saavedra

   16    Forestry Area Managing Director    52

Mario Urrutia(2)

   14    Project Development Director    60

Juan Pablo Guzmán

   20    Administration Director    46

Mauricio Pinto

   10    Human Resources Director    43

 

(1)

Matías Domeyko worked at Arauco from 1987 to 1994. He rejoined Arauco in 1997.

(2)

Mario Urrutia worked at Arauco from 1989 to 1991 and from 1995 to 1998. He rejoined Arauco in 2002.

Included below are brief biographical descriptions of each of our executive officers and the directors of each area or department.

Matías Domeyko is the President and Chief Executive Officer of Arauco. Mr. Domeyko is also a member of the board of directors of Puerto Lirquén S.A. He worked at Arauco from 1987 to 1994. He rejoined in 1997 and served as our Chief Financial Officer until 2005. He previously served as the Director of Development of Copec. Mr. Domeyko holds a degree in commercial engineering from the University of Chile.

Gianfranco Truffello is the Chief Financial Officer of Arauco. He joined Arauco in 1994 and was previously our Finance Manager. He also served as the Chief Financial Officer of Alto Paraná S.A. Mr. Truffello holds a degree in civil engineering from the Catholic University of Chile and a master’s degree in business administration from the Massachusetts Institute of Technology.

Robinson Tajmuch is the Chief Accounting Officer of Arauco. He joined Arauco in 1991 and was previously our Comptroller. Before joining Arauco, he served as Auditing Manager at Price Waterhouse. Mr. Tajmuch holds a degree in accounting and auditing from the Santiago University of Chile.

Hernán Arriagada is our Engineering and Construction Director. He joined Arauco in 1991 and was previously the Engineering Manager and Engineering and Maintenance Manager of the mills at the Arauco site. Mr. Arriagada holds a degree in mechanical engineering from the University of Santiago.

Franco Bozzalla is our Panels Area Managing Director of Arauco. He joined Arauco in 1990. He was formerly a sales representative of Forestal Arauco. Mr. Bozzalla holds a degree in civil engineering from the Catholic University of Chile.

Jorge Garnham is the Woodpulp Area Managing Director of Arauco. He joined Arauco in 1978. He was formerly the Managing Director of Alto Paraná S.A., Chief Accounting Officer and Manager of Forestry Sales of Arauco. Mr. Garnham holds a degree in civil engineering from the Catholic University of Chile.

Cristián Infante is the Argentina and Brazil Managing Director. He joined Arauco in 1996 as a woodpulp sales representative, where he worked for two years. In 1998, Mr. Infante was appointed sales manager for industrial lumber and remanufactured products of Forestal Arauco, where he worked until 1999, at which time he moved to Centromaderas S.A., where he worked for two years. Mr. Infante holds a degree in civil engineering from the Catholic University of Chile.

 

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Charles Kimber is the Corporate Affairs & Marketing Director of Arauco. Mr. Kimber also supervises the Environmental Area Managing Director, Andrés Camaño. He graduated from the Catholic University of Chile with a degree in Commercial Engineering and joined Arauco in 1986, where he has held several positions in sales. He was previously Managing Director of Arauco Wood Products Inc.

Antonio Luque is the Sawn Timber Area Managing Director of Arauco and has held that position since 1993. Before joining Arauco, he was the General Manager of Cabildo S.A. and a research engineer at Compañía Industrial. Mr. Luque holds a degree in civil engineering from the University of Chile.

Alvaro Saavedra is the Forestry Area Managing Director of Arauco. He joined Arauco in 1991. Previously, he was the Director of Development of Forestal Arauco. He holds a degree in civil engineering from the University of Chile and a masters degree in science from the University of London.

Mario Urrutia is the Project Development Director of Arauco. He was the Director of Construction for the Arauco II Project and of the Valdivia Project. He was director of the Nueva Aldea Project until 2006. Mr. Urrutia holds a degree in civil engineering from the University of Chile.

Juan Pablo Guzmán is the Administration Director of Arauco. Mr. Guzmán holds a degree in commercial engineering from the Diego Portales University. He was previously the Director of Finance and Operations of Arauco Wood Products.

Mauricio Pinto is the Human Resources Director of Arauco. He graduated from the Catholic University of Chile with a degree in Commercial Engineering and joined Arauco in 1997.

Compensation

For 2007, the aggregate compensation of all our directors and executive officers and senior managers paid or accrued in that year for services in all capacities, including salaries and compensation for their service to those executive officers who serve as directors, was approximately U.S.$22.3 million. We do not maintain any pension or retirement programs or incentive compensation plans for our directors or executive officers. We also do not maintain any plans providing for benefits upon termination of employment. The following table sets out the compensation of our directors for their services as directors in the years provided.

 

     2006    2007

Roberto Angelini

   U.S.$ 67,475    U.S.$ 190,888

José Tomás Guzmán

     116,950      165,962

Carlos Croxatto

     67,475      199,722

Manuel Bezanilla

     61,475      108,541

Anacleto Angelini(1)

     24,738      25,446

Jorge Andueza

     24,738      43,808

Jorge Bunster

     24,738      43,808

Alberto Etchegaray

     74,213      60,169

Eduardo Navarro

     —        13,904

Juan Cambiaso

     18,000      18,000

Antonio Luque

     20,548      21,676

Matías Domeyko

     75,286      104,250

René Katz

     10,261      10,833

Manfred Mayer

     10,261      10,833

Jorge Garnham

     20,547      21,676

Eduardo Zañartu

     10,287      10,843

Alvaro Saavedra

     31,548      33,676

Franco Bozzalla

     22,287      22,843

Cristián Infante

     12,000      12,000

Charles Kimber

     20,548      21,676

Timothy C. Purcell

     24,738      43,808
             

Total compensation

   U.S.$ 738,113    U.S.$ 1,184,362
             

 

(1)

Mr. Anacleto Angelini passed away on August 28, 2007.

 

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Employees

The following table provides a breakdown of our employees by main category of activity as of the end of each year in the three-year period ended December 31, 2007.

 

     As of December 31,
     2005    2006    2007

Pulp mill employees

   1,812    1,930    2,326

Other industrial employees

   3,432    3,229    3,828

Forestry employees

   527    538    1,160

Administrative employees

   414    711    585
              

Total

   6,185    6,408    7,899
              

In addition, as of December 31, 2007, we had contracts with approximately 869 contractors, who employed approximately 28,012 employees. Contractors that are not affiliated with us or with each other operate our 12 sawmills and 4 remanufacturing facilities in Chile. The 12 independent contractors that operate our Chilean sawmills employed 3,857 employees at December 31, 2007. The independent contractors that operate our Chilean remanufacturing facilities employed 1,920 employees at December 31, 2007 and the independent contractor that operates the laminating beams line employed 110 employees at December 31, 2007.

Under Chilean labor legislation, we are secondarily liable for the payment of labor and the social security obligations owed to employees of our contractors. In the event that we do not exercise the rights granted to us by the labor laws regarding the supervision of our contractors in their compliance of their labor and social security obligations, then our responsibility is elevated from secondary to joint and several, thus enabling an employee of a contractor to bring a claim relating to these obligations against both the contractor and to us, as the party hiring such contractor, although the contractor would remain primarily liable for such obligations. Furthermore, we are also responsible for the health and safety conditions of the contractors’ workers and are obligated to ensure that the contractors comply with all obligations related to such conditions while such workers are performing activities for us within our corporate purpose.

Approximately 14.4% of our employees in Chile, 22.2% of our employees in Argentina and 35.0% of our employees in Brazil were unionized at December 31, 2007. We negotiate collective bargaining agreements of two or three years’ duration with unionized employees.

Our Chilean operations have not experienced any strikes or other work stoppages in the last five years other than a six-day work stoppage in May 2007 at our Horcones complex (which includes the Arauco pulp mill, a panel plant and two sawmills), located in the Province of Arauco in the Eighth Region in Chile, due to a work stoppage by the employees of our third party forestry contractors in that region. We consider our relations with our employees to be good. In June 2002, we experienced a one-day strike at the Puerto Esperanza Mill in Argentina. In 2006, the Faplac Mill experienced two strikes each lasting 30 days and 12 days, respectively. The Faplac Mill also experienced a 12-day stoppage during January and February 2007 due to problems with the labor union of its chemical division. Also in February 2007, a group of approximately 150 power saw operators went on strike, resulting in the shutdown of the Alto Paraná Mill for six days of operations. These strikes did not materially affect mill operations, and management considers relations with our employees in Argentina to be satisfactory. During the last five years, there have been no strikes at our Brazilian subsidiaries.

 

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SHARE OWNERSHIP

Our former director, Anacleto Angelini, who passed away on August 28, 2007, owned 20.8% of Inversiones Angelini y Compañía Limitada, or Inversiones Angelini, which is the principal shareholder of AntarChile. He directly owned 0.9% of AntarChile. Through his direct and indirect interests in Inversiones Angelini, AntarChile and Empresas Copec, Anacleto Angelini beneficially owned 8.3% of our shares. With Mr. Angelini’s passing, the above-mentioned interests are currently owned by his estate. The procedures regarding the probate of his estate are currently in progress and must be concluded within the term of two years after the date of his death.

Our First Vice-Chairman, Roberto Angelini, owns 12.2% of Inversiones Angelini. He directly owns 0.2% of AntarChile. Through his direct and indirect interests in Inversiones Angelini, AntarChile and Empresas Copec, Roberto Angelini beneficially owns 4.7% of our shares.

Our Chairman, José Tomás Guzmán, owns 1.9% of Inversiones Angelini. Directly and indirectly through Agroforestal e Inversiones Maihue S.A., he owns 4.1% of AntarChile and 2.6% of Empresas Copec. Through his interests in Inversiones Angelini, AntarChile and Empresas Copec, José Tomás Guzmán beneficially owns 2.6% of our shares.

None of our other directors or executive officers beneficially owns 1% or more of our shares.

 

Item 7. Major Shareholders and Related Party Transactions

MAJOR SHAREHOLDERS

Our only outstanding voting securities are shares of common stock of a single series, without nominal (par) value. The following table sets forth certain information concerning ownership of our common stock, as of June 22, 2008, with respect to each shareholder known by us to own more than 5% of the outstanding shares of our common stock and all of our directors and executive officers, as a group.

 

     Number of
Shares Owned
   Percentage
Ownership
 

Empresas Copec

   113,127,452    99.98 %

Directors and executive officers of the Company, as a group

   —      —    

Through its ownership of our Common Stock, Empresas Copec currently has voting control over us.

Empresas Copec is a Chilean public company listed on the Santiago Stock Exchange, the Valparaíso Stock Exchange and the Chilean Electronic Stock Exchange. It is a holding company, the principal interests of which are in Arauco, gasoline distribution, electricity, gas distribution and fishing. Before October 1, 2003, Empresas Copec’s legal name was Compañía de Petróleos de Chile S.A. As of that date, Compañía de Petróleos de Chile S.A. transferred all its gasoline- and fuel-related business assets to a new subsidiary, Compañía de Petróleos de Chile COPEC S.A., which we call COPEC, and changed its legal name to Empresas Copec S.A. In May 2005, AntarChile purchased 3.1 million shares of COPEC, increasing its ownership to 60.4% of Empresas Copec. At December 31, 2007, AntarChile owned 60.8% of Empresas Copec.

Through its ownership in Empresas Copec, AntarChile beneficially owned 60.8% of our shares at December 31, 2007. As of May 31, 2008, AntarChile beneficially owns 60.8% of our shares.

Inversiones Angelini y Compañía Limitada (“Inversiones Angelini”) in turn owns 62.0% of AntarChile’s shares, and certain other related investors own an additional 12.3% of AntarChile. Inversiones Angelini and such other investors are defined herein as the “Angelini Group.”

 

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The principal equity owners of interest in Inversiones Angelini were Mr. Anacleto Angelini with approximately 20.8%, Mrs. María Noseda Zambra with approximately 15.8%, Mr. Roberto Angelini Rossi with approximately 12.2%, and Mrs. Patricia Angelini Rossi with approximately 12.2%.

As of December 31, 2007, the Angelini Group controls Arauco through the ownership structure described above.

RELATED PARTY TRANSACTIONS

We engage in a variety of transactions in the ordinary course of business with affiliates. Article 89 of the Chilean Companies Act requires that our transactions with related parties be on a market basis or on terms similar to those customarily prevailing in the market. Directors and managers of companies that violate Article 89 are liable for losses and damages resulting from such violation.

In addition, Article 44 of the Chilean Companies Act provides that any transaction in which a director has a personal interest or is acting on behalf of a third party that has an interest in the transaction may be approved only when the board of directors has been informed of and has approved the transaction and when the terms of the transaction are similar to those prevailing in the market.

When the transaction involves material amounts, the board of directors must determine whether the terms of such transaction are similar to those prevailing in the market. If the board decides that it is not possible to determine whether the terms of the transaction are similar to those prevailing in the market, the board, with the abstention of the interested director, may approve or reject the transaction or designate two independent appraisers. Any transaction involving material amounts must be reported to the Chilean Securities Commission (Superintendencia de Valores y Seguros). Moreover, resolutions approving such transactions must be reported to our shareholders at the next annual shareholders’ meeting.

Article 44 presumes that a director has a personal interest in a transaction when

 

   

the director, his or her spouse, certain relatives, a company in which such director is also a director or in which such director has a minimum direct or indirect ownership interest of at least 10% are involved in the transaction,

 

   

or the companies in which any of the above mentioned persons is a director, a direct or indirect owner of 10% or more of our paid in capital are involved in the transaction; or

 

   

the persons for whom such director acts as a representative are involved in the transaction.

Violation of Article 44 may result in administrative or criminal sanctions and civil liability to shareholders or third parties who suffer losses as a result of such violation, but it does not affect the validity of the transaction. We believe that we have complied with the requirements of Article 89 and Article 44 in all transactions with related parties.

Our transactions with affiliates include the following:

 

   

We purchase goods and services that may also be provided by other suppliers. Among the most significant are our fuel purchases from COPEC, a subsidiary of Empresas Copec, our majority shareholder; and

 

   

We obtain legal services from Portaluppi, Guzmán y Bezanilla, a law firm of which two of our directors, José Tomás Guzmán and Manuel Bezanilla, are partners.

Financial information concerning transactions with affiliates is included in Note 11 to our audited consolidated financial statements.

 

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On June 11, 2007, in order to refinance the notes (obligaciones negociables) issued by Alto Paraná S.A. in 2001 (the “APSA Notes”) and other existing debt and to finance capital expenditures in the ordinary course of business, Alto Paraná S.A. issued U.S.$270 million of 6.375% Notes due 2017 in the form of Rule 144A/Regulation S notes sold in the international debt and debt capital markets. Arauco fully and unconditionally guaranteed these Notes. Alto Paraná paid the APSA Notes with the proceedings of the 6.375% Notes.

 

Item 8. Financial Information

See “Item 18—Financial Statements.”

EXPORT SALES

Export sales constituted approximately 76.9% of our sales revenue for the year ended December 31, 2007. Our total export sales revenue for 2007 was U.S.$2,748.3 million. Our principal overseas markets are North America, Asia and Western Europe. See “Item 4. Information on the Company—Description of Business—Domestic and Export Sales.”

LEGAL PROCEEDINGS

We have been and continue to be subject to environmental proceedings related to allegations by the Chilean environmental regulators and private parties. We are also subject to certain other legal proceedings arising from the ordinary course of our business. For more information regarding the environmental proceedings and other legal proceedings arising from the ordinary course of business, see Note 12 to our audited consolidated financial statements.

Since the end of 2004, various criminal proceedings relating to alleged violations of several environmental laws have been instituted in Chile in which some of our mills may be affected. We cannot predict the outcome or impact of these proceedings or when they may be resolved. While Chilean law provides that only individuals can be convicted in criminal actions, as a consequence of these proceedings, certain measures may be taken that could materially and adversely affect our business or operations. The proceedings related to our operating plants could have a material and adverse effect on our business, financial condition and results of operations. See “Item 8. Financial Information—Legal Proceedings.” See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—We are subject to legal proceedings related to our mills, which could adversely affect our business, financial condition and results of operations.”

Valdivia Mill

On January 18, 2005, the COREMA for the Tenth Region of Chile, initiated an administrative proceeding against the Valdivia Mill, claiming that there were several differences between the project as approved by CONAMA in 1998 and the constructed mill. In connection with this proceeding and based on the Administrative Proceedings Law No. 19,880, the COREMA for the Tenth Region of Chile ordered suspension of production at the Valdivia Mill as an interim preventive measure. To achieve prompt resolution of the matter, we accepted, among other things, an annual production limit of 550,000 tons, including daily maximum requirements, and agreed to be reviewed under the Environmental Impact Evaluation System before increasing production capacity beyond that limit. As a result, the COREMA for the Tenth Region of Chile lifted its suspension order on February 17, 2005, and we recommenced operations at the Valdivia Mill promptly thereafter. On March 18, 2005, the COREMA for the Tenth Region of Chile terminated the administrative proceeding against us described above and imposed a fine of approximately U.S.$77,000. We have determined that the suspension of operations at the Valdivia Mill resulted in a loss of sales of approximately U.S.$1,000,000 per day and a loss of profit of approximately U.S.$250,000 per day.

On January 17, 2005, in a separate judicial claim before the Court of Appeals of Valdivia, a group of private citizens and local organizations requested suspension of production at the Valdivia Mill until the differences between the approved design and the executed project were resolved under the Environmental Impact Evaluation System. On April 18, 2005, the Valdivia Court of Appeals issued a decision ordering us to again cease operations at the Valdivia Mill and to resolve the differences between the Valdivia Mill’s design and the project as completed.

 

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We appealed the decision, and on May 30, 2005, the Supreme Court reversed the decision of the Valdivia Court of Appeals. Since the decision of Valdivia Court of Appeals was subject to the review of the Supreme Court, there was no suspension of operations at the Valdivia Mill during the review of this claim.

The COREMA for the Tenth Region of Chile evaluated claims regarding the migration and death of black-neck swans, whose habitat in the nearby Carlos Anwandter Nature Sanctuary is downstream from the mill on the Cruces River. There have been allegations of a causal connection between the migration and death of black-neck swans and the operations at the Valdivia mill, and in a study dated April 18, 2005, researchers at the Austral University in Valdivia concluded that wastewater discharges from the Valdivia mill had significantly altered the quality of the Cruces River. The study also concluded that the effluent discharges were a significant contributing factor in the death or migration of a large population of the black-necked swans in the Carlos Anwandter Nature Sanctuary downstream from the Valdivia Mill.

On June 8, 2005, we voluntarily suspended operations at the Valdivia Mill, which we estimate resulted in a loss of sales of approximately U.S.$1.0 million per day and a loss of profits of approximately U.S.$250,000 per day. Pursuant to the decision of our board of directors based on certain clarifications provided by the COREMA for the Tenth Region of Chile, the mill resumed operations on August 12, 2005 at a reduced annual production of 440,000 metric tons, or 80% of its authorized production capacity, after 64 days of suspended operations. In order to achieve the full production capacity authorized by applicable permits (equal to 550,000 metric tons of wood pulp per year), the pulp mill had to comply with certain new requirements established by the COREMA for the Tenth Region of Chile, including modifications to the effluents’ parameters (including, among others, aluminum, sulfate, nitrogen and chlorate). In March 2006, Knight Piesold, an independent environmental auditing firm appointed by the COREMA for the Tenth Region of Chile, officially determined that the Valdivia Mill had complied with the applicable requirements. On January 18, 2008, the COREMA authorized the Valdivia Mill to return to its annual authorized production capacity of 550,000 metric tons. The mill gradually increased its production over a four month period starting in March 2008 and reached full capacity in June 2008. The suspension of operations at the Valdivia Mill adversely affected our business, financial condition and results of operations. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants can be expected to have similar adverse effects. We offer no assurance that the Valdivia Mill will be able to operate without further interruption. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—Environmental concerns led us to temporarily suspend our operations at the Valdivia Mill, which adversely affected, and in the future may continue to adversely affect, our business, financial condition and results of operations” and “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Valdivia Mill.”

As part of the environmental resolution that modified the Valdivia Mill environmental permit, the COREMA of the Tenth Region asked CONAF to elaborate an Integral Environmental Management Plan for the wetland, which was completed in 2006. The plan concluded that there was a need to develop a Conceptual Ecosystem Model for the wetland. CONAF selected the Science Faculty of the University of Chile to conduct this study.

The study indicated in its second progress report that the disappearance of the “luchecillo,” a water weed that was an important food source of black-necked swans, was likely related to natural causes. Specifically, the study proposed that the disappearance of the “luchecillo” was caused by the convergence of three factors in May 2004: (i) low levels of precipitation, (ii) low levels of water flow in the rivers and the wetland and (iii) three instances in which temperatures reached zero degrees Celsius or lower. According to the study, the simultaneous occurrence of these factors was likely responsible for the disappearance of the “luchecillo” which, in turn, lead to the death and migration of the swans.

The National Defense Council has instituted an action seeking reparations, damages and indemnification from us for environmental harm allegedly caused by the Valdivia Mill.

In 2005, the COREMA for the Tenth Region of Chile instructed us to present by March 31, 2006, an environmental impact study for the construction of a pipeline to discharge the Mill’s wastewater in a body of water other than the Cruces River or the Carlos Anwandter Nature Sanctuary or their sources. The COREMA also instructed us to construct and put into operation the above-mentioned pipeline not later than 15 months from the date in which the resolution of COREMA approving the environmental impact study is final. COREMA initially

 

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extended the deadline for the presentation of this environmental impact study to April 2007 and, prior to the expiration of the April 2007 deadline, extended it again to March 31, 2009. At the time of approving the new deadline, COREMA required us to present an additional environmental impact study for the implementation of substantial technological improvements on the quality of the effluents generated by the Valdivia Mill. This study was submitted on June 13, 2007. As of the date of this annual report, we have not been notified of the resolution that would conclude the environmental evaluation process by the COREMA.

The COREMA has appointed a Canadian consulting company, Ecometrix, to analyze and prepare a report on different feasible alternatives for discharge of the Valdivia Mill effluents. Approval by the COREMA of our environmental impact study regarding a pipeline, the construction and operation of such a pipeline and also the approval of the environmental impact study regarding the improvement of the quality of the effluents are each subject to many environmental, regulatory, engineering and political uncertainties at this time. As a result, we cannot give you any assurance that such projects will ever be approved or completed. If either our environmental study or the installation of the pipeline is delayed for reasons that COREMA attributes to us, we may face sanctions that include warnings, fines or the revocation of the Valdivia Mill’s environmental permit of operation. Alternatively, if COREMA considers that such delays are beyond our control, we believe that COREMA should extend the applicable deadlines. However, we offer no assurance that any of such deadline extensions would be granted, even if all the requirements set forth by the authority were complied with. As a result, we offer no assurance that the Valdivia Mill will be able to operate without further interruption. Any future suspension of operations at the Valdivia Mill or at any other of our significant operating plants would likely have a material and adverse effect on our business, financial condition and results of operations. See “Item 3. Key Information—Risk Factors—Risks Relating to Arauco and the Forestry Industry—We are subject to legal proceedings related to our mills, which could adversely affect our business, financial condition and results of operations,” “Item 4. Information on the Company—Description of Business—Pulp—Pulp mills—Chile—Valdivia Mill.” and “Item 8. Financial Information—Legal Proceedings”.

Nueva Aldea

In January 2001, we obtained environmental approval for the Nueva Aldea Project that included the construction of a pulp mill with an annual production capacity of 550,000 metric tons. After obtaining approval, we determined that we could increase the annual production capacity of the mill to 856,000 tons without an additional environmental impact study. The COREMA for the Eighth Region of Chile determined that it was necessary to formally review the difference in capacity before we proceeded with construction, and in August 2004, we submitted a new environmental impact study that considered the higher capacity. In September 2004, while this new study was under consideration, we began construction of the pulp mill according to the parameters approved in 2001. The COREMA for the Eighth Region of Chile disagreed with our decision and, on January 12, 2005, initiated an administrative proceeding and ordered suspension of construction of the mill until the new environmental impact study was reviewed and approved.

On March 10, 2005, the COREMA for the Eighth Region of Chile unanimously approved the new study and expressly authorized construction of the mill with installed annual capacity of 856,000 metric tons. We promptly resumed the construction of the pulp mill. The COREMA for the Eighth Region of Chile’s new approval requires submission of a new environmental impact study of the discharge of wastewater through a pipeline into the sea. On February 20, 2006, the COREMA of the Eighth Region of Chile approved this new environmental impact study. Certain proceedings relating to these approvals are pending. See Note 12 to our audited consolidated financial statements.

Licancel Mill

Since June 2007, our operations at the Licancel Mill, a pulp mill located in the Seventh Region of Chile, have been subject to environmental scrutiny by Chilean environmental regulators and the public. On June 5, 2007, in connection with the death of fish in the Mataquito River, approximately 15 kilometers downstream of the mill, we decided to voluntarily suspend our operations in the Licancel Mill as a preventive measure. In addition, Chilean authorities, including the health authorities and the Superintendencia de Servicios Sanitarios (Sanitary Services Superintendency), required that we suspend activities at the Licancel Mill and that we suspend any further discharges into the river. We also commenced independent investigations relating to the cause of the death of the

 

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fish. On June 18, 2007, as a result of a pipe leakage in the water treatment system currently in place at the Licancel Mill, an estimated 50 cubic meters of effluents reached the Mataquito River. On that same date, we decided to close the mill indefinitely and informed the Sanitary Services Superintendency of the incident. On October 3, 2007, we requested to the health authority (Autoridad Sanitaria) of the Seventh Region of Chile that it remove the suspension of activities at the Licancel Mill. On October 22, 2007, the health authority of the Seventh Region of Chile removed the suspension and imposed certain conditions relating to our activities in the mill consisting primarily of the implementation of certain emergency detection and control programs and systems, with which we have complied. Furthermore, on November 12, 2007 the Sanitary Services Superintendency removed the suspension regarding the release of discharges by the Licancel Mill. The mill resumed operations during January 2008.

By resolution dated June 7, 2007, the Sanitary Services Superintendency ordered that we suspend the discharge of effluents from the Licancel Mill into the Mataquito River. On June 9 and June 12, 2007, the Regional Ministerial Secretary of Health of the Seventh Region of Chile (the “SEREMI”) ordered that we suspend operations of the Licancel Mill as a preventive measure for a period of thirty days and/or until the SEREMI determines that any potential health risk has been resolved. By resolution dated June 13, 2007, the Sanitary Services Superintendency commenced an administrative proceeding against us with respect to the quality of the effluents discharged from the Licancel Mill. Several other administrative and judicial proceedings have been commenced regarding the event, at the Licancel Mill, including the death of fish at the Mataquito River. Those proceedings and the sanctions that have been imposed on us as of December 31, 2007 are included in our financial statements in Item 18.

DIVIDEND POLICY

Chilean law currently requires that, unless otherwise decided by the unanimous vote of our issued and subscribed shares eligible to vote, public corporations distribute a cash dividend in an amount equal to at least 30% of the corporation’s consolidated net income for each year on the basis of Chilean GAAP, unless and except to the extent the corporation has unabsorbed losses from prior years. In April 2002, our shareholders approved the current dividend policy, setting the cash dividend at 40% of our consolidated net income for each year, on a Chilean GAAP basis.

In accordance with a resolution adopted by our board of directors on October 24, 2006, we approved an interim dividend for 2006, which was distributed on December 13, 2006. On April 24, 2007, our shareholders approved a final dividend for 2006, which was distributed on May 9, 2007. On April 22, 2008, our shareholders approved a final dividend for 2007, which was distributed on May 7, 2008. In the aggregate, dividends distributed equaled 40% of our consolidated net income for 2006, on a Chilean GAAP basis.

Although the board of directors has no current plans to recommend changes in our dividend policy, the policy has been changed in the past and no assurance can be given that the policy will not be changed in the future, due to changes in Chilean law, capital requirements, operating results or other factors.

 

Item 9. The Offer and Listing

Neither our stock nor our securities are listed on any stock exchange or other regulated market.

Trading in our securities takes place primarily in the over-the-counter market. Accordingly, we are unable to obtain reliable information on such trading.

 

Item 10. Additional Information

ARTICLES OF INCORPORATION AND BY-LAWS

When we refer to the “Company,” “Arauco” or “we,” in this description of the articles of incorporation and by-laws, we mean Celulosa Arauco y Constitución S.A.

 

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Organization and Registration

We are a corporation (sociedad anónima) organized in Chile under the laws of Chile, and subject to the rules of the Chilean public corporations (sociedades anónima abiertas) and registered on August 18, 1971, by resolution 300-S of the Chilean Securities Commission and recorded in the Santiago Commercial Register of 1971 on page 6433 under entry number 2994 and on page 6431 under entry number 2993. Notice was published in the Official Gazette on September 4, 1971.

Objects and Purposes

Our purpose, as stated in our estatutos, or by-laws, includes the manufacture of forestry products, the management of forestry lands and other activities that are incidental to the forestry industry.

Capital

In 2002, our by-laws were amended such that our capital is denominated in U.S. dollars. In 2002, we and two of our subsidiaries, Aserraderos Arauco and Paneles Arauco, received authorization from the Chilean Internal Tax Service to prepare our audited consolidated financial statements in U.S. dollars, beginning January 1, 2002. In January 1, 2003, our subsidiaries Forestal Arauco, Bosques Arauco, Forestal Valdivia, Forestal Celco and Cholguán obtained the same permission from the Chilean Internal Tax Service.

Directors

Pursuant to our by-laws, our board of directors is composed of nine members elected by a general meeting of our shareholders. Our directors are not required to be shareholders. Our by-laws state that the amount of compensation to be received by the directors for their directorial services shall be fixed by the general shareholders’ meeting. Directors may be compensated for any non-directorial services rendered to us at levels of compensation comparable with compensation commonly paid for these services, compensation which is compatible with the directors’ compensation fixed by the general shareholders’ meeting. The by-laws also state that our board of directors has all of the authorities of administration and disposal that Chilean law or the by-laws do not confer upon the general shareholders’ meeting. The board of directors has the right to act on our behalf without the need for a special power of attorney, even in cases where a power of attorney is required by law. In particular, the by-laws provide that the board of directors is empowered to encumber our assets, real and personal property with mortgages, easements or pledges regardless of the value of such property or the amount of the respective encumbrances and to borrow money paying interest, with or without a guaranty for the loan.

Our by-laws provide that we may enter into acts or contracts in which one or more directors are interested only if the interested director’s interest is made known to the board, the acts or contracts are approved by the board and the terms of the act or contract conform to those prevailing in the market. In addition, board resolutions approving interested director transactions must be reported by the chair of the meeting at the first general shareholders’ meeting following the approval of the interested director transaction.

See “Item 6. Directors, Senior Management and Employees” for further information about our board of directors.

Shareholders

Our share capital consists of ordinary shares of no par value issued in registered form. Record holders of shares are registered in our share register. Any transfer of shares must be noted in our share register.

Voting Rights

Each share of our stock entitles the holder to one vote at any meeting of shareholders. Resolutions may be taken upon a vote of an absolute majority of the voting shares present or represented. Any resolution relating to amendments to our by-laws must be approved by an absolute majority of the voting shares issued. Resolutions with regard to the following matters require the affirmative vote of two-thirds of the voting shares issued:

 

   

transformation, including division or merger with another company;

 

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advanced dissolution;

 

   

change of corporate domicile;

 

   

reduction in our equity capital;

 

   

approval and appraisal of non-cash capital contributions;

 

   

reduction in the number of members of the board of directors;

 

   

disposal of our assets and liabilities or all of our assets; and

 

   

changes to the way in which corporate benefits will be distributed.

According to our by-laws, holders of our shares also have the right to vote at the general shareholders’ meeting for the election of directors. Shareholders or their representatives may accumulate their votes in favor of one candidate or distribute them among various candidates. A vote on the election of directors may be omitted if an election is proposed by acclamation and none of the shareholders present or represented opposes the motion. The board of directors may also be dismissed by a regular or special general shareholders’ meeting, though the shareholders may only vote to dismiss the board as a whole.

Changes to Shareholders’ Rights

To change the rights of holders of our shares or create a new series of our shares, we must amend our by-laws. In addition, under Chilean law, any public company wishing to issue a new class of shares must register the new class of shares with the Chilean Securities Commission. Any reduction in the number of our shares also requires a two-thirds majority vote of all holders of our shares under Chilean law. Chilean law also requires that public corporations distribute a cash dividend in an amount equal to at least 30% of the corporation’s consolidated net income for each year (on a Chilean GAAP basis), unless otherwise decided by a unanimous vote of the corporation’s issued and subscribed shares eligible to vote. Any changes to the corporation’s dividend policy must be approved by a two-thirds majority of all holders of the corporation’s shares.

Shareholders’ Meetings

Our by-laws provide that the board of directors shall call general shareholders’ meetings. Notice of general shareholders’ meetings must be made by a prominent notice published at least three times, on different days, in the newspaper of one of our corporate domiciles, as determined by a general shareholders’ meeting, or in the absence of a determination, in the Official Gazette.

A shareholder must be registered in our share register five business days before the meeting date to be entitled to participate and vote at any shareholders’ meeting. In addition, other persons may represent shareholders at general meetings. Powers of attorney must be given in writing and must be granted with respect to all of the shares the shareholder is entitled to vote as of the date five days before the general shareholders’ meeting.

General shareholders’ meetings may be regular or special meetings. Regular shareholders’ meetings are held once a year within the first four months of the year. Among other things, the regular general shareholders’ meeting appoints independent external auditors to examine our accounts, inventory, balance sheet and other financial results. The by-laws provide that the following matters are to be considered at regular shareholders’ meetings:

 

   

the review of our results of operations and external auditors’ reports and the approval or rejection of our annual report, our balance sheet and financial statements;

 

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the distribution of profits of each financial period and the distribution of our dividends;

 

   

the election or dismissal of the members of the board of directors; and

 

   

any matter of corporate interest that is not transacted at a special general shareholders’ meeting.

Special shareholders’ meetings may be held at any time required by corporate needs to consider any matter that the law or our by-laws require to be considered at a general shareholders’ meeting. Our by-laws require the meeting notice to disclose any matters to be discussed at a special shareholders’ meeting. According to the by-laws, the following matters must be considered at special shareholders’ meetings:

 

   

dissolution;

 

   

transformation, merger or division and the amendment of our by-laws;

 

   

the issue of bonds or debentures convertible into shares;

 

   

the disposal of our fixed assets and liabilities or of all of our assets; and

 

   

the grant of real or personal guarantees to secure obligations of third parties, unless they are subsidiaries, in which case the approval of the board of directors will be sufficient.

Any other matters within the competence of general shareholders’ meetings may be considered at special shareholders’ meetings.

Any act of a general shareholders’ meeting relating to our dissolution, transformation, merger or division, the amendment of our by-laws, any disposal of our fixed assets and liabilities or all of our assets or the issue of bonds convertible into shares or convertible debentures must be held before a notary public, who must certify that the minutes of such meeting are the true expression of what occurred and was resolved at the meeting.

Allocation of Net Income and Distribution of Dividends

Our by-laws provide that the shareholders at a general shareholders’ meeting shall determine the annual distribution of our net profits for each financial period, within the limitations prescribed by law. The shareholders shall also set the date on which any distribution shall be paid, within the time limits prescribed by law. Chilean law prescribes that distributions shall be paid within 30 days of the general shareholders’ meeting at which such distribution was determined.

In accordance with Chilean law, in the event of liquidation, capital can be distributed to the shareholders only after the rights of the creditors have been secured or debts owed to creditors have been paid. Our by-laws provide that a general shareholders’ meeting will appoint one or more liquidators to carry out the liquidation and to call shareholders’ meetings, as required under Chilean law.

Regulation of and Restrictions on Foreign Investors

There are no limitations on the rights to hold securities, including rights of non-resident or foreign shareholders to hold or exercise voting rights on securities.

Disclosure of Shareholder Ownership

We register certain information about our shareholders in our shareholder registry. We are required to disclose this information to the Chilean Securities Commission on a quarterly basis.

 

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Rights of Shareholders

Our by-laws provide that, in the case of a dispute between shareholders or between shareholders and management, the parties will submit their dispute to a mixed arbitrator, who may determine the procedural rules to be used in the arbitration but must issue a final judgment in accordance with Chilean law. Subject to limited exceptions, the arbitrator’s judgment shall not be subject to appeal. The parties shall appoint the arbitrator by mutual agreement and if no agreement is reached, an arbitrator will be appointed by the civil court system from among present and former associate justices of the Supreme Court of Justice of Chile.

EXCHANGE CONTROLS

The Central Bank is responsible for, among other things, monetary policies and exchange controls in Chile. Prior to 1989, Chilean law permitted the purchase and sale of foreign exchange only in cases explicitly authorized by the Central Bank. Law No. 18,840, the Organic Law of the Central Bank of Chile (Ley Orgánica Constitucional del Banco Central de Chile), or the Central Bank Act, enacted in 1989, liberalized the rules that govern the ability to buy and sell foreign exchange.

The Central Bank Act empowers the Central Bank to determine which types of foreign exchange operations must be carried out in the Formal Exchange Market rather than the Informal Exchange Market (Mercado Cambiario Informal). The Central Bank has ruled that certain foreign exchange transactions, including those attendant to foreign investments and bond issuances, may be effected only in the Formal Exchange Market. The Central Bank may also impose restrictions on foreign exchange operations that are conducted or are required to be conducted in the Formal Exchange Market. These restrictions may include the requirement of prior authorization from the Central Bank, the imposition of reserve requirements and the limitation of foreign exchange operations that may be conducted by the entities that participate in the Formal Exchange Market.

The Formal Exchange Market consists of banks and other entities authorized by the Central Bank to participate in such Formal Exchange Market. On April 16, 2001, the Central Bank agreed that, effective April 19, 2001, the prior foreign exchange restrictions would be eliminated and a new Compendium of Foreign Exchange Regulations (Compendio de Normas de Cambios Internacionales) would be applied.

The main objective of this change is to facilitate capital movements from and into Chile and to encourage foreign investment.

The following specific restrictions were eliminated:

 

   

a reserve requirement with the Central Bank for a period of one year;

 

   

the requirement for prior approval by the Central Bank for certain operations, such as repatriation of investments and payments to foreign creditors;

 

   

the mandatory return of foreign currencies to Chile; and

 

   

the mandatory conversion of foreign currencies into Chilean pesos.

Under the amended regulations, only the following limitations are applicable to these operations:

 

   

the Central Bank must be provided with information related to certain operations, such as foreign investments and foreign credits; and

 

   

certain operations, such as money transfers to and from Chile, must be conducted within the Formal Exchange Market.

 

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International Issue of Bonds

Before April 19, 2001, any international issue of bonds was subject to approval by the Central Bank after submission of an application to the Central Bank through a bank or other participant in the Formal Exchange Market. Absent the Central Bank’s authorization, issuers were unable to offer bonds outside of Chile. On April 19, 2001, the Central Bank issued new foreign exchange regulations, effective as of March 1, 2002, that were included in the new Chapters XIV and VIII of the Compendium, applicable to bond issues made either from Chile or through an agency abroad. It must be noted however, that all debt issues made before the new regulations remain subject to the regulations existing at the time of their issue.

Debt securities issued directly by us

In accordance with regulations issued by the Central Bank, which were included in the new Chapter XIV of the Compendium, effective March 1, 2002, as amended, any international issue of bonds in an aggregate amount exceeding U.S.$10,000 must be registered and dated by the Central Bank or by a bank or other entity authorized by the Central Bank to participate in the Formal Exchange Market before the proceeds from the issuance can be remitted to Chile and received by the issuer or simultaneously with the remittance into Chile of such proceeds. The issuer must submit forms regarding the offering to the registering entity or directly to the Central Bank, along with a letter of instructions indicating whether it prefers to receive the proceeds in Chilean pesos or in a foreign currency. If presented through a Formal Exchange Market entity, such entity must, in turn, verify that the forms submitted by the issuer are in accordance with the documentation relating to the issue and inform the Central Bank of the operation no later than 11:00 a.m. on the banking business day following the date on which the proceeds of the issue are transferred to the issuer.

If the issuer opts to receive the proceeds of the issue outside of Chile, it must report this to the Central Bank directly or through a Formal Exchange Market entity during the first ten calendar days of the month following the one in which the proceeds were received.

Chapter XIV of the Compendium also states that proceeds from the issue, as well as payment of capital and interest relating to the issue, must be received and sent from and through the Formal Exchange Market, but purchases of U.S. dollars in connection with payments on debt securities issued directly by us can be made either in the Formal or in the Informal Exchange Market. There can be no assurance, however, that we will be able to purchase U.S. dollars in the Informal Exchange Market or in the Formal Exchange Market at the time or in the amounts required to pay debt service related to any such debt securities. There can also be no assurance that further Central Bank regulations or legislative changes to the current foreign exchange control regime in Chile would not restrict or prevent our purchase of U.S. dollars to make payments under our securities.

In the case of debt securities issued directly by us before the effectiveness of the new regulations, the registration of the debt securities with the Central Bank grants us access to the Formal Exchange Market for the purchase of U.S. dollars necessary to make payments in respect of those securities but requires that payments on such debt securities shall be made only with U.S. dollars purchased in the Formal Exchange Market.

The regulations of Chapter XIV of the Compendium do not make any reference to the one-year mandatory deposit in the Central Bank that was previously required by Chapter XIV. However, the Central Bank is authorized, under the Central Bank Act, to impose such a requirement.

Debt securities issued through our Panamanian agency

In December 1996, we established a registered agency in Panama. We may from time to time issue debt securities directly or through our Panamanian agency depending on, among other factors, whether or not we expect to bring the proceeds thereof into Chile. In such cases, the proceeds of such issuance of the notes may be brought into Chile or held abroad. In either case, however, in accordance with Chapter VIII of the Compendium, we were required to inform the Central Bank of the issuance of international bonds through our Panamanian agency during the first ten calendar days of the month following the one in which the disbursement of funds to the agency was produced, and provide the schedule of payments of the notes. On December 27, 2007, the requirement to provide information to the Central Bank was eliminated. We will no longer be required to inform the Central Bank of future issuances of bonds made through our Panamanian agency.

 

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Purchases of U.S. dollars in connection with payments on debt securities issued through our Panamanian agency, whether before or after April 19, 2001, can be made either in the Formal Exchange Market or in the Informal Exchange Market. Although we were required to inform the Central Bank of the issuance of debt securities through our Panamanian agency, such communication to the Central Bank did not give us access to the Formal Exchange Market for the purchase of U.S. dollars necessary to make payments in respect of those debt securities.

There can be no assurance that we will be able to purchase U.S. dollars in the Informal Exchange Market or in the Formal Exchange Market at the time or in the amounts required to pay debt service related to any such debt securities. There can also be no assurance that further Central Bank regulations or legislative changes to the current foreign exchange control regime in Chile and will not restrict or prevent our purchase of U.S. dollars to make payments under our securities from Chile.

TAXATION

General

The following summary contains a description of the principal Chilean and United States federal income tax consequences of the purchase, ownership and disposition of our securities, but it does not purport to be a comprehensive description of all the tax considerations that may be relevant to a decision to purchase our securities. This summary does not describe any tax consequences arising under the laws of any state, locality or taxing jurisdiction other than the United States and Chile.

This summary is based on the tax laws of Chile and the United States as in effect on the date of this Form 20-F, as well as regulations, rulings and decisions of Chile and the United States available on or before such date and now in effect. All of the foregoing is subject to change, and any changes could apply retroactively and could affect the continued validity of this summary.

Prospective purchasers of our securities should consult their own tax advisors as to the Chilean, United States or other tax consequences of the purchase, ownership and disposition of our securities, including, in particular, the application to their particular situations of the tax considerations discussed below, as well as the application of state, local, foreign or other tax laws.

Currently, there is no tax treaty between the United States and Chile.

Chilean Taxation

The following is a general summary of the principal consequences under Chilean tax law, as currently in effect, of an investment in our securities made by a foreign holder. Foreign holder means either:

 

   

in the case of an individual, a person who neither is a resident nor is domiciled in Chile (for purposes of Chilean taxation, an individual holder is domiciled in Chile if this individual has his or her principal place of business in Chile, and is resident in Chile if the individual has resided or has been domiciled in Chile for more than six months in one calendar year or a total of more than six months in two consecutive fiscal years); or

 

   

in the case of a legal entity, a legal entity that is not organized under the laws of Chile, unless our securities are assigned to a branch or a permanent establishment of the entity in Chile.

Under Chile’s income tax law, our payments of interest made from Chile in respect of our securities to a Foreign Holder will generally be subject to a Chilean withholding tax assessed at a rate of 4.0% (the “Chilean Interest Withholding Tax”).

 

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We have agreed, subject to specific exceptions and limitations, to pay to the foreign holders of Notes additional amounts in respect of the Chilean Interest Withholding Tax in order that the interest the foreign holder receives, net of the Chilean Interest Withholding Tax, equals the amount which would have been received by the foreign holder in the absence of withholding. If we pay additional amounts in respect of the Chilean Interest Withholding Tax, any refunds of the additional amounts will be for our account. In the event of certain changes in Chilean tax laws requiring us to pay additional amounts in excess of the additional amounts that would be payable were payments of interest on our securities subject to the Chilean Interest Withholding Tax at a 4.0% rate, we have the right to redeem our securities.

Under existing Chilean law and regulations, a foreign holder will not be subject to any Chilean taxes in respect of payments of principal that we make with respect to our securities. Our payments with respect to our securities of amounts not considered principal or interest may be subject to a Chilean withholding tax of up to 35%.

The Chilean Income Tax Law provides that a foreign holder is subject to income tax on his Chilean source income. For this purpose, Chilean source income means earnings from activities performed in Chile or from a sale, disposition or other transaction in connection with assets or goods located in Chile. Therefore, any capital gains realized on the sale or other disposition by a Foreign Holder of our securities generally will not be subject to any Chilean taxes provided that such sale or other disposition occurs outside Chile.

A foreign holder will not be liable for estate, gift, inheritance or similar taxes with respect to its holdings unless the securities held by a foreign holder:

 

   

are located in Chile at the time of such Foreign Holder’s death or at the time the transfer takes place, or

 

   

were purchased or acquired with monies obtained from Chilean sources.

A foreign holder will not be liable for Chilean stamp, registration or similar taxes.

The issue of our securities directly by us was subject to stamp tax, which we paid. The issue of our securities through our Panamanian agency was not subject to stamp tax.

United States Taxation

This summary of certain United States federal income tax considerations deals principally with United States Holders that acquire our securities as part of the initial offering of our securities and will hold our securities as capital assets and whose functional currency is the United States dollar. It does not purport to be a comprehensive description of all of the tax considerations that may be relevant to a particular investor’s decision to purchase our securities and generally does not address the tax treatment of United States Holders that may be subject to special tax rules, such as banks, financial institutions, tax-exempt entities, regulated investment companies, real estate investment trusts, insurance companies, dealers in securities or currencies, traders in securities electing to mark to market, certain short-term holders of our securities, persons that will hold our securities as a position in a “straddle” or conversion transaction, or as part of a “synthetic security” or other integrated financial transaction, persons that own (or are deemed to own for United States tax purposes) 10% or more of our voting stock or persons that are not United States Holders. United States Holders should be aware that the U.S. federal income tax consequences of holding our securities may be materially different for investors described in the previous sentence, including as a result of certain laws applicable to investors with short holding periods or that engage in hedging transactions.

As used under this section “United States Taxation,” the term “United States Holder” means a beneficial owner of a Note that is a citizen or resident of the United States or a United States domestic corporation or that otherwise is subject to United States federal income taxation on a net income basis in respect of our securities.

Taxation of Interest and Additional Amounts

A United States Holder will treat the gross amount of interest and Additional Amounts (i.e., without reduction for Chilean Interest Withholding Tax, determined utilizing the 4.0% Chilean Interest Withholding Tax rate applicable to all United States Holders of our securities) as ordinary interest income in respect of our securities at the

 

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time that such payments are accrued or are received, in accordance with the United States Holder’s method of tax accounting. Any Chilean Interest Withholding Tax paid will be treated as foreign income taxes eligible for credit against such United States Holder’s United States federal income tax liability, subject to generally applicable limitations and conditions, or, at the election of such United States Holder, for deduction in computing such United States Holder’s taxable income. Interest and Additional Amounts will constitute income from sources outside the United States for foreign tax credit purposes. Such income generally will constitute “passive income.” Foreign tax credits will not be allowed for withholding taxes imposed in respect of certain short-term or hedged positions in securities and may not be allowed for withholding taxes imposed in respect of arrangements in which a United States Holder’s expected economic profit is insubstantial. United States Holders should consult their own advisors concerning the implications of these rules in light of their particular circumstances.

The calculation of foreign tax credits and, in the case of a United States Holder that elects to deduct foreign taxes, the availability of deductions, involves the application of rules that depend on a United States Holder’s particular circumstances. United States Holders should consult their own tax advisors regarding the availability of foreign tax credits and the treatment of Additional Amounts.

A Holder of our securities that is, with respect to the United States, a foreign corporation or a nonresident alien individual (a “Non-U.S. Holder”) generally will not be subject to United States federal income or withholding tax on interest income or Additional Amounts earned in respect of our securities, unless such income is effectively connected with the conduct by the Non-U.S. Holder of a trade or business in the United States.

Taxation of Dispositions

Gain or loss realized by a United States Holder on the sale, redemption or other disposition of our securities generally will be treated as capital gain or loss and such gain or loss will be long-term capital gain or loss if at the time of the disposition, our securities have been held for more than one year. The net amount of long-term capital gain realized by a United States Holder that is an individual is taxed at a maximum rate of 15%. Gain, if any, realized by a United States Holder generally will be treated as U.S. source income for U.S. foreign tax credit purposes.

A Non-U.S. Holder of our securities will not be subject to United States federal income or withholding tax on gain realized on the sale or other disposition of our securities unless (i) such gain is effectively connected with the conduct by the Non-U.S. Holder of a trade or business in the United States or (ii) in the case of gain realized by an individual Non-U.S. Holder, the Non-U.S. Holder is present in the United States for 183 days or more in the taxable year of the sale and certain other conditions are met.

Backup Withholding and Information Reporting

Payments of principal, premium, if any, and interest on our securities and payment of the proceeds of any disposition of our securities made to certain United States Holders may be subject to U.S. information reporting requirements. In addition, certain United States Holders may be subject to a U.S. backup withholding tax in respect of such payments if they do not provide their taxpayer identification numbers to the payor or otherwise establish an exemption. Non-U.S. Holders generally are exempt from these withholding and reporting requirements, but may be required to comply with applicable certification and identification procedures to establish their eligibility for such an exemption.

DOCUMENTS ON DISPLAY

We are subject to the informational requirements of the Securities Exchange Act of 1934, as amended. In accordance with these requirements, we file reports and other information with the Securities and Exchange Commission. These materials, including this Annual Report and the exhibits thereto, may be inspected and copied at the Commission’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Copies of the materials may be obtained from the Public Reference Room at the Commission at 450 Fifth Street, N.W., Washington, D.C. 20549 at prescribed rates. In addition, the Commission maintains an Internet website at http://www.sec.gov, from which these materials may be electronically accessed. The public may obtain information on the operation of the Commission’s Public Reference Room by calling the Commission in the United States at 1-800-SEC-0330.

 

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Item 11. Quantitative and Qualitative Disclosures About Market Risk

The following discussion about our risk management activities includes forward-looking statements that involve risk and uncertainties. Actual results could differ materially from those projected in such forward-looking statements.

We are exposed to market risk from changes in interest rates and currency exchange rates. From time to time, we assess our exposure and monitor opportunities to manage these risks, including entering into derivative contracts. In the normal course of business, we also face risks that are either non-financial or non-quantifiable. Such risks principally include country risk, credit risk and legal risk and are not represented in the tables below.

INTEREST RATE RISK

Interest rate risk exists principally with respect to our indebtedness that bears interest at floating rates. At December 31, 2007, we had outstanding approximately U.S.$2,693.1 million of indebtedness excluding accrued interest, of which approximately 67.5% bore interest at fixed interest rates and approximately 32.5% bore interest at floating rates of interest. These average rates do not reflect the effect of swap agreements. 99.9% of the indebtedness was denominated in U.S. dollars as of that date. The interest rate on our variable rate debt is determined principally by reference to LIBOR.

The following table summarizes our long-term debt obligations, including 2008 maturities, at December 31, 2007 that are sensitive to changes in interest rates. The table presents the aggregate principal amount of each category of indebtedness maturing in each year, at the weighted average interest rate for each category of indebtedness. Average interest rates for liabilities are calculated based on the prevailing interest rate for each loan at December 31, 2007.

 

     As of December 31, 2007
     Average
Interest
Rate(1)
    Expected contractual maturity date    Total Long
Term Debt
   Fair Value(2)
     2008    2009    2010    2011    2012    Thereafter      
     (U.S.$ equivalent in millions)

Long-Term Interest Bearing Debt

                         

Fixed Rate

                         

(U.S.$-denominated)

   6.8 %   —      100.0    270.5    387.0    —      1,065.0    1,822.5    1,892.4

Variable Rate

   LIBOR  +                       

(U.S.$-denominated)

   0.3 %   124.3    200.0    39.1    58.3    82.3    202.3    706.2    706.2

(R.$-denominated)

   —       2.8    0.2    —      —      —      —      3.0    3.0

 

(1)

Average interest rate means, for variable rate debt, the weighted average prevailing interest rate at December 31, 2007, on our variable rate debt, and for fixed rate debt, the weighted average prevailing interest rate at December 31, 2007, on our fixed rate debt. Average rates do not reflect the effect of swap agreements.

(2)

These figures were calculated based on the discounted value of future cash flows expected to be received or paid, considering current discount rates that reflect the different risks involved. See Note 10to our audited consolidated financial statements.

FOREIGN CURRENCY RISK

Our principal exchange rate risk involves changes in the value of the Chilean peso, the euro and, to a lesser extent, the Argentine peso and the Brazilian real relative to the dollar. We generally believe that our foreign currency exposure is not material to our net income. In 2007, substantially all of our consolidated revenues were denominated in or indexed to foreign currencies. We estimate that a majority of our consolidated costs and expenses are denominated in dollars. As of December 31, 2007:

 

   

A significant portion of our accounts receivable were denominated in U.S. dollars;

 

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53.2% of our short-term investments were denominated in U.S. dollars and 27.4% were denominated in euros;

 

   

substantially all of our indebtedness was denominated in U.S. dollars; and

 

   

a significant portion of our consolidated total assets was denominated in U.S. dollars.

Substantially all of our foreign currency-denominated revenues, costs and expenses, receivables and indebtedness are denominated in U.S. dollars. As of December 31, 2007, all of our long-term debt was denominated in U.S. dollars. Accordingly, variations in the value of the Chilean peso relative to the dollar will not have a significant effect in the cost in dollars of our foreign debt service obligations.

 

Item 12. Description of Securities Other than Equity Securities

Not applicable.

 

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PART II

 

Item 13. Defaults, Dividend Arrearages and Delinquencies

None.

 

Item 14. Material Modifications to the Rights of Security Holders and Use of Proceeds

None.

 

Item 15. Controls and Procedures

(a) Disclosure controls and procedures. We carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Accounting Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as of December 31, 2007. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective controls and procedures can only provide reasonable assurance of achieving their control objectives. Based upon our evaluation, our Chief Executive Officer and Chief Accounting Officer concluded that the disclosure controls and procedures, as of December 31, 2007, were effective to provide reasonable assurance that information required to be disclosed in the reports we file and submit under the U.S. Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Commission’s rules and forms and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Accounting Officer, as appropriate to allow timely decisions regarding required disclosure.

(b) Management’s annual report on internal controls and procedures. Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Accounting Officer, we conducted an evaluation of the effectiveness of our internal control over financial reporting based on the framework in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Our internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Our internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of our assets; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorizations of our management and directors; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the our assets that could have a material effect on our financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate. Based on our evaluation under the framework in Internal Control—Integrated Framework, our management concluded that our internal control over financial reporting was effective as of December 31, 2007.

 

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(c) Attestation Report of the registered public accounting firm. This annual report does not include an attestation report of the Company’s registered public accounting firm regarding internal control over financial reporting. Management’s report was not subject to attestation by the Company’s registered public accounting firm pursuant to temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

(d) Changes in internal controls over financial reporting. There has been no change in our internal control over financial reporting during 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Item 16A. Audit Committee Financial Expert

We do not have an audit committee. Accordingly, certain rules under the U.S. federal securities laws that would otherwise apply to the audit committee apply to our board of directors as a whole. We believe that the members of our board of directors have sufficient financial and other experience to perform their responsibilities under these rules. Our board of directors has determined that Timothy C. Purcell qualifies as an “audit committee financial expert” within the meaning of Item 16A of Form 20-F. Our board of directors has determined that Timothy C. Purcell is independent as that term is defined in Rule 10A-3 under the Exchange Act. For a description of Mr. Purcell’s professional experience, see “Item 6. Directors, Senior Management and Employees—Directors and Executive Officers.”

 

Item 16B. Code of Ethics

We have adopted a code of ethics, as defined in Item 16B of Form 20-F under the Securities Exchange Act of 1934, as amended. Our code of ethics applies to our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer. We will provide any person without charge, upon request, a copy of such code of ethics. Requests for a copy of the code of ethics may be made to Celulosa Arauco y Constitución S.A., El Golf 150, 14th Floor, Santiago, Chile, Attn: Gianfranco Truffello, tel. (011-562) 461-7200, fax (011-562) 461-7541. If we amend the provisions of our code of ethics that apply to our Chief Executive Officer, Chief Financial Officer and Chief Accounting Officer, or if we grant any waiver of such provisions, we will disclose the amendment or waiver in our annual report on Form 20-F.

 

Item 16C. Principal Accountant Fees and Services

Audit and Non-Audit Fees

The following table sets forth the fees billed to us by our independent auditors, PricewaterhouseCoopers, during the fiscal years ended December 31, 2006 and 2007.

 

     Year ended
December 31,
     2006    2007
     (U.S.$ in thousands)

Audit fees

   $ 1,186.1    $ 1,188.7

Audit-related fees

     119.9      299.3

Tax fees

     88.9      148.5

Other fees

     —        75.7
             

Total fees

   $ 1,394.9    $ 1,712.2
             

 

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Audit fees in the above table are the aggregate fees billed by PricewaterhouseCoopers in connection with the audit of our annual financial statements in accordance with Chilean GAAP and U.S. GAAP, as well as the review of other filings.

Audit-related fees in the above table are the are the aggregate fees billed by PricewaterhouseCoopers for assurance and related services that are reasonably related to the performance of the audit or review of our financial statements or that are traditionally performed by the external auditor, including consultations regarding the Sarbanes-Oxley Act, due diligence related to acquisitions and review of offering memorandums prepared in connection with the issuance of debt under Rule 144A.

Tax fees in the above table are fees billed by PricewaterhouseCoopers associated with the issuance of certificates for tax and legal compliance purposes in Mexico and Argentina; tax consultation on the impact of debt restructured by our subsidiaries in Argentina and Brazil; and tax consultation in the United States.

Other fees in the above table are fees billed by PricewaterhouseCoopers in connection with training services and consultations in International Financial Reporting Standards.

Audit Committee Approval Policies and Procedures

Our board of directors has established pre-approval policies and procedures for the engagement of our independent auditors. Pursuant to our pre-approval policy, our board of directors has pre-approved a list of services that our independent auditors are allowed to provide to us or our subsidiaries.

Additionally, our board of directors expressly approves, on a case-by-case basis, any engagement of our independent auditors for audit and non-audit services that are not included on the pre-approved list.

 

Item 16D. Exemptions from the Listing Standards for Audit Committees

Not applicable.

 

Item 16E. Purchases of Equity Securities by the Issuer and Affiliated Purchasers

Not applicable.

 

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PART III

 

Item 17. Financial Statements

Not applicable.

 

Item 18. Financial Statements

See our audited consolidated financial statements beginning on page F-1, incorporated herein by reference.

 

Item 19. Exhibits

Documents filed as exhibits to this annual report:

 

1.1    English translation of the by-laws (estatutos) of Celulosa Arauco y Constitución S.A., dated as of January 31, 2008
8.1    List of subsidiaries
12.1    Certification of chief executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
12.2    Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
13.1    Certification of chief executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
15.1    Valuation and qualifying accounts

Omitted from the exhibits filed with this annual report are certain instruments and agreements with respect to our long-term debt, none of which authorizes securities in a total amount that exceeds 10% of our total assets. We hereby agree to furnish to the SEC copies of any such omitted instruments or agreements as the SEC requests.

 

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The registrant hereby certifies that it meets all of the requirements for filing on Form 20-F and that it has duly caused and authorized the undersigned to sign this annual report on its behalf.

 

CELULOSA ARAUCO Y CONSTITUCIÓN S.A.

By:  

/s/ MATÍAS DOMEYKO

  Matías Domeyko
  Chief Executive Officer

Date: June 26, 2008


Table of Contents

Index of Exhibits

 

1.1    English translation of the by-laws (estatutos) of Celulosa Arauco y Constitución S.A., dated as of January 31, 2008
8.1    List of subsidiaries
12.1    Certification of chief executive officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
12.2    Certification of principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
13.1    Certification of chief executive officer and principal financial officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
15.1    Valuation and qualifying accounts


Table of Contents

CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Consolidated financial statements

December 31, 2007

ThU.S.$ - Thousands of United States dollars

Ch$ - Chilean pesos

 

F - 1


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LOGO

 

    

 

PricewaterhouseCoopers

RUT: 81.513.400-1

Santiago de Chile

Av. Andrés Bello 2711-Torre Costanera

Las Condes

Teléfono [56] (2) 940 0000

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of

Celulosa Arauco y Constitución S.A.

In our opinion, the accompanying consolidated balance sheets and the related consolidated statements of income and comprehensive income, of stockholders’ equity and of cash flows present fairly, in all material respects, the financial position of Celulosa Arauco y Constitución S.A. and its subsidiaries at December 31, 2007 and 2006, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2007 in conformity with accounting principles generally accepted in the United States of America. In addition, in our opinion, the financial statement schedule included under Exhibit 15.1 presents fairly, in all material respects, the information set forth therein when read in conjunction with the related consolidated financial statements. These financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and financial statement schedule based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers

Santiago, Chile.

June 24, 2008

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Consolidated Balance Sheets

 

     At December 31,
     2007    2006
     (U.S.$ in thousands)

ASSETS

     

CURRENT ASSETS:

     

Cash and cash equivalents 1d)

   $ 37,507    $ 22,180

Time deposits

     36,260      21,719

Short-term investments 1e)

     193,509      143,851

Trade receivables – net

     592,074      550,746

Other receivables – net (2)

     167,682      120,911

Inventories 1f), (3)

     451,315      409,251

Prepaid expenses and other current assets (4)

     161,979      130,393
             

Total current assets

     1,640,326      1,399,051
             

LONG-TERM ASSETS:

     

Forest 1g)

     2,241,737      2,016,637

Property, plant and equipment – net 1h), (5)

     3,562,250      3,447,037

Investments in affiliates

     120,356      90,834

Goodwill 1n)

     25,679      27,240

Other long-term assets

     110,028      88,153
             

Total long-term assets

     6,060,050      5,669,901
             

Total assets

   $ 7,700,376    $ 7,068,952
             

Notes to the financial statements are an integral part of these financial statements.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Consolidated Balance Sheets

 

     At December 31,
      2007    2006
     (U.S.$ in thousands)

LIABILITIES AND STOCKHOLDERS’ EQUITY

     

CURRENT LIABILITIES:

     

Short-term debt

   $ 168,352    $ 203,453

Current portion of long-term notes (8)

     124,588      168,596

Current portion of long-term bonds 1p)

     —        99,980

Accounts payable (6)

     449,826      424,431

Accrued liabilities and other current liabilities (7)

     138,281      124,405
             

Total current liabilities

     881,047      1,020,865
             

LONG-TERM LIABILITIES:

     

Long-term notes (8)

     582,063      570,485

Long-term bonds 1p) (8)

     1,818,193      1,579,586

Deferred income taxes (9)

     358,159      285,582

Other long-term liabilities

     80,170      66,197
             

Total long-term liabilities

     2,838,585      2,501,850
             

MINORITY INTEREST

     140,395      115,678
             

STOCKHOLDERS’ EQUITY:

     

Common stock (nominal par value, 113,152,446 shares authorized and issued)

     —        —  

Paid-in capital

     363,833      363,833

Retained earnings

     3,398,822      3,025,246

Accumulated other comprehensive income

     77,694      41,480
             

Total stockholders’ equity

     3,840,349      3,430,559
             

Total liabilities and stockholders’ equity

   $ 7,700,376    $ 7,068,952
             

Notes to the financial statements are an integral part of these financial statements.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Consolidated Statements of Income and Comprehensive Income

 

     Year Ended December 31,  
     2007     2006     2005  
     (U.S.$ in thousands)  

Net sales

   $ 3,576,719     $ 2,850,012     $ 2,373,907  

Operating costs and expenses:

      

Cost of sales, exclusive of depreciation

     (2,108,730 )     (1,626,038 )     (1,388,322 )

Depreciation (13)

     (240,299 )     (186,995 )     (170,291 )

Selling and administrative

     (279,868 )     (229,220 )     (180,355 )
                        

Total operating costs and expenses

     (2,628,897 )     (2,042,253 )     (1,738,968 )
                        

Income from operations

     947,822       807,759       634,939  
                        

Non-operating income (expense):

      

Interest income

     47,735       40,899       34,487  

Other income gains (losses)

     10,820       (344 )     (2,225 )

Foreign exchange gains (losses)

     (1,942 )     10,510       (6,249 )

Interest expense

     (136,595 )     (82,460 )     (109,886 )
                        

Total non-operating income (expense)

     (79,982 )     (31,395 )     (83,873 )
                        

Income before taxes, minority interest and equity in earnings of unconsolidated affiliates

     867,840       776,364       551,066  

Provision for income taxes (9)

     (178,924 )     (161,958 )     (113,328 )

Minority interest in consolidated subsidiaries

     (1,079 )     100       (72 )

Equity in earnings of unconsolidated affiliates

     9,520       7,926       6,682  
                        

Net income

     697,357       622,432       444,348  
                        

Other comprehensive income

      

Foreign currency translation adjustment

     36,214       10,643       30,837  
                        

Comprehensive income

   $ 733,571     $ 633,075     $ 475,185  
                        

Notes to the financial statements are an integral part of these financial statements.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Consolidated Statements of Cash Flows

 

     Year Ended December 31,  
     2007     2006     2005  
     (U.S.$ in thousands)  

CASH FLOWS FROM OPERATING ACTIVITIES

      

Net income

   $ 697,357     $ 622,432     $ 444,348  

Adjustments to reconcile net income to net cash provided by operating activities:

      

Depreciation

     240,299       186,995       170,291  

Minority interest in net income of consolidated subsidiaries

     1,079       100       72  

Earnings of unconsolidated affiliates

     (9,520 )     (7,926 )     (6,682 )

Deferred income taxes

     54,280       44,091       10,730  

Allowance for doubtful accounts

     3,919       2,532       (628 )

(Gain) loss on sale of fixed assets

     145       (761 )     (590 )

Investments and proceeds in trading securities

     (64,199 )     146,982       59,787  

Decrease (increase) in receivables

     (45,247 )     (181,487 )     29,760  

Decrease (increase) in inventories

     (42,064 )     (45,581 )     (52,836 )

Decrease (increase) in other assets

     (7,029 )     (40,326 )     (34,046 )

Increase in accounts payable

     (14,659 )     71,290       64,323  

Increase in other liabilities

     86,354       215,488       66,423  
                        

Net cash provided by operating activities

     900,715       1,013,829       750,952  
                        

CASH FLOWS FROM INVESTING ACTIVITIES

      

Additions to property, plant and equipment and forest

     (461,794 )     (1,094,360 )     (631,480 )

Proceeds from sales of property, plant and equipment

     5,511       6,460       1,893  

Investment in related companies

     (212,052 )     (10,176 )     (237,397 )

Dividends received from related companies

     —         8,598       1,846  
                        

Net cash used in investing activities

     (668,335 )     (1,089,478 )     (865,138 )
                        

CASH FLOWS FROM FINANCING ACTIVITIES

      

Bonds issued

     268,110       —         400,000  

Bank borrowings and notes

     1,183,007       957,005       372,230  

Debt issue costs

     (3,309 )     —         (3,710 )

Payment of notes and bond principal

     (1,380,518 )     (690,443 )     (445,135 )

Dividends paid

     (284,343 )     (194,691 )     (207,724 )
                        

Net cash provided by (used in) financing activities

     (217,053 )     71,871       115,661  
                        

Net increase (decrease) in cash and cash equivalents

     15,327       (3,778 )     1,475  

Cash and cash equivalents at beginning of year

     22,180       25,958       24,483  
                        

Cash and cash equivalents at end of year

   $ 37,507     $ 22,180     $ 25,958  
                        

Notes to the financial statements are an integral part of these financial statements.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Consolidated Statements of Stockholders’ Equity

 

     Year Ended December 31,  
     2007     2006     2005  
     (Dollar and Share Amounts in Thousands,
Except Per Share Amounts)
 

Common Stock

     —         —         —    

Nominal par value

      

(113,152,446 shares authorized and issued at December 31, 2007, 2006, and 2005)

      

Paid in capital

      

Balance at beginning of year

   $ 363,833     $ 363,833     $ 363,833  

Balance at end of year

     363,833       363,833       363,833  
                        

Retained earnings

      

Balance at beginning of year

     3,025,246       2,695,448       2,423,434  

Initial application of SAB 108

     —         (32,403 )     —    

Net income

     697,357       622,432       444,348  

Dividends

     (323,781 )     (260,231 )     (172,334 )

Balance at end of year

     3,398,822       3,025,246       2,695,448  
                        

Accumulated other comprehensive income

      

Foreign currency translation adjustments

     77,694       41,480       30,837  
                        

Total stockholders’ equity

   $ 3,840,349     $ 3,430,559     $ 3,090,118  
                        

Notes to the financial statements are an integral part of these financial statements.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

a) Nature of operations

Celulosa Arauco y Constitución S.A., a Chilean corporation (“the Company”), and its subsidiaries (the Company, together with its subsidiaries, “Arauco”) are principally engaged in the production of pulp, forestry and wood products, and the management of their forestry assets. Arauco owns and operates facilities in Chile, Argentina, Brazil and Uruguay and has customers throughout the world including Asia, Europe, North America and Central and South America.

b) Use of estimates in the preparation of financial statements

The preparation of financial statements in conformity with generally accepted accounting principles in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include the carrying value of property, plant and equipment; recoverable forest; allowance for doubtful accounts; inventories and deferred income tax assets. Actual results could differ from those estimates.

c) Consolidation

The consolidated financial statements include the accounts of the Company and all majority owned subsidiaries in which the Company has voting control and variable interest entities (“VIEs”) in which the Company is the primary beneficiary. Investments in affiliates, companies in which the Company owned from 20% to 50% of the shares, (directly or indirectly), and therefore exercises significant influence, but which it does not control, and where the entity is either not a VIE or the Company is not the primary beneficiary, are accounted for under the equity method. The Company’s share of earnings of such investments is shown in the income statement under the heading “Equity in earnings of unconsolidated affiliates”.

In October 2006, Fondo de Inversión Privado Bío-Bío (“Forbío”) acquired Forestal Bío-Bío’s assets for U.S.$ 346 million. At the same time, Arauco signed with Forbío certain contracts to become the administrator and exclusive buyer of these forestry assets which include 40,000 hectares of plantations. Arauco receives an annual fee for the administration of the forest. Arauco also signed a purchase contract with Forbío whereby it has the obligation to buy the wood, plantations and land over a seven-year term starting in October 2006. Forbío was formed by Arauco’s unrelated companies Foresta Administradora de Fondos de Inversión S.A. and Fondo Inmobiliario Independencia. Forbío was financed through financial debt amounting to U.S.$ 240 million and capital contributions. The Company has determined that Forbío is a variable interest entity and the Company is the primary beneficiary. As such, commencing in October 2006, the Company consolidates Forbío. There are no assets of the Company that serve as collateral for Forbío and the creditors of Forbío have no recourse to the general credit of the Company.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

d) Cash and cash equivalents

Arauco considers all highly liquid securities with maturities of three months or less at the time of purchase to be cash equivalents. Arauco invests its excess cash in short-term time deposits and repurchased agreements with high quality financial institutions. These time deposits and repurchased agreements are included in cash and cash equivalents at fair value. Arauco generally holds these cash investments until maturity and is therefore not subject to significant market risk. The Company has accounts with a variety of banks and does not hold significant deposits with any single bank.

e) Short-term investments

Arauco’s short-term investments consist primarily of investments in mutual fund units, which are classified as trading securities. These short-term investments are recorded at fair value with unrealized holding gains and losses included in earnings. Net unrealized holding gains included in net earnings amounted to U.S.$0.5 million, U.S.$0.5 million and U.S.$9.7 million for the years ended December 31, 2007, 2006, and 2005, respectively.

f) Inventories

Inventories of raw materials, work-in-process and spare parts are stated at the lower of cost or market, primarily using the average cost method. Finished goods are stated at the lower of average production costs for the period or market. Inventory costs include materials, labor, transportation, depreciation of fixed assets and production overhead as appropriate.

g) Forests

Timber and timberlands are stated at cost less cost of timber harvested. The costs incurred in developing and growing timber such as site preparation, property taxes, seedling, planting, fertilization, insect and wildlife control, herbicide application and thinning, are capitalized. Direct and indirect interest costs incurred in connection with the development of timber and timberlands are also capitalized. These capitalized costs are accumulated by specifically identifiable farm blocks. Accounting practices for these costs do not change when timber becomes merchantable and harvesting commences.

Costs incurred related to logging roads are capitalized and amortized over their expected useful lives or as the related timber is harvested.

Depletion, or costs attributed to timber harvested is determined by each identifiable farm block that is in the harvesting stage based on the relationship of unamortized timber costs to the estimated volume of recoverable timber multiplied by the amount of timber cut. The estimated volume of recoverable timber is determined using statistical information and other data related to growth rates and yields gathered from physical observations, models and other information gathering techniques. Changes in yields are generally due to adjustments in growth rates and similar matters and are accounted for prospectively as changes in estimates. The cost of timber harvested is included in the carrying values of raw material and product inventories and in the cost of products sold as these inventories are sold to third parties.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

h) Property, plant and equipment

Property, plant and equipment are stated at cost less accumulated depreciation. Depreciation of buildings, equipment and other depreciable assets is primarily determined using the straight-line method. Expenditures that substantially improve and/or increase the useful life of facilities or equipment are capitalized. Interest costs associated with financing the construction of property, plant and equipment are capitalized. Maintenance and repair costs are expensed as incurred. Profits and losses on the sale of property, plant and equipment are accounted for as the difference between the book value and the consideration received.

i) Asset impairments

Arauco reviews long-lived assets for impairment when events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable. Losses are recognized when the book values exceed expected undiscounted future net cash flows from the use and eventual disposition of the asset. These undiscounted cash flows are based upon management’s estimate of future cash inflows and outflows. The key assumptions in estimating these cash flows are future pricing of forest and future estimates of expenses to be incurred. When impairment is indicated, the book values of the assets are written down to their estimated fair value.

j) Income taxes

Arauco uses the asset and liability method of accounting for income taxes. Under this method, the provision for income taxes includes amounts currently payable and amounts deferred as tax assets and liabilities, based on differences between the financial statement carrying amounts and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to be recovered or settled. Deferred tax assets are reduced by a valuation allowance which is established when it is more likely than not that some portion or all of the deferred tax assets will not be realized. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.

Effective January 1, 2007, the Company adopted the provisions of FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes”. The adoption of FIN 48 had no effect on the financial information or disclosures.

k) Derivative financial instruments

To cover risk of exposure to interest rate differences, Arauco utilizes interest rate swap derivative financial instruments. It has established procedures for assessing risk and approving, reporting and monitoring derivative financial instrument activities. Contracts are recorded on the balance sheet and measured at fair value. The interest differential paid or received is recognized in interest expense in the period incurred. Arauco does not use hedge accounting treatment or utilize derivative instruments for trading or speculative purposes.

 

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CELULOSA ARAUCO Y CONSTITUCION S.A. AND SUBSIDIARIES

Notes to the Consolidated Financial Statements

l) Allowance for doubtful accounts and trade receivables

Arauco provides an allowance for doubtful accounts based on a review of the specific receivables. As of December 31, 2007 and 2006, no single customer accounted for more than 10% of the outstanding balance of accounts receivable. At December 31, 2007 and 2006, the balance in the allowance account for receivables was U.S.$12.6 million and U.S.$12.1 million, respectively.

The trade receivables at December 31, 2006, include restricted receivables amounting to U.S.$70,388 thousand that secure the payment of short-term debt. There were no rectricted trade receivables at December 31, 2007.

m) Currency translation

The functional currency of the Company and its subsidiaries, except for Brazilian subsidiaries, is the U.S. dollar. The Company has subsidiaries that maintain their records in local currencies. Because the U.S. dollar is the functional currency, subsidiaries that maintain their records in local currency remeasure their financial statements into U.S. dollars using the historical exchange rates for non-monetary assets and liabilities and shareholders’ equity accounts. For monetary assets and liabilities, the year-end exchange rate prevailing on December 31 of each year is used. The income statement amounts are remeasured into U.S. dollars at a weighted average exchange rate for the year. Re-measurement gains or losses are recorded in foreign exchange gains (losses) in the income statement.

In the case of Brazilian subsidiaries, the local currency is the functional currency. As such, assets and liabilities are translated using the exchange rates in effect at the balance sheet date. Income and expenses are translated at the average exchange rates during the year. Translation gains and losses not reflected in earnings are reported in accumulated other comprehensive income in stockholders’ equity.

n) Goodwill

Goodwill is the excess of acquisition cost of a business over the fair value of identifiable net assets acquired. Goodwill is deemed to have an indefinite life and is not amortized. However, these indefinite life assets are tested for impairment on an annual basis and when indicators of impairment are determined to exist by applying a fair-value based test.

o) Revenue recognition

Revenues are recorded at the time of shipment of products to the customer. Revenue from inter-segment sales is recorded when the forest is harvested and sold; such inter-segment sales, which are generally made at prices that approximate market prices, are eliminated in the consolidated financial statements. The following criteria must be met in order to recognize revenue: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the price to the buyer is fixed or determinable; and (4) collection is reasonably assured.

p) Bonds

Bonds are shown at face value plus accrued interest less discount on issue of the bonds. The expenses incurred in the issue of the bonds are shown under other current and long- term assets and are amortized using the interest method of amortization over the term of the instruments. Total capitalized costs associated with bonds were U.S.$11.0 million and U.S.$10.0 million at December 31, 2007 and 2006, respectively.

 

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Notes to the Consolidated Financial Statements

q) Research and development expenses

The cost of research, project development and special studies are charged to income in the year in which they are incurred. The cost of research and development charged to income was U.S.$3.2 million, U.S.$3.2 million and U.S.$3.4 million for the years ended December 31, 2007, 2006, and 2005, respectively.

r) Software

External direct costs of materials and services consumed in developing or obtaining internal use computer software are capitalized. Payroll and payroll-related costs for employees who are directly associated with and who devote time to the internal use computer software project and interest costs incurred while developing internal use computer software are capitalized. Maintenance, training, data conversion and reengineering costs are charged to the results of operations as incurred. Purchased software is capitalized and amortized over the estimated useful life up to a maximum of three years. Capitalized software assets are classified in “Property, plant and equipment”.

s) Severance benefit plan

Arauco sponsors a retirement plan that covers certain employees. It has recorded a liability for long-term severance indemnities based on agreements it has entered into with its employees at certain of its companies in Chile. Generally, upon leaving Arauco, employees who have completed five years of service are entitled to one month’s salary for each year of service, up to the retirement age of 60 and 65 years for women and men, respectively. In accordance with Emerging Issues Task Force (“EITF”) 88-1, Arauco records the undiscounted obligation for this plan as if it was payable at each balance sheet date. Severance expense for this plan was U.S.$7.1 million, U.S.$3.9 million and U.S.$4.6 million, for fiscal 2007, 2006 and 2005, respectively. The severance liability is recorded in other long-term and current liabilities and amounted to U.S.$30.4 million and U.S.$24.0 million, at December 31, 2007 and 2006 respectively.

t) Acquisitions

During the year ending on December 31, 2007, Arauco made the following acquisitions:

On September 27, 2007, Arauco successfully concluded negotiations with Stora Enso Oyj, of Switzerland and Finland, and thereby incorporated into its acquisitions the assets that Stora Enso Oyj had acquired from International Paper in Brazil.

The acquired companies were as follows:

i) The subsidiary Arauco Internacional S.A. acquired an 80% controlling interest in Stora Enso Arapoti Empreendimientos Agrícolas S.A. (now Arauco Florestal Arapoti S.A.), which owns 50,000 hectares of land, including plantations of 25,000 hectares of pine and 5,000 hectares of eucalyptus in the town of Arapoti, Paraná, Brazil.

 

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Notes to the Consolidated Financial Statements

ii) The subsidiary Placas do Paraná S.A. acquired 20% of the capital stock of Stora Enso Arapoti Industria de Papel S.A., which owns a paper producing plant with a production capacity of 205,000 tons of paper per year, also located in the town of Arapoti, Paraná in Brazil.

iii) The subsidiary Placas do Paraná S.A. acquired 100% of the company Stora Enso Arapoti Serraria Ltda., which owns a sawmill with a production capacity of 150,000 m3/year, in Arapoti, Paraná, Brazil.

The initial purchase price of Arauco’s acquisitions in Brazil in 2007 has been allocated as follows:

 

     ThU.S.  

Accounts receivable

   $ 28,242  

Inventories

     8,117  

Other current assets

     6,586  

Non-current assets

     8,728  

Property, equipment and forest

     195,060  

Investment in affiliate

     14,311  

Current liabilities

     (28,415 )

Long-term liabilities

     (8,691 )

Deferred tax liabilities

     (15,573 )
        

Total purchase price

     208,365  
        

The following unaudited pro forma financial information reflects the results of operations of Arauco as if the acquisitions of the companies in Brazil described above had taken place on January 1, 2006. The pro forma financial information is not necessarily indicative of the results of operations as it would have been had the transaction been effected on the assumed date.

 

     2007    2006
(In thousands)    Pro forma    Pro forma

Net sales

   3,610,435    2,886,711

Net income

   709,119    639,975

On October 11, 2006, through the subsidiary Aserraderos Arauco S.A., Arauco acquired the company Norwood S.A. for U.S.$4.7 million. Goodwill amounting to U.S.$ 2.0 million was allocated to the Wood products segment. In 2007, the Company completed the purchase price allocation and reclassified U.S.$1.6 million from goodwill to property and equipment.

On November 10, 2006, through the subsidiary Arauco Internacional S.A., Arauco acquired the Argentine company, La Señora del Milagro S.R.L., for U.S.$5.4 million. Goodwill amounting to U.S.$ 2.3 million was allocated to the Forestry segment.

u) Initial application of SAB 108

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, "Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements." SAB 108 was issued in order to eliminate the diversity of practice surrounding how public companies quantify financial statement misstatements.

 

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Notes to the Consolidated Financial Statements

Traditionally, there have been two widely-recognized methods for quantifying the effects of financial statement misstatements: the “roll-over” method and the “iron curtain” method. The roll-over method focuses primarily on the impact of a misstatement on the income statement—including the reversing effect of prior year misstatements—but its use can lead to the accumulation of misstatements in the balance sheet. The iron-curtain method, on the other hand, focuses primarily on the effect of correcting the period-end balance sheet with less emphasis on the reversing effects of prior year errors on the income statement. Prior to our application of the guidance in SAB 108, the Company used the roll-over method for quantifying financial statement misstatements.

In SAB 108, the SEC staff established an approach that requires quantification of financial statement misstatements based on the effects of the misstatements on each of the company's financial statements and the related financial statement disclosures. This model is commonly referred to as a “dual approach” because it requires quantification of errors under both the iron curtain and the roll-over methods.

SAB 108 permits existing public companies to initially apply its provisions either by (i) restating prior financial statements as if the “dual approach” had always been applied or (ii) recording the cumulative effect of initially applying the “dual approach” as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to the opening balance of retained earnings. The Company elected to record the effects of applying SAB 108 using the cumulative effect transition method. The following table summarizes the effects (up to January 1, 2006) of applying the guidance in SAB 108:

 

     Period in which the
misstatement originated(1)
     Year ended
December 31,
    Adjustment
recorded as of
January 1,
2006
     2004     2005    
     ThU.S.$     ThU.S.$     ThU.S.$

Property, plant and equipment-deferred tax liability(2)

   28,236     16,311     44,547

Fair value of interest rate swaps (3)

   —       14,632     14,632

Effect on deferred tax liability of interest rate swaps (3)

   —       2,488     2,488

Impact on net income (4)

   (28,236 )   (4,167 )   —  

Retained earnings(5)

   —       —       32,403

 

(1) The Company previously quantified these misstatements under the roll-over method and concluded that they were immaterial.
(2) The Company’s subsidiaries located in Argentina and Brazil did not properly quantify and record in 2004 and 2005, a deferred tax liability for the temporary differences between book and tax basis on certain property, plant and equipment. As a result of this error, the Company’s income tax expense was understated by ThU.S.$ 28,236 and ThU.S.$ 16,311 for the years ended December 31, 2004 and 2005, respectively. The Company recorded a ThU.S.$ 44,547 increase in its deferred tax liability as of January 1, 2006 with a corresponding reduction in retained earnings to correct this misstatement.
(3) The Company did not record an asset associated with the fair value of certain interest rate swap agreements. As a result of this misstatement, the Company’s interest income was understated by ThU.S.$ 14,632 and income tax expense was understated by ThU.S.$ 2,488 for the year ended

 

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Notes to the Consolidated Financial Statements

December 31, 2005. The Company recorded a ThU.S.$ 14,632 increase in its other receivables and ThU.S.$ 2,488 increase in its deferred tax liability as of January 1, 2006 with a corresponding net increase in retained earnings of ThU.S.$ 12,145 to correct this misstatement.

(4) Represents the net over-statement of net income for the indicated periods resulting from these misstatements.
(5) Represents the net reduction to retained earnings recorded as of January 1, 2006 to give effect to the initial application of SAB 108.

v) New accounting pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS No. 157”). SFAS No. 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. This statement does not require any new fair value measurements; rather, it applies to other accounting pronouncements that require or permit fair value measurements. The provisions of this statement are to be applied prospectively as of the beginning of the fiscal year in which this statement is initially applied, with any transition adjustment recognized as a cumulative-effect adjustment to the opening balance of retained earnings. The provisions of SFAS No. 157 are effective for the fiscal years beginning after November 15, 2007 for financial assets and liabilities and November 15, 2008 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually); therefore, the Company anticipates adopting this standard as of January 1, 2008. It has not determined the effect, if any, the adoption of this statement will have on its financial condition or results of operations.

In February 2007, the FASB issued Statement No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (Statement 159). Statement 159 allows entities the option to measure eligible financial instruments at fair value as of specified dates. Such election, which may be applied on an instrument by instrument basis, is typically irrevocable once elected. Statement 159 is effective for fiscal years beginning after November 15, 2007, and early application is allowed under certain circumstances. The Company anticipates adopting this standard as of January 1, 2008. It has not determined the effect, if any, the adoption of this statement will have on its financial condition or results of operations.

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”) - An Amendment of ARB No. 51. SFAS 160 establishes new accounting and reporting standards for the noncontrolling interest in a subsidiary and for the deconsolidation of a subsidiary. Specifically, this statement requires the recognition of a noncontrolling interest (minority interest) as equity in the consolidated financial statements and separate from the parent’s equity.

The amount of net income attributable to the noncontrolling interest will be included in consolidated net income on the face of the income statement. SFAS 160 clarifies that changes in a parent’s ownership interest in a subsidiary that do not result in deconsolidation are equity transactions if the parent retains it controlling financial interest. In addition, this statement requires that a parent recognize a gain or loss in net income when a subsidiary is deconsolidated. Such gain or loss will be measured using the fair value of the noncontrolling equity investment on the deconsolidation date. SFAS 160 is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company does not expect the adoption of SFAS 160 will have an effect on its consolidated financial statements.

 

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Notes to the Consolidated Financial Statements

In December 2007, the FASB issued FASB Statements No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”). In this statement, the FASB retained the fundamental requirements of Statement No. 141 to account for all business combinations using the acquisition method (formerly the purchase method) and for an acquiring entity to be identified in all business combinations. However, the fair value principles in the revised Statement are a major change from Statement No. 141’s cost allocation process, together with other revisions from past practice. Among other changes, SFAS 141R requires the acquiring entity in a business combination to:

 

   

Recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions.

 

   

Recognize and measure the goodwill acquired in the business combination or a gain from a bargain purchase.

 

   

Expense acquisition-related costs, such as legal and due diligence costs, when incurred.

 

   

Recognize any restructuring costs that the acquiring entity expects to incur with respect to the acquired business as an expense, rather than capitalize as part of the acquisition.

 

   

Disclose to investors and other users all of the information they need to evaluate and understand the nature and financial effect of the business combination.

 

   

Recognize changes in the amount of deferred tax benefits that are recognizable because of a business combination either in income from continuing operations in the period of the combination or directly in contributed capital, depending on the circumstances.

SFAS 141R applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Earlier adoption is prohibited. The Company does not expect the adoption of SFAS 141R to have an effect on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161 “Disclosures about Derivative Instruments and Hedging Activities” (“SFAS 161”). The new standard is intended to improve financial reporting about derivative instruments and hedging activities by requiring enhanced disclosures to enable investors to better understand their effects on an entity’s financial position, financial performance, and cash flows. It is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008, with early application encouraged. The Company is in the process of evaluating the financial impact of adopting SFAS 161.

 

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Notes to the Consolidated Financial Statements

NOTE 2 - OTHER RECEIVABLES - NET

 

     December 31,  
     2007     2006  
     ThU.S.$     ThU.S.$  

Value added tax receivable

   46,570     78,603  

Income tax receivable

   34,895     —    

Related party receivables

   11,379     2,243  

Other receivables

   75,999     41,842  

Allowance

   (1,161 )   (1,777 )
            

Total other receivables - net

   167,682     120,911  
            

NOTE 3 - INVENTORIES

Inventories were valued in accordance with the policy described in note 1(f). The principal components were as follows:

 

     December 31,
     2007    2006
     ThU.S.$    ThU.S.$

Finished goods

   235,192    244,796

Work in progress

   22,628    14,528

Sawlogs, pulpwood and chips

   72,705    53,696

Raw materials

   80,941    67,484

Other parts and materials

   39,849    28,747
         

Total inventories

   451,315    409,251
         

NOTE 4 - PREPAID EXPENSES AND OTHER CURRENT ASSETS

 

     December 31,
     2007    2006
     ThU.S.$    ThU.S.$

Prepaid freight and other expenses

   89,603    69,169

Deferred tax assets

   —      1,269

Spare parts

   47,884    42,600

Other current assets

   24,492    17,355
         

Total prepaid expenses and other current assets

   161,979    130,393
         

 

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Notes to the Consolidated Financial Statements

NOTE 5 - PROPERTY, PLANT AND EQUIPMENT - NET

 

          December 31,  
     Useful lives    2007     2006  
          ThU.S.$     ThU.S.$  

Land and improvements

   —      659,810     585,770  

Buildings and improvements

   30 years    1,912,924     1,795,274  

Machinery and equipment

   12 years    2,914,035     2,771,776  

Construction in progress

   —      109,751     115,264  

Other

   12 years    267,731     253,812  
               
      5,864,251     5,521,896  

Accumulated depreciation

 &n