The Race To Wire Europe

Phones, TV, the Net--who will dominate?

Dial into a British Web site called Band-X, and you see firsthand how radically Europe's telecom industry is changing. A London-based brokerage for phone lines, Band-X offers telephone companies a chance to hawk their extra capacity online to competitors or corporate clients at cut-rate prices, the way other traders sell pork bellies or North Sea crude. That's a huge change from just a few years ago, when phone rates were practically carved in stone. Thanks to fierce competition, benchmark Paris-London long-distance rates have tumbled 70% in the past six months.

Band-X is just one soldier in an army of dealmakers and entrepreneurs closing in on the Continent's $200 billion telecommunications industry. The battlefield now encompasses phones, software, and media, and the fighters include upstarts no one had heard of just a few years ago, as well as global leaders. Microsoft Corp.'s William H. Gates III is trolling for a piece of Germany's cable-TV market to anchor his growing European portfolio. MCI WorldCom Inc. Chairman Bernard J. Ebbers is spending billions to wire Europe with fiber-optic cable.

Then there's Roberto Colaninno, chairman of the rejuvenated Olivetti and the hero of the moment. He has just astounded the business world with his successful hostile takeover of his much larger rival, Telecom Italia, battling off a rival bid from Deutsche Telekom in the process. The move sent alarms ringing through Europe. "This was the first time a company that had practically no money was able to do a hostile takeover simply because it wanted to," says Maximilian Ardelt, head of telecommunications at conglomerate Viag.

The Telecom Italia takeover in many ways encapsulates the trends turning Europe into a telecom battleground, where money and high-tech hopes are fusing into a powerful force. Deregulation and privatization made Telecom Italia, a former state monopoly, a target. And with markets surging, the amount of capital hungry for hot deals has increased tremendously in Europe. So has tolerance for risk. In this superheated atmosphere, Colaninno offered an unusual mix of cash, stock, and debt to Telecom Italia shareholders--and found enough takers to win the day. Now, Colaninno's investors are betting he can turn Telecom Italia into Italy's dominant provider of Internet services and an attractive partner in other high-tech ventures across Europe.

For all its promise, Europe is a far rougher market to gauge than North America. Even with the new common currency, it remains splintered by languages and governments. And the differences in technology are vast. While Northern Europe is plugged into the Web at near-American levels and has among the largest cable-TV audiences in the world, the Mediterranean countries remain virtual cyberdeserts, and uncabled to boot. Despite fast growth, Europe has only half the personal computers per capita as the U.S. and a third the Web-surfing population. Europe's local phone systems are still under firm control of former monopolies, which have been slow to wire homes with high-speed Internet connections.

At the same time, Europe's phone companies are pushing into mobile telephony far more aggressively than their U.S. counterparts. So while few Europeans have fast Internet connections to their PCs, they could soon be surfing the Net at warp speed on their mobile phones. Over the next 10 years, analysts expect technologies on the two continents to converge. In the meantime, the U.S. remains a developing market in mobile services--while Europe plays catch-up at getting wired for the Internet.

The game of catch-up spells opportunities that are sure to spark more communications deals in Europe. And the winners will control the lucrative convergence of Europe's telephone, TV, and Internet markets. Next to the U.S., the Continent is the key place on the globe where players big and small are scrambling to stake out a position in the new digital age. "In this market, those who think defensively are going to have trouble surviving," says James G. Richardson, Europe president for network heavyweight Cisco Systems Inc. For Cisco and many other communications equipment suppliers, Europe is now the world's fastest-growing market.

The rapid emergence of the Internet is increasing the stakes. The region is expected to generate $250 billion in E-commerce revenues alone within the next three years. What's more, Europeans are among the world's chattiest cellular-phone users. All of this is driving up demand for telephone services, and a host of newcomers--from New York's Viatel Inc. and London's Colt Telecom Group PLC to big names such as MCI WorldCom--are hustling to provide them.

NEW CABLES. Such companies are wrapping the Continent in superfast fiber-optic cable, which will carry Net services that involve huge flows of data and dwindling amounts of voice signals. You can see workers burying cables near airport highways in Mannheim and Nancy, from the windows of the high-speed trains to Brussels, and along the ring road in Paris. New market entrants are riding high, with big plans to take on the phone giants. "We want to be a direct competitor to the incumbent carriers," says H. Brian Thompson, chairman of Virginia-based Global Telesystems Group Inc., one of the fastest-growing newcomers.

Former national champions are already feeling the pain. Deutsche Telekom, for example, has lost 30% of its long-distance phone market in the last year to dozens of startups. With time, these newcomers should break the German behemoth's hammerlock on the local market and offer a host of digital services, including interactive television, through high-speed phone lines. The pressure is forcing DT to start installing high-speed connections of its own.

Telephone giants aren't the only ones angling for Europe's high-speed market. Take Microsoft. The software king is teaming up with Bertelsmann for what appears to be a multibillion-dollar bid for Deutsche Telekom's cable-TV business in Germany. Microsoft wants to establish a prominent place for its products, both information and software, on Europe's Web. The idea is that once they're established, Microsoft sites will lead Europeans to a host of shopping and service providers via TV or cable modem. But cable-TV technology can also offer telephone services. So Microsoft could soon, through its cable partnerships, be taking on Europe's phone giants.

Microsoft's power grab shows how the new players could disrupt old alliances. Bertelsmann, the world's leading publisher, is eager to get on high-speed cable lines to battle online bookselling upstarts such as Inc. Its partnership with Microsoft could lead Gates straight into battle with Bertelsmann's Internet ally in Europe, America Online Inc.

One much publicized partnership has already frayed badly in this tumultuous world. Over the past three years, Deutsche Telekom and France Telecom have forged a tight partnership that includes an Internet R&D center, a global joint venture in business telephony, and cross-holding in each other's stock. But Deutsche Telekom Chairman Ron Sommer dealt a serious blow to that linkup when he launched his bid for Telecom Italia in April without even consulting France Telecom President Michel Bon.

PREY CONFLICT. Bon reacted angrily, and in mid-May France Telecom filed papers to sue its German partner for breach of contract, alleging damages in the billions of dollars. Now, in the wake of Deutsche Telekom's failed bid, phone giants are both seriously weakened. As they try to expand outside their home markets, they may find themselves battling over the same prey, perhaps Spain's Telefonica or Britain's Cable & Wireless PLC. There's only a small chance, analysts say, that the two companies can put the Italian embarrassment behind them and come together again, forming a cross-Rhine powerhouse.

Meanwhile, Deutsche Telekom's humiliation spells another triumph for rival Mannesmann. Germany's leader in mobile phones, Mannesmann benefited from the tumult in Rome by grabbing control of the profitable mobile-phone joint venture Omnitel that it shared with Olivetti. With its operations in France and Austria, Mannesmann is now the largest alternative phone carrier in Europe.

But the biggest challenge to traditional phone companies comes from upstarts. Viatel is typical of the new players. An eight-year-old New York-based company, for years it eked out a living in niche markets such as prepaid calling cards. But a year ago, Viatel issued $890 million in junk bonds to bankroll an 8,700-kilometer fiber-optic network connecting 40 cities in Europe. Now, Viatel is underselling the big companies with cheap long-distance service. What's more, its stock, viewed by investors as an Internet play, has risen seven-fold in the last year. This gives the $200 million Viatel, like many other newcomers, financial clout in Europe far beyond its size.

Such success stories remind tech-happy investors of another formerly unknown small player, MCI WorldCom. The $30 billion American company is spending about $1 billion per year to build its own 9,000-kilometer European system. The plan is to link businesses, by far the biggest data users, to a high-speed network that circles the globe.

The next battle for the new competitors is over the so-called last mile. That's the critical connection from high-speed networks to individual homes. So far, the former monopolies still control the last mile. With the exception of Deutsche Telekom, few are hurrying to upgrade these connections with high-speed technology. Instead, they are pouring capital into fast-growing cell-phone networks. So Europeans are still stuck with pokey dial-up modem speeds, even while superfast fiber cables stretch across their Continent. It's as if they were condemned to scootering on the Autobahns.

Only new competition in high-speed connections is likely to goose the big telcos into upgrading the last mile. But to date, the leading independents, such as Germany's Mannesmann and Italy's Olivetti, have also been far more eager to grow in cellular. Meanwhile, the new cable-laying competitors, led by MCI WorldCom, have been content to wire up lucrative business clients rather than pay access fees to wire Europe's homes, and slug it out door-to-door with the national carriers. "Business traffic is the low-hanging fruit," says Ron Higgins, chairman of Digital Island, a San Francisco-based company that sells high-speed data connections.

One way to avoid a costly battle over the last mile is to use cable networks to wire homes for the Net. This is Microsoft's approach. Before it even looked at a cable deal with Deutsche Telekom, Microsoft had bought two cable companies in Britain and invested in a Dutch cable operation. To turn the cable into a two-way connection costs an average $600 per home. But once that investment is made, the cable can zip data at a blistering 4 megabits per second, fast enough for live video on a home PC.

Cable-TV companies should start rolling out major Internet connections across Europe by next year, analysts say. This, in turn, will present telecom companies with some nasty choices. Do they lay out billions upgrading local phone lines to compete with the cable-modem threat? Or do they up the ante, moving on to next-generation technology? A modem due to emerge from the labs next year could process a mind-boggling 25 megabits per second through the phone line, enough to power four TV channels simultaneously.

Thus, European phone companies could jump into the TV business--just as cable companies reach for the phones. This mingling of digital businesses should lead to tempestuous times in Europe, with lots more buyouts and new alliances. When the dust clears, Europe's telecom business is sure to emerge transformed. Far less certain is which companies will come out of this process on top. The game is just beginning.

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