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Why Does Telecom Italia Want AOL Germany?

Telecom Italia Chairman Marco Tronchetti Provera may be gone, but his strategy to transform the former state-owned monopoly into more of a media company lives on. Only two days after the wealthy Italian industrialist resigned as chairman due to a squabble with the Italian government, Telecom Italia (TI) announced plans to buy the Internet access business of AOL Germany (TWX) for $857 million.

Analysts were less than thrilled. The move came a week after Telecom Italia announced plans to spin off its fixed-line network and mobile unit—presumably to raise money to pay down its enormous debt. Now, it's spending richly for a business some worry has dubious prospects. "Internet access is a fiercely competitive business in Europe, with prices falling quite dramatically," says Ian Fogg, senior analyst for broadband at Jupiter Research in London. The company's New York-traded shares have fallen 6% since Sept. 12.

So why do it? In June, AOL Germany had 1.1 million German broadband subscribers and 1.3 million narrowband subscribers. Telecom Italia had previously acquired a German Internet access business called Hansanet in 2003. Combining the two units, the company figures, will give it 3.2 million Internet customers in Germany, of which 2 million are broadband.

SAME MISTAKE TWICE? The acquisition fits into Telecom Italia's new strategy, announced on Sept. 11, to focus on broadband Internet access and media, rather than on conventional telephony (see, 9/12/06, "Telecom Italia: Losing a Limb"). But analysts worry that the price is inflated, based on market comparisons and revenue models.

Telecom Italia is paying $357 per subscriber for the AOL business, which researcher Gartner argues is too high. "This looks like an attempt to give solid background to the new [media] strategy," says Monica Basso, a research vice-president with Gartner Group. "It's an initial mistake being repeated."

Indeed, Jupiter predicts that average revenue per user for broadband Internet access will decline 54% across Western Europe between 2005 and 2011. With telecom, cable TV, and mobile phone companies all converging and competing in Internet access, analysts say the challenge will be to offer the sexiest new services over broadband.

AD SUPPORT. Telecom Italia is trying to do this in Italy and in Germany via its Alice service, which offers voice, Internet, and television over broadband. In Italy, the company has a strong presence in digital terrestrial television, in addition to being the largest fixed-line and mobile operator.

And as part of the deal with AOL, the two companies will jointly operate a Web portal in Germany for at least the next five years. The remainder of AOL Germany, without its access business, will be responsible for advertising sales and for co-branded audience services and content.

For Time Warner, the German sale is part of an overall thrust to get out of Net access and switch instead to a content and advertising-supported business model (see, 8/8/06, "AOL Shifts Strategies in Europe").

TOGETHER/APART. The company's British network also is for sale, and Time Warner is close to selling its Internet-access unit in France, which had more than 800,000 customers at the end of the second quarter, to French fixed-line carrier Neuf Cegetel. Analysts figure the unit could fetch as much as $380 million.

The move to "de-merge" Telecom Italia Mobile (TIM) has engendered its own storm of criticism. Only 18 months ago, the parent company announced with great fanfare that it was re-integrating its mobile unit in order to offer customers bundled packages of fixed-line and mobile phone service. European peers, such as France Telecom (FTE) and Deutsche Telekom (DT) have made similar moves.

The Sept. 11 announcement of the TIM spin-out puzzled analysts. "It would seem that either the company decided its earlier decision lacked vision, or it was unhappy with the results 18 months on," says Gartner's Basso. "But 18 months wasn't enough time, especially given that other companies in Europe are integrating fixed and mobile businesses. It was clearly a financial decision, not an industrial one."

GOVERNMENT INTEREST. Now Italy's parliament has opened a debate on the strategy and on government interference in the strategic decisions of a private-sector company. The government's critical response to Tronchetti Provera's plan to spin out TIM prompted the chairman to resign on Sept. 15 (see, 9/18/06, "Telecom Italian Boss Abruptly Quits").

Independent directors of Telecom Italia reportedly were in favor of commissioning a third-party evaluation of the new strategy. Since it was announced, a top government advisor has resigned and a judicial investigation has been opened.

Telecom Italia's respected new chairman, Guido Rossi, now faces the task of soothing markets and sorting out the mess. Observers say Rossi was named primarily to mediate the conflict with Italian Prime Minister Romano Prodi, who is reportedly concerned about the prospect of the mobile business or Telecom Italia itself being sold to a foreign company. Rossi has said that he does not intend to change the strategic direction of the company during his leadership.

AFTER THE SPIN-OFF. That leaves analysts wondering why Telecom Italia would plow ahead with a questionable strategy and spend needed cash in a market where competition is cutthroat. "This doesn't make medium to long-term sense at all," said Lars Godell of Forrester Research. "In Germany, mobile operators are trying to steal business from fixed-line operators." Telefónica's (TEF) O2 unit, for example, is offering a "home zone" package to its 3.7 million German mobile customers, with tariffs comparable to fixed-line rates in the areas right around their homes.

Given the turmoil around Telecom Italia, observers wonder what else the future may hold. All eyes are on the company to see whether it will sell its mobile business now that it is being spun off. Private equity fund Carlyle has been rumored as a potential buyer, given that its Italian head, Marco De Benedetti, used to run the unit.

Another possibility is the sale of Telecom Italia itself. After talks over the sale of an equity stake to Rupert Murdoch's News Corp. (NWS) failed recently, former Prime Minister Silvio Berlusconi's Mediaset has said it could be interested in the company, though this would depend on the outcome of new media ownership laws under discussion in Italy.

INDEPENDENT NETWORK. Another possible next step is the sale of the local loop network back to the state or to a third party that would manage it. Research on this possibility by an Italian government advisor for Telecom Italia was leaked to the Italian press, fueling the already explosive national debate over government interference in private-sector business.

Such a solution could, however, not only provide Telecom Italia with needed cash but also help Italy's competitive environment. An independent network, analysts say, would allow other phone companies to negotiate access deals with a disinterested network infrastructure operator, rather than piggybacking on incumbent Telecom Italia for their connections.

These are turbulent days at Telecom Italia. The next few months could tell whether Tronchetti Provera's strategy was inspired, or an ill-advised move by a desperate businessman.

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