Nov. 8 (Bloomberg) -- Telefonica SA, Europe's second- largest phone company by value, may buy 8 percent of Hong Kong's PCCW Ltd. for about HK$3.2 billion ($411 million) to drive expansion in China, two people familiar with the deal said. PCCW shares jumped 6.9 percent.

Telefonica may combine its stake in Hong Kong's biggest phone company with the 20 percent held by China Network Communications Group, the people said, asking not to be identified before an announcement. Madrid-based Telefonica already has a shareholding alliance with China Network, owner of the nation's second-largest phone company.

By teaming up with state-owned China Network, Telefonica Chief Executive Officer Cesar Alierta may be able to increase his share of the market in China, where new subscribers in the past year exceeded the 82 million population of Germany. The alliance would also end concerns among Chinese officials that an unwanted buyer would take control of PCCW.

``To go to China on your own is crazy, you have to have a good partner,'' said Glen Spencer-Chapman, an analyst at Madrid- based Ibersecurities SA. For some companies ``it's a real nightmare because it's a very tough market.''

Telefonica and China Network's venture will become the biggest single shareholder in PCCW. The Spanish company owns a 5 percent stake in China Netcom Group Corp. (Hong Kong) Ltd., the publicly traded operating unit of China Network.

Francis Leung

Telefonica is buying the holding from former Citigroup banker Francis Leung. Leung agreed in July to purchase more than a fifth of PCCW from a company controlled by Richard Li, son of Hong Kong billionaire Li Ka-shing, as a stop-gap measure while seeking other investors. Richard Li had been in talks to sell the stake to Macquarie Bank Ltd. and Texas Pacific Group.

China Network indicated at the time that it would block the sale to the two buyout firms.

Leung declined to comment, as did Li Tao, a spokesman for China Network, and Telefonica's Miguel Angel Garzon in Madrid.

The Li Ka-shing Foundation, a charitable body, will buy just 12 percent of PCCW from Leung, alleviating concerns that regulators would block the deal, the people said. Li, Asia's richest resident according to Forbes Magazine's annual list in March, already controls Hutchison Telecommunications International Ltd., the territory's biggest mobile phone company.

The telecommunication authority in Hong Kong will only examine a shareholding change if it exceeds 15 percent.

Laura Cheung, a Hong Kong-based spokeswoman for Li Ka- shing's foundation, declined to comment.

Shareholder Vote

Shareholders of Pacific Century Regional Developments Ltd., a publicly traded Singapore company that controls PCCW, must approve the sale.

Richard Li, who is selling Pacific Century Regional's 22.66 percent stake for HK$9.2 billion ($1.18 billion), will be barred by Singapore's stock exchange from voting because his father is involved in the purchase. The younger Li holds 75 percent of the Singapore company.

``The biggest question mark now is whether minority shareholders approve the transaction,'' said Allan Ng, an analyst at BOC International (Holdings) Ltd.

Leung in July agreed to pay HK$6.00 a share for the PCCW stake. The stock has fallen 13.5 percent since his announcement, because of the uncertainty about what Leung will do with the stake, stagnant local growth and slow expansion in China.

PCCW's shares closed 33 Hong Kong cents higher at HK$5.12 today, their biggest gain since June 22.

Board Seats

Leung, who bought an additional 0.7 percent of PCCW after the July agreement, will retain 3.4 percent and may be appointed chairman of the Hong Kong company, the people said. The total 23.4 percent stake to be held by the three parties would be valued at about HK$9.4 billion, the people said.

Telefonica would have two PCCW board seats, the people said, while China Network may have four. The deal hasn't been completed yet and terms may change, the people said.

Telefonica bought 2.99 percent of Netcom Group, which operates most of its parent's units, in June last year. The Spanish company boosted its stake in China's second-biggest fixed-line operator to 5 percent in September 2005. CEO Alierta had said he wanted to double the holding.

Telefonica plans to cooperate on interactive television, international traffic and call center services, the people said. The three companies will also develop high-speed phone services in China should Netcom receive a so-called ``third generation'' wireless license, the people said. The government may issue the licenses by February.

China's telephone subscribers rose 12.3 percent in the 12 months through September to 812.5 million, from 723.7 million a year earlier, according to the Ministry of Information Industry.

Internet TV

China Netcom said in August it is waiting for the Chinese government to award Internet Protocol TV, or IPTV, licenses and may team up with PCCW to offer the services in China. The company's first-half profit fell 1.7 percent to 5.8 billion yuan ($736 million) after competition from cell-phone companies such as China Mobile Ltd. increased.

PCCW's broadband TV subscribers rose 38 percent to 608,000 as of June 30 from a year earlier. That compares with a 1 percent increase in fixed-line customers.

``Telefonica is very interested in IPTV,'' said Spencer- Chapman. ``It's going to be one of the killer applications for developing broadband.''

To contact the reporter on this story: Cathy Chan in Hong Kong at kchan14@bloomberg.net

Last Updated: November 8, 2006 04:06 EST