Telefonica looks to Europe

Nov 3rd 2005
From The Economist Global Agenda

Telefonica, Spain’s leading telecoms firm, has agreed to buy O2, a big British mobile operator. As Europe’s phone companies replenish their stocks of cash after some trying times, a new telecoms bubble looks increasingly likely

SPAIN has relied before on Latin America for its riches. Its colonisation of the New World in the 16th century paved the way for it to become, briefly, the world’s most powerful country.
Telefonica, formerly Spain’s state-owned telecoms monopoly—and currently Europe’s second-largest phone firm by market capitalisation—has based its strategy on strength in its home market and expansion in Latin America. On Monday October 31st, however, Telefonica broke with tradition and said that it would spend £17.7 billion ($31.5 billion) to buy O2, one of Britain’s leading mobile operators and the sixth largest in Europe. The price represents a hefty 20% premium over O2’s market value before the offer.

Telefonica’s decision to make its move for O2 comes amid a flurry of activity and rumour among Europe’s big telecoms firms. The Spanish firm also paid (some say overpaid) €2.7 billion ($3.3 billion) in June this year for a controlling stake in Cesky Telecom, the Czech Republic’s biggest phone company (and splashed out again to increase the stake to 69% in September). In July, France Télécom, another former state monopoly, bought 80% of Amena, Spain’s third-largest mobile operator, for some €8.5 billion. Several smaller cross-border deals have also been concluded.

Moreover, there is plenty of potential for further deals. TDC, Denmark’s leading phone company, has attracted the attention of several private-equity firms, and suggestions have emerged that Deutsche Telekom, Germany’s biggest phone company, and Swisscom, another market leader, may be interested too. And a couple of days after Telefonica's bid for O2, fresh rumours circulated that Swisscom was considering a bid of around €3 billion for Eircom, Ireland's former state-run telecoms operator. Telefonica and others have had their eye on KPN, a leading Dutch operator that recently bought a domestic rival, Telfort. KPN and Deutsche Telekom were mooted as possible joint bidders for O2. On Wednesday the German giant, also widely tipped to make a solo offer for O2, ruled itself out of the contest. Even so, it would seem that there are plenty of permutations for refashioning Europe’s telecoms landscape.

This new-found vigour comes at a time when the big phone companies have at last begun to recover from the ill effects of the industry's last burst of exuberance. The dotcom bubble brought forth new firms that hoped to build the infrastructure and capacity to support the internet. Telecoms incumbents, keen to grab a slice of the action, tried to turn themselves into global operators through the expansion of their existing networks and the acquisition of foreign firms. At the height of the boom, France Télécom famously splurged €40 billion on Orange, a British mobile operator.

Europe’s phone firms compounded their indebtedness by gambling on a leap in demand for mobile capacity, paying a whopping €100 billion or so for licences to operate “third-generation” (3G) networks. The expected demand failed to materialise and boom turned to bust. Telefonica made far fewer rash decisions than some of its competitors and weathered the crash better. But now Europe’s other big phone firms have regained lost ground, paying down much of their debt and piling up cash earned from their vast fixed-line businesses.

These former monopolies have clung on to a large proportion of the fixed lines that they ran under state control. But though this part of their business is lucrative, the opportunities it offers for growth are limited. Demand for additional fixed lines in home markets is slowing (Telefonica added only 3m in Spain between 1997 and 2004). Moreover, the incumbents face increased competition from new entrants, such as cable-TV companies, and this has hit profits. Prices are coming under even more pressure as internet-based telephony takes off. On the same day that Deutsche Telekom said it would not bid for O2, it unveiled plans to relieve the pressure of intense competition at home: it will reduce its German workforce by 19,000, some 11% of the total, over the next three years. The cuts will come mainly at the firm's fixed-line operations.

That is why the big telecoms companies have turned to mobile telephony and foreign markets to provide growth. Telefonica itself more than doubled its number of overseas fixed-line customers between 1997 and 2004, to over 23m; over the same period, its mobile business went from having 5m subscribers to 74m, both in Spain and abroad. Europe’s former monopolies have been keen to expand their mobile operations not only to boost revenue but also to allow them to offer bundled fixed, mobile and broadband services.

Most of Telefonica’s mobile growth has come in Latin America. The company began to expand there in the 1990s as the region’s state-owned telecoms operators were privatised. Now it is the biggest phone company in Brazil, Argentina, Chile and Peru. Nevertheless, its Latin American businesses have not grown as quickly as anticipated nor provided the hoped-for bumper profits. Volatile economies, political upheaval and depreciating exchange rates against the euro have conspired to disappoint.

In turning away from Latin America, Telefonica is gambling that its cash is better spent buying European mobile customers. Though it is paying a large premium for O2, it is getting its hands on a well-regarded brand in a country where consumers spend a lot of time making mobile calls and sending text messages.

The British firm makes a tempting target because, though it is small compared with some former monopolies, it generates healthy profits from its 25m mobile customers. It is particularly strong in two big markets, Britain (where it is jostling for top spot) and Germany. Moreover, Telefonica thinks it can squeeze out cost savings of €293m a year by 2008.

There are concerns that Telefonica may be paying over the odds to establish itself in Europe beyond the Iberian peninsular. Deutsche Telekom concluded that it would not counter-bid for O2 in part because of fears of antitrust action arising from its own big presence in the German mobile market. But the steep premium offered by Telefonica was probably the determining factor behind the German firm's reluctance to get involved. Although a bidding war between the Spanish and the Germans has been avoided this time, further battles may yet break out between industry giants with money to spare. If so, another telecoms bubble in Europe could be in prospect.

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