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Telefónica FindsGrowth in a Tank of Oxygen

Telefónica wants to grow bigger.Already, it is the largest telecomcompany in Spain, and it operates inMorocco, the Czech Republic, China,and several countries in LatinAmerica. Now Telefónica has tabledan offer worth 26 billion euros forO2, the second-largest cellularphone company in the United

Kingdom and a player in the German market.

Although another competitor could still launch a counter-offer forO2, that is highly unlikely because its largest rivals -- DeutscheTelekom, France Telecom and Telecom Italia -- have no intention of bidding for the British firm. In addition, since Telefónica has takenthe first step with its offer of 26 billion euros ($30.5 billion), othercompanies would have to raise their offers by at least 10% [if therewere another bid]. Deutsche Telekom, the largest telecom operatorin Germany, has already dismissed rumors that it might show someinterest [in O2]. For its part, the management of O2 has agreed toaccept Telefónica’s move, which means that they already havecommitted 0.03% of the capital in advance. Given the absence of legal barriers involving anti-competition law, everything pointstoward Telefónica taking control of O2. The Spanish firm predictsthat the process will be finalized by January 2006.

The negative aspect of the deal involves indebtedness. The netfinancial debt of the Telefónica group was €27.99 billion at the endof June, and it will almost double after the company takes onadditional debt of £18.5 billion (€27.2 billion) provided by the Royal

Bank of Scotland, Citigroup and Goldman Sachs.

A Very Logical Strategy

The deal is the largest European takeover in the telecom sector infive years, and it will inject plenty of fresh oxygen into Telefónica.

O2 will bring some €20 billion in additional revenues to Telefónica,as well as €2.6 billion in EBITDA (gross earnings), which willaccelerate Telefónica’s growth rate as well as its EBITDA revenues.

“I believe it is an excellent acquisition, since it positions Telefónicaas a global telecom operator,” says Javier Busquet, director of thesystems department of ESADE. “O2 is an extraordinary company. It

is innovative; it has a strong brand and a broad portfolio of

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elefónica Finds Growth in a Tank of Oxygen

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services.”

According to Telefónica, the acquisition will generate economies of scale worth €300 million a year simply by reducing the cost of purchasing equipment and improving cost-efficiencies along itsnetwork. Another source of synergies will be the acquisition of content and the development of applications and services. Inaddition, Telefónica, headed by Cesar Alierta, will become thefourth-largest mobile phone operator in the world, behind only twoChinese companies and Vodafone.

“The deal has a very clear logic,” says Joaquin Garralda, vice-deanof academic planning at the Instituto de Empresa (IE). “On the onehand, it will permit Telefónica to gain scale, which will favor costsavings in production. On the other hand, it will enable it toincrease the value of its customer network.”

The acquisition will allow Telefónica to diversify its business both interms of sectors and geographical regions. Until now, the Spanishcompany had focused its growth strategy on Latin America. Movinginto Europe, which offers less potential for growth but greatersecurity, will counter-balance the company’s risks in South America.Latin America’s share of Telefónica’s total income will drop from

34% now to 28%. However, Telefónica has no intention of abandoning the Latin American market, where it has competitiveadvantages. Despite its volatility, growth rates in that region aremuch higher.

“It is a golden opportunity for Telefónica, which needs to continuegrowing but in markets that are less volatile than those in LatinAmerica,” says Mauro Guillén , a professor of internationalmanagement at Wharton. Adds Busquet: “Telefónica has changedits method but not its strategy, which is to expand in strongmarkets. Choosing Europe does not mean that it is forgetting itsinterests in Latin America, where it is betting more on medium-termresults. Although achieving profitability is a slower process, LatinAmerica provides a large critical mass, especially in markets likeBrazil, Mexico and Chile.” To illustrate that point, at the end of lastyear, Cesar Alierta’s company acquired the Latin American cellularoperations of BellSouth, thereby expanding Telefónica’s presence inthat region. Telefónica already had a presence in Mexico and inBrazil, where it was a partner of Portugal Telecom. With theacquisition of BellSouth’s [cellular] assets in the region, thecompany is now also in Peru, Colombia, Argentina, Chile,Venezuela, Uruguay, Bolivia, El Salvador and Guatemala.

When it comes to sectors, the deal will also mean that Telefónica’scellular division (Movistar) will provide 48% of the company’s

profits, up from 38%. Building Customer Loyalty

The deal will mark an end to a lengthy chapter in Telefónica’shistory. The company will finally expand in Europe, where it has apresence in only two countries -- Spain and the Czech Republic.

“Europe is a profitable market, and it has great growth potential,not only in the number of customers, but in the profitability of manyof them,” notes José Ignacio López Sánchez , management professorat the Complutense University of Madrid. “You also have toemphasize the role that will be played by emerging nations of Eastern Europe.”





O2’s 24 million customers are all in three countries: The UnitedKingdom, Ireland and Germany. “With this move, Telefónica willenter the marketplace in Britain, Ireland and Germany where thereare some of the most profitable customers in the Old Continent,” explains Busquet. “Entering Germany means that the company willhave an excellent platform for penetrating the countries of EasternEurope.”

The attraction of the United Kingdom lies in the number of O2customers there. Half of O2’s revenues come from this market,

where O2 has a 22% market share. O2’s strategy -- whichTelefónica has announced that it will not change -- involves thefollowing: First, focusing on those users who have higher averageannual revenues (known as ARPU); second, reducing costs in orderto improve efficiencies; and third, investing those savings inwinning market share away from its competitors.

Ireland is a more complicated market. Although O2 boasts a 39%market share in that country -- behind only Vodafone (which has a50% share), O2 can be damaged in Ireland by such rivals as Meteorand Hutchinson Whampoa, a recent arrival. Ireland provides only9% of O2’s total revenues, but its customers have the highestaverage value of any country, with annual spending of 565 euros

($662), far above the 363 euros spent by the average German, andthe average of 414 euros spent by British customers.

In Germany, O2 has 8.4 million customers and a 12% marketshare. That makes O2 the third-largest mobile operator in thatcountry behind T-Mobile and Vodafone. In 2000 Telefónica tried toenter that market by buying third-generation (UMTS) mobiletelephone licenses. However Telefonica ultimately abandoned itsplans to develop a UMTS network in Germany. It expected to sell itsfrequencies and recover part of its investment. Nevertheless, if thedeal with O2 moves forward, Telefónica will strengthen its Germansubsidiary with those frequencies. The German market is thefastest-growing market for O2.

“This deal will enable it to expand the value of its customernetwork,” says Garralda. “Telefónica is interested in expanding thevalue of its network in order to capture new users and build loyaltyamong its current users, so that it is more competitive in the globalarena.”

Telefónica’s latest publicity campaign points in that direction. “Withits slogan, ‘In Movistar, we are more, and we pay less,’ thecompany is explaining that the more users there are [on itsnetwork], the less each user will pay. You can expect that in thefuture, mobile operators will become more profitable not merely by

reaching an important critical mass [in the number of customers],but by achieving interaction among their own users. Until now,operators have yet to produce that ‘positive network effect’ but it ispossible that such a thing could be created among users of thesame operator in the future, because of the scale they arereaching,” says López Sánchez.

Telefónica has 145 million customers around the world. Adding O2will enable it to expand its network of users to 170 millionworldwide.

The Trend tow ard the Old Continent

“This deal is especially beneficial for the British market and for the





European market in general,” says López Sánchez. “The arrival of astrong telecom operator will revitalize competition, and customerswill be grateful for that.”

If Telefónica acquires O2, it will be the latest in a line of acquisitionsmade by Spanish companies in Britain. A year ago, BancoSantander paid $15.787 billion for Britain’s Abbey Bank. Accordingto Thomson Financial, the research firm, starting in October 2004,Spanish companies have played a leading role in corporatetakeovers that is the equivalent of 34% of the total value of all

corporate acquisitions in Britain. Of the £83.41 billion (€122.6billion) that non-U.K. companies have moved into Britain sinceOctober 2004, £28 billion came from Spain. The Spanish pioneerswere Ferrovial, which bought Amey ( a company that maintains andupgrades the Metro lines in London) and Albertis, which acquiredTBI (which manages the Luton airport.)

However, the U.K. is not the only object of desire for Spanishcompanies. In France, Metrovacesa, the Spanish real estate firm,purchased Gecina for €5.5 billion. Inmobiliaria Colonial took overSociété Foncière Lyonnaise for €1.558 billion. In addition, Fadesa,the property development company, acquired a small firm calledFinanciere Rive Gauche. Finally, BBVA tried to buy BNL, the Italian

bank, before ultimately giving up its attempt.

The key reasons for moving into Europe are the following: Spain’sbiggest companies have cleaned up their accounts, and they have agreat deal of liquidity and foreign experience. Moreover, they nolonger look exclusively at Latin America as their focus for growth.This doesn’t mean that the Spanish companies have abandonedLatin America. “It’s not a question of chance but of circumstances,” says López Sánchez. “There was a time when the big Spanishcompanies, such as Telefónica, Repsol YPF, Santander, Endesa andBBVA, identified opportunities in South American countries that theycould not afford to miss out on. Their maxim is to diversify andcontinue to grow. For more than 10 years, the European marketoffered no options, but nowadays things have changed.”

“At first, Spanish companies preferred Latin America because of thelanguage, the cultural proximity [to Spain], and the room forgrowth that those markets provided, even if they were volatile.Now, however, economic problems are making that growth moredifficult,” says Garralda. “As a result, Spanish companies havedecided to grow in Europe instead.” Nevertheless, Garralda addsthat they have entered only a few sectors, such as banking, a fewutilities, construction and real estate. “Spanish banks are verycompetitive globally, and have a very good scale of operation. Inaddition, they have had a presence in Latin America for several

years. For their part, the real estate firms have chosen Europebecause they are thinking about using markets like France andGermany as springboards into Eastern Europe.”

“Spanish companies will continue to look at Europe, and they willalso try to penetrate the United States,” says Guillén. “Within a fewyears, they will look more towards Asia.” López Sánchez agrees that

“in the very short term, Europe is where people are looking, mainlyin the telecom sector and banking. Longer term, the rest of theworld is their goal. What happens in the future will be determinedby the circumstances at any particular moment. Other key factorswill be companies’ strengths and weaknesses, and the opportunitiesand dangers in the market.” Adds Garralda: “Companies will





continue to look for markets both in [Western] Europe and inEastern Europe.”

Publish Date: Nov 30, 2005

Enlaces Spain’s Largest Bank Reenters U.S. Market: Let the CompetitionBegin, Again: Universia-Knowledge@Wharton Telmex and Telefónica Step on the Gas Pedal in LatinAmerica:Universia-Knowledge@Wharton

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