Vodafone looks to T-Mobile for link up

Vodafone may be the world's largest mobile phone company but it has struggled in its fragmented home market. Is the time ripe for consolidation?

T-Mobile believes that "Life's for Sharing". A series of adverts showing Britons breaking into impromptu song in Trafalgar Square – part of the craze known as flashmobbing – promote the benefits of being together. It seems that rival Vodafone was watching.

Vodafone has been in discussions with the German-owned mobile phone operator over a potential joint venture or even a takeover, with speculation of a deal worth between £3bn and £6bn. Analysts believe consolidation in the UK market is due, and the emergence of Vodafone's interest could spark a bidding war for T-Mobile UK.

Neither side would comment yesterday, but sources close to the talks confirmed they had met, cautioning that the negotiations were at a "very early stage". The move would catapult Vodafone to becoming the dominant player in the UK.

Several analysts said Vodafone's plan is to build scale in its home market. Terence Sinclair, a telecoms analyst at Citi, said that a tie-up would see the company lifting earnings before charges by up to £300m after three to five years. The merged company would have a 40 per cent share of the market.

Will Draper, an analyst at Execution, added that there would be the potential to slash costs: "Vodafone would be able to reduce operating costs from reducing the duplication of offices, employees, call centres and billing systems. They could also collapse two national networks into one," he said. Emeka Obiodu, a senior analyst at Ovum, added: "The increased revenue potential is fairly obvious."

T-Mobile's parent company, Deutsche Telekom, has struggled during the downturn, and the share price has underperformed the sector for some time. It is under pressure from shareholders, including the German government and the private equity giant Blackstone, to boost its operations, and the flagging UK division is especially in focus.

Deutsche Telecom took a huge hit on T-Mobile UK earlier this year, with an asset writedown of €1.8bn. The decision sparked speculation that it was ready to put the business on the auction block. The appointment of an investment banking adviser to review the business in JP Morgan added fuel to the fire.

Talk in the market has also been building on whether Vodafone might look for a deal in the UK. Its new chief executive, Vittorio Colao, has signalled that the group would be willing to participate in potential consolidation where it makes sense.

While Vodafone has grown worldwide it has struggled somewhat in its home market recently and has brought in a new head of UK operations in Guy Laurence. He said earlier this year that the group was hit harder than expected by the downturn, and should have stripped out more costs in response. Vodafone is the world's largest mobile phone company by revenues, but has 25 per cent of the UK market, behind O2's 27 per cent. T-Mobile UK has 15 per cent.

Mr Obiodu said: "Vodafone is the de facto incumbent in the UK, yet it doesn't have the largest market share. It would want to dominate its domestic market."

The deal would still face issues. T-Mobile UK has lost customers year on year in the past three quarters, while insiders at rival networks said the group's customers were on low-paying deals, which are less attractive. The tie-up would also include unravelling a complex network-sharing deal as T-Mobile has tied up with 3 and Vodafone has signed an infrastructure deal with O2. Charlotte Patrick, an analyst at Gartner, was sceptical over the deal, saying: "It just doesn't strike me as hugely appetising."

Should a deal still be struck, Vodafone's domination would interest the regulators, according to Mr Sinclair of Citi. He said: "40 per cent is the benchmark for regulatory hurdles and European Union scrutiny would likely be intense. However, the group could offer to sell the Virgin contract as a remedy if the authorities feared market failure, as well as reduced tied distribution."

Mr Obiodu believed it should be cleared as Spain, France and Italy all have dominant players enjoying more than 40 per cent of market share, with KPN in the Netherlands even hitting 50 per cent. "Three viable operators is generally enough to sustain competition in the market and we do not see any threat to consumer choice. In fact, we believe the fear of higher consumer prices is somewhat overblown," he added.

Vodafone could face competition. One industry source predicted that France Telecom, which owns Orange in the UK and had reportedly shown interest in the past, could see the merits of a counter-offer. The source was sceptical over whether Telefónica, the Spanish owner of O2, would look to get involved. One even suggested that BT would look at the deal, potentially being its last chance to get back into mobile telecoms.

Mr Draper said: "The UK is the most competitive market in Europe, it is overcompetitive really. Another reason for doing the deal would be for 'market repair'. Taking out one of the five UK operators would make the market more benign although still competitive. The return on capital expenditure is very low for these companies at the moment."

Should T-Mobile be taken out it leaves the market fearing for the future of 3 UK. Mr Obiodu said: "Surely they can not survive in direct competition to Vodafone, O2 and Orange." Execution's Will Draper agreed. "3 is the next one to go. If T-Mobile is taken out, that's the only one other move that can go through."

Deals that have shaped the industry: Vodafone, the biggest hitter in M&A

Vodafone is no stranger to multibillion-pound takeovers, and shook up the mobile market a decade ago when it secured the two largest deals the industry has seen, according to the data from Thomson Reuters.

The UK group bought Germany's Mannesmann in 2000 with an all-share offer worth $203bn (£123bn) , following a drawn-out takeover battle. The move came the year after it secured AirTouch Communications in the US, with a $65.7bn offer.

In 2000, France Telecom bid $39.6bn for Orange, and created the second largest mobile group in Europe. The UK business was sold by Mannesmann in the wake of its takeover by Vodafone, to appease the competition regulators. The other significant acquisition in the UK was Telefonica's $31.7bn takeover of O2 in 2005.