CF: Telefónica bid sparks questions on leveraging

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By:
Denise Bedell
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Cash offer for O2 prompts concerns that telecoms sector might be about to embark on another debt binge.

Spanish telecoms company Telefónica’s £17.7 billion ($30.3 billion) offer for mobile operator O2 – the largest all-cash takeover offer ever in Europe – has led to speculation that the latest round of M&A might lead telcos to gear up to the destructive levels last seen in 2001. However, analysts expect greater caution and less leveraging from others in the sector on the acquisition trail.

Telefónica stunned the market in October with its takeover bid for O2, offering shareholders a 22% premium for their stakes in the wireless service provider. The company plans to fund the offer entirely with bank debt, followed by a public bond offering. It also takes the company’s pro forma debt to ebitda up to 3.6 times, versus an expected 2.3 times in 2005, according to independent research firm Gimme Credit.

Dave Novosel of Gimme Credit is concerned that, given this, Telefónica will not refrain from further stock buybacks and instead plans to reduce the amount of debt incurred using its enhanced free cashflow. He estimates this will be lower than last year, at €2.5 billion in 2005. But, as he points out, “even if €4 billion of debt were repaid annually over the next several years, Telefónica would be nowhere near eliminating the incremental debt”.

The situation could have been even worse had the offer provoked a bidding war for the UK group. Such bidding wars were

Sean Carney,
HSBC
partly responsible for the high debt levels taken on by telecoms, particularly European ones, in the late 1990s and early 2000s, which led many such companies into trouble. However as yet no counter-bids have been announced. Indeed, one main candidate for a counter bid – German group Deutsche Telekom – has said it will not put in a counter-offer.

Overall, though, analysts say that after much restructuring, the industry is once again on its feet and telecoms companies have the balance sheet capacity for the next round of expansion. Satyajit Chatterjee, credit analyst at SG, says the M&A cycle is definitely on the up, with large telecom operations looking for geographic expansion, as they experience slowing growth in domestic markets, and they have strengthened balance sheets to support it.

There is room for some leveraging up in this market, and so far acquisitions have been quite logical: in-market consolidation, minority buyouts and footprint expansion. Sean Carney, global sector head of telecoms at HSBC, says: “Most telecom companies appear much more focused on financial prudence in the current string of acquisitions. Post-acquisition leverage is lower and many of the assets being acquired are generating positive cashflow. In 1999-2001, many acquisitions were cash-burning new builds, such as cable companies or 3G licences.”

But, according to Chatterjee, some recent M&A activity might not be as well thought out. “France Telecom’s purchase of Amena and Telefónica’s O2 bid are less rational. For the large companies, like FT and Telefónica, clearly their ambitions are to become global players.” The purchases it has made around the globe recently lend credence to this. In the last 12 months, it has bought BellSouth’s Latin American wireless assets for nearly $6 billion, Cesky Telecom for €6 billion and a €400 million stake in China Netcom. Other analysts fear Telefónica won’t stop with this deal, but will look for other acquisition targets that will further impede its financial flexibility and increase leverage.

And, more worryingly, it’s not just strengthened balance sheets but also the ready availability of cheap financing that is driving these deals. “So far in 2005 we have seen $70 billion in completed and announced M&A transactions in the sector,” says Chatterjee. “The bulk of this has been cash funded. The ability to raise cheap funding has been a key driver of acquisitions. The sector has the ability to fund such transactions given its significant additional debt capacity.”

Furthermore, shareholders feel the sector is underleveraged at the moment and there is a lot of pressure to gear up. “We could see net-debt-to-ebitda going to two and a half, or perhaps three times,” he says.

However, overall, Chatterjee does not think there’s any risk that debt piles at the leading telecoms players will go back to the alarming levels that the market saw back in 2001. “Companies will be very careful in managing this process,” he says.

Debt profile of major telcos
 Net debt/(cash mlns)2005eNet debt/(cash mlns)2006eNet debt/(cash mlns)2007eNet debt/EBITDA 2005eNet debt/EBITDA 2006e  Net debt/EBITDA 2007e
Deutsche Telekom (A) 40,675 33,216 28,499 2.0 1.6 1.3
France Telecom (A) 49,554 42,467 33,981 2.7 2.1 1.6
KPN (A) 7,795 6,725 6,361 1.7 1.5 1.5
Telecom Italia (A) 42,398 39,862 37,519 3.1 2.8 2.6
Telefonica (A) 26,968 23,004 16,808 1.8 1.4 1.0
Vodafone (£) 10,888 8,564 5,597 0.8 0.6 0.4
Average    2.0 1.7 1.4
Median    1.9 1.6 1.4
 e = estimate                                                                                        Source: SG Equity Research