Investors have not yet fully grasped the rationale behind this month’s surprising £18 billion ($32 billion) bid for O2, says Telefónica chief financial officer Santiago Fernandez Valbuena, in an interview with CFO Europe for its December issue.

The offer for Britain’s number-two mobile operator has been criticized for suddenly putting the Spanish phone giant on a different strategic track. Previously Telefónica had been pursuing growth in developing markets such as Latin America and Eastern Europe; by acquiring O2, it would be competing in Europe’s two largest markets in mobile — mature markets facing intensifying competition, at that. Telefónica has also been criticized for offering little in the way of synergies to justify the 25 percent premium (to October’s average share price for O2), and for being driven by a Spanish tax advantage on amortizing goodwill.

Although the element of surprise blew competitors out of the picture,
says Valbuena, he maintains that favorable bank lending conditions were the single biggest factor in the timing of the offer. Telefónica raised the largest syndicated loan in Europe since France Télécom’s record-setting €30 billion ($36 billion) loan in 2000, when it bought Orange. Compared with France Télécom’s borrowing, Telefónica’s £18.5 billion loan comes with a similar interest-rate margin (averaging about 37.5 basis points) and slightly lower fees, and it has flexible terms and covenants that will give Telefónica the freedom to refinance in the bond markets over the next three years.

“The gap between the cost of debt and the cost of equity is so large by historical standards,” says Valbuena, that “if there was ever a time to stretch out the balance sheet, this is the time. We have excess leverage capital, as is proven by the [loan] deal we assembled.”

In O2, Telefónica is acquiring a company that has seen revenue grow at a compound annual rate of 21 percent since being spun off by British Telecom in 2001, reaching almost €10 billion by the end of March 2005. In the same period, EBITDA increased at more than twice that rate, to nearly €3 billion. And according to Morgan Stanley’s projections, free cash flow will grow by 32 percent over the next three years, even before accounting for any operating or capital expenditure savings and synergies from the deal. Those are ratios that leave a large margin for error, observes Valbuena.

Much of the initial analysis of the deal harped on the fairly minimal cost synergies because there is little market crossover, even though it would propel Telefónica to the number-two spot among European mobile telecommunications companies, trailing only Britain’s Vodafone. There was also much focus on “the Spanish tax advantage” when it came to amortizing goodwill.

Valbuena is keen to set these in context. Regarding synergies, Telefónica’s initial offer estimated about €200 million of annual cost reductions by 2008, through things like pooled purchase of handsets and other equipment, and rationalized spending on marketing and R&D, estimated to have a total net present value of €3.3 billion. “We didn’t want to make too many waves on this front,” says the CFO. “This is about a third of the level of savings we engineered in BellSouth [the assets in 10 Latin American countries, which Telefónica acquired last year for $5.8 billion], and it is a number that is hard to disagree with.” He says, however, that “we were shy with this figure,” adding that the “revenue and first-to-market synergies” of the deal haven’t even been discussed, as Telefónica held fire lest there be another bidder on the horizon.

The tax advantage, on the other hand, has been vastly overestimated by commentators, maintains Valbuena. Many of these observers have assumed that the estimated €10 billion difference between book value and purchase price will be counted as goodwill and amortized, and therefore available for tax deduction; some estimates have given it a net present value of nearly €2 billion. But as Valbuena points out, international financial reporting standards require that as much of the goodwill as possible must be assigned to intangibles, “and intangibles are something that O2 is rich in — client lists, license values, brand names. Those are valuable assets, and we paid a lot of money for them.”

Auditors will determine how much of the assumed €10 billion will be assigned to intangibles — perhaps 20 percent, perhaps 80 percent, says Valbuena — and the remainder will be available for tax deduction as amortized goodwill. In any case, the goodwill tax advantage is minimal compared with Spain’s corporate tax disadvantage; at 35 percent, observes the finance chief, it’s the highest in Europe, and a full 9 percentage points above Germany’s.

Valbuena and Telefónica aren’t looking merely to acquire 27 million customers in two of Europe’s largest markets; they’re also bending over backward to keep O2’s top management in place. In a highly unusual move after a takeover, Peter Erskine will remain as chief executive of O2 and will take a seat on Telefónica’s board of directors. Valbuena says of Erskine: “Despite the €15 million, €20 million, or whatever he’s going to pocket [from O2 options held], he’s not going to play golf the rest of his life. It is the competitive urge that moves him. The guy wants to beat Vodafone at its game, that’s what he wants to do. And Rudy [Rudolf Gröger, CEO of O2 Germany] is a killer. These are the guys, as we say here, with the knives in their teeth.”

Refinancing the debt from the O2 bid — as well as that from BellSouth, from the 51 percent of Cesky Telecom bought from the Czech government for €2.7 billion earlier this year, and other strategic acquisitions — is Valbuena’s next challenge. The finance chief says he already has “gotten hell from the bond investors, who are the losers in this game,” after Telefónica dropped one or two notches from its single-A rating. After the O2 deal’s expected January close, he plans to go on the road to try to win back their favor.

Valbuena insists, though, that he won’t let bond-market conditions preoccupy him too much. “With €50 billion in debt, we are going to be visiting the bond markets about every other month or so for the next three years,” he says. “So, I couldn’t care less about market conditions, quite frankly, because I cannot optimize that. It’s not that I have to issue €2 billion and I want to pick the best possible point. There will be good months and not so good months. We are not going to go sailing because the weather is good. We are sailors.” Even so, Valbuena the sailor will be hoping for a fair wind.