Insight: Collusion probe latest Mexico woe for Telefonica

MEXICO CITY (Reuters) - When TELEFONICA (TEF.MC)arrived in Mexico about a decade ago, the Spanish phone company framed the expansion as a social crusade as much as a business: It would bring wireless service to the country's poor while taking on Carlos Slim, the tycoon who has dominated Mexico's telephone industry for a generation.

Telefonica says it has achieved part of its goal. Cellphone use has quadrupled since the company arrived, it says, and it has helped put handsets into the hands of rural peasants and street vendors while shrinking the cost of service.

But from a business perspective, Telefonica has spent a fortune in Mexico while remaining a low-end brand. And in struggling to reach solid ground, it has run into regulatory trouble.

The company's $13 billion investment in Movistar, the Mexico unit, has won it 22 percent of mobile phone lines in the country, yet it gets only 12 percent of what Mexicans spend on such service. High-end rival Nextel has the same share of mobile spending with only 4 percent of phone lines.

Telefonica does not disclose its net profit for Mexico, and a spokeswoman declined to provide figures. What is clear, analysts say, is that the company performs poorly, given what it spends in Latin America's second-biggest economy.

In 2010, the year Telefonica invested in its 3G network, the Mexico unit reported operating income of about a third of the roughly $2.1 billion invested.

Last year was not much better. Operating income sank 8 percent, and the company curtailed investment.

While investors shake their heads, regulators are giving Telefonica a closer look.

In late January, a federal court ordered the country's competition watchdog to investigate ties between Telefonica and Slim's businesses.

Telefonica rivals raised flags after the company broke with the rest of the industry in late 2010 and agreed to pay Slim much more to tap his vast phone network than other phone operators were willing to pay.

That sudden, accommodating attitude towards Slim smacks of collusion, rivals say.

"We have long sought an investigation that will allow healthy and fair competition in the phone market," said an official with Televisa , the country's top television broadcaster, which asked for the Telefonica probe.

Telefonica and Slim deny the charges and insist that they compete throughout Latin America.

Analysts say it is odd that Telefonica agreed to pay higher interconnection rates, the toll a phone company charges for access to its network.

Telefonica executives say they have an awkward explanation: While low interconnection tariffs would let it challenge Slim with better service or phone gadgets, the company relies on the connection fees that other phone users pay to reach their poorer clients.

So while the company hopes to one day lure the wealthy with low rates, it cannot yet forgo the revenue it gets from calls made to its dial-shy customers.

"The market conditions have changed and we need to adapt," said a Telefonica executive who requested anonymity to speak openly about company strategy.

That dilemma - keeping low-end clients while chasing more affluent users - has defined Telefonica's recent years in Mexico.

AWKWARD TRANSITION

Telefonica's revenue in Mexico dropped 15 percent last year, and executives acknowledge that pressure from investors to sell their Mexico stake could increase without a quick turnaround.