It has been a disappointing year so far for European telecommunications stocks, but that could change in the coming quarter following a recent wave of merger and acquisition activity in the sector.

The FTSE Eurofirst 300 telecommunications sub-index has barely changed since January, although it has rallied 6 per cent since hitting a 2005 low in April. By comparison, the Eurofirst 300 index has climbed about 11 per cent this year.

The weakness for telecoms stocks seen early in the year followed some poor results from the sector, highlighting the difficulties companies were having maintaining margins.

But the focus of the cash-rich sector has returned to dealmaking after three years of divestments aimed at repairing balance sheets ravaged by heavy spending on acquisitions and next-generation mobile licences in the late 1990s.

Justin Funnell, telecoms analyst at CS First Boston, notes that, although second-
quarter results helped fuel a rebound in earnings momentum in the sector, a strong performance across the rest of the stock market kept telecoms stocks in the shade in terms of relative performance.

“Looking ahead, M&A is likely to remain a dominant theme,” he says. “We expect bidders using under-geared balance sheets to achieve financial upside from deals, and the list of potential targets is growing as strategic buyers and private equity groups become more confident.

“M&A represents still more upside than downside for investors, although the risks are growing as balance sheets are utilised and as more expansionist strategies emerge, best seen to date in France Telecom’s acquisition of Amena and Telefonica’s acquisition of Cesky Telecom.”

Last July, France Telecom bought Spanish mobile phone company Amena for €6.4bn. In September, Spain’s Telefonica spent €2.7bn to win 51 per cent of Cesky Telecom of the Czech Republic, while UK group Cable and Wireless bought smaller rival Energis for £674m, and Wind, the telecommunications arm of Italian utility Enel, was the subject of Europe’s biggest-ever leveraged buy-out.

All that has led to a frenzy of speculation about what the next deal might be.

TDC, the Danish telecoms operator, has been approached about a takeover by several groups of investors, driving its shares up 40 per cent this year to their best level since 2001.

O2, the UK mobile operator, has been the subject of several takeover rumours, pushing its share price up more than 33 per cent this year. In the summer, Deutsche Telekom and KPN of the Netherlands held talks about making a joint bid for O2, although these were abandoned.

There have been subsequent rumours that Deutsche Telekom could opt to mount a solo takeover bid for O2. Deutsche Bank believes a bid by Telekom for O2 would make sense at a price of up to 200p. “Reassessment of O2 synergy benefits indicates that even a 200p bid would be earnings per share-, free cash flow- and return on investment capital-accretive,” says analyst Guy Peddy.

Meanwhile, KPN itself has been widely seen as a potential target. Telefonica was rumoured to be a possible suitor, although several analysts said the fit between the two was less than ideal and that the Spanish group would be better off looking elsewhere, such as in Portugal or Greece.

Stephen Pope, head of equity research at Cantor Fitzgerald Europe, warns that costly national regulation in the Netherlands could be a barrier to foreign companies wishing to enter the Dutch market.

However, that has not stopped KPN’s shares rising some 8.4 per cent since the start of the year.

Mr Pope suggests the rapid decline in the share price of Cable and Wireless could be a weakness that might lay the stock open to competitors.

“The company has said that its proposed £710m acquisition of Energis might be delayed as the UK’s Office of Fair Trading examines the deal,” he says. “Could we have a situation where the shareholder base who appear hungry for cash would be willing to listen to an approach from an outsider?

“Even if the [Energis] deal goes through, C&W are still small scale when compared to BT,” Mr Pope adds.

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