The partners plan to reach an agreement by the end of October, Deutsche Telekom said on Tuesday. If the talks succeed, the deal would remove one of five operators from the crowded market and help relieve intense competition.
Merging Deutsche Telekom's T-Mobile UK with France Telecom's Orange UK is expected to generate synergies worth more than 4 billion euros ($5.74 billion), the German group said.
The transaction should boost free cash flow per share from 2010 and earnings per share from 2011, it added.
Gervais Pelissier, France Telecom's finance chief, told French radio station BFM that the deal made sense given the competitiveness of the British market. Five licenses in the UK was too many, and even with four, it still might be too many.
The trend is toward consolidation and the reduction of the number of operators, Pellissier said.
Deutsche Telekom Chief Executive Rene Obermann said earlier this year that he was considering all options for the struggling UK unit, but as any consolidation in the UK market will likely draw the attention of regulators, analysts say a direct sale might not have commanded a sufficiently attractive price.
The 50:50 joint venture puts to rest speculation about a sale to Vodafone
O2 has about 27 percent of the market in Britain, followed by Vodafone with 25 percent, Orange with 22 percent, T-Mobile with 15 and Hutchison Whampoa's <0013.HK> 3 UK with 8 percent.
Deutsche Telekom shares were up 0.5 percent at 3:58 a.m. EDT, while France Telecom stock had gained 3 percent.
Analysts have been divided over the merits of a joint venture or a straight sale of T-Mobile, with some saying a joint venture could be complicated without one group taking control.
But Daiwa analyst Michael Kovacocy said Deutsche Telekom was unlikely to sell for the price it wanted and that a joint venture was better than a further write-down.
This is good news for the industry at large and it will benefit Vodafone and Telefonica, who are not involved, ING analyst Lawrence Sugarman said.
From a France Telecom perspective I think it's a decent situation as they get benefit from consolidation, he said.
The French operator is carrying nearly 35 billion euros in debts from an acquisition spree during the height of the Internet bubble that nearly bankrupted the group.
The largest deal was France Telecom's entry to the UK market in 2000 by purchasing Orange for about $40 billion.
Since then Orange UK has become France Telecom's second-biggest revenue generator, but it has struggled to generate strong profits given its smaller size and the competitive pressure on prices.
It's probably positive and better than doing nothing. But whether it is the best option (for Deutsche Telekom) is debatable, said Sugarman.
Deutsche Telekom estimated that operating cost savings should reach an annual 445 million pounds ($729 million) from 2014 onwards.
The venture would incur 600 million-800 million pounds in integration costs from 2010 to 2014, Deutsche Telekom said.
Deutsche Telekom said it would contribute T-Mobile UK on a cash-free, debt-free basis, including T-Mobile UK's 50 percent holding in its 3G network joint venture with Hutchison and gross tax losses carried forward of at least 1.5 billion pounds.
France Telecom would contribute the whole of Orange UK including 1.25 billion pounds of intra-group net debt.
Immediately after closing, Deutsche Telekom would grant a 625 million pound loan to the joint venture, which would be used to reimburse 625 million pounds to France Telecom. As a result, the joint venture would have debt of 1.25 billion pounds.
(Additional reporting by Leila Abboud in Paris and Kate Holton in London, editing by Will Waterman)