KPN-Telefonica German Merger of Foes Augurs More Dealmaking

Telefonica SA and Royal KPN NV’s $10.7 billion German wireless merger, combining two of Europe’s fiercest competitors, sets up the likelihood of more deals in a region where phone stocks have lost about 40 percent since 2007.

Talks between “Teresa” and “Kate,” as the two companies were codenamed during negotiations, have been held on and off for a decade, and they heated up last week, according to people familiar with the matter, asking not to be identified because the deliberations were private. Over the weekend, the discussions were almost called off because KPN demanded a higher price for the E-Plus division, the people said.

With earnings under pressure, carriers from EE in the U.K. and France’s SFR to Telecom Italia SpA and Spain’s Yoigo are considering partnerships or share sales. Vodafone Group Plc already snapped up Kabel Deutschland Holding AG last month for $10 billion. And now KPN and Telefonica uniting signals the industry is ripe for more combinations, said Espen Furnes, who helps oversee $75 billion at Storebrand Asset Management.

“Carriers are finally coming to grips with reality,” said Oslo-based Furnes. “Finally we’re starting to see some consolidation.”

The German deal adds a dimension to the relationship of Telefonica Chief Executive Officer Cesar Alierta and KPN investor Carlos Slim, who are feisty rivals in Latin America. Although Slim’s America Movil SAB owns almost 30 percent of KPN as its largest shareholder, it’s unclear whether he personally supports the E-Plus sale, two people familiar with the matter said. A spokesman for America Movil declined to comment.

Slim Bid?

The sale also removes a restriction that capped Slim’s stake in KPN at about 30 percent, KPN said today. To buy KPN outright, America Movil would need to cancel a share buyback and obtain $4 billion of debt financing, Sanford C. Bernstein & Co. analysts said in a note. It could also partner with AT&T Inc. for a bid, they said. KPN rose as much as 3.6 percent and added 3.4 percent to 1.91 euros at 12:53 p.m. in Amsterdam.

Ward Snijders, a spokesman for the Hague, Netherlands-based KPN, and Miguel Angel Garzon, a spokesman for Madrid-based Telefonica, declined to comment on how the deal came together.

European mobile carriers’ sales have slid for at least four years as almost everyone already has a mobile phone and rivalry between operators in the small national markets has eaten into call and data prices. The need for capital spending hasn’t eased as users demand faster speeds -- yet aren’t willing to pay more.

German IPO

After Vodafone agreed to buy Kabel Deutschland, Germany’s No. 1 cable provider, in June, KPN and Telefonica resumed talks over a deal because of heightened competition, the people said.

The cash-and-stock agreement for Telefonica Deutschland Holdings AG to acquire E-Plus would create an entity with more than 43 million customers, toppling market leaders Deutsche Telekom AG, with 37 million, and Vodafone’s 32.4 million, data compiled by Bloomberg showed. The combination remains smaller than Vodafone and T-Mobile by sales, the data showed. The purchase would be the biggest European wireless deal this year.

Senior Telefonica executives were surprised by the announcement yesterday as the Spanish carrier has for the past year been disposing of assets instead of looking for ways to bulk up its German businesses, the people said. Those sales included almost a quarter of Telefonica Deutschland in Europe’s biggest initial public offering last year.

Although Telefonica Deutschland shares were trading close to their IPO price before the deal, they have outperformed KPN’s stock, which had lost almost 30 percent this year before the talks with Telefonica were reported this week.

Shrinking Bills

Standard & Poor’s and Moody’s Investors Service, which effectively blocked Telefonica’s bid to merge its German unit with E-Plus last year over concerns about the Spanish carrier’s debt, support the deal this time, two of the people said.

Morgan Stanley, Citigroup Inc. and HSBC Holdings Plc advised Telefonica, while KPN was assisted by Goldman Sachs Group Inc. and JPMorgan Chase & Co. Telefonica Deutschland was advised by Bank of America Merrill Lynch and UBS AG.

Europe’s carriers have suffered from the region’s cultural, political and regulatory divisions, which have left it with dozens of isolated wireless markets, limiting the operators’ growth and spending power. There are more than 100 carriers in Europe, compared with 4 major ones in the U.S.

While carriers such as Telefonica and Vodafone have expanded across borders in a bid to reduce aggregate costs, they too have failed to report sales or earnings growth recently. Wireless phone bills in Europe have declined steadily since 2000, the GSMA industry group said in May.

Slim last tried to acquire a major western European operator in 2007 with an offer for a stake in Telecom Italia, before he was beaten by Telefonica. The two compete in Latin American markets such as Brazil and Mexico.

Scale Needed

As Neelie Kroes, the EU commissioner in charge of the digital agenda, pushes reform in favor of a single European telecommunications market, carriers have become more emboldened to pursue deals. Potential benefits from a merger include shared expenses to build so-called fourth-generation networks to cope with rising demand for video and data services, as well as lower administrative, marketing and development costs.

“Telco consolidation is all about taking out costs,” Furnes said. “There are just too many operators and too much capital spending needed in these markets so the cost synergies are vital to sustain earnings.”

Western Europe’s carriers need to spend about $12 billion on 4G networks alone through 2017, according to Gartner Inc., as consumers increasingly use services such as Netflix on their mobile devices. KPN and Telefonica, which operates under the O2 brand in Germany, said their deal will result in savings and additional revenue of 5 billion euros to 5.5 billion euros.

Borrowing Costs

“As the third and fourth players, O2 and E-Plus didn’t have the scale to adequately compete in a market where ferocious price competition has led to declining revenues and profits,” said Emeka Obiodu, an analyst at researcher Ovum.

Lower borrowing costs have helped to increase consolidation activity, said Daniel Lacalle, a senior portfolio manager at Ecofin Ltd. in London.

The average yield investors demand to hold investment-grade corporate bonds in euros has fallen to 2.09 percent from an eight-month high of 2.38 percent reached June 24, according to Bank of America Merrill Lynch index data.

“The main reason why Telefonica is doing this deal now is because capital markets are more stable while tensions from credit ratings companies have eased,” Lacalle said. “A year ago, the debt market was completely closed.”

SFR, Yoigo

Carriers who have sought buyers or partners span the continent.

Telecom Italia started an in-depth review earlier this year for a wireless merger with Hutchison Whampoa Ltd., only to decide against it. Yoigo, controlled by TeliaSonera AB, and Finland’s DNA Oy both halted their sale processes.

Orange SA and Deutsche Telekom, who have combined their U.K. businesses, are weighing an initial public offering of a minority stake in the joint venture, called EE. AT&T Inc. is sizing up EE as it seeks acquisitions in Europe, people familiar with the company’s plans have said. EE has also received interest from private-equity firms, Orange said.

Vivendi SA said last month its French wireless carrier SFR is ready for an IPO. This week, SFR said it is in talks with Bouygues SA about sharing part of their French mobile-phone networks to cover more ground for less.

Vodafone, meanwhile, said yesterday it would consider an offer for its stake in Verizon Wireless, which partner Verizon Communications Inc. has said it’s interested in buying. That deal, valued by analysts at $120 billion or more, would provide Vodafone with a war chest for further acquisitions in Europe.

Regulator Scrutiny

To be sure, hurdles remain for more combinations. Competition authorities want to ensure that no merger results in a carrier becoming too dominant, said Paul Hughes, European competition counsel at law firm Steptoe & Johnson LLP in Brussels. Remedies required by authorities may include spectrum disposals by the merging companies and granting network access to virtual mobile operators, he said.

Still, “clever mergers and acquisitions like these nice examples in Germany appear to be the right solution,” said Peter Braendle, who manages $500 million at Swisscanto Asset Management in Zurich, including KPN and Telefonica Deutschland shares. “Those deals may now trigger further consolidation in the telecommunications industry.”

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