Telefonica to Buy O2 For $31.4 Billion

Spanish Titan to Purchase U.K. Cellphone Operator To Expand European Reach 

JASON SINGER and KEITH JOHNSON / Wall Street Journal 31oct2005

[Mergers: Ranking Big Deals - Wall Street Journal 31oct2005]

Telefonica SA agreed to buy British cellphone operator O2 PLC for £17.7 billion ($31.4 billion or €26 billion), the Spanish telecommunications company said Monday.

The deal is part of Telefonica's efforts to expand in Europe after years of building its business in Latin America.

Extending Reach Wireless-customer breakdowns for Telefonica and O2 by region: Note: Latest data available; figures don't total 100% due to rounding *Telefonica regions: Northern region: El Salvador, Guatemala, Mexico, Nicaragua and Panama; Andean region: Colombia, Ecuador, Peru and Venezuela; Southern cone: Argentina, Chile and Uruguay. Source: the companies

The agreed cash deal, at 200 pence a share, represents a 22% premium to O2's share price at the close of trade Friday. The deal ends years of speculation about O2's future. O2, the star performer in the European mobile telecoms sector over the past three years, has attracted attention from German telecoms giant Deutsche Telekom AG and Dutch incumbent operator KPN NV over the past two years.

Telefonica will acquire O2's assets in the U.K., Germany and Ireland, and won't face the same regulatory hurdles as other rumored bidders as Telefonica doesn't operate in those markets.

Madrid-based Telefonica, which is the world's fifth-largest telecommunications company by market value, has been looking for an acquisition in Europe, where the telecommunications industry has been on a mergers-and-acquisitions spree in the past year.

Telefonica recently approached KPN NV of the Netherlands over whether the companies should begin merger negotiations. But KPN was cool to the overture and no talks ensued, people familiar with the matter said.

The Spanish company then focused its sights on O2, these people said. O2 was spun out of BT Group PLC, the United Kingdom's largest traditional phone-service company, in 2001. Based in Slough, England, O2 has 15,000 employees and 24.6 million mobile-phone customers in the U.K., Ireland and Germany.

After working their way out from under mountains of debt incurred in the late 1990s, many European telecommunications companies are flush with cash, prompting the larger ones such as Telefonica to look for deals and making smaller ones attractive acquisition targets.

This year operators have been snapped up in multibillion-euro deals in the Netherlands, Austria, Italy, Spain and the Czech Republic. Private-equity firms are in the midst of attempting a $12 billion deal to buy TDC AS of Denmark, that country's largest carrier, which also has big businesses in Switzerland, Poland, Germany and elsewhere.

Moreover, some of Europe's huge traditional, fixed-line service providers such as France Telecom SA and Telecom Italia SpA are pushing their wireless and fixed businesses closer together. In July, France Telecom in a surprise move that encroached directly on Telefonica's turf, spent €6.4 billion ($7.7 billion) for Spanish mobile-phone operator Amena.

Buying cellphone operators makes sense for fixed-line providers because the intense competition and new technology such as telephone calls over the Internet have turned traditional telephone calls into a low-margin, commodity business. Upstart companies offering extremely low-cost voice calls also have driven prices down.

Telefonica's mobile-phone division, Telefonica Móviles SA, has more than 90 million customers in 15 countries. (Telefonica owns 92% of Móviles.) But the cellular operator derives about half of its sales from Spain and much of the rest from Latin America. Telefonica had first-half revenue of €17.4 billion and net profit of €1.8 billion.

For Telefonica, O2 will provide geographic diversity. It will also boost Móviles's size. That is important for cost savings through sales and distribution, but perhaps more so because bigger cellphone companies pay manufacturers less for handsets that they then sell to their customers. After acquiring Bell South's Latin American cellular assets last year, Móviles lowered by 35% the average cost of handsets because of its greater clout in that market. In the second quarter, Móviles's net profit rose 4.5% to €495.7 million from a year earlier on sales of €4.1 billion.

Takeover speculation has swirled around O2 for months. Deutsche Telekom and KPN together tried to formulate a plan to buy O2 earlier this year, the companies said at the time, but no deal emerged. The two companies were forced by U.K. takeover regulators to shelve their plans for six months, but would be allowed to revisit the proposal and potentially make a counterbid if Telefonica launched a formal offer.

The U.K. cellphone market is extremely competitive, with four major players — Vodafone Group PLC of the U.K., the world's largest cellphone operator by sales; Orange, owned by France Télécom; O2; and Deutsche Telekom's T-Mobile. In addition, a service called "3" owned by Hutchison Whampoa Ltd. of Hong Kong has aggressively been promoting the next generation of cellphone service known as 3G, which permits users to perform more sophisticated functions such as browsing the Internet and watching video clips.

But O2 has been performing strongly. The company said recently it expects stronger growth in revenue in the U.K. and more robust profit margins in Germany than it previously anticipated. In the U.K., the company said rapid growth in subscribers pushed its customer base to more than 15 million for the first time, excluding 750,000 customers using the Tesco Mobile service, a joint venture with the U.K.'s largest retailer, Tesco PLC.

Telefonica invested several years ago in third-generation licenses to operate in Germany, Italy and Switzerland but eventually wrote off more than €5 billion in the value of those investments.

Goldman Sachs Group Inc. and Citigroup are acting as advisors to Telefonica in the O2 deal. Telefonica has obtained committed financing, arranged by Citigroup, Goldman Sachs and the Royal Bank of Scotland Group PLC.

J.P. Morgan, Cazenove and Merrill Lynch & Co. advised O2.

In London on Friday, shares in O2 climbed 2.7% to 164.25 pence ($2.91); in Madrid, shares in Telefonica closed down 0.3% at €13.62.

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