Cashing In On An Internet Bonanza

The Continent's telecoms are set to spin off their hot Web units

Even in an era of turbocharged Internet stocks, it was an astounding takeoff. When Spanish phone company Telefonica spun off its Internet unit Terra Networks last month, Terra shares more than tripled on their first day of trading in Europe and the U.S. Now valued at more than $10 billion, Terra has roared past Britain's Freeserve PLC to become Europe's biggest Internet company. It won't remain No. 1 for long, though. Other European telephone companies are planning Internet spin-offs that would dwarf Terra. Two of the largest offerings, from Deutsche Telekom and Telecom Italia, will probably be out of the blocks in the next six months.

MORE CASH. These initial public offerings will rev up the nascent market for European Internet stocks, bringing some of the sector's biggest players out of the shadows of their corporate parents and into the arms of investors. What's more, the IPOs will speed transformation of the telephone business in Europe. Former phone monopolies, facing tough competition at home, can't survive unless they push into new territory and new businesses. Spinning off their fastest-growing holdings, such as Internet and mobile-phone units, generates cash for expansion.

By keeping a controlling stake in these spin-offs, phone companies also can boost their own share prices, fortifying their defenses against possible takeover bids. Shares in Telefonica, which owns 67% of Terra, jumped 30% in the weeks before the IPO and have climbed another 12% since then. And, as Vodafone AirTouch's $128 billion hostile takeover bid for Mannesmann illustrates, telecom companies will need ever bigger war chests to survive as global players. But ironically, by spinning off their fastest-growing businesses, the phone giants could be creating offspring that will one day overshadow them, and might even swallow them up.

For the short term, though, the Internet has created a treasure trove for Europe's companies. Unlike in the U.S., where startups such as America Online Inc. led the move onto the Web, in Europe the dominant Internet-access providers are telephone companies. Internet service providers such as Deutsche Telekom's T-Online aren't profitable yet. But because local calls in Europe are billed by the minute, they rake in revenues every time a customer logs on to the Net.

LATIN PROBLEMS. Not everyone is a winner when phone companies try to spin off their hottest businesses. In Latin America, where Telefonica has taken large stakes in several national phone companies, it has sparked an uproar by trying to sell those companies' Internet holdings to Terra Networks. Minority investors in Chilean phone company Compania de Telecomunicaciones de Chile (CTC) are threatening to sue CTC and Telefonica, contending that an online service provider owned by CTC was sold to Terra for far less than its market value.

Still, the march toward spin-offs continues apace--mirroring a trend in the U.S., where AT&T is considering issuing a separate stock for its wireless division. Portugal Telecom has just spun off its Internet unit, raising $523 million.

For now, companies such as Telefonica, Deutsche Telekom, and Telecom Italia plan to keep controlling stakes in the units they spin off. But they'll be tempted to sell off more shares to raise capital. At the same time, the spin-offs will be growing much faster than their parents. One possible outcome: Successful offspring might take over their parent companies and sell off the fixed-line phone holdings.

Indeed, some argue that the phone companies are heading in exactly the wrong direction. Maybe so. But phone companies, facing fierce competition and takeover threats, may feel they don't have a choice. For now, those spin-offs will keep on spinning.