Matthew Key, CEO of Telefónica Europe, talks exclusively to telecoms.com about the challenges faced across his portfolio, his future plans and the new shape of the mobile industry.

The O2 brand that was born when UK incumbent BT spun out its cellular arm almost eight years ago remains highly visible within its markets of operation. But behind the bubbles the carrier is Telefónica to the marrow, says Matthew Key, chief executive of Telefónica Europe, the stable that comprises the O2 operations in the UK, Germany, Ireland, Czech Republic and Slovakia.

O2 has now been part of Telefónica for as long—four years—as it was independent of BT before the Spanish player snapped it up. These last four years seem to have passed quicker than the previous four, a perception that exists internally as well as externally, Key says. Today, he adds, staff at O2 offices across the five markets for which he is responsible, are more likely to talk about being part of Telefónica than they are about having being bought by the firm.

And they certainly are part of something bigger. Telefonica is the fourth largest carrier in the world by proportionate subscriptions, with 181.9 million subscribers across a range of markets in Q309, according to Informa Telecoms & Media’s World Cellular Investors service. The firm’s revenue powerhouse is Latin America, where it has operations in 13 markets, most of which are wholly owned.

Key’s markets totalled 43 million proportionate customers in Q309 according to Informa (Telefónica owns 69.4 per cent of the Czech and Slovak operations) and represent 26 per cent of the group’s overall customer base in January 2010, when Key is speaking to telecoms.com. His unit’s revenue contribution is slightly higher than that, he says, while his share of OIBDA is slightly lower. Spain, which operates as a separate division within Telefónica, is the leading market by this metric.

Four years into life as part of Telefónica, Key says the relationship has borne fruit: “We’ve taken on a huge amount from Telefónica in terms of their disciplines, their financial driving, their purchasing power, their scale. But it’s really been a two-way process and they’ve taken things on from us; the level of focus on the customer across the whole organisation is much higher now.

What the Telefónica financial muscle will not be doing, however, is funding further expansion of the European footprint. The firm’s watchword for growth in Europe is ‘organic’ and Germany-Europe’s largest market where O2 sits fourth and last (15.4 million subscribers at Q309)-is top of the list for development.

Key says maintaining the performance of the flagship UK operation (first place, with 21.9 million subscribers at Q309) while building up the German operation, are his priorities. The UK is of particular importance, he says, because it is the market in which Telefónica Europe’s trends emerge first, offering useful guidance for the rest of the portfolio.

Things are a little more complicated in Ireland and the Czech Republic (through which Telefónica entered Slovakia, where it had a little over half a million subscribers at the end of last year). Here, says Key, the aim for the carrier is to dig its heels in.

“In Ireland we’ll just continue to operate as best we can,” he says. “It’s a very difficult market; GDP is still struggling and our view is that Ireland will probably recover 12 months after a lot of the other Northern European economies. In the Czech Reuplic we’ve got a fantastic product range but a very difficult economy. The economy has gone minus five or minus six and, as the largest network, we’ve been disproportionately impacted by the drop in inbound roaming.

“It’s made even more difficult for us because we have a very large share of the corporate and government segment. There’s an interim Government in the Czech Republic that will probably be in place until next May. They’re not placing any forward orders, or creating consumer confidence,” he says. Key stresses, though, that Telefónica remains committed to the Czech Republic, where he says it leads the market in mobile, fixed and DSL.

The economic downturn has forced international operators to renew focus on a smaller number of core markets, Key says, quoting Vodafone CEO Vittorio Colao’s assertion last year that he has five essential operations in Europe and question marks over all the rest. “The economic issues we’ve all had have accelerated natural patterns,” he says. “The weak players have become weaker, so the thinking they’re doing about their model has been accelerated. So you get things like the T-Mobile/Orange merger in the UK as businesses question their future in different markets.”

In Germany, O2 is clearly the weaker player. It had 15 per cent of the market at end Q309, with less than half the subscribers of market leader T-Mobile and close second Vodafone. But with the market one of three publicly earmarked for major investment by Telefónica group (the other two are Mexico and Brazil) Key is expecting this to change.

Until the end of last year, O2’s German network was still roaming onto T-Mobile to fill gaps in its national coverage but this is no longer necessary. Network investment has taken the firm to comparable levels to the first and second players in Germany, according to independent performance ratings, Key says, leaving E-Plus off the pace. Telefónica has installed a new German CEO, and is in the process of acquiring fixed player Hansenet. Overtaking E-Plus should be achievable for Key’s team this year, but making ground on Vodafone and T-Mobile is a far stiffer challenge.

In Germany Key may no longer be reliant on national roaming with T-Mobile but, across the portfolio, Telefónica Europe has acknowledged the need for joint efforts. In March last year the firm struck a passive network sharing deal with Vodafone that sees the two companies now sharing what Key describes as “steel and concrete”; sites, masts and antennas, and the like.

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Key says that, since the deal was announced, he has learned two lessons above all: “First you have to be strategically aligned at the top and as corporations and, second, deriving benefits from this sort of project takes quite a while.” Key is a former Vodafone employee, although he didn’t work with the firm’s European CEO Michel Combes, with whom he struck the network share deal last year. And, while they didn’t cross paths at Vodafone, Key knew Vodafone’s group CTO Steve Pusey from Pusey’s days at Canadian vendor Nortel.

While this smoothed the path of the deal, it hasn’t been without its issues. Again, says Key, Ireland has proven a problem. “In Ireland we’ve been a bit slow to get off the mark,” he concedes, “which is disappointing. It’s been about corporate focus; we’ve needed to get both companies focused on that being one of the priorities.”

In Germany, he says, the two firms are “on track” but he explains that in markets where there is disparity between the sizes of the two networks (Telefónica is much smaller in Germany and much larger in Spain) the exercise is “more difficult”.

If symmetry is important, it is at least more readily available in the UK, where the network share deal is most advanced, Key says. His team has 1,700 new sites planned for the UK and 80 per cent of these will be shared with Vodafone. The two carriers have not yet declared the number of shared sites that have gone live and Key says that it is still too early to claim that there has been a step change in the customer experience across the board as a result of the programme.

Key is one of the less gung-ho carrier CEOs when it comes to the issue of network sharing. While some people have suggested that a single network is all a market needs, with operators competing on service and offering, Key still believes the network is an essential differentiator and the kind of passive share that he has with Vodafone is an economic necessity rather than an admission that the industry has moved beyond network competition, he says.

“In this industry we’ve seen a ten per cent per annum price reduction to the consumer. Not many industries can go through that and not take a good, hard look at their cost base. But are we naturally cautious of giving away the crown jewels of customer experience? Yes we are,” he says.

Key argues that, while the first wave of network competition-based on coverage-has passed in many markets, a new phase, based on capacity and performance, has begun. For him, this makes the network an asset that must be owned, controlled, and protected. “We’re now going into the next stage of the industry where network will again start to be a differentiator, because of throughput. So it’s really important to be able to control your own roadmap of how fast you’re investing, and where. So if you are going to share, you have to be partnering with somebody who is very like-minded on investment.”

Performance has been a prickly issue for O2 in the UK, particularly in London, where Key says the network share deal will be less in evidence. The firm faced a good deal of criticism from angry customers last year as network performance in the UK capital took a dive. UK CEO Ronan Dunne even made an apology to users affected.

The finger of blame has been pointed at the carrier’s much trumpeted exclusivity deal for Apple’s iPhone, which has seen data usage rocket while the network has at times failed to keep pace. “Did the explosion in data usage take us by surprise? Yes it did,” he says. “Any company that has a throughput increase that doubles every three months is going to struggle to manage,” he adds by way of mitigation.

The boom in traffic wasn’t the only learning curve, with the way that the devices interact with the network proving to be “something that we’d never seen before.” He says. The clustering of iPhone users in London, where the press and analysts are also found in greatest density, he says, exposed O2 to criticism. “We had problems in London. Did we have them outside London? Not such that you would notice.”

AT&T, Apple’s partner for the iPhone in the US, has already said that it is going to introduce tiered pricing in a bid to deter excessive data consumption by a niche of high usage customers and Key concedes that this strategy is being discussed at O2 in the UK. While restricting usage is viewed by some commentators as disastrous from a customer service standpoint, Key argues that all customers deserve good service and the usage patterns of a few should not be allowed to impact the many.

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If the exclusivity of the iPhone proved a double-edged sword for O2 in the UK-drawing a multitude of customers but generating serious network headaches-then it is at least no longer an issue. Apple ended its exclusivity deals during 2009 and all eyes are on the continued performance of those few anointed networks that were given first option on the iconic device.

Key is a little cagey on the topic, refusing to admit to real concern over the loss of exclusivity. “Would I have liked to keep exclusivity? Yes,” he says. “Was it a key differentiator for the two years we had it? Yes. Have we seen a significant downturn in our volumes since Orange took it on? No.”

It is an open secret in the industry that carriers have had to kick back a percentage of iPhone related data revenues to the device vendor, an issue on which Key offers neither comment nor denial, and he says it has not affected his relationship with other handset vendors. Exclusivity deals remain important to O2, evidenced by the high profile deal with resurgent vendor Palm for its Pre device.

“If a handset is going to be a differentiator in the market, exclusives are important. But we think it has to work for both partners,” he says. “So with the iPhone and the Pre we could give real clarity and focus around that product. We haven’t declared any numbers on the Pre yet but, are we happy with the sales? Yes-customer satisfaction is very high.” The Pre is going to the kind of users who were the first to adopt the iPhone, he says, and he describes the phone as having “fantastic capabilities”. He doesn’t believe, however, that the Pre will be the iPhone killer whose arrival some within the industry seem intent on heralding. “Do I think the Pre will be as big as the iPhone? No,” he says.

The likes of Apple and Google (through Android) have altered the landscape of the handset space irreversibly and those players that were once at the vanguard find themselves struggling to innovate. Their greatest challenge, says Key, is to build the kind of integrated ecosystem that has given the iPhone such a powerful hold over consumers.

But this challenge is not limited to the vendors; carriers are also under pressure to create their own space in this new value chain, with some believing that nurturing their own ecosystem is the best way to retain the customer relationship. And in much the same way as he views the network as the “crown jewels of customer experience”, Key is in no mood to relax his grip on the customer relationship.

“It is part of our raison d’être to maintain a customer relationship and that customer advocacy is at the heart of how we operate,” he says. “How the industry plays out over the next two or three years will be fascinating because if you can create value that the customer perceives, they will maintain their relationship with you.

“But we’ve always said that we’ll be very flexible with our business model. Where we need to partner with the best, we’ll do so. Where we can do it ourselves, well do so. You shouldn’t be dogmatic about drawing a line between different types of player,” he says.

Telefónica has no intention of getting involved in hardware platforms, he says, but the software and application space is something that he describes as a “natural place for us to be looking at; all the operators are looking at it.” Just because all the operators are looking at it doesn’t make it the right thing to be looking at, of course, and Key poses the most crucial question of all when he says: “What we need to figure out is how we turn it into a success.”

In searching for he answer to this conundrum, of course, Matthew Key is not alone.