Euro Telcos: "We Have Touched Bottom"

They're cutting deals and getting back into fighting trim

They've gone from darlings to dogs in the eyes of many investors, but Europe's telecommunications companies still draw the gaze of empire builders. On Aug. 3, a group led by former H.J. Heinz Co. Chairman Sir Anthony O'Reilly and financier George Soros won a nine-month battle for Irish phone company Eircom (EIR ). Across the Irish Sea, British Telecommunications PLC (BTY ) is fielding unsolicited offers for its local phone network, including a $25.6 billion bid from a group led by German investment bank WestLB. Down in Italy, tiremaker Pirelli and the Benetton family made waves with their successful July 28 grab for Telecom Italia (TI ).

Sounds almost like the good old days. Back in early 2000--it seems eons ago--raiders such as Vodafone (VOD ) pursued rivals in record takeovers and telcos vied to outspend one another on next-generation networks. It was an era of pie-in-the-sky optimism--and it all ended when investors realized that the Continent's carriers were cratering under a ton of debt.

LESS DEBT. The boom times haven't come back. But carriers are starting to dig their way out from under the debt pile by trimming assets, workers, and expenses. "I am confident the situation will turn positive soon," says Telecom Italia's new chairman, Marco Tronchetti Provera. Rick Deutsch, head of European credit research at BNP Paribas in London, agrees: "We have touched bottom and begun the ascent upwards." Some leading carriers are even reporting respectable results. Deutsche Telekom's (DTBKY ) first-half operating profits rose 20%, to $528 million. Spanish wireless carrier Telefónica Móviles (TEM ) reported that second-quarter net income rose 24% as data services such as text messaging grew. And France Télécom's (FTE ) first-half sales rose over 33%, to nearly $18 billion, thanks mainly to its wireless subsidiary, Orange.

More important, telcos are improving their ravaged balance sheets. None has done more to slash debt than British Telecom. By unloading minority stakes in Japan Telecom (JPNTY ) and Airtel, dumping $3 billion in real estate, and issuing $8 billion in stock rights, BT has cut its debt from $42 billion at yearend 2000 to $25 billion. France Télécom, meanwhile, ended 2000 with debt of $57 billion, or 5.6 times its cash flow. By selling off non-French assets, it should lower that ratio to a less perilous 4.9, according to brokerage Credit Suisse First Boston.

Such progress has not escaped the attention of market watchers. All of Europe's major carriers still carry investment-grade ratings. Since March, the spread between European telecom bonds and prevailing corporate rates has fallen 30%, to about 100 basis points, an indication that the market now sees lower risk in holding the phone companies' paper. "The Chicken Little phase is over," says telecom analyst Delia MacMillan at researcher Dataquest Gartner in Egham, Britain.

Of course, the Continent's top eight carriers still bear $200 billion in debt. Their stocks remain weak--70% off their March, 2000, peaks and still searching for a floor. Raising new equity is nearly impossible, especially after France Télécom's disastrous flotation of Orange in February. "The market for IPOs has been knocked on its head," says John Crompton, co-head of European equity markets at Morgan Stanley Dean Witter & Co. in London.

To compensate, carriers are scrambling to boost cash flow. After years of slashing prices to entice new customers, wireless operators have finally slammed the brakes on discounting and subsidizing mobile handset sales. As a result, average wireless revenues per user should soon reverse their decline. Carriers "have backed away from suicidal competition," says BNP's Deutsch.

GENERATION GAP. Companies are also pushing new revenue sources. British researcher Mobile Streams figures Europeans sent a staggering 47.5 billion text messages from Web-enabled cell phones in the second quarter, plopping a juicy $4.28 billion into operators' pockets. Meanwhile, BT reported that traffic at its Genie wireless Net portal was up 37% in the quarter, a sign that consumers may finally be embracing the wireless Web.

Customers may have to wait a while longer for faster wireless service, though. To conserve cash, European telcos are dribbling out new 2.5G services, which bridge the gap between today's second-generation digital systems and the whizzy 3G networks envisioned for 2003 and beyond. Even the launch date of 3G has been pushed back.

The next step: another big round of consolidation. "Europe can't support this many independent companies," says Matthew N. Norden, European research director for Forrester Research Inc. in Amsterdam. One likely linkup: the Netherlands' troubled Royal KPN (KPN ) and neighboring Belgacom. More mergers? More deals? Maybe the great telecom game isn't over after all.

By Andy Reinhardt in Paris, with bureau reports

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