Maybe Europe's Telecoms Aren't So Tough After All

Investors are worried about the fate of Europe's phone monopolies after deregulation

They're big, they're brawny, and for decades looked as invincible as Europe's ancient castles. The Continent's Big Three phone companies--France Telecom, Deutsche Telekom, and Telecom Italia--stood secure behind the wall of government protection. And until recently, their technological prowess and rich home markets made their prospects for standing up to global rivals in a deregulated Europe look good. No wonder the German government had an easy time floating $13 billion in Deutsche Telekom shares last November. Now, Paris and Rome plan to follow suit, with the October sale of up to $25 billion worth of France Telecom and Telecom Italia stock.

But as the Jan. 1 date for deregulation draws near, investors are having second thoughts about how well the Big Three can compete. A less-than-rosy profit outlook helped send Deutsche Telekom shares plunging almost 10%, to $18.50, in mid-September--below its 1996 initial price and 25% off its July high. Days later, the Italian Treasury got into a messy, last-minute scramble to place 15% of Telecom Italia with a core of private shareholders. The Treasury found takers for only 10%, with big potential investors, such as the Netherlands' ABN-Amro and Italy's Benetton Group, getting cold feet. That could be inauspicious for Telecom Italia's planned Oct. 20 privatization, the biggest ever in Europe.

In Paris, meanwhile, officials of the new Socialist government have backed away from the former administration's plans to sell off 49% of France Telecom and now will float just 20%. In the days following the share-price announcement of $28 to $31, investors said they were satisfied and expected to see more shares floated later. But they recognize that with unemployment raging in France, the government, as France Telecom's biggest shareholder, may balk at putting the $25 billion giant on a diet to compete with leaner rivals. "There is likely to be less restructuring now," says Keith Mallinson, managing director of London-based market researcher Yankee Group Europe.

Investors are more intensely focused than ever before on the new competition that will challenge Europe's former phone monopolies when the Continent's telecom market is fully deregulated next year. True, the Big Three enjoy the advantages of size and entrenched market share. But deep-pocketed newcomers, already attacking profitable niches such as cellular service, are aiming at core phone business more keenly than anyone feared. If those efforts succeed quickly, the rich profit margins enjoyed by Europe's traditional players could erode.

That is haunting executives such as Deutsche Telekom's Ron Sommer. Bowing to pressure from new players such as the telecom joint venture between industrial giant Mannesmann and the German railway system, German regulators decided DT can charge newcomers much less than it had hoped to connect to its network. As a result, Deborah McCutcheon, telecom analyst at Robert Fleming Securities in London, reduced her 1997 net profit projection for DT by 8%, to $2.24 billion. The decision also signals that DT won't be getting special favors from the government in the post-deregulation era. "This will have a negative impact on our midterm expectations," says Sommer.

Besides facing new rivals, the Big Three are challenging one another more directly in their home markets. For example, Deutsche Telekom recently teamed up with Enel, Italy's giant electric utility, to bid for the country's third cellular license next month. Neither Enel nor DT is trying to hide the fact that the mobile license is merely the first step in a frontal assault on Telecom Italia's core phone business. Already racing to lay fiber-optic cable along its 13,000-km electricity grid in Italy, Enel says it will have the infrastructure in place as early as mid-1998 to offer telecom services. "The competition is turning out to be much stronger than we expected," says one Telecom Italia director.

The payoff for Enel and DT could be huge. The two companies, says Tommaso Pompei, Enel's head of telecommunications services, are jointly planning to pump $5 billion into building up their network in Italy over the next five years. By 2005, predicts Pompei, the joint venture could steal more than 10% of Italy's total telephone market. And if France Telecom joins in the deal, as Telecom Italia insiders fear, the threat will be even deadlier.

True, the big Continental phone companies still enjoy plenty of advantages, from fully depreciated national networks to virtually captive markets. And their rich cash flows can help finance expansion into other markets, from Telecom Italia's $2 billion push in South America to DT's drive in Central Europe and Southeast Asia. But their traditional market dominance can also be a handicap. All three companies, for example, have suffered from government-imposed tariff imbalances that keep local calls cheap and long-distance and international services relatively expensive. Despite moves to rebalance rates, the latter two niches are attracting a flood of new competition.

France Telecom, bound by law to offer the same prices for its services throughout France, admits that its rivals' ability to pick and choose clients is its biggest worry. Companies such as Cegetel, the joint venture between BT and deep-pocketed Compagnie Generale des Eaux, "have a flexibility of tariffing we don't have," complains Jean-Yves Gouiffes, executive vice-president for networks at France Telecom.

"ARTIFICIAL HANDICAP." While Cegetel is already testing sophisticated telecom services that it will be able to sell just in the rich Paris market, France Telecom would have to offer the same services in less lucrative regions of France. "This is an artificial handicap that worries us more than any technological ones," says Gouiffes.

Since early last year, France Telecom has cut domestic and international tariffs by as much as 26% to boost traffic growth as well as hit back at the new competition. Further sharp cuts are scheduled for early October. But some analysts think even that may not be enough to keep customers loyal to France Telecom. Cegetel's lean organization--it has 2,100 workers compared with France Telecom's 165,000--means it can easily cut prices by 30%. "Cegetel doesn't have the same overhead as France Telecom," says Kathy Burrows, telecommunications analyst at London-based International Data Corp. "And they can be sure they've got the customers before they pay to build out their network."

Europe's big phone companies won't wither away anytime soon. Although their margins are under pressure, the European telecommunications market as a whole is booming. Each company has a headstart in cellular service, now a $24 billion business that's growing at a 41% clip in Europe. And all three are at the cutting edge of other new services, from the Internet to high-speed networking and new, low-cost wireless technology. If they can keep ahead in those services, they may be able to make up for no longer being the only players around.