Telefónica wants to grow bigger. Already, it is the largest telecom company in Spain, and it operates in Morocco, the Czech Republic, China, and several countries in Latin America. Now Telefónica has tabled an offer worth 26 billion euros for O2, the second-largest cellular phone company in the United Kingdom and a player in the German market.


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


The negative aspect of the deal involves indebtedness. The net financial debt of the Telefónica group was 27.99 billion at the end of June, and it will almost double after the company takes on additional 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 in five 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 will accelerate Telefónica’s growth rate as well as its EBITDA revenues. “I believe it is an excellent acquisition, since it positions Telefónica as a global telecom operator,” says Javier Busquet, director of the systems department of ESADE. “O2 is an extraordinary company. It is innovative; it has a strong brand and a broad portfolio of 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 its network. Another source of synergies will be the acquisition of content and the development of applications and services. In addition, Telefónica, headed by Cesar Alierta, will become the fourth-largest mobile phone operator in the world, behind only two Chinese companies and Vodafone.


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


The acquisition will allow Telefónica to diversify its business both in terms of sectors and geographical regions. Until now, the Spanish company had focused its growth strategy on Latin America. Moving into Europe, which offers less potential for growth but greater security, 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 competitive advantages. Despite its volatility, growth rates in that region are much higher.


“It is a golden opportunity for Telefónica, which needs to continue growing but in markets that are less volatile than those in Latin America,” says Mauro Guillén, a professor of international management at Wharton. Adds Busquet: “Telefónica has changed its method but not its strategy, which is to expand in strong markets. Choosing Europe does not mean that it is forgetting its interests in Latin America, where it is betting more on medium-term results. Although achieving profitability is a slower process, Latin America provides a large critical mass, especially in markets like Brazil, Mexico and Chile.” To illustrate that point, at the end of last year, Cesar Alierta’s company acquired the Latin American cellular operations of BellSouth, thereby expanding Telefónica’s presence in that region. Telefónica already had a presence in Mexico and in Brazil, where it was a partner of Portugal Telecom. With the acquisition of BellSouth’s [cellular] assets in the region, the company 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’s cellular 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’s history. The company will finally expand in Europe, where it has a presence 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 many of them,” notes José Ignacio López Sánchez, management professor at the Complutense University of Madrid. “You also have to emphasize the role that will be played by emerging nations of Eastern Europe.”


O2’s 24 million customers are all in three countries: The United Kingdom, Ireland and Germany. “With this move, Telefónica will enter the marketplace in Britain, Ireland and Germany where there are some of the most profitable customers in the Old Continent,” explains Busquet. “Entering Germany means that the company will have an excellent platform for penetrating the countries of Eastern Europe.”


The attraction of the United Kingdom lies in the number of O2 customers there. Half of O2’s revenues come from this market, where O2 has a 22% market share. O2’s strategy — which Telefónica has announced that it will not change — involves the following: First, focusing on those users who have higher average annual revenues (known as ARPU); second, reducing costs in order to improve efficiencies; and third, investing those savings in winning 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 a 50% share), O2 can be damaged in Ireland by such rivals as Meteor and Hutchinson Whampoa, a recent arrival. Ireland provides only 9% of O2’s total revenues, but its customers have the highest average value of any country, with annual spending of 565 euros ($662), far above the 363 euros spent by the average German, and the average of 414 euros spent by British customers.


In Germany, O2 has 8.4 million customers and a 12% market share. That makes O2 the third-largest mobile operator in that country behind T-Mobile and Vodafone. In 2000 Telefónica tried to enter that market by buying third-generation (UMTS) mobile telephone licenses. However Telefonica ultimately abandoned its plans to develop a UMTS network in Germany. It expected to sell its frequencies and recover part of its investment. Nevertheless, if the deal with O2 moves forward, Telefónica will strengthen its German subsidiary with those frequencies. The German market is the fastest-growing market for O2.


“This deal will enable it to expand the value of its customer network,” says Garralda. “Telefónica is interested in expanding the value of its network in order to capture new users and build loyalty among its current users, so that it is more competitive in the global arena.”


Telefónica’s latest publicity campaign points in that direction. “With its slogan, ‘In Movistar, we are more, and we pay less,’ the company is explaining that the more users there are [on its network], the less each user will pay. You can expect that in the future, 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 is possible that such a thing could be created among users of the same operator in the future, because of the scale they are reaching,” says López Sánchez.


Telefónica has 145 million customers around the world. Adding O2 will enable it to expand its network of users to 170 million worldwide.


The Trend toward 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 a strong telecom operator will revitalize competition, and customers will be grateful for that.”


If Telefónica acquires O2, it will be the latest in a line of acquisitions made by Spanish companies in Britain. A year ago, Banco Santander paid $15.787 billion for Britain’s Abbey Bank. According to Thomson Financial, the research firm, starting in October 2004, Spanish companies have played a leading role in corporate takeovers that is the equivalent of 34% of the total value of all corporate acquisitions in Britain. Of the £83.41 billion (122.6 billion) that non-U.K. companies have moved into Britain since October 2004, £28 billion came from Spain. The Spanish pioneers were Ferrovial, which bought Amey ( a company that maintains and upgrades the Metro lines in London) and Albertis, which acquired TBI (which manages the Luton airport.)


However, the U.K. is not the only object of desire for Spanish companies. In France, Metrovacesa, the Spanish real estate firm, purchased Gecina for 5.5 billion.  Inmobiliaria Colonial took over Société Foncière Lyonnaise for €1.558 billion. In addition, Fadesa, the property development company, acquired a small firm called Financiere 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’s biggest companies have cleaned up their accounts, and they have a great deal of liquidity and foreign experience. Moreover, they no longer look exclusively at Latin America as their focus for growth. This doesn’t mean that the Spanish companies have abandoned Latin America. “It’s not a question of chance but of circumstances,” says López Sánchez. “There was a time when the big Spanish companies, such as Telefónica, Repsol YPF, Santander, Endesa and BBVA, identified opportunities in South American countries that they could not afford to miss out on. Their maxim is to diversify and continue to grow. For more than 10 years, the European market offered no options, but nowadays things have changed.”


“At first, Spanish companies preferred Latin America because of the language, the cultural proximity [to Spain], and the room for growth that those markets provided, even if they were volatile. Now, however, economic problems are making that growth more difficult,” says Garralda. “As a result, Spanish companies have decided to grow in Europe instead.” Nevertheless, Garralda adds that they have entered only a few sectors, such as banking, a few utilities, construction and real estate. “Spanish banks are very competitive globally, and have a very good scale of operation. In addition, they have had a presence in Latin America for several years. For their part, the real estate firms have chosen Europe because they are thinking about using markets like France and Germany as springboards into Eastern Europe.”


“Spanish companies will continue to look at Europe, and they will also try to penetrate the United States,” says Guillén. “Within a few years, they will look more towards Asia.” López Sánchez agrees that “in the very short term, Europe is where people are looking, mainly in the telecom sector and banking. Longer term, the rest of the world is their goal. What happens in the future will be determined by the circumstances at any particular moment. Other key factors will be companies’ strengths and weaknesses, and the opportunities and dangers in the market.” Adds Garralda: “Companies will continue to look for markets both in [Western] Europe and in Eastern Europe.”