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Telefónica's balancing act

José María Alvarez-Pallete López helped the company transform from a sleepy, state-owned monopoly to a force in the global marketplace since he took over in 1996.

It's a warm day in early winter, and Telefónica's chief financial officer, José María Alvarez-Pallete López, is sitting at a small antique table in his ninth-floor office in the 72-year-old headquarters building in Madrid. It is an elegant office, with dark wood paneling, rich leather-bound volumes arranged in orderly ranks in glass-fronted bookcases. An inconspicuous door leads to the company's former boardroom, which is adorned with floor-to-ceiling paintings of current King Juan Carlos and King Alfonso XIII.

Alvarez-Pallete's office is one of a few in the building not to have been redecorated by Telefónica's flamboyant former CEO, Juan Villalonga. And the offices are the least of what has been redesigned at Telefónica: The company has been transformed from a sleepy, state-owned monopoly to a force in the global marketplace. Started in 1924 by the International Telephone & Telegraph Co., Telefónica was nationalized in 1945 and fully privatized in 1997. Unleashed, it embarked on a series of acquisitions. The biggest changes came after Villalonga, who aspired for Telefónica to be among the top five telcos globally, took over in 1996. He resigned amidst scandal in 2000, and current management, led by former Tabacalera chairman César Alierta Izuel and COO Fernando Abril-Martorell Hernández, pushed ahead, bidding aggressively in Europe for Universal Mobile Telecommunications System, or 3G, licenses. Today the company commands a major presence in fixed-line and wireless telephony in Spain and Latin America and boasts a large Internet operation in Europe and the U.S. as well as licenses to build 3G wireless networks in Austria, Germany, Italy, Spain and Switzerland.

"We have become a player," sums up Alvarez-Pallete. "We were not a player before."

Of course, being a player in telecommunications today is no unalloyed blessing. The company's exposure is split between Latin America and Europe: Argentina imploded in December, and the European telecom landscape is flooded with companies bloated with debt and facing radically lower growth prospects. Telefónica soared during the bull market days under Villalonga, with its share price increasing sixfold between 1996 and 2000. But 2001 net profit fell 15.9 percent, to E2.1 billion ($1.8 billion), the first drop in a decade, in part because of a E369 million charge related to Argentina.

Telefónica has less debt than other European telecoms, which gives it a strong credit rating - and is a source of great pride. But even that silver lining is a beginning to tarnish: In February Standard & Poor's downgraded the company because of its Argentinean exposure, its sizable investment in 3G licenses and the prospective cost of building a 3G network. It was a minor downgrade - from A+ with a negative outlook to A with a stable outlook - but it rattled the company's management. Still, Alvarez-Pallete can argue with justification that Telefónica's finances remain healthier than those of most companies in the sector.

"We are in much better financial shape than our competitors," he insists. "We still have the strongest risk profile. We are in good shape relatively and absolutely."

From a balance-sheet perspective, that's true. Although Telefónica's earnings before interest, taxes and depreciation and amortization are similar to its competitors' - E12.8 billion in 2001, compared with estimates of E14.7 billion at Deutsche Telekom and E12.2 at France Télécom - it has much less debt, about E29 billion, compared with E65 billion each for the German and French giants. Telefónica has no government ownership, although the Spanish government's "golden share" gives it veto power over strategic decisions until 2007.

The company's strength showed last year, when its shares fell just 10 percent, to E14.74 at year end, compared with drops of 50 percent for Royal KPN, 49 percent for France Télécom and 38 percent for Deutsche Telekom. In December 1999 Telefónica ranked as the 15th-biggest telecom in the world by market cap and No. 5 among Europe's old state-run telcos. Today it stands tenth in the world and second in Europe, behind Deutsche Telekom.

The company's strategic positioning, however, is a more complicated matter. In its efforts to become a global player, Telefónica has spent heavily since 1990, investing $23 billion in Latin America - $7 billion in Argentina alone. Its wireless unit, Telefónica Móviles has shelled out E6.5 billion for 3G licenses in Europe. Though 3G remains a dream, Latin America, at least, is contributing to the bottom line. Telefónica derived 43.1 percent of its 2001 ebitda from Latin America; 11.3 percent of ebitda came from Argentina. Santander Central Hispano estimates that Telefónica's 2002 ebitda will be reduced by 7 percent, or E875 million, because of January's devaluation of the Argentinean peso; total earnings per share could fall 15 percent, based on a 50 percent devaulation.

As a result, Telefónica now faces tough choices. After spending billions in Latin America, it must decide whether to dial back its investment in the region. It must also decide whether or not to go forward with building a 3G network in Europe. The technology for 3G - which is intended to deliver faster and improved cell phone access to data services like streaming video - is lagging, and demand is uncertain. If Telefónica goes ahead, it will be a new entrant in an unproven market, competing against incumbents that are already building expensive networks. If it doesn't, it will have wasted the billions it spent to acquire the licenses.

"Telefónica is at a strategic crossroads," concludes María Rotondo Urcola, executive director and senior telecom analyst at Santander.

With uncertainty shrouding the prospects for its key business lines, the company is playing for time. "We'll play our optionality," declares COO Abril-Martorell, 40, who runs the day-to-day business and reports to CEO and chairman Alierta. "Optionality" is a popular word in Telefónica's Madrid headquarters these days, used by company executives to mean "wait and see."

"Since the day I came back, the whole sector has changed dramatically," says Abril-Martorell, a former Telefónica CFO who at Alierta's request rejoined the company in 2000. "The expectations have changed, the business landscape has changed, and the competitive environment has changed."

To meet the challenge, the company is battening down the hatches and focusing on two priorities: customer retention in the face of stronger domestic competition and increasing its return on capital. Telefónica plans to unload marginal assets to raise cash as well as reduce capital expenditures. Just before its debt rating was downgraded, Telefónica announced that it would freeze spending plans for its Italian 3G network. And it won't be pouring money down other holes. Says Alvarez-Pallete, "We will avoid putting any capital into UMTS in Germany." After the downgrade, Telefónica announced that it could cut its debt in half by 2004 unless - that optionality again - it decides to make further acquisitions.

Santander's Rotondo estimates that over the next three years, Telefónica's moves will generate an additional $14 billion in free cash flow (cash flow after taxes and required capital expenditures). "That's a lot of money," she says. "Do they want to reduce debt, expand more in Latin America or go on with an expansion in Europe?"

That's where Telefónica's strategy gets tricky. Top management recognizes that building a European wireless network - through the separately traded Telefónica Móviles, of which Telefónica owns 93 percent - would make the company even more global. But its E8.4 billion bid for a 3G license in Germany - a joint offer with Finnish telecom Sonera Corp. - in August 2000 now seems like overreaching for a company that since its first days in Spain has never built a network from scratch. "Until the bid in Germany, everyone looked at Telefónica as a focused company with a focused strategy, and they were rewarded for that," says one London-based analyst. Now its once high-flying stock has reversed, in part because of the telecom market but also because of the uncertainty about its bet on 3G. Telefónica's shares sold at E13.63 in early March, down from E18.70 a year earlier.

Telefónica's critics argue that its European 3G strategy is ill-conceived - too little, too late - and far too expensive to succeed against entrenched rivals. That has tarred it as a company with an enormous sunk cost and huge future expenditures with little prospect of favorable returns.

"They will have to find a partner or leave the [European 3G] market," says Luis Prota, a Madrid-based telecom analyst for Morgan Stanley. "The market is very competitive, and they can't do it alone."

Telefónica's Abril-Martorell replies: "Germany is the most important market in Europe. It's a tough, competitive market, but we are not in the worst shape among the competitors."

Though Europe presents a continuing challenge, Telefónica has proved adept at acquiring and turning around companies in Latin American markets. Since Telefónica took control in 1998, Telecomunicações de São Paolo, its fixed-line company in Brazil, has wired 5.6 million customers, cut waiting periods from 105 months to two months and tripled productivity.

Telesp contributed E2.5 billion to Telefónica's 2001 ebitda. Last year Telefónica formed a 50-50 joint venture with Portugal Telecom to combine all their cellular assets in Brazil. And the Spanish company remains on the prowl: Telefónica is currently negotiating with Pegaso, a wireless operator in Mexico, its only weak Latin American market.

"Our target client base is Spanish and Portuguese," says Abril-Martorell. "There are 500 million people in Latin America. That's more than enough to deliver the critical mass and synergies to aspire to a much different position globally."

Still, focusing on Latin America is clearly not without risks. The devaluation in Argentina and the ensuing political crisis - the country went through four presidents in two weeks in December - will put pressure on the company's earnings. "Nobody is protected from a devaluation," says Alvarez-Pallete. "We are not immune. But we are diversified and if we suffer in one country, we can grow in others."

"Telefónica is one of the best-managed telecom companies in Europe," says Santander's Rotondo. "They make mistakes like the rest, but they make fewer mistakes, and they usually react promptly to address any adverse situation."

Much of the company's strength comes from its home base. Arriving passengers at Madrid's Barajas international airport are greeted by a giant Telefónica sign. "Telefónica wants to help you reach home," it says, in English. When Spanish residents order a phone line, they get a Telefónica phone even if they opt to use another company to carry those calls. Pay phones lining the sidewalks carry the Telefónica logo. The company's headquarters building is a historical landmark that was hit by artillery fire during the battle for Madrid in the Spanish Civil War.

Being ubiquitous has meant big money for Telefónica. Almost 75 percent of estimated 2001 ebitda came from its fixed-line business in Spain and Latin America; Spain alone produced 35 percent of the total. "The domestic Spanish business is an excellent business, because it is relatively underregulated," says Patrick Foulis, telecom analyst at UBS Warburg. "They have been able to sustain market share and profitability far in excess of their northern European peers."

While Deutsche Telekom lost 39 percent of its market share after Germany was opened to competition, Telefónica has lost only 10 percent of its home market. Spain deregulated its local and long-distance markets in December 1998 - a year after Germany - and competitors complain that domestic regulators continue to show favoritism to Telefónica in setting prices and opening parts of the market.

"Telefónica has never been threatened by a strong competitor in its home market or in Latin America," says Chris Bieck, head of Spanish operations for Primus Telecommunications Ibérica, a Barcelona-based rival. "They've forced everyone to focus on the small- and medium-enterprise market. No one considers going after their top-tier customers, because Telefónica will do anything to keep them."

Telefónica expanded from this solid base with strategic acquisitions. Starting in 1989, when Chile privatized its telephone monopoly, followed by Argentina in 1990, Telefónica actively courted telephone companies around Latin America. At first, it bought small stakes but assumed management control. Over the decade Telefónica increased those stakes, all the while collecting handsome management fees for its no-nonsense approach to cutting costs - aggressively laying off workers, for example. Its moves created great value. In 1989, for example, it paid $468 million for 43.6 percent of Cía. de Telecomunicaciones de Chile; today Telefónica's stake is worth $1.5 billion. "Telefónica was a turnaround operator in Latin America," says SCH's Rotondo. "They've been there for ten years, and they've done a great job of creating profitable companies."

But Telefónica really moved into high gear under Villalonga, the former McKinsey & Co. consultant and Bankers Trust deal maker who was appointed chairman and CEO in 1996 by center-right Prime Minister José María Aznar, a friend since grade school. Villalonga aimed to make Telefónica not just global but one of the top five telecoms in the world by market cap. His efforts bore fruit: Telefónica's market cap soared from E17 billion in 1996 to a high of E92 billion in early 2000. It's E63 billion today.

Villalonga knew he needed to expand Telefónica's operations beyond Spain and Latin America. The government agreed to open the domestic telecom business for competition in 1997, allowing rivals to start operating in late 1998. That meant Telefónica had to plan to offset any lost market share at home with high-growth businesses abroad.

Villalonga quickly made his name through a stream of high-profile multibillion-dollar deals - overpaying for most of them - as well as constant confrontation with the government and personal scandal. He inherited a company already heavily invested in Latin America, but he quickly increased Telefónica's presence there. In July 1998, with a consortium that included Portugal Telecom, he made a massive bet on Brazil, offering $4.9 billion for Telesp, the fixed-line operator for São Paulo, Brazil's largest state, whose 35 million population almost equaled Spain's. Determined to win, Villalonga raised his price by 20 percent at the last minute. In the end, he paid more than $6 billion for Telesp and Brazilian cellular company Tele Sudeste, 64 percent above the minimum price set by the government. "He didn't even tell his partners he was going to raise the bid," recalls one individual who worked on the transaction.

Still, Telesp turned out to be a smart purchase. "The most effective hedge we have in Latin America is that Telesp has become one of the most efficient wireline companies in the world, with ebitda margins of 64 percent," says CFO Alvarez-Pallete.

Villalonga's ambitions were enormous. In 1998 he tried to crack the U.S. market by forging a joint venture with British Telecommunications and then MCI-WorldCom. Telefónica wanted a strategic partner to help it increase international phone activity, leverage the traffic it controlled in Latin America and build networks in new markets. The complex agreement fell apart, however, when the companies could not agree on the details of how to make a joint venture work.

Of course, all telco executives were trigger happy in the late 1990s. It was the height of the dot-com boom, and investors saw telecoms as pipelines that would deliver the promise of the Internet. Many used their high-priced shares to fund acquisition sprees: Mannesmann bought Orange, then Vodafone Group bought them both and sold Orange to France Télécom; Deutsche Telekom bought VoiceStream Wireless Corp. "Even dilutive transactions were welcomed by the market because of the implication of future growth," says Alvarez-Pallete.

Villalonga took a similar approach. He created Terra Networks - a Spanish Internet service provider wholly owned by Telefónica - then spent $600 million buying up and integrating ISPs in major Latin American markets like Mexico and Brazil. In October 1999, correctly gauging the appetite for dot-coms, Villalonga took 15.2 percent of Terra public, raising E546.5 million. The share price soared 185 percent above the offer price of E13; suddenly, Telefónica was the majority shareholder in Europe's largest publicly traded Internet company - a business with a $9 billion market cap.

Terra and Telesp were preludes to Villalonga's marquee deal: Operation Verónica. Villalonga and his finance team - led by Alvarez-Pallete, who had just become CFO, with Morgan Stanley and Goldman, Sachs & Co. as bankers - decided that to create more value for shareholders, the company should be restructured along business rather than geographic lines. To gain more financial control, Telefónica would take ownership control directly rather than through small holdings in local affiliates. Because Telefónica had major stakes and management control in an array of both mobile and fixed-line entities in Latin America, the restructuring would require tender offers for four companies - one each in Argentina and Peru and two in Brazil. (It chose not to make a tender offer in Chile because of the regulatory environment.) At Alvarez-Pallete's recommendation, some say, Telefónica used its high-priced stock rather than cash - a decision that proved prescient shortly thereafter, when the telecom market crashed.

In January 2000 Telefónica executed four simultaneous exchanges - valued at $16.7 billion - in which it swapped its own shares for the Latin American companies' shares, paying a 40 percent premium. In each country, Telefónica was able to tender for most of the shares: It increased its stake from 28.8 percent to 97.9 percent in Telefónica Argentina; from 17.5 percent to 86.6 percent in Telesp; from 17.6 percent to 75.6 percent in Brazil's Tele Sudeste Celular Participações; and from 40 percent to 93.2 percent in Telefónica del Perú. The deals made Telefónica a dominant player in every major Latin market but Mexico.

"Latin American share prices were very attractive," says Bertrand Kan, head of European telecom M&A at Morgan Stanley, who worked as a banker on the deal. "It contributed to the company's strong capitalization and set them in good stead for the downturn that followed."

"Verónica changed the company, the shape of the company, the size, the financial profile," says Alvarez-Pallete. "It was key to opening a lot of opportunities."

Telefónica could create multiple equity currencies with which to do deals, for example. Telefónica Móviles grouped together the company's mobile assets around the world and spun off 7 percent in November 2000, raising $2.8 billion. In late 2000 Telefónica used its own stock to buy Motorola's wireless assets in northern Mexico for Telefónica Móviles.

Following Verónica came an additional rash of multibillion-dollar deals that fed Villalonga's insatiable appetite for growth. "He was into empire-building," says one associate. In March 2000 Telefónica paid E4.5 billion in stock for Endemol, a Dutch media company that even Villalonga admitted had no assets but which he said had good ideas - like the reality TV show Big Brother, a hit across Europe and the U.S.

The Endemol acquisition was based on Villalonga's conviction that media, the Internet and telecommunications were rapidly converging - the 3G market would be part of that convergence - and that it was important to have strategic interests in all of them. In May 2000 Terra paid an astronomical $12.5 billion in stock for U.S. portal Lycos, creating the world's third-largest ISP and giving Telefónica an entry into the American market. Telefónica's stake in the new Terra Lycos was reduced from 84.8 percent to 37.6 percent.

It remains unclear to what extent media, the Internet and telecom actually will converge. Will Terra Lycos customers someday be able to receive content from Endemol over their cell phones from Telefónica Móviles? And Terra Lycos is still bleeding money: It lost E232 million in 2001. Its shares have fallen from a high of $122 in March 2000 to $7 in February. But the pieces are attractive assets and add to Telefónica's "optionality." More to the point, Villalonga made his purchases with Telefónica stock and did not cripple the company with debt.

At about the time of the Terra Lycos merger, Villalonga was negotiating an even bigger deal than Verónica: a mega-merger with Dutch telecom Royal KPN, which would give Telefónica control of 60 percent of the combined company. Telefónica's market cap at the time was almost $80 billion; Royal KPN's was about $50 billion. But instead of being the pinnacle of Villalonga's deal-making career, the proposed merger contributed to his downfall.

Key Telefónica shareholders, the country's leading banks, opposed the deal because they felt that it didn't give Telefónica enough control and because the Dutch government, which owned 43.5 percent of Royal KPN, would own 17 percent of the combined company. That ignited Spanish nationalist sentiment, as the Dutch government would have had a significant say in the affairs of one of Spain's few corporate titans. Even though the Dutch government promised to sell its stake, diffusing that issue, Royal KPN stepped away from the deal, recognizing that there was not sufficient support on the Telefónica side. The Spanish government had also expressed concern about the merger and reportedly wanted to curtail the hyperactive Villalonga's ambitions.

Villalonga's fall came swiftly. Just before the March 2000 elections, the CEO came under attack from Prime Minister Aznar's Socialist opponents for the extravagant stock option package he had put in place for management (reportedly awarding himself about $16 million, hefty by Spanish standards). When Aznar asked Villalonga to revoke the package, he refused. Villalonga's stock options weren't his only public relations problem. The then-married CEO was carrying on a public affair with a former Miss Mexico, Adriana Abascal. He even conducted a board meeting from Miami by videoconference - in a pink polo shirt - while he and the beauty queen awaited the birth of their daughter.

Less than a month after the KPN deal fell apart, the government reopened an insider-trading investigation against Villalonga, focusing on options he bought in 1998, when Telefónica was considering a merger with MCI-WorldCom. To some, it appeared that the insider-trading probe was chiefly a vehicle for harassing someone who had become a liability to the government. In late July 2000 Villalonga resigned and moved to Miami. The investigation was dropped a week later.

Telefónica's board named César Alierta to succeed Villalonga as chairman. Alierta was a member of the Telefónica board and a respected ex-chief executive of Tabacalera, Spain's former state-run tobacco company. A lawyer with an MBA from Columbia University, Alierta had first worked as a stockbroker, founding and heading Beta Capital. In 1996, about the same time that Villalonga was named head of Telefónica, Alierta took over Tabacalera. He oversaw its privatization - and sale, in 1999, to French tobacco giant Seita. Unlike Villalonga, who had a flair for the inappropriate, Alierta appears uncomfortable in public and has had little interaction with bankers and analysts. He brought back Telefónica veteran Abril-Martorell to run day-to-day operations. Abril-Martorell had been CFO from 1997 to 1999 and then overseen the company's yellow pages business. But he left in June 2000, reportedly because of differences with Villalonga. Formerly J.P. Morgan & Co.'s treasurer for Spain, the tall, energetic Abril-Martorell is deeply versed in telecom issues and comfortable talking to investors. "He's very transparent and open and acknowledges when they have problems," says one analyst. "A lot of managers in Europe prefer to tell their investors that they have no problems."

Alierta is everything that Villalonga was not: conservative, media-shy, and eager to manage a company rather than simply direct it. "He's the steady hand on the tiller," says one person who has worked with him. "He brings a lot of experience and judgment and a good relationship with the government" - a point not lost on those who had watched Aznar's relationship with Villalonga deteriorate.

Alierta maintains a low profile among investors. He waited until the spring of last year to present his strategic plan for the company. But Alierta has not come without his own baggage: Spain's anticorruption commission is investigating an investment company he set up and gave to his nephew in 1997. That firm bought shares of Tabacalera, where Alierta was chairman, before two major corporate announcements that caused the shares to rise. Spain's stock market commission looked into the purchase at the time and came up with nothing.

It was clear from the start that Telefónica's new management team faced a fresh set of challenges - mainly, incorporating the sprawl of acquisitions Villalonga had made and managing the company in a suddenly bearish market. Today Telefónica runs six major subsidiaries: fixed telephony in Spain and five major Latin America countries; its mobile unit, Telefónica Móviles; Internet service provider Terra Lycos; a data services company; a media unit; and a yellow pages division; as well as a group of other holdings.

Until recently, among major telcos only Telefónica and Vodafone have managed to stay above the rubble of the tech stock crash. Most telecom companies' shares have sunk by more than half, and their debt has been repeatedly downgraded.

"Most operators have highlighted the need to restore balance sheets and focus on cash flow preservation and generation," says Anthony Moverly, high-grade telecom credit analyst at Merrill Lynch Global Securities. "Before, they were chasing growth at all costs."

Hence Telefónica's dual focus on return on capital and customer retention. "We have to focus on how to continue to transform the company to a more commercial enterprise and keep the clients we have, and we have to be far more strict about the return on capital we are employing," says Abril-Martorell.

The most obvious part of that strategy is to cut extraneous costs. Telefónica announced in mid-2001 that it would cut its debt by E2.89 billion, through asset sales and reductions in capital expenditures of 5 percent a year until 2004. Assets sales include noncore holdings like the company's 5 percent stake in U.K. media company Pearson. The reductions in capital expenditures will come mainly from Telesp in Brazil, where Telefónica has invested heavily to gain access to the whole country's long-distance market. It will also invest less in the mobile business in Spain.

The mobile business in Europe, meanwhile, is looking increasingly expensive. When the stardust settled after the European 3G license auctions of 2000, telecom companies had forked over $100 billion and faced as much as $100 billion more in network buildout costs.

In Europe 3G technology uses a different part of the spectrum from the existing digital network, requiring installation of a whole new network. Currently, 2.5G networks are being rolled out. This upgraded technology allows users to be online all the time and to send and receive long text messages and basic video. It's much slower than 3G, which will enable video streaming - the convergence Villalonga and others foresaw. But it's uncertain how much demand exists for such advanced capabilities, and the rollout of 3G has been repeatedly delayed. Worse, a massive capital crunch has settled in as the equity and high-yield markets for telecom companies have dried up.

Through a combination of financial savvy and sheer luck, Telefónica escaped much of the balance-sheet meltdown experienced by companies paying exorbitant fees for 3G licenses. It passed on the U.K.'s expensive March 2000 auction because the prices - as much as E9.5 billion - were too high for even the ambitious Villalonga. The company was also tied up in the massive Verónica transaction. "When others were investing in 3G licenses," notes Alvarez-Pallete, "we were buying back shares in Latin America in an accretive transaction."

But it became clear that, having passed on the U.K. and French licenses, Telefónica had to make a bid in Germany if it wanted the option of being a European player. "To be global, they have to expand into Europe, and that's the weakest part of their strategy," says José Ignacio López, head of telecom research at Banco Bilbao Vizcaya Argentaria.

So Telefónica joined forces with Finland's Sonera, forming a joint venture named Group 3G; the group invested E8.4 billion in buying a German license in August 2000, shortly after Villalonga's resignation. Telefónica also bought licenses in Switzerland, Austria and Italy, although it has no networks or customers in those countries, either.

Clearly, Telefónica's biggest bet is on Germany - but the odds of success appear long. The leading German telecoms, Deutsche Telekom and Vodafone, have wireless networks and sizable market share: DT has 41 percent and Vodafone 39 percent. They have upgraded their networks to 2.5G and can test how much users will pay for expanded wireless data services.

Already, Telefónica is scrambling to lower its buildout costs. Last June Group 3G signed a roaming agreement with Royal KPN's German unit, EPlus, which has a 13 percent market share in Germany. In September the two companies forged a network-sharing agreement, which will save Group 3G E3.8 billion, or 60 percent of the E6.2 billion the venture planned to invest over ten years. Group 3G still has not started to build its 3G network; however, it started offering services through its roaming agreement in November.

"We paid too much," acknowledges Alvarez-Pallete of the 3G licenses. "We could challenge the market and say we will double the cash to prove we are right and say we will acquire everyone we need. But if we do that, we think we will destroy more value than we would create. We acknowledge the message from the markets, and we will try to improve the perception of the situation in Germany."

Other 3G options are just as tricky. Consolidation of licenses is difficult because the German regulators will not allow the operators to trade spectrum. At a late February meeting of European Union telecom ministers, Alierta lobbied for more flexible rules, criticizing the regulatory framework in Europe as "not conducive to the risk-taking that is necessary in an information society." Currently, if two companies join forces, one has to write off its license acquisition cost. Thus if, as rumors hint, Telefónica were to buy mmO2, the U.K.'s No. 3 wireless company (with 6 percent market share in Germany), the two would overlap in Germany, and one would have to forfeit its license fee. "UMTS is the future of mobile communications," says Alvarez-Pallete. "The question is timing. You should not expect us to be the first mover. Valuations are not attractive, and spectrum is not tradable."

In short, 3G implementation has been delayed, demand is uncertain, and the cost of building a network is enormous. When - and if - a market is demonstrated in Germany, two powerful competitors already have most of the customers. What Telefónica has is a large sunk cost for licenses. Its options are to spend billions more to build a pan- European network and hope to attract customers in countries where market share and profitability estimates seem to dwindle daily, or to abandon its licenses and move on.

Although Telefónica is not eager to walk away from its 3G investment, time is working against it. Germany's six licensees must build UMTS networks to cover 25 percent of the population by the end of 2003 or risk having their costly licenses revoked; in Switzerland, Telefónica is supposed to have 20 percent of the population covered by the end of this year. The company has yet to start building in either country and has already frozen its buildout in Italy.

Even as Telefónica grapples with Europe, it is continuing to pursue the Latin American market. The new management team's only major acquisition took place in late 2000 when the company paid $1.8 billion in stock to buy Motorola's assets in northern Mexico, and it is in discussion about acquiring Mexican wireless company Pegaso.

Argentina presents a continuing headache. The government, which guaranteed Telefónica's tariffs in dollars, has rescinded the guarantee and "pesoized" the tariffs. Telefónica could take legal action, but the company is playing down the problem until it works out an agreement on rates with the government. "This is not the first time we have been through a devaluation in the region," says Alvarez-Pallete. "We will suffer because Argentina will suffer, but the impact is limited because we are a diversified company and we are in several countries. We are in Latin America to stay. The world is waiting to see the restructuring efforts of the government. Until we know what they will do, we cannot know how it will affect us."

The greatest risk Telefónica faces in Latin America is if Argentina's problems spill over to Brazil, where Telefónica has massive fixed-line and wireless investments. So far this doesn't appear to be a concern in Madrid. "We are protected in Latin America because we are not dependent on any one company or country," says Alvarez-Pallete. But if Brazil's economy were to collapse, he might not be so optimistic.

While Telefónica wrestles with the complex European market and Argentinean economic turmoil, its investors are clamoring for less risk and more return. "In 1997-'98 Telefónica was primarily focused on the Spanish and Portuguese-speaking market, and investors were pushing for a European strategy," says Morgan Stanley's Kan. "The markets said, 'Now, with greater market volatility, investors are more risk-averse and prefer that Telefónica focus on its existing activities, based primarily in Spain and Latin America - because that's where they know how to make money."

Meanwhile, time is running out on the company's cherished options.

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