... it rears its head – the discussion about a merger of E-Plus and O2 Germany. E-Plus CEO Thorsten Dirks commented again last Wednesday in the Financial Times Deutschland about the rationale behind this scenario. The discussion always centres on the same arguments: economies of scale and synergies, which have enabled the two big competitors – T-Mobile and Vodafone – to achieve EBITDA margins of around 40% in the past, could be realised with a combined customer base and through the consolidation of networks, IT systems and central functions. However, this discussion is often carried out relatively indiscriminately, overlooking the fact that an earlier merger of the two leaders in the German mobile communications market would have undoubtedly made more sense than it does today.

For years, the market and competitive environment of mobile phone users in Germany has been shaped by the fact that the two dominant players, Vodafone and T-Mobile, command approximately 70%-75% of the market – depending on whether you take turnover or customer base as your measurement. For years both players have achieved EBITDA margins of around 40%, both rely on GSM, 3G and HSDPA technologies, and both hope for the much-anticipated „take-off“ of mobile data. In keeping with their fixed divisions T-Home and Arcor, both also employ an integrated approach, allowing them to offer a one-stop comprehensive communications package to the customer.

On the other hand, the financial situation and strategic approaches of the two competitors, O2 Germany and E-Plus, appear to be heterogeneous. Whereas for years O2, together with subsidiary company Telefónica Deutschland, has attempted to market an integrated approach consisting of mobile voice and data services, fixed line and DSL, E-Plus has dedicated itself for a long time to a concentrated GSM mobile communications strategy. This meant that with a background of plummeting sales – contingent primarily on regulatory procedures – E-Plus was able to disproportionately lower its cost base. In spite of the competitive market, thanks to its systematic multibrand strategy E-Plus has managed to implement the eagerly-awaited economies of scale and to raise EBITDA margins above the 30% hurdle. Despite various cost-cutting programs in 2007/2008, O2 in Germany is still some way off from achieving this.

In networking operations, the argument for potential economies of scale in the case of a merger of the two „little ones“ certainly cannot be negated. However, these impacts have consistently dwindled in the last 10 years. During the network rollout of the late 90s, a combined GSM and UMTS rollout would have meant enormous impacts – orders of magnitude, which back then were calculated time and again in the corporate headquarters, wavered around savings of 1 billion Euro Capex and 500 million Euro Opex. After the rollouts, however, these impacts have largely been reduced to the Opex impact – i.e. maintenance and repair of the infrastructure, combined marketing, saving on national roaming costs on the part of O2, and impacts in the administrative sector. The complexity of network and IT solutions has also led to the fact that the potential Opex savings have been increasingly adjusted downwards. But even with a lesser reduction of the accumulated cost base, the merger could add around €500 million to the company value.

However, the really interesting question is: Who should actually be taking over whom? Let’s start with KPN: With a total turnover of €12.6 billion in Europe and a current market focus on the Netherlands, Germany and Belgium, KPN would not be ranked in the premiership of telecommunications corporations. Because of the resulting limited financial power of the corporate group, a takeover of O2 would pose an enormous challenge. Although in the past months we have learned, as in the case of Porsche and Schaeffler, that even the weak can be moved into a position where they are able to handle very tough takeovers.

The main argument against a takeover by KPN, however, could be that Telefónica is not likely to give up a prime asset such as the O2 group, inherited at a cost of €26 billion, lightly. Because to the Spaniards, O2 Germany – despite having only partially achieved expectations – is still the core element of their central European strategy. This crops up not least in the internationalising of the O2 brand, as well as the acknowledgement that further significant investments are planned for Germany.

From the point of view of financial muscle alone, a takeover of E-Plus by the Telefónica group could be considered more likely. Advocates of this strategy would say that E-Plus could be acquired much more cheaply due to the financial crisis. If E-Plus were to be released from the KPN group, however, KPN would show little interest in its current position on the capital markets. Market prices play a subordinate role in this case. The valuation approach is DCF i.e. discounted cash-flows plus synergies. And so the asking price is certainly still going to be over €7 billion. And in our view a takeover of the KPN group would make little sense because it would involve the acquisition of non-strategic company divisions and regulatory obstacles are anticipated.

The question of opportunities also confronts globally-operating Telefónica. As market leader in South America, investor in Eastern Europe and having taken its first steps in the direction of Asia and China, you wonder where potential acquisition funds will be flowing to next. Consequently it is still very doubtful as to whether E-Plus even ranks in the top 10 on the candidate lists for inorganic strategies discussed at the Madrid group’s headquarters.

Last but not least, comes the question of whether KPN is willing to sell. Because E-Plus is still a central element of KPN with regard to the cash-flow. Without the E-Plus component there is no knowing how KPN’s market storyline would develop.

So, we can be certain that in 2009 once again the justification for the merger between O2 and E-Plus will be discussed, over and over. Because the arguments in favour of it cannot be completely dismissed. However, the O2/ E-Plus topic will also keep being pushed back behind rival strategic decisions and investments in 2009 – be it internal or external. For this reason, we will no doubt be delivering an article on the „Year after year“ theme next year too.

Article by

Jens Meyer

, 30 November 2008