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his study examines the linkages between relatedness and synergy in the context of diversification among U.S. pharmaceutical firms for the period 1960-1980. Rather than assume
(as in the entropy, Herfindahl and concentric indices of diversification) that the levels of synergy
generated by different related combinations of business units are identical, we estimate synergy
directly using a modified version of the concentric index. In addition to estimating synergy
using capital market performance of the firm as a whole, we examine the effects of nondrug
diversification on the innovative productivity of firms' pharmaceutical divisions alone.
Our two main findings are that production relatedness, such as that between drugs and
chemicals, in fact did not imply synergy over the period of our study; and that the patterns of
synergy for different types of relatedness shifted over time with the industry life cycle.
{Diversification; Synergy; Industry-Evolution; Pharmaceuticals)
1. Introduction
If diversification strategy is to succeed it is imperative
that synergy, or super-additivity' in valuation of business combinations, be achieved. The failure to achieve
expected synergies in large part accounts for the mixed
success of diversification strategy among U.S. firms
(Amit and Livnat 1988, Porter 1987). As Reed and
Luff man (1986) have written, "while the benefits of
synergy are truly legendary... as every student knows,
those particular benefits show an unshakable resolve
not to appear when it becomes time for their release."
Given that many combinations of businesses fail to
achieve synergies, it is important for both researchers
and corporate strategists to be able to identify reliable
' By synergy, we mean super-additivity in valuation of business combinations. In simpler terms, synergy means that the valuation of a
combination of business units exceeds the sum of valuations for stand
alone units.
Economies of scope (cost sub-additivity) would produce synergy,
but so also would revenue-side advantages of combinations.
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0025-1909/93/39n/1334$01.25
Copyright 1993, The Institute of Management Sciences
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The strategic importance of the drug-chemical dissynergy should not be underestimated. Hill and Hansen
(1991) found that pharmaceutical firms had few opportunities for related diversification in SIC 2800
(Chemical and Allied Products), and that attempts in
this direction were not associated with value creation.
Furthermore, the existence of drug-chemicals dissynergy
provides strong explanation for the nonentry of most
U.S. chemical firms into pharmaceuticals (refer Table
1), despite the fact that pharmaceuticals are among the
most profitable industries in the U.S. (Comanor 1986).
3. Analytical Framework
There are two approaches to the measurement of relatedness in the literature. Existing measures of relatedness have tended to be described as categoric (Wrigley
1970, Rumelt 1974) or continuous (Montgomery 1982,
Palepu 1985); however, the critical difference between
them is not in the scale of their data but rather in their
approaches, judgmental versus mechanistic, to determining relatedness.
The categoric measurement of relatedness, originated
by Wrigley (1970) and more fully developed by Rumelt
(1974), is judgmental in nature as it depends greatly on
the individual researcher's judgement for its execution.
In this approach, classification of relatedness is based
on business units being "in some way" related through
"common skills, resources, markets, or purpose" (p. 29).
The correct use of Rumelt's schema requires that the
researcher have intimate knowledge of each of the many
firms to be classified, as well as extensive knowledge of
different types of relatedness at all points of the value
chain across all industries. Then, in a manner that is
difficult to specify and to replicate, relatedness is determined by the researcher as an implicit weighted average of similarities/dissimilarities at different points
of the value chain. These informational and judgmental
demands have led researchers to search for alternatives
that were simpler to use and more straightforward to
replicate.
output-based rationale of relatedness by 2-digit SIC codes, healthproducts (3800) and drugs (2830) appear to be unrelated, but they
are clearly related on the basis of marketing to hospitals and physicians.
Table 1
25 Largest
Chemical Firms
Nondrug Chem.
Drug
Pharmaceutical Firms
Nondrug Chem.
Drug
(Rank-ordered)
% Total Sales
% of Total Sales
(Rank-ordered)
% Total Sales
% of Total Sales
2.5
0.0
0.0
0.0
0.0
0.0
0.0
75.0
Pfizer
15.0
25.0
Upjohn
20.0
38.4
0.0
0.0
35.0
Richardson-Merrell
10,0
34,6
Searle
10,0
38,7
Squibb
23,4
Winthrop/Sterling
0,0
0,0
American Cynamid
30.0
9,0
Syntex
18.3
51.7
Robins
0,0
0,0
0,0
0,0
0.0
75,0
Du Pont
99.0
0.8
Dow Chemical
54.3
10.6
6.6
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
0,0
0.0
0.0
9.0
0.0
0.0
0.0
0.0
0.0
0.0
0.0
Exxon
Monsanto
38.7
Union Carbide
63.2
Celanese
100.0
Shell Oil
18.6
10.3
Atlantic Richfield
8.3
WR Grace
50.1
Allied
24.2
Phillips Petroleum
16.8
Gulf Oil
9.0
Occidental Petrol.
19.7
Eastman Kodak
18.9
Mobil
Hercules
3.0
100.0
American Cyanamid
30.0
93.2
Stauffer Chemicals
88.1
Tenneco
11.9
Texaco
2.6
Ethyl Corp.
62.6
US Steel
11.5
Borden
33.7
Merck
Amer. Home Prod.
Eli Lilly
Smith Kline French
Johnson & Johnson
Bristol-Myers Co.
Warner-Lambert
Schering-Plough
Abbott
Eaton-Norwich
Rorer
Marion
Block
Pennwalt
Carter-Wallace
Baxter
31,5
45,3
52,1
18,8
25,4
23.0
25.9
23.0
15,8
75,0
86,0
23.0
50.0
6.0
0.0
0.0
34.0
5,6
In contrast to Rumelt's (1974) methodology, the continuous measures of relatedness suggested by Montgomery (1982) and Palepu (1985) are mechanistic in
their application. These measures are based on the assumption that all relatedness between business units is
fully delineated by 2-digit SIC codes. Thus, using this
single criterion, combinations of business units within
the same 2-digit code are deemed as related, and therefore, synergistic, while combinations of units with different 2-digit codes are deemed as unrelated, having
neither synergy nor dissynergy. The most commonly
used of these continuous, mechanistically generated
measures are the Herfindahl index (Berry 1974, Montgomery 1982), the entropy index (Amit and Livnat
1988, Jacquemin and Berry 1979, Palepu 1985), and
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Dissynergy exists.
1338
Concentric Index
(1)
1=1 y=i+i
where f, denotes the proportion of corporate assets invested in industry I, and Stj is the coefficient of synergy
between industries ; and ;. This index is designed to
approximate the contribution of relatedness to synergy
across all business combinations of the firm. In the
studies by Caves et al, (1980) and Montgomery and
Wernerfelt (1988) mentioned above, the values for the
coefficient, Sy, were mechanistically imposed and arbitrarily assumed to be 1 if industries i and / have the
same 2-digit codes (hence are "related"), and assumed
to be 2 if industries i and ; have different 2-digit SIC
codes (hence are "unrelated"). These studies also computed the concentric index at the 3-digit level,^ We will
use the concentric index in Equation (1), but will replace
the mechanically imposed coefficients Sjj with statistically estimated valuesOLS coefficients on variables
{Fi*Fj), such as (% drugs*% chemicals) or (% drugs*%
health). When S,y is estimated to be positive, there is
synergy between industries i and;', When S^ is negative
there is dissynergy in combination of industries i and
' Caves et al, (1980) and Montgomery and Wernerfelt (1988) overcome an important limitation of the SIC by using 3-digit SIC codes
as the basis for relatedness. Many 2-digit categories are very diverse
and thus when used as the sole basis for relatedness, relatedness is
often overstated. However, Davis and Duhaime (1992) (discussed
above) show that both 2-digit and 3-digit SICs fail to effectively capture relatedness, as output-based relatedness often goes across 2-digit
SIC codes. It is this latter type of relatedness which is not captured
by the SIC (2-digit or 3-digit) on which we focus our attention.
j . When Sij is zero, there are neither synergies nor dissynergies. Equation (1) is thus a linear approximation
to some true but perhaps more complicated formula for
synergy (super-additivity).
We will estimate the synergy coefficients S,y as follows.
For the moment, we will develop our model under circumstances where only physical capital and synergy
contribute to the value of the firm, so that we may focus
on the role and measurement of diversification. Later,
in the empirical section, we will add back into the model
prior to estimation other important factors that contribute to valuation of thefiirm,such as short-term disequilibria and intangible capital. Consider first operations
in only two industries i andj. Denote the physical assets
invested in industry i as K, and physical assets in industry / as Kj. These assets are appropriately measured
at replacement cost value. With no short-run industry
shocks and no intangible capital, we may approximate
the capital-market value (denoted M) of a diversified
investment in both industries as:
M = (Ki + Kj) +
(2)
(5)
(6)
;#drug
r^-
(^^
Kj *Kk* Sjk
K
K
/V
2 m
where Idmg denotes drug innovations and R&Ddrug denotes pharmaceutical research and development expenditures (properly capitalized). The coefficients of
synergy Pj indicate whether the combination of pharmaceuticals and industry ' / ' improves or worsens the
1339
Table 2
Sample Firms
1. Abbot
24. Mallinkrodt
2. Alcon
3. Allergan
26. Merck
4. American Cyanamid
27. Merrell
7. Armour
30. Pennwalt
8. Baxter
31. Pfizer
9. Block
32. Plough
11. Calbioghem
34. Robins
13. Chattem
36. Rorer
14. Cooper
37. Schering
15. Cutter
38. Searle
16. Dow
17. Dupont
40. Squibb
41. Sterling
42. Syntex
43. Upjohn
21. Key
44. US Vitamin
22. Lilly
The sample for this study consists of 45 major U.S.owned firms participating in the drug industry. These
firms have been identified by FDA approvals of new
chemical entities (NCEs), U.S. patent office filings of
bio-affecting compositions, and scholarly studies of the
pharmaceutical industry (refer Table 2 for the list of
sample firms).
Data for 'M', constant dollar stock market value of
common equity, are taken from the COMPUSTAT tapes
and supplemented by the National Stock Summary. Stock
prices are deflated by the U.S. GNP deflator.
Data for R&D are a distributed lag of defiated corporate expenditures for research and development. R&D
expenditure data are from the COMPUSTAT tapes,
supplemented by corporate inquiries in 5 percent of the
cases where there were missing data, and are deflated
by the U.S. National Institutes 'of Health (NIH)
biomedical deflator. Weights for the distributed lag are
from Thomas (1990) (adapted from Wardell et al. 1982
and Hansen 1979). The estimates of pharmaceutical
R&D used by this study (when reported accounting data
were not available) were provided by the strategic
planning divisions of two large U.S. drug firms. These
corporate estimates were used in approximately 5 percent of all observations. The data provided by both firms
23. Marion
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Miles Labs
Allergan
Mead Johnson
Armour
Parke Davis
Calbiochem
Plough
Cutter
US Vitamins
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-I- ajGROW
+ 2 2 h*Fi*S,A. (7)
Equation (7) is nonlinear in the independent variables: K, R&D/K, GROW, and the disaggregated components of the Concentric Index. Taking logarithms of
both sides of Equation (7), using the approximation
that X log(l + x) when x is small, we have a linear
approximation ^:
' This procedure and specification is based on the work by Montgomery
and Wemerfelt (1988).
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+ 2 2 F,*Fy*S,;.
(8)
i'yfy.
(9)
(10)
5. Results
The effects of diversification on the stock market value
of common equity of the 45 sample firms of this study
are estimated using Equation (8) and reported in Table
3. The key coefficients are the S^ terms of the estimated,
disaggregated concentric index (defined above in Equation (1)). We examine the pharmaceutical firms' diversification into four industries: two industries, general
chemicals and agricultural products (predominantly
pesticides and veterinary drugs), that have the same 2digit SIC code (2800) as pharmaceuticals, and two in-
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DAVIS AND
THOMAS
Table 3
OLS Estimates of Diversification Contributions to Stocic Market Valuations, U,S, Pbarmaceutical Firms, 1960-1980
1960-1980
Time Periods
Independent
Variables
Intercept
In (Book value)
R&D/Book value
Growth
Drug*Chemicals
Drug* Health
1960-1962
Drug* Other
1975-1980
Variable
*(year-60)
Variable
-0,17
0.68
-0,09
-0.31
1,32
-0.10
(3.21)
(-0.28)
(-1.13)
(4,85)
(-5,14)
0.89
0.95
(19.67)
(32.99)
1.08
(30,83)
1.14
(45.92)
0.95
0.01
(27,43)
(2,49)
7.10
9,03
5.04
2,26
4.33
-0.07
(6.09)
(4.87)
(3.39)
(2.08)
(3.21)
(-1,40)
0,72
0.46
0.34
0,47
0.33
0.01
(2.35)
(2,72)
(1,30)
(1.14)
(2.55)
(0,21)
0.40
-2.80
-5,73
-4.06
-2.80
-0.19
(0,21)
(-2,68)
(-3.50)
(-2.97)
(-5.14)
(-1.04)
-2.17
0.51
(-0.85)
1.20
2.91
-0.86
0.12
(1.33)
(4,96)
(-1.46)
(3.85)
-3.02
1.66
6,30
4.85
3,02
0.15
(-0.96)
(1.25)
(3.95)
(5.10)
(3.64)
(0.96)
0.54
-0.48
1,84
0.05
0.94
-0,05
(0.65)
(-0.85)
(2.04)
(0.11)
(1.33)
(-0.75)
0.92
1969-1974
(-0.33)
(-2,39)
Drug*Agrlc,
1963-1968
79
0.22
0,87
195
0,26
0,86
212
0.93
194
0.18
0.88
693
0,31
0.23
Notes: Dependent variable is logarithm of constant-dollar stock market value of common equity for each observation.
f-statistics in parentheses.
The right-most specification pools all 4 sample periods and 16 independent variables, i.e., 8 base variable and 8 interaction terms
comprised of the base variable multiplied by (year-60) for each observation.
1344
Table 4
Intercept
1960-1962
1963-1968
1969-1974
1975-1980
-1.85
-3.09
(-5.72)
-4.11
(-5.07)
-7.16
(-6.02)
0.97
(4.61)
1.49
(6.20)
(-3.77)
Log (R&D)
0.30
(2.50)
0.84
(5.25)
Log (% Drug)
1.02
(2.91)
0.60
(2.60)
% Chemicals
2.19
(1.52)
-1.15
(-2.14)
-1.40
(-2.06)
-1.55
(-2.27)
% Health
0.52
(0.47)
0.94
(1.22)
0.14
(0.64)
1.66
(1.86)
% Agriculture
0.70
(0.53)
0.50
(0.77)
0.64
(1.05)
1.02
(0.97)
Chi-squared
Dispersion parameter
Observations
38.7
1.34
123
65.1
0.84
250
0.63
(2.13)
74.6
0.82
230
0.57
(2.19)
135.7
0.56
211
the findings of Tables 3 and 4 to be in one-to-one agreement, and thus are not surprised when there are differences between the two tables. In the case of health
care, the expected synergies during the later sample
years are probably due to marketing of given innovations, not discovery of more innovations. Such noninnovative synergies will not be captured in Table 4. In
the case of agricultural products, any drug-agriculture
synergies may well occur in agricultural innovation, not
in discovery of new drugs for humans that is the basis
for Table 4. Synergies realized outside the human pharmaceutical industry will not be captured in Table 4.
6. Conclusion
Though our study focussed on the historic patterns of
diversification within the pharmaceutical industry, our
findings are generalizable to other industries. Our contribution to diversification research derives from our
exploration and testing of the critical assumption that
all relatedness is synergistic. We studied the assumption
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