Telco merger hype carries echoes of bubble days

London Briefing: The decision by Telefónica of Spain to buy a relatively small-scale British mobile phone operator, O2, provides a case study into the issues facing the telecommunications industry.

O2, which has operations in Germany and Ireland, as well as Britain, has long been rumoured to be the subject of a takeover bid, the main reason for which is the simple fact that it is a small-scale player. Large is good in the world of telecoms and the only way you can bulk up quickly is to buy somebody else.

Indeed, Telefónica's own rationale for the deal made prominent use of the word "scale".

Those bid-stories turned out to be more than rumours when, two months ago, KPN of the Netherlands and Deutsche Telekom confirmed they had thought about a joint approach for O2 but decided against proceeding.

Regulatory issues were one factor here, with Deutsche apparently concerned about its existing operations in Britain and Germany attracting attention from the competition authorities.

Nevertheless, some analysts think that Telefónica's bid may prompt Deutsche and/or KPN - or maybe somebody else - to make O2 into a contested target.

O2 and Telefónica stated that the deal would be earnings accretive from year one. Right now, markets love this sort of thing: deals like this have been welcomed, particularly if that magical word "accretive" is seen.

Anything that boosts earnings is given a positive market vote, with, in many cases, both sides of the deal seeing their share price rise.

This is the first clue for those of a sceptical nature. This kind of thing carries echoes of the bad old bubble days - when, incidentally, telephony in all its guises was a big part of the collective madness.

History and an acquaintance with some simple accountancy teaches us that mergers are often value-destructive.

Profits may well go up but it is important to look at other, far more important measures, not least the return on capital. Two capital-intensive telcos may well see profits rise, but return on capital might fall - and this is far more significant from a shareholder perspective.

Why the urge to merge? Telefónica had not been tipped to buy O2 so what was the attraction?

Perhaps the company is right and the purchase of "scale" will ultimately benefit shareholders. But I doubt it. Telcos are buying each other - there will be many more such deals - because the industry is in trouble.

The threats posed by internet telephony and other disruptive technologies pose possibly an even bigger concern for mobile operators, as they do to fixed-line incumbents.

The purchase of more capacity is just that. There are no new products or services being acquired, just more networks; more of the same. Flush with cash (telephone companies are currently hugely cash-generative) and totally lacking in imagination, telcos are buying each other rather thinking up innovative ways to deploy their capital.

Buying another company may provide some instant gratification but the buzz will soon wear off.

As ever, look to the US for the latest trends. In telephony, there is a peculiar underground movement that is calling for "connectivity" to be the right of every citizen. Free internet access in the 21st century is argued to be as important as the establishment of free libraries of the 19th and 20th centuries.

Annoyed by the high margins and low broadband performance of the private sector, some people are calling for publicly provided wireless broadband access. This will bridge the digital divide, be socially inclusive, raise economic growth and send many telephone companies to the wall.

Which will be the first European country to adopt this vote-winning measure? Electorates will simply adore any politician who comes up with the idea to provide free, wireless, broadband internet access.

San Francisco is thinking of teaming up with Google to provide free broadband to its inhabitants and variants are being considered in many other cities and towns. No wonder that the phone companies have been accused of trying to block internet phone calls. The industry is also denying claims that it is lobbying Congress to outlaw public broadband provision.

The Telecommunication industry used to be regarded as a "utility" by stock market participants.

Utilities are companies that typically have stable and predictable cash flows. By my reckoning, telco cash flows in future years are going to be anything but.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.