Some Serious Questions Confront the Latest Telefónica Spectacle

Once again, everyone is talking about Telefónica. The Spanish phone company is immersed in two ambitious deals that could wind up being the tip of the iceberg in its new growth strategy. The deals involve Brazil’s Vivo and Italy’s Telecom Italia. However, Telefónica’s strong appetite for acquisitions is making markets suspicious. On the one hand, Telefónica can wind up paying a very high price for control of Vivo. On the other hand, its move for Telecom Italia will demand a premium of 30% over the current price of that company’s shares. That spells bad news for Telefónica, which promised investors at a meeting last May that it was committed to limiting its purchases to 1.5 billion euros ($1.97 billion) in 2007.

 

That promise now seems impossible to keep given the plans on the table. On the one hand, the price of the Vivo deal could shoot up to 2.5 billion euros. The player responsible for this growth is Portugal’s Sonaecom, which has launched its own takeover offer for Portugal Telecom, which together with Telefónica, controls 63% of Vivo. However, if Sonaecom takes control of PT, then Telefónica would wind up having total control of Vivo.

 

The higher the price Sonaecom pays for its Portuguese rival, the higher the price that Telefónica will have to pay for Vivo. That’s because Vivo shares represent 22% of the total value of Portugal Telecom, according to Ahorro Corporación, a Spanish research firm. This explains why doubts have arisen in the market now that Sonaecom has raised its takeover price for PT by 10%. This will make it more expensive for Telefónica to pursue its plans to acquire Vivo.

 

People are starting to wonder: Will Telefónica buy [Vivo] at any price? Can one confidently expect Telefónica to wind up closing the deal? “To the extent that it meets with the limitations announced in its latest meeting of shareholders, I believe the answer is yes,” notes Julian de Cabo, deputy director general of the Instituto de Empresa, a business school, and an expert in telecommunications. Adds Esteban Garcia-Canal, a professor in the management department of the University of Oviedo, Spain: “It is more likely that it [Telefónica] will purchase PT’s ownership in Vivo because that involves increasing its ownership in a company where it already has a presence and which it already controls in partnership with PT. Nevertheless, the deal will have to await the resolution of its takeover offer for PT.”

 

In contrast, the market is a lot more dubious about Telefónica’s possible takeover of Telecom Italia. That news was only recently announced. Telefónica is negotiating with Pirelli to acquire its 30% ownership in Olimpia, a company that owns 18% of Telecom Italia. It didn’t take long for the Italian government to react. In an interview with Il Sole 24 Ore, Paolo Gentiloni , Italy’s minister of communications, made it clear that his government wants control of Telecom Italia’s network “to remain in the hands of investors from this country.” This means that it will be very hard for Telefónica to take control of the Italian company, especially now that it has been confirmed that the Italian executive branch has pulled all the strings at its disposal to thwart the arrival of foreign companies in such strategic sectors as banking and highways.

 

This complex scenario has raised doubts at Goldman Sachs, the investment banking firm, which has said in a research report that “it is not very likely that Telefónica is interested in buying a minority position that would provide it [Telefónica] with neither clear control [of Telecom Italia] nor any important synergies.” GarciaCanal agrees with that view. “The Italian deal makes sense on paper. but in practice it seems impossible to implement in a satisfactory way. Given the current condition of the industry, you cannot justify the deal [for Telecom Italia] if it is not about controlling the [Italian] company, and that doesn’t seem possible,” he notes. GarciaCanal adds that “It seems the markets believe that it is impossible to obtain any synergies [from such a deal] so they have reacted negatively” to it.

 

Such doubts have removed much of the luster from the promising forecasts that analysts had predicted for Telefónica. From the beginning of 2006, the target price of Telefónica jumped from 14.8 euros to 18 euros per share, according to a consensus of forecasts gathered by FactSet Research Systems. The positive forecasts have been based on two factors: the quality of Telefónica’s management and its low price-earnings ratio, compared with the rest of the sector.

 

However, as de Cabo notes, the market’s confidence in Telefónica could be punctured if the company does not pursue the investment policy it announced earlier. As de Cabo points out, “Every executive who has ever managed a publicly traded company knows that share prices don’t always run in parallel with what makes rational sense for the business, in terms of what happens from day to day.”

 

Expanding to Survive

 

Despite such doubts, analysts applaud Telefónica’s spirit. “Telecommunications is a market that has a significant total volume of business. Both deals seem very complementary with Telefónica’s geographical coverage. Their goals are perfectly understood by the current management, a fact that enormously simplifies their potential,” said de Cabo. “Finally, a significant part of managing effectively is about knowing when it makes sense to grow and when your priority should be to streamline operations. At the moment, Telefónica is maintaining a sensible balance between both considerations,” he adds.

 

“The problem facing telecom companies,” Garcia-Canal adds, “is that their growth possibilities are very limited. They depend on concessions for licenses that are in the process of being deregulated, or on taking control of other telecom operators who are in the process of privatizing or re-structuring their base of shareholders. All of these options depend on factors outside the control of the company. This leaves companies no alternative than to take advantage of opportunities presented to them [by a takeover]. Otherwise, they have to wait for another opportunity, and they don’t know when that will show up.”

 

Although both deals pursue the same goal of achieving greater scale, the two deals have different meanings for Telefónica. “The Vivo deal means strengthening its control over the Brazilian company in a context where they have maintained an alliance with PT. However, joint control of Vivo no longer makes sense. The Telecom Italia deal would be justified by the possibility of getting control of the Italian telecom operator. A priori, the two moves make sense, but the more reasonable strategy for Telefónica is to strengthen its network in Latin America and to expand in Europe,” notes Garcia-Canal. Nevertheless, he suggests that “there is no chance of taking control of the Italian company, given the composition of the company’s shareholders and the unsuccessful record of other Spanish companies in Italy” when they sought to take control of Italian companies.

 

Whatever happens, experts emphasize that Telefónica will continue to look for buying opportunities because that approach appears to be the most feasible way to guarantee growth in a market that is becoming increasingly concentrated, and where Telefónica is losing influence in its own market, Spain. In the domestic market, says Garcia -Canal, “the most that Telefónica can hope for is to preserve its market share while giving up ground on its [financial] margins. For that reason, acquiring other telecom companies in foreign countries is a more attractive road to growth for the company [Telefónica], especially when some diversification deals, such as the deal involving Endemol– [Telefonica owns 75% of this television-production company, which is based in the Netherlands] — have not led to the anticipated results. In addition, now that markets have already been deregulated in many countries, it is not always easy to attain growth by taking control of other telecom operators, especially because of the large size of these companies and [the key role of] local interests [in those countries].”

 

In recent months, the growing competitiveness of the Spanish market has led to the appearance of new operators, such as Carrefour or Yoigo. Some of Telefónica’s rivals are trying to enter new markets by providing more reasonable prices than Telefónica charges. At the same time that prices are dropping, the tariff system is also changing in Spain. This will force Telefónica, like other companies, to charge by the second instead of structuring their calls in blocks of 30 seconds, as they have until now. This change in the regulations has forced Telefónica to raise its rates so that it can maintain its margins. This approach has not only sparked controversy, but it could lead many customers to go elsewhere.

 

Telefonica’s interest in gaining scale can be explained by conditions outside Spain. Telefónica is already one of the leading companies in Latin America . The question is, can they gain the same leading stature in Europe? “It will be very hard to do in Europe what they have done in Latin America ,” warns Garcia-Canal, “but Telefónica should be called on to play a more important role in Europe than it currently plays.” Nevertheless, he adds, “The Telecom Italia option is neither a necessary nor a sufficient condition for achieving that goal. In the future, we will see trans-border mergers and acquisitions between telecommunications companies but they will be deals that involve great complexity. As I have already said, that’s because of the scale of these companies’ operations and because of [the role of] local interests [in those countries]. Deals such as France Telecom’s purchase of [80% of] Spain’s Amena are less complex in every sense, and they mark the road for the industry to follow.”

 

When De Cabo is asked to recommend which company Telefónica should buy, he notes that there is another way for Telefónica to expand. “I don’t know if I would recommend that they buy [another company] but that they accelerate their initiatives in the world of digital convergence, which is going to be critical for guaranteeing their ability to compete in the [world’s] most advanced markets.”

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