European telecoms. Survivial of the biggest

Telefonica's bid for Britain's O2 would create the largest phone company in the western world. That does not mean it is a good idea

THERE used to be a gentlemen's agreement between Europe's incumbent telecoms operators that they would not invade each other's home territory. But the old non-aggression pact has been eroding for some time. On October 31st it finally collapsed when Spain's Telefonica made a £17.7 billion ($31.5 billion) all-cash offer for O2, one of the largest mobile-phone operators in both Britain and Germany. O2 is recommending the offer.

A union between Telefonica and O2 would create the world's second-largest phone company by number of customers (after China Mobile), with 170m mobile and fixed-line users in Europe and Latin America. On one level, the bid is a sign of the boisterous confidence of the Spanish operator. But it is also a symptom of the fact that European telecoms companies know that they are operating in a new and tougher environment, in which sitting comfortably in your home market is no longer really an option. The combination of the after-effects of the technology bubble of 2000, the cost of third-generation wireless licences and the rapid entrance of new rivals and technologies means that companies now need to look further afield to grow - and even to survive.

A different sort of symptom of this new era for telecoms came on November 2nd when Deutsche Telekom announced that it plans to lay off 32,000 workers out of its total work force of 244,000. Kai Uwe-Ricke, the company's chief executive, said the job cuts were a necessary reaction to "the worldwide realignment of the industry, the rapid pace of technological development and...the tough competitive environment." Retrenchment on one front is likely to be accompanied by expansion elsewhere. However, Deutsche Telekom's T-Mobile, which tried to buy O2 earlier this year, said it did not intend to make a rival bid to Telefonica's.

The big European telecoms firms are jostling each other for fear of coming off worst in a continent-wide wave of consolidation. Telefonica's bid for O2 is itself partly a reaction to the fact that its own home turf was invaded by France Telecom in July, when the French firm bought an 80% stake in Amena, Spain's second-largest mobile company. As the last major independent wireless firm in Europe, O2 is also attractive to suitors who simply want to prevent rivals from acquiring it first. The O2 deal would then set the stage for even more consolidation.

If the Telefonica-O2 deal goes through, it will sharpen competition in the mobile market. But it will also eventually threaten the incumbent fixed-line carriers, such as Britain's BT and Deutsche Telekom. This is because while entry into the market is via mobile phones, it comes at a time when wireless technology is increasingly a substitute for both traditional copper-wire phone calls, and soon, broadband internet access. Among major mobile operators, only Vodafone remains true to a pure wireless strategy worldwide - other wireless firms are mainly old telecoms incumbents attempting to salvage their business through diversification.

Telefonica's chairman, Cesar Alierta, justified the proposed acquisition as a way of broadening the firm's reach across different markets and technologies. Today, the majority of Telefonica's sales come from Spain and Latin America, as well as from traditional fixed-line calls. With O2, the percentage of revenue from elsewhere in Europe will increase from 5% to 21%, and the proportion of fixed-line revenue will decrease by ten percentage points, in favour of wireless.

Yet in some ways the deal represents a step back in time, not forward. Only five years ago, the fashion was for incumbent operators to spin off their wireless and internet divisions. Now telecoms carriers are putting these assets back together again. The idea is that customers will want a seamless service. But inevitably, as the wave of consolidation and counter-consolidation gets going, mistakes will be made. Moving into new (and mature) markets by paying a huge premium for a mobile operator may not make good business sense, since the price of mobile calls is falling and there is no certainty that new mobile services will fill the revenue gap.

Investors have given the Telefonica bid a lukewarm reception. The deal is expensive: a 25% premium over the company's average share price in October. And it appears to offer few obvious synergies or opportunities to cut costs or increase revenues. Nevertheless, there are likely to be more mergers in the coming months. Telefonica, Deutsche Telekom and France Telecom are expected to be the main consolidators. Private-equity firms would also like to be buyers, although they might be constrained by financial considerations from bidding as much as the telecoms giants which can cite long-term strategic necessity. Norway's Telenor, Portugal Telecom and Bouygues, a French mobile telecoms firm, are thought to be among the juiciest potential acquisition targets.

Europe is not the only place where big telecoms mergers are underway. This week, America's Federal Communications Commission (FCC) finally gave formal approval to the acquisitions earlier this year by Verizon of MCI (the formerly bankrupt WorldCom), and SBC of AT&T (with the groom taking on the bride's better-recognised brand-name). In contrast with the recent telecoms consolidation in America - which has reduced the number of telecoms operators - so far the takeover wave in Europe has not led to fewer operators, since it has largely been driven by companies in one market moving into another.

In America, consumer-advocacy groups complained that the mergers would decrease competition and successfully persuaded the FCC to impose conditions. It required the firms involved to sell broadband without forcing customers to pay for a separate voice line - thus boosting the prospects for internet telephony. And it forbade the firms from discriminating against the source of internet traffic that flows across their networks - to prevent them from blocking internet phone calls and soon TV, in order to sell these services themselves. As they seek to follow suit, European firms (and regulators) should take note.

Telefónica's bid for 02 would create the largest phone company in the western world. That does mean it is a good idea.

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