Deutsche Telekom AG (NYSE: DT) and Orange (NYSE: FTE) confirmed today that they are in exclusive talks to merge their U.K. businesses, T-Mobile (UK) and Orange UK , in a 50-50 joint venture and create the largest mobile operator in the country.

The news must come as a relief to Deutsche Telekom's senior management, who have been looking for a solution for their troubled U.K. business for some time. Reportedly turning down bids in the range of $5.7 billion each from Telefónica SA (NYSE: TEF)'s Telefónica UK Ltd. and Vodafone Group plc (NYSE: VOD), Deutsche Telekom has opted for a joint venture with Orange. (See Battle for T-Mobile UK Heats Up, T-Mobile Preps UK Revamp, Vodafone Mulls T-Mobile Bid, and T-Mobile UK Update.)

If the deal goes through and wins regulatory approval from the European Commission , the combination of Orange and T-Mobile -- the U.K.'s mobile laggards in third and fourth position by market share, respectively -- will become the market leader with 28.4 million mobile customers and around a 37 percent share of U.K. subscribers, knocking O2 and Vodafone down to second and third place, respectively.

But with the proposed joint venture's plans for a massive integration that spans networks, back-office systems, and sales and marketing operations, the new entity faces big challenges. As Gartner Inc. analyst Katja Ruud puts it, "One plus one has to be more than two." Not only will the joint venture need to achieve all of the cost synergies envisioned from this deal, but it will also have to "deliver a superior service organization, and that is not easy," she explains.

The nuts and bolts of the deal
Here's how the joint venture will be put together: Deutsche Telekom will contribute T-Mobile UK on a cash-free and debt-free basis, as well as its 50 percent share in the 3G network sharing joint venture with Three UK -- called Mobile Broadband Network Ltd. -- and gross tax losses of at least £1.5 billion (US$2.5 billion). France Telecom will contribute all of Orange UK (which includes the fixed broadband business) and £1.25 billion ($2 billion) of intra-group net debt to even out the value of its contribution. (See 3 & T-Mobile Share 3G in the UK.)

After completion, Deutsche Telekom would give a £625 million ($1 billion) shareholder loan to the joint venture, which would be used to reimburse France Telecom. So, the joint venture would have debt of £1.25 billion ($2 billion), with Deutsche Telekom and France Telecom each holding a shareholder loan of £625 million ($1 billion).

The joint venture's CEO will be Tom Alexander, currently CEO of Orange UK, and the venture's COO will be Richard Moat, currently CEO of T-Mobile UK. In addition to these execs, the board will have four other members, with Deutsche Telekom and France Telecom each having two representatives.

And here's the plan
The operators plan to combine their networks and IT systems, as well as sales distribution and marketing operations. This integration would lead to workforce reductions as well.

On the network side, the operators plan to combine their 2G GSM and 3G HSPA networks while at the same time expanding 3G coverage. The result would be a 20 percent reduction in the number of base stations currently deployed by each operator and a 35 percent reduction in the number of cell sites.

In their 2G networks, Orange has 13,000 base stations, and T-Mobile has 10,000. The joint venture plans to dismantle redundant 2G base stations and upgrade some to 3G in order to bring the total base stations in the network down to between 14,000 and 16,000.

On the 3G networks, Orange and T-Mobile each have 7,000 base stations deployed. The joint venture's planned shared buildout of the 3G network, which will use existing 2G sites, will bring the total number of 3G base stations to between 14,000 and 16,000 as well.

The operators also plan to share the backhaul transport network as well as the core network.

The Orange and T-Mobile brands will remain intact for at least 18 months, after which the joint venture will decide on a new brand strategy.

The resulting operating cost savings are expected to be on the order of £445 million per year from 2014. The operators expect integration costs to be between £600 million and £800 million ($990 million and £1.3 billion) over the 2010 to 2014 time period.

And the operators hope to shave off some capital expenditure too. The potential capex savings is estimated to be £620 million ($1 billion) on a cumulative basis during 2010 and 2014.

Those planned capex cuts could be bad news for infrastructure suppliers. Nokia Networks in particular looks exposed to potential spending cuts, according to this Reuters story, because it supplies both Orange and T-Mobile. (See Vendors Scrap Over Managed Services Deals, NSN Wins Orange UK Deal, and NSN Scoops UK Deal.)

— Michelle Donegan, European Editor, Unstrung