Telecom's New Giant

Can Deutsche Telekom and Telecom Italia make their merger work?

Franco Bernabe's days as chief executive of mighty Telecom Italia certainly looked numbered in mid-April. Facing a ferocious, $62 billion hostile assault from feisty Olivetti, Bernabe was quickly losing support from key shareholders and from the Italian government. Then, on Apr. 12, after the boyish-looking 51-year-old even failed to garner enough votes to convene a Telecom shareholders' meeting, Bernabe quietly commented to associates: "I might have a little surprise in store."

Only Bernabe--a reserved, even socially awkward manager brought up in Italy's far Alpine north--could have gotten away with such an understatement. The "little surprise" turned out to be nothing less than an audacious plan to merge Telecom Italia with Germany's state-controlled carrier, Deutsche Telekom. Secretly ironed out since mid-February in a series of rendezvous between Bernabe and Deutsche Telekom CEO Ron Sommer, the $177 billion German-Italian combine would be the largest corporate merger in history as measured by market capitalization--half again as big as Daimler's hookup with Chrysler Corp. and more than twice the size of Exxon Corp.'s buyout of Mobil Corp.

Under the deal, Deutsche Telekom would offer one of its shares for every three Telecom Italia shares--the equivalent of about $13.75 per share. To gain Italian backing, the German government pledges to abstain from exercising voting rights on its 72% stake in Deutsche Telecom and to begin selling off the stake next year.

If the deal can win the support of shareholders and survive the scrutiny of regulators, Europe's new telecom giant would overshadow all its rivals on the Continent. With $64 billion in sales, it would rank as the world's largest mobile-phone operator and the No. 2 operator of fixed-line telephones, after NTT. Although weak in the U.S., the company would stand out as a powerful player in Latin America and Central Europe. "This is going to be a big company with a marvelous future," Bernabe told Telecom's 13 board members on Apr. 21, before they approved the deal.

But is bigger better? The eye-popping merger throws into sharp contrast two competing visions of how European telecommunciations--and even European capitalism--could develop. One model is represented by Olivetti and other fast-moving companies: A vision totally driven by market forces and riding the wave of cash available for deals. The very survival of these companies hinges on high growth, and on moving in on lumbering players such as Telecom Italia and Deutsche Telekom.

But another possible model is emerging where old monopolies combine forces to hang on to their dominant positions and avoid taking tough restructuring steps. Thus the proposed deal between Deutsche Telekom and Telecom Italia could pave the way for other cross-border transactions between ex-monopolies, from electric utilities to postal services.

Europeans won't have to wait long to find out which vision is stronger. On Apr. 30, Olivetti's tender offer for 5.1 billion Telecom Italia shares kicks off. If a little more than one-third of shareholders vote for Olivetti CEO Roberto Colannino's offer of $12.20 a share--lower than Deutsche Telekom's, but mostly in cash--the bold plans of Bernabe and Sommer will come to nothing. Still, since the Deutsche share offer is sweeter, Telecom Italia executives are confident its shareholders will vote for the German offer. "Shareholders are going to like the opportunities Deutsche Telekom and Telecom Italia can bring to the table," predicts a top adviser to Bernabe.

BAD SIGN? Maybe. But a Deutsche Telekom-Telecom Italia linkup certainly seems to be a classic defensive move rather than the centerpiece of a value-creating, offensive strategy. The fact that the former monopolies are circling the wagons against the onslaught of competition could be a bad sign for Europe, some analysts say. The two groups, after all, are among the least efficient operators in the business. Deutsche Telekom's sales per employee of $197,000 in 1998 was half the average for American companies, for example. Improving on those poor numbers inside the new, elephantine DT-Telecom Italia will be tough.

And while companies everywhere in Europe have been throwing off state control, the German-Italian deal seems a step back from earlier commitments to let market forces work freely. Initially neutral on the deal, Italian Prime Minister Massimo D'Alema and German Chancellor Gerhard Schroder are actively supporting the merger. "The German government," complains Klaus Esser, deputy CEO of Dusseldorf-based Mannesmann, a fierce competitor to Deutsche Telekom, "should be worrying about fixing the German economy and not favoring one company."

Naturally, Bernabe and Sommer believe they are creating a European colossus that could compete globally with outfits such as AT&T and MCI WorldCom Inc. "What is better," asks a Bernabe adviser, "that Telecom winds up in the hands of Colaninno and his pals, who then take it apart and make a hell of a lot of money for themselves? Or that two of the largest ex-monopolies in Europe get together to find a future for themselves in the market?"

The company would be a powerhouse, even if--as is likely--it is forced by antitrust authorities in Brussels to give up chunks of business. Combining networks could create valuable efficiencies. And merging Deutsche Telekom's $5.1 billion in capital expenditures this year with Telecom Italia's $7.7 billion could throw off vast savings in purchasing. "They can protect their business better if they can cut costs," says James Richardson, president of Cisco Systems Inc.'s European operations. "That's the big if."

More important, the sheer scale of the new group would give it financial and strategic flexibility. Very few potential acquisitions would be too big for the new outfit to handle--even targets as expensively priced as Sprint Corp. Deutsche Telekom already owns 10% of Sprint, and there has long been speculation it would attempt a takeover. Britain's Cable & Wireless PLC is another focus of speculation.

The size of the combined group means that it could withstand any earnings dilution coming from a purchase. And just in case, Sommer in mid-April announced he would tap markets for $11 billion in cash. "Their ability to leverage would increase because of their size," says Kenn Walter of Munich-based Global Technology Advisors. "Anytime they want a deal, anyone would think twice about bidding against them."

If they move smartly, Bernabe and Sommer could create new businesses in Internet, cable communications, and mobile Internet access, then spin them off. It is a strategy that Telecom Italia already used brilliantly when it floated off its Telecom Italia Mobile cellular unit in 1997. New spin-offs, with their own shares, could pursue their own global alliances free from the constraints of the mother group.

Yet moving ahead in the fast-changing telecom market while streamlining operations will be immensely difficult. Take staffing. Although Telekom's Sommer succeeded in cutting his workforce 6.3%, to 179,000, in 1998, the company would have to cut another 80,000 workers to deliver the same sales per employee as AT&T. For its part, Telecom Italia needs to cut as many as 40,000 jobs out of 120,000 to stay competitive. Its press and public-relations office alone has a staff of close to 400, the size of a midsize corporation in Italy.

Cutting that kind of fat is sure to spark an outcry from workers. And for now, at least, Bernabe and Sommer seem to be protecting managers: The proposed merger envisages the maintenance of two separate corporate headquarters--one in Rome and another in Bonn. Because of cultural sensitivities, there's the risk of duplicating positions throughout the new group, such as the plan to make Sommer and Bernabe co-CEOs.

FASTER, FASTER. While the two executives grapple with these problems, their rivals certainly won't be slowing down. In the 16 months since Germany deregulated its telecom market, Deutsche Telekom has lost 30% of its profitable long-distance market to nimbler newcomers such as Mannesmann and MobilCom. By contrast, it took MCI WorldCom a decade to wrest just 10% of AT&T's U.S. market share. Similarly, Telecom Italia is besieged by a host of new players, both homegrown and foreign.

New technologies promise even further acceleration. Communication over Internet technology, for example, is far cheaper than using the vast, installed systems of the old telecoms. To maintain revenues, even the jumbo telecom companies must push more calls onto cheaper mobile lines and cash in on the lucrative data market over fixed lines. If the German-Italian behemoth moves slowly, it risks losing valuable data business to new players such as Global Telesystems Group (box).

NEW RIVALS. Not only small fry are likely to make life difficult for Deutsche Telekom and Telecom Italia. MCI WorldCom is ramping up its presence in Europe as it lays thousands of kilometers of fiber-optic cable from London to Stockholm. Houston-based SBC Communications Inc. has investments in France and Switzerland and may soon be operating in Denmark, Belgium, and Hungary if its merger with Chicago-based Ameritech Corp. goes through. "Between the two of us, we will have more investment in Europe than any non-European," says James S. Kahan, SBC's senior vice-president for corporate development.

Meanwhile, a Deutsche Telekom-Telecom Italia pairing could turn former partners of the giants into new rivals. The deal is sure to destroy Global One, an alliance linking France Telecom, Deutsche Telekom, and Sprint. And Rome-based Wind, the ambitious two-month-old alliance linking France Telecom, Deutsche Telekom, and Italian electricity giant Enel, is under strain as well. Enel says that even if the German-Italian deal fails, it will still demand over $1 billion in penalties from Deutsche Telekom for having opened up formal negotiations with Telecom Italia. Industry observers are also watching British Telecommunications PLC carefully to see if it seeks out new partners to stand up to the German-Italian combine.

Few are willing to predict what the telecom landscape of Europe will look like a few years out. But if telecommunications in two of the Continent's largest economies are locked into defensive, job-saving strategies, Europe's entry into the information economy could slow down considerably. "This allows them to continue their old monopolistic ways," warns Tim Sheedy, telecommunications analyst at International Data Corp. Bernabe and Sommer should reflect on that warning if they finally get the nod from shareholders for their extraordinary merger plans.