Telefonica's bold move into the UK may be a step too far

Telefónica's main overseas expansion plans have until now centred on the emerging markets of Latin America as well as dominating in its domestic market.

But yesterday it moved decisively to rebalance its portfolio of assets with the 200p-a-share acquisition of one of the most successful mobile operators in the most competitive and well-developed Western European markets.

Having largely avoided the pitfalls of the 1999 to 2000 telecoms acquisition boom, there are fears that the Spanish company, led by its chairman César Alierta, has this time overpaid and fallen into the same trap that the likes of Vodafone and France Telecom suffered five years ago.

Jim McCafferty, at Seymour Pierce, said: "Yesterday's [Monday's] surprise announcement of a deal between Telefónica and O2 is a reminder of events in the telecoms sector in the 1999 to 2001 period. Investors should have learned that in bid situations, bidders tend to overpay for assets, and shareholders in the bidding company tend to suffer in the aftermath. Vodafone acquired AirTouch in 1999 followed by the acquisition of Mannesmann in 2000. Meanwhile, shares in Vodafone have underperformed the UK market by 40 per cent in the past five years."

The danger for Telefónica is that it will suffer a similar fate, despite trying to make a strong virtue out of the fact that the deal will reduce its reliance on Spain and Latin America from 61 and 34 per cent of group earnings to 51 and 28 per cent. The rest of Europe - O2 has operations in Germany and Ireland as well as the UK - will go from 5 per cent to 21 per cent.

Certainly the Spanish stock market caught a chill in the aftermath of Telefónica's announcement of its O2 bid. Telefónica's shares fell 3 per cent on Monday and were down 1.8 per cent yesterday. Conversely, shares in O2 traded above Telefónica's offer price yesterday, closing up 1.7 per cent at 209.25p reflecting continuing hopes that a counter bid might materialise, scuppering Telefónica's strategy.

Mr McCafferty said: "Commentators suggest that the most serious contender is Deutsche Telekom among others, including Hutchison Whampoa and NTT DoCoMo.

"Orange shareholders in 1999 to the 2000 period will remember that an agreed bid by Mannesmann resulted in a subsequent transaction which saw Vodafone acquire Mannesmann. In that case, the UK competition authority would not allow Vodafone to own Orange UK and it was forced to sell this business to France Telecom. We see it unlikely that Deutsche Telekom would be allowed to own two UK cellular networks [it owns T-Mobile]."

The deal, according to Seymour Pierce, also sets new valuation benchmarks for mobile phone companies making it feel even more frothy for the sceptics.

All this talk of the telecoms boom making a comeback will further unsettle shareholders in Telefónica, some of whom will be struggling to understand the industrial logic of buying into one of the world's most fiercely contested markets, albeit one that has delivered double digit revenue growth for O2.

A research note published by Dresdner Kleinwort Wasserstein summed up these concerns. "On balance, we think Telefónica has got a fair deal. Strategic question marks remain, however: Why is Telefónica entering core Europe, especially the UK which is very competitive? Will they need to do more deals or does this complete their European footprint? Our concerns are as follows: Telefónica has denied interest in O2 in the past so there are credibility issues; strategically it seems questionable; and it is not in Telefónica's area of expertise - emerging markets."

So while analysts can live with the price Telefónica is paying for O2, they are less sure that the Telefónica management can make the deal work and create value.

To soothe these fears, the Spanish company is keeping hold of the O2 management that has succeeded in growing the value of group from a low of 37.5p a share 12 months after its demerger from BT in 2001, to yesterday's 209.25p. Peter Erskine, the chief executive of O2, and David Arculus, the chairman, will join the Telefónica board.

For the Spanish, the O2 deal is attractive because it makes it a serious pan-European player with critical mass and should deliver savings of £200m a year. It also taps into a stream of lower-risk earnings and revenues that are growing healthily, despite the highly competitive natures of the markets they are generated in. Mr Alierta, Telefónica's chairman, said the deal would "enhance our growth profile, it will allow us to gain economies of scale, it will open the group to the two largest European markets with sizeable critical mass and it will balance our exposure across business and regions".

O2 has confounded the critics over the past couple of years and it seems likely that, under the current management, it would have grown to become an even more valuable company if it had been left as an independent entity.

Under the proposed structure of the deal, O2 will remain a relatively independent unit, keeping its brand and management, so stands a decent chance of continuing its recent run of success. There are risks for Telefónica, however, notably how well Mr Erskine and his UK management get on with their new Spanish masters, although this will be of no concern to O2's shareholders who look forward to the prospect of banking £17.7bn.