Lex: Telefónica

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Telefónica traditionally begins its annual investor conference with a paradox. It highlights its strong value creation record.

Simultaneously it boasts about its market capitalisation, now the global sector's third biggest, from 11th place in 2000. This mix of competence and ambition is why constant deal speculation, most recently about KPN, cannot be totally dismissed.

The poverty of KPN's outlook is certainly matched by its cheap valuation. However, buying declining cash flows requires big margins for error. SBC's annual savings from purchasing a dying AT&T were as big as its target's profits. In contrast cross-border deals create few synergies. A cash bid would be a financial strain, particularly since a third of Telefónica's earnings are from risky Latin America. A stock deal would anger shareholders, given recent, lacklustre, performance.

Telefónica bears scars. Its abortive merger with KPN in 2000 split its board, which eventually deposed the chairman. The subsequent foray into German 3G was a fiasco. The management today is capable but stretched. One senior executive attends board meetings in Spain, Brazil, Argentina, Chile, Peru and China.

Yet, one cannot be sure. The recent purchase of Cesky was clearly unneccessary. Spain's government backs expansion, subsidising its cost by making goodwill on foreign deals tax deductable. Telefónica, one of the sector's most respected operators, now has a genuine reputational problem. It is not wholly of the media's making.

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