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This third article in our series on economic value added (EVA) looks at how businesses generate value as a system. This takes us much more into a more expansive thinking space - one where the basic economic principles of valuing cashflows are taken as read and where the main thing now is to use these techniques imaginatively to explore the possible value of a novel business model.

Entrepreneurs understand how economic value is generated as a system, but managers and accountants alike frequently struggle with the idea. For example, in my earlier series of articles on strategy, we looked at Virgin Galactic, a venture in economy space flight. Using the Optopus tool, we generated myriad ideas for possibilities, implicit in which were a large number of possible value-creating activities. Out of these Richard Branson might pick up on things like:

  • the venture is a lot more than putting bums on seats in space - assuming that they could be made to stick to them!
  • the obvious strand was the additional media-related opportunities
  • and sponsorship
  • together with creating a bigger range of flights and destinations
  • with a lot more going on before, after and during each flight - stretching the value over time curve (see again my earlier series of articles on strategy)
  • with much more refined customer segmentation, etc.

So it is quite possible that in understanding the latent value of this business model it could be of an order of magnitude different to what was originally envisaged. In this business model the whole is truly greater than the sum of the parts. In short, it is a system and it is these systemic properties that we will now explore.

The business value system

The idea for the business value system originally came to me in my doctoral research over 20 years ago into the linkages between strategy and EVA.

A chance comment by the then director of corporate strategy at Rolls-Royce Aero engines, Simon Hart, on the topic of interdependences was: 'The real money comes when the customer says, I will have an aeroplane, I am going to take your engine, and I have a customer lined up who says he will buy 30 aircraft - and all these factors line up.'

So economic value more often than not is captured when certain conditions are lined up. This means that when looking at the value of a business, of a project or something more micro, you have to take a holistic view and not one that is unduly narrow. I gave this the motto 'vision helps value'. Nowhere is this truer than in the football industry to which we now turn.

Value in the football industry

Around 1994 - 95 two important things happened. First my son James, who was then about 11, decided he wanted to go to watch Arsenal. I hadn't been to a football stadium for 25 years - when I had run on to the pitch at Manchester United and a policeman threw me back over the wall. So after those years in the wilderness, I was reborn - as an Arsenal fan.

The second thing was that three of my MBA students decided to do a project on the football industry. They looked at the big teams and only one had consciously adopted a strategy: Manchester United. The project concluded that the new business model developed by United had vast potential for economic value creation.

At the time United was, in EVA terms, still modestly small. Prior to the development of satellite TV, which then cornered the major rights to broadcast the Premier League, United's turnover was around GBP10m a year and its profit GBP1m; that turnover is around 3% of what it is now.

Recapping on the strategy series, Porter's five competitive forces for the football industry look like this:

  • buyer power: very low - very favourable force
  • entry barriers (to the top tier): very high - very favourable force
  • business rivalry (to acquire fans): low - favourable force
  • substitutes: very low - very favourable force
  • suppliers: very high - very unfavourable force.

From this we can see that the margin environment (at least within the top clubs) would be very positive, save for the one force of supplier power - the players and their agents. So does that matter? Yes, it does - a lot! For that power means whenever new revenue is created by the clubs, around half of it seems to fall into the hands of the players in a process that has been described as 'financial diarrhoea'.

There is a very important lesson here for EVA: only a single competitive force needs to be wrong to act as a major drain at the operating profit margin (OPM) level and ultimately on EVA.

In my last article I mentioned the supermarket price war in the early 1990s in the UK, foretold in a case study published just before this war crystallised. New low-cost players like Aldi and Netto came in undercutting the major players; this had the effect of increasing rivalry and also the bargaining power of buyers - as well as reducing entry barriers. The result was GBP1bn was wiped off industry margins in a single year.

Now let's look at the value-creating activities of the Premier League football industry, as shown in the diagram opposite.

At the centre of the system is 'match performance'. Without the game itself there would be no revenue, full stop. If match performance were continually bad, then the system would suffer too.

Match performance drives not only gate takings (indeed, prior to 1990 that was about it as far as the model went), but also sales of merchandise, which was an engine of growth particularly at United in the 1990s. But by the late 1990s satellite TV became an even more important source of revenue, fuelling the system.

After this wave of extra revenue in the post-2000 period, especially towards the end of the first decade, more revenues swept in from sponsorship - from stadium naming rights (for example, at Arsenal 
and Manchester City) and the like. Each time a new wave of money 
swept in, the players simply got wealthier, with wages sometimes over GBP200,000 a week.

Two subsystems are apparent in the model shown in the diagram. One is the role of the brand in reinforcing revenue generation; the other is the subsystem which deals with player attraction, acquisition, development and disposal. The brand also loops into new player attraction.

On the topic of brands, two other clubs now vie with United: Chelsea and Manchester City. Both have spent hundreds of millions of pounds to do so. Chelsea has won some key trophies, including the 2012 European Champions League, putting its brand even more on the map. City also wrested the Premiership title from United on goal difference in 2011/12 and staked its claim to be a serious longer-term rival.

Interestingly neither of these clubs actually makes any money; in fact, they lose it in buckets, all because of the supplier force in Porter's five forces (as explained in my series on strategy) and the sheer salaries they are paying. Maybe their investment will pay off in the longer term - the see-saw effect described in the last article on EVA - or maybe it won't.

Power of Porter

So while the business value system of the top clubs is an interesting model commercially, the effects are spoilt by just one of Porter's forces, combined with the desperation of the City and Chelsea owners to win trophies - they are billionaires and indulging in what seems to be a hobby.

Two of the top clubs do try - and succeed - in making money still: Manchester United and Arsenal.

United was once a plc but after a leveraged buyout in 2005 is now very much run as a business, albeit with a mountain of debt (reducing by GBP60m a year) and high interest bills. Arsenal is also a conservative club and while there are overseas investors Arsenal has never had the massive influx of money that Chelsea and City have. While the accountants are happy, on the pitch it shows at Arsenal: no trophies for seven years, partly because of underinvestment. The elements of the business value system are hugely interdependent and affect the financing systems too.

The lessons

Now stepping back a little from this industry, we have seen:

  • The business value system evolves over time.
  • This can happen in an emergent way or a deliberate way
  • It can be accelerated if there is an appropriate strategic vision
  • This can generate increasing and leveraged value added - with one area of value generation playing off the other
  • Or it can end up being far too dilutive or complicated
  • Potential value creation can get destroyed by an adverse set of Porter's five forces.

In my next article we will do a 'deep dive' into the business value system by looking closer at value and cost drivers.

Dr Tony Grundy is an independent consultant and trainer, and lectures at Henley Business School in the UK.

www.tonygrundy.com