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Dear All-

Thought you might be interested in this article I wrote on the EPlus deal and wider issues regards BLS & European telecom.

BillM

FOOL ON THE HILL
An Investment Opinion

The Tangled Web of European Telecom

By Bill Mann (TMF Otter)
December 10, 1999

In this morning's Breakfast With the Fool article, Richard McCaffery (TMF Gibson) reported on the impending deal between BellSouth (NYSE: BLS) and KPN Telecom NV (NYSE: KPN) to purchase the 77% stake in E-Plus, the third largest mobile phone operator in Germany. This agreement would seemingly thwart the attempt by France Telecom (NYSE: FTE) to take over E-Plus.

This announcement portends to the continued push by American telecommunications companies to increase their footholds in Europe, including MCIWorldcom (Nasdaq: WCOM), which expects to triple the reach of its fiber optic assets in Europe this year. It also highlights the European companies' continuing period of consolidation. In the past year we have seen a period of hyperactivity, as companies such as Vodaphone Airtouch (NYSE: VOD), Olivetti, Deutsche Telekom (NYSE: DT), British Telecom (NYSE: BTY) and Cable & Wireless (NYSE: CWP) have either attempted or consummated mergers, takeovers, or strategic partnerships with other eurotelecoms.

Why the frenzy? The trends of privatization and deregulation in the latter half of the decade for telecommunications in Europe are certainly catalysts, and they are bolstered by the surging demand for high bandwidth connectivity and mobile services. With the exception of Great Britain, which has had private communications companies for decades, most of Europe's "incumbent" (meaning the ones that held the monopoly for a particular country) telecommunications companies are scarcely removed from the time that they were government owned PTT's (standing for Post Telegraph and Telephone). These factors have conspired to create a volatile environment in which every company is seeking to make strategic moves to build up a presence in markets outside of their home territory, and all the while trying to protect their home turfs.

In other words, European telecom is like a giant game of capture the flag. Except that there are multiple flags. And each is worth several billion dollars (or Euros).

KPN, for example, is the former PTT in the Netherlands. In and of itself, the company has a sizable market, over 8 million fixed line customers and 2 million wireless ones in its own market. KPN's home turf is also quite valuable as a hub for telecommunications facilities between Great Britain and Germany. These factors make KPN by itself one of the mid-major communications companies on the Continent, one of a sufficient size to make it an appealing takeover target by the companies rooted in larger markets. KPN responded to its position by becoming an aggressive acquirer of other assets, including majority stakes in companies in Netherlands, Germany, and Bulgaria. It also holds a 50-50 stake in KPN Orange Belgium with Britain's Orange (Nasdaq: ORNGY), control of Danish GSM mobile operator Sonofon, and a minority controlling stake in KPNQwest (Nasdaq: KQIP) held with Qwest Communications (Nasdaq: QWST).

It is this last stake that makes the BellSouth deal quite intriguing. This creates a situation in which Qwest and KPN have a joint venture, KPN and BellSouth have a joint venture to be structured as a loan from KPN to BellSouth, and BellSouth owns 10% of Qwest. This portends of a potential blockbuster deal in which the three companies combine into one single company with a combined market capitalization in excess of $185 billion (including the combined market caps of Qwest and USWest (NYSE: USW), which are currently undergoing regulatory scrutiny of their own merger). This would make the combined company, at current market caps, the second largest telecommunication services company on earth, behind Nippon Telegraph and Telephone (NYSE: NTT).

A brief review of the holdings of BellSouth and Qwest shows why such a merger is not outside the realm of possibilities.

BellSouth is the incumbent local exchange carrier in the Southeastern United States. It has more than $37 billion in assets, over 23.6 million access lines and 5.8 million cellular customers worldwide. BellSouth components provide basic telecommunications services in its regulated region, including local calling, yellow pages, broadband/cable, BellSouth Mobility cellular services, and Internet Services provided by BellSouth.net. BellSouth provides services to more than 31 million customers internationally in the U.S., Chile, Brazil, China, Israel, Nicaragua, Panama, Denmark, Uruguay, Venezuela, Germany, Peru, and Ecuador.

For its part, Qwest operates an 18,000 mile fiber optic network in the United States, connecting 150 cities. In addition it has a 1400 mile fiber optic link to Mexico, and holds strategic investments in current or planned undersea fiber optic cables running between the United States and Europe and the United States and Asia. Qwest's impending merger with USWest would add a 25 million customer local network in 14 Midwestern states, cable television, and Wireless services.

The combined reach of these companies is immense and does not have a significant amount of geographical overlap except in areas where the companies are already co-operating. In fact the biggest inhibiting factor to any imminent consideration of such a deal might really be limited by the controlling nature of each company's chief executive. KPN, for example, famously will not enter into an acquisition unless it maintains control.

In the end, the prize is not control of a combined entity, which may or may not happen, but rather control of a lucrative portion of the explosive European telecommunications market. KPN's strategy to date has been through acquisition and partnership, avoiding in the process the overtures from the larger players in the market. By aligning itself with BellSouth, KPN is in a position where it can leverage its position in tiny Netherlands into a controlling position of significant portions of the fiercely competitive American and European markets.

Still, the other players in the market are unlikely to cede much to their smaller cousins. British Telecom has tried to combine strengths with both AT&T (NYSE: T) and MCI. Deutsche Telekom and France Telecom are partners with Sprint (NYSE: FON) in GlobalOne, Global Crossing (Nasdaq: GBLX) is merging with Racal (UK), and Telenor (Norway) and Telia AB (Sweden) are planning to merge to form a Scandinavian supercompany. Even Telefonica (NYSE: TEF), the former PTT of Spain, is flexing its muscle, positioning itself as the communications provider of choice between Europe and Latin America. The atmosphere in Europe is likely to remain cloudy for some time, but when it clears the companies left standing are virtually guaranteed to be extremely powerful.

Have a great weekend.
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