14th Mar 2005 10:17
Telefonica SA14 March 2005 ANTONIO J. ALONSO UREBA Director , General Secretary and Secretary to the Board of Directors Telefonica, S.A., as provided in article 82 of the Spanish Market Act (Ley delMercado de Valores), hereby reports the following SIGNIFICANT EVENT Telefonica submitted registration form F-4 to the Securities and ExchangeCommission (SEC), the US stock market regulator, on March 7, 2005, in relationto its announced takeover of Terra Networks, S.A. and in its capacity as theacquiring company, in accordance with US stock market regulations; the shares ofTelefonica, S.A. ("Telefonica") and Terra Networks, S.A., ("Terra") are listedin the US. Pursuant to these regulations, this document is currently subject toreview by the SEC until the SEC declares it effective. During this period,Telefonica may supplement and update the information in this document or mayintroduce changes to its content. In accordance with US stock market regulation requirements, the submitted F-4form comprises the following section headings: • "Questions and answer about the Merger". • Risks factors relating specifically to the Merger. • The Merger: general; background of the Merger; Telefonica and TerraNetworks' reasons for the Merger; accounting treatment; material Spanish and USFederal Taxation consequences; relationship between Telefonica and TerraNetworks; comparative per ordinary share and per ADS market price information;opinion of independent expert appointed pursuant to Spanish law ( to be includedwhen issued); management share ownership and stock option plans; summary ofopinion of Morgan Stanley & Co. Limited for Telefonica; summary of opinion ofLehman Brothers Europe Limited for Terra; summary of opinion of Citigroup GlobalMarkets Limited for Terra; the Merger Plan; other expenses. • Information about Meetings and Voting for Telefonica and TerraNetworks: matters relating to the Meetings; vote necessary to approve Telefonicaand Terra Networks proposals; proxies and other business. • Legal information: comparison of shareholder rights; summary ofmaterial differences between current rights of Terra Networks shareholders andTerra Networks ADS holders and rights those shareholders and ADSs holders willhave as Telefonica shareholders and Telefonica ADS holders following the Merger;Stock Exchange information on Telefonica share; Stock exchange listing,delisting and deregistration of Terra Networks ordinary shares and ADSs • Information about Telefonica: selected historical consolidatedfinancial information. • Information about Terra Networks: selected historical consolidatedfinancial information • Additional information for shareholders. A summarized translation* of the information contained in the F-4 form submittedby Telefonica on March 7 in relation to the opinions provided by Morgan Stanley& Co. Limited to the board of directors of Telefonica, and by Lehman BrothersEurope Limited and Citigroup Global Markets Limited to the board of directors ofTerra, is included as an annex to this document. Madrid, March 11th , 2005 * Telefonica wishes to expressly state that the original language of thetranslation included as an annex to this document is English, and that thistranslation has been carried out for information purposes only. In the event ofdiscrepancies between the texts, the original English version of this documentshall prevail. ANNEXSUMMARY OF THE OPINION OF MORGAN STANLEY & CO. LIMITED Telefonica retained Morgan Stanley & Co. Limited to provide it with financialadvisory services and a financial opinion in connection with its merger withTerra Networks. Telefonica selected Morgan Stanley & Co. Limited to act as itsfinancial advisor based on Morgan Stanley & Co. Limited's qualifications,expertise and reputation. On February 23, 2005, Morgan Stanley & Co. Limitedrendered its written opinion, that, as of that date, based upon and subject tothe various considerations set forth in the opinion, the merger exchange ratioto be paid by Telefonica and the extraordinary dividend to be distributed byTerra Networks to its shareholders, including Telefonica, pursuant to the mergerplan was fair from a financial point of view to Telefonica. The full text of the written opinion of Morgan Stanley & Co. Limited, dated asof February 23, 2005 sets forth, among other things, the assumptions made,procedures followed, matters considered and limitations on the scope of thereview undertaken by Morgan Stanley & Co. Limited in rendering its opinion.Morgan Stanley & Co. Limited's opinion is directed to Telefonica's Board ofDirectors and addresses only the fairness from a financial point of view of themerger exchange ratio to be paid by Telefonica and the extraordinary dividend tobe distributed by Terra Networks to its shareholders, including Telefonica,pursuant to the merger plan to Telefonica as of the date of the opinion. Itdoes not address any other aspects of the merger and does not constitute arecommendation to any holder of Telefonica or Terra Networks ordinary shares asto how to vote at their annual general shareholders' meetings. . In addition,this opinion does not, in any manner, address the prices at which Telefonica'sordinary shares will trade following consummation of the Merger. The summary of the opinion of Morgan Stanley & Co. Limited set forth in the F4prospectus is qualified in its entirety by reference to the full text of theopinion. In connection with rendering its opinion, Morgan Stanley & Co. Limited, amongother things: a) reviewed certain publicly available financial statements and otherbusiness and financial information relating to Telefonica and Terra Networksrespectively; b) reviewed the reported prices and trading activity for the ordinaryshares of Telefonica and Terra Networks respectively; c) compared the financial performance of Terra Networks and Telefonica andthe prices and trading activity of the ordinary shares of each of Telefonica andTerra Networks with that of certain other comparable publicly-traded companiescomparable with Telefonica and Terra Networks, respectively and theirsecurities; d) reviewed the financial terms, to the extent publicly available, ofcertain comparable merger transactions; e) reviewed certain equity research reports prepared by a number ofinvestment banks relating to Telefonica and Terra Networks respectively; f) reviewed certain equity research reports prepared by a number ofinvestment banks relating to certain publicly-traded companies comparable withTelefonica and Terra Networks respectively; g) reviewed certain internal financial statements and other financial andoperating information concerning Telefonica and Terra Networks respectively; h) reviewed Terra Networks' management business plan dated February 14,2005; i) discussed the past, current and future operations of Terra Networkswith the management of Telefonica; j) reviewed the pro-forma impact of the merger on Telefonica's earningsper share; k) reviewed the merger plan and certain related documents; and l) considered such other factors, reviewed such other information andperformed such other analyses as Morgan Stanley & Co. Limited deemedappropriate. In arriving at its opinion, Morgan Stanley & Co. Limited assumed and reliedupon, without independent verification, the accuracy and completeness of theinformation reviewed by it for the purposes of its opinion. With respect tointernal financial statements, the financial projections and other financialdata, Morgan Stanley & Co. Limited assumed that they had been reasonablyprepared on bases reflecting the best currently available estimates andjudgments of the future financial performance of Terra Networks and Telefonica.Morgan Stanley & Co. Limited discussed with the management of Telefonica thestrategic rationale for the merger and the perceived strategic, financial andoperating benefits of the merger for Telefonica if the merger is consummated.Morgan Stanley & Co. Limited did not make any independent valuation or appraisalof the assets or liabilities of Telefonica or Terra Networks, nor was itfurnished with any such appraisals. Further, in accordance with Telefonica'sinstructions, Morgan Stanley & Co. Limited only conducted a limited duediligence review for the purposes of its opinion and, in particular, MorganStanley & Co. Limited was not provided with, or had, access to the management ofTerra Networks. With respect to legal, tax and accounting matters relating tothe merger, Morgan Stanley & Co. Limited relied upon the information provided byand the judgments made by Telefonica and its legal, tax and accounting advisors. In arriving at its opinion, Morgan Stanley & Co. Limited was not authorized tosolicit, and did not solicit, interest from any party with respect to themerger. Morgan Stanley & Co. Limited's opinion was necessarily based on financial,economic, market and other conditions as in effect on, and the information madeavailable to it as of the date of its opinion. Events occurring after the dateof its opinion may affect Morgan Stanley & Co. Limited's opinion and theassumptions used in preparing it, and Morgan Stanley & Co. Limited did notassume any obligation to update, revise or reaffirm its opinion. In addition,Morgan Stanley & Co. Limited assumed that the merger will be consummated inaccordance with the terms set forth in the merger plan without any waiver,amendment or delay of any terms or conditions. The following is a brief summary of the material analyses performed by MorganStanley & Co. Limited in connection with the preparation of its written opinionletter dated February 23, 2005. Some of these summaries of financial analysesinclude information presented in tabular format. In order to fully understandthe financial analyses used by Morgan Stanley & Co. Limited, the tables must beread together with the text of each summary. The tables alone do not constitutea complete description of the financial analyses. The various analyses summarized below were based on closing prices for theordinary shares of Telefonica and Terra Networks as of February 21, 2005,adjusted to reflect the announced dividend distributions by each of the twocompanies: i) Telefonica's share price: adjustedfor a total of €0.80 per share in dividends declared by Telefonica (and whichwill not be payable to Terra Networks' current shareholders with respect to theTelefonica shares they will receive following the merger, pursuant to the mergerplan) as follows: (a) €0.23 per share cash dividend from 2004 net income payableto Telefonica's current shareholders on May 13, 2005; and, (b) one Telefonicashare for each 25 Telefonica shares to be distributed to current Telefonica'sshareholders from the Additional Paid-in Capital Reserve and following the 2005annual general shareholders' meeting to be tentatively held on May 25, 2005(estimated at €0.57 per share at Telefonica's closing share price as of February21, 2005); ii) Terra Networks' share price:adjusted for the €0.60 per share cash dividend announced by Terra Networks'Board of Directors on February 23, 2005, which will be distributed to TerraNetworks' current shareholders prior to the merger. Trading Range Analysis Morgan Stanley & Co. Limited reviewed the range of closing prices of Telefonicaand Terra Networks ordinary shares for various periods ending on February 21,2005. Morgan Stanley & Co. Limited observed the following: Period Ending February 21, 2005 Telefonica Terra Networks Last Three Months €12.18 - €13.76 €2.20 - €2.70Last Six Months €10.66 - €13.76 €2.17 - €2.70Last Twelve Months €10.40 - €13.76 €2.17 - €2.70 Morgan Stanley & Co. Limited calculated that the exchange ratio of 2 Telefonicaordinary shares for every 9 Terra Networks ordinary shares pursuant to themerger plan represented a 15% price premium to the unaffected share price ofTerra Networks ordinary shares as of February 11, 2005, and a 14% price premiumto the 30 trading days average of Terra Networks ordinary shares prior toFebruary 21, 2005. Comparable Companies Analysis Morgan Stanley & Co. Limited compared certain financial information ofTelefonica and Terra Networks with publicly available consensus financialestimates for other companies that shared similar business characteristics toTelefonica and Terra Networks, respectively. The companies used in thiscomparison included the following companies: i) With respect to Telefonica: Belgacom, British Telecom, Deutsche Telekom, France Telecom, KPN, Hellenic Telecommunications (OTE), Portugal Telecom, Swisscom, Tele Danmark (TDC), Telecom Italia, TeliaSonera, Telekom Austria and Telenor; and ii) With respect to Terra Networks: using as reference the "unaffected" closing share price of T-Online as of October 8, 2004 (prior to Deutsche Telekom's announcement of a minority buy out tender offer followed by a statutory merger with T-Online). For the purposes of this analysis, Morgan Stanley & Co. Limited analyzed theratio of aggregate value (defined as market capitalization plus total debt lesscash and cash equivalents, plus other adjustments) to estimated calendar year2005 earnings before interest, taxes, depreciation and amortization forTelefonica and to estimated calendar year 2006 earnings before interest, taxes,depreciation and amortization for Terra Networks. Morgan Stanley & Co. Limitedapplied this multiple to Telefonica's 2005 and Terra Networks' 2006 earningsbefore interest, taxes, depreciation and amortization, utilizing as informationsources for Telefonica, publicly available consensus financial forecasts, andfor Terra Networks, financial forecasts prepared by the management of TerraNetworks. Based on Telefonica's and Terra Networks' current outstanding ordinary sharesand options, Morgan Stanley & Co. Limited estimated the implied value perTelefonica and Terra Networks ordinary share, respectively, as of February 21,2005, as follows: Calendar Year Financial Financial Statistic Comparable Companies Implied Value Per Share Multiple StatisticTelefonica Aggregate Value to Estimated 2005 €14,301 MM 5.6x - 6.6x €10.89- €13.77Earnings Before Interest, Taxes, Depreciationand Amortization Terra Networks Aggregate Value to Estimated €60 MM 12.6x €2.672006 Earnings Before Interest, Taxes,Depreciation and Amortization No company utilized in the comparable companies analysis is identical toTelefonica or Terra Networks. In evaluating comparable companies, MorganStanley & Co. Limited made judgments and assumptions with regard to industryperformance, general business, economic, market and financial conditions andother matters, many of which are beyond the control of Telefonica or TerraNetworks, such as the impact of competition on the businesses of Telefonica orTerra Networks and the industry generally, industry growth and the absence ofany adverse material change in the financial condition and prospects ofTelefonica or Terra Networks or the industry or in the financial markets ingeneral. Mathematical analysis (such as determining the average or median) isnot in itself a meaningful method of using comparable company data. Discounted Cash Flow Analysis Morgan Stanley & Co. Limited calculated the range of equity values per ordinaryshare for each of Telefonica and Terra Networks based on a discounted cash flowanalysis. With respect to Telefonica, Morgan Stanley & Co. Limited relied onpublicly available consensus financial forecasts for calendar years 2005 through2010 and extrapolations from such projections for calendar years 2011 through2014. In arriving at a range of equity values per share of Telefonica ordinaryshares, Morgan Stanley & Co. Limited calculated the terminal value by applying arange of perpetual growth rates ranging from 1.0% to 1.5%. The unlevered freecash flows from calendar year 2005 through 2014 and the terminal value were thendiscounted to present values using a range of discount rates of 8.0% to 9.0%.With respect to Terra Networks, Morgan Stanley relied on Terra Networks'financial projections provided by the management of Telefonica (as received bythem from Terra Networks) for calendar years 2005 through 2008 andextrapolations from such projections for calendar years 2009 through 2014. Withrespect to those financial projections and other information and data relatingto Terra Networks, including information as to Terra Networks' material taxattributes, Morgan Stanley & Co. Limited was advised by the Telefonicamanagement that such forecasts and other information and data were reasonablyprepared on bases reflecting the best current estimates and judgments of themanagement of Telefonica as to the future financial performance of TerraNetworks and the expected realization by Terra Networks of its material taxattributes. In arriving at a range of equity values per share of Terra Networksordinary shares, Morgan Stanley & Co. Limited calculated the terminal value byapplying a range of perpetual growth rates from 3.0% to 4.0%. The unleveredfree cash flows from calendar year 2005 through 2014 and the terminal value werethen discounted to present values using a range of discount rates of 11.5% to12.5%. The unlevered free cash flows included the benefits to Telefonicaresulting from future tax or business or other savings as well as payments to bereceived by Terra Networks under its strategic agreement with Telefonica. The following table summarizes the results of Morgan Stanley & Co. Limited'sanalysis:Key Assumptions Implied Equity Value (•MM) Implied Equity Value Per Share Telefonica: 1.0% - 1.5% perpetual growth rate, 8.0% - €69,928 - €88,215 €14.11 - €17.809.0% discount rate Terra Networks: 3.0% - 4.0% perpetual growth rate, 11.5% €1,448 - €1,522 €2.55 - €2.68- 12.5% discount rate Equity Research Analysts' Price Targets Morgan Stanley & Co. Limited reviewed and analyzed future public market tradingprice targets for Telefonica and Terra Networks ordinary shares prepared andpublished by equity research analysts. These targets reflect each analyst'sestimate of the future public market trading price of Telefonica and TerraNetworks ordinary shares. The range of equity analyst price targets reviewedfor Telefonica and Terra Networks were €13.70 - €15.70 and €2.30 - €2.65,respectively. The public market trading price targets published by equity research analysts donot necessarily reflect current market trading prices for Telefonica or TerraNetworks ordinary shares and these estimates are subject to uncertainties,including the future financial performance of Telefonica and Terra Networks andfuture financial market conditions. Analysis of Precedent Transactions Morgan Stanley & Co. Limited reviewed Deutsche Telekom's minority buy out tenderoffer for the 26% free float of T-Online it did not own and the follow-onstatutory merger between Deutsche Telekom and T-Online announced on October 9,2004. For the purposes of this analysis, Morgan Stanley & Co. Limited analyzed theratio of aggregate value, defined as market capitalization plus total debt lesscash and cash equivalents plus other adjustments, to estimated calendar year2005 earnings before interest, taxes, depreciation and amortization and appliedthis multiple to Terra Networks' 2005 earnings before interest, taxes,depreciation and amortization, included in the financial forecasts prepared bythe management of Terra Networks. Based on Terra Networks' current outstandingordinary shares and options, Morgan Stanley & Co. Limited estimated the impliedvalue per Terra Networks ordinary share as of February 21, 2005 as follows: Valuation Statistic and Calendar Year Financial Comparable Implied Value Per Statistic Company Multiple Share Range for Statistic Terra Networks Aggregate Value to Estimated 2005 Earnings Before €52 MM 17.7x €2.96Interest, Taxes, Depreciation and Amortization No company or transaction utilized in the precedent transaction analyses wasidentical to Terra Networks or the merger. In evaluating the precedenttransactions, Morgan Stanley & Co. Limited made judgments and assumptions withregards to general business, market and financial conditions and other matters,which are beyond the control of Terra Networks, such as the impact ofcompetition on the business of Terra Networks or the industry generally,industry growth and the absence of any adverse material change in the financialcondition of Terra Networks or the industry or in the financial markets ingeneral, which could affect the public trading value of the companies and theaggregate value of the transactions to which they are being compared. Exchange Ratio Analysis Morgan Stanley & Co. Limited reviewed the ratios of the closing prices of TerraNetworks ordinary stock divided by the corresponding closing prices ofTelefonica ordinary stock over various periods ending February 21, 2005. MorganStanley & Co. Limited examined the premiums represented by the merger exchangeratio of 0.2222, as set forth in the merger plan, over the benchmarks mentionedbelow and found them to be as follows: Telefonica Terra Networks Implied Implied (•/share) (•/share) Premium(1) Exchange RatioLast 90 Days Avge. €12.18 - • 13.76 €2.20 - €2.70 0.181 - 0.196 12% - 13%Last Six Months Avge. €10.66 - €13.76 €2.17 - €2.70 0.196 - 0.204 9% - 13%Last Twelve Months Avge. €10.40 - €13.76 €2.17 - €2.70 0.196 - 0.209 6% - 13% (1) Implied premium defined as announced exchange ratio of 0.2222 divided byimplied exchange ratio for each trading average. SUMMARY OF OPINION OF LEHMAN BROTHERS EUROPE LIMITED The Board of Directors of Terra Networks engaged Lehman Brothers Europe Limitedto act as its financial advisor in connection with a possible businesscombination transaction with Telefonica. As part of its engagement, LehmanBrothers Europe Limited was asked to render an opinion to Terra Networks' Boardof Directors with respect to the fairness, from a financial point of view, tothe shareholders of Terra Networks (other than Telefonica) of the exchange ratioto be offered in the merger. On February 23, 2005, Lehman Brothers EuropeLimited rendered its oral opinion, subsequently confirmed in writing, to theBoard of Directors of Terra Networks that based upon and subject to mattersstated therein, as of the date of its opinion, from a financial point of view,the exchange ratio of two Telefonica ordinary shares per each nine TerraNetworks ordinary shares to be offered in the proposed merger was fair to theshareholders of Terra Networks (other than Telefonica). In connection withrendering its opinion, Lehman Brothers Europe Limited assumed, among otherthings, payment of the proposed dividend of €0.60 per Terra Networks ordinaryshare to be paid to all Terra Network shareholders prior to the merger. Lehman Brothers Europe Limited's opinion was provided for the information andassistance of the Board of Directors of Terra Networks in connection with itsconsideration of the proposed merger. Lehman Brothers Europe Limited's opinionis not intended to be and does not constitute a recommendation to anyshareholder of Terra Networks as to how such shareholder should vote withrespect to the proposed merger. Lehman Brothers Europe Limited was notrequested to opine as to, and Lehman Brothers Europe Limited's opinion does notin any manner address, Terra Networks' underlying business decision to proceedwith or effect the proposed merger. In arriving at its opinion and in relation to Terra Networks, Lehman BrothersEurope Limited reviewed and analyzed: (1) a draft of the merger planand the specific terms of the proposed merger; (2)publicly available informationconcerning Terra Networks that Lehman Brothers Europe Limited believed to berelevant to its analysis; (3) financial and operating informationwith respect to the business, operations and prospects of Terra Networksfurnished to Lehman Brothers Europe Limited by Terra Networks; (4) a tradinghistory of Terra Networks' ordinary shares since its initial public offering tothe date of its opinion and a comparison of that trading history with those ofother companies that Lehman Brothers Europe Limited deemed relevant; and (5) acomparison of the financial terms of the proposed merger with the financialterms of certain other recent transactions that Lehman Brothers Europe Limiteddeemed relevant. In addition, Lehman Brothers Europe Limited had discussions with the managementof Terra Networks concerning Terra Networks' business, operations, assets,financial condition and prospects and undertook such other studies, analyses andinvestigations as Lehman Brothers Europe Limited deemed appropriate. In arriving at its opinion and in relation to Telefonica, Lehman Brothers EuropeLimited reviewed and analyzed such publicly available information as LehmanBrothers Europe Limited deemed relevant and, in particular the consensus pricetargets for Telefonica ordinary shares published by research analysts and ananalysis of the recent trading performance of Telefonica ordinary shares. LehmanBrothers Europe Limited did not have access to non- public information relatingto Telefonica nor did Lehman Brothers Europe Limited meet with Telefonica'smanagement team to assess its future prospects. In arriving at its opinion, Lehman Brothers Europe Limited assumed and reliedupon the accuracy and completeness of the financial and other informationprovided to Lehman Brothers Europe Limited without assuming any responsibilityfor independent verification of such information and further relied upon theassurances of management of Terra Networks that they were not aware of any factsor circumstances that would make such information inaccurate or misleading. Atthe request of Terra Networks' Board of Directors, Lehman Brothers EuropeLimited also retained independent counsel to advise it on certain mattersrelating to the material tax attributes of Terra Networks and the effect of theproposed merger on those attributes, and Lehman Brothers Europe Limited reliedon that advice. With respect to the financial projections of Terra Networks,including information as to Terra Networks' material tax attributes, upon adviceof Terra Networks, Lehman Brothers Europe Limited assumed that such projectionsand information were reasonably prepared on a basis reflecting the bestcurrently available estimates and judgments of, and information available to,the management of Terra Networks as to the future financial performance and taxattributes of Terra Networks. However, for purposes of its analysis, LehmanBrothers Europe Limited also utilised its own sector wide and company specificassumptions and estimates which resulted in certain adjustments to theprojections of Terra Networks. Lehman Brothers Europe Limited discussed theseadjusted projections with the management of Terra Networks and management agreedwith the logic of the use of such adjusted projections in arriving at LehmanBrothers Europe Limited's opinion. In arriving at its opinion, Lehman Brothers Europe Limited (i) took intoaccount, among other factors, the proposed dividend of €0.23 to be paid byTelefonica to its shareholders in respect of 2004 and the proposed distributionby Telefonica of one Telefonica share for each 25 Telefonica shares, in whichTerra Networks shareholders will not participate, and (ii) did not conduct aphysical inspection of the properties and facilities of Terra Networks and didnot make or obtain any evaluations or appraisals of the assets or liabilities ofTerra Networks. In addition, Lehman Brothers Europe Limited was not asked orauthorized to solicit, and Lehman Brothers Europe Limited did not solicit, anyindications of interest from any third party with respect to the purchase of allor a part of Terra Networks' business. Based on publicly available information,Lehman Brothers Europe Limited has assumed, for the purposes of its opinion,that the Company has 561.2 million shares currently in issue, which numberexcludes treasury shares and options to acquire shares currently out of themoney. Lehman Brothers Europe Limited's opinion necessarily was based uponmarket, economic and other conditions as they existed on, and could be evaluatedas of, the date of its opinion. In connection with rendering its opinion, Lehman Brothers Europe Limitedperformed certain financial, comparative and other analyses as described below.The preparation of a fairness opinion involves determinations as to the mostappropriate and relevant methods of financial and comparative analysis and theapplication of those methods to the particular circumstances, and therefore,such an opinion is not readily susceptible to summary description. Accordingly,Lehman Brothers Europe Limited believes that its analyses must be considered asa whole and that considering any portion of such analyses and factors, withoutconsidering all analyses and factors as a whole, could create a misleading orincomplete view of the process underlying its opinion. In its analyses, LehmanBrothers Europe Limited made numerous assumptions with respect to industryperformance, general business and economic conditions and other matters, many ofwhich are beyond the control of Terra Networks and Telefonica. None of TerraNetworks, Telefonica, Lehman Brothers Europe Limited or any other person assumesresponsibility if future results are materially different from those discussedor assumed. Any estimates contained in these analyses were not necessarilyindicative of actual values or predictive of future results or values, which maybe significantly more or less favorable than as set forth therein. In addition,analyses relating to the value of businesses do not purport to be appraisals orto reflect the prices at which businesses may actually be sold. The following is a summary of the material financial analyses used by LehmanBrothers Europe Limited in connection with providing its opinion to TerraNetworks' Board of Directors. Certain of the summaries of financial analysesinclude information presented in tabular format. In order to fully understandthe financial analyses performed by Lehman Brothers Europe Limited, the tablesmust be read together with the text of each summary. The tables alone do notconstitute a complete description of the financial analyses. Accordingly, theanalyses listed in the tables and described below must be considered as a whole.Considering any portion of such analyses and of the factors considered, withoutconsidering all analyses and factors, could create a misleading or incompleteview of the process underlying Lehman Brothers Europe Limited's opinion. Terra Networks Valuation Sum-of-the-Parts Analysis Lehman Brothers Europe Limited reviewed the stand-alone valuation of TerraNetworks on the basis of a sum-of-the-parts approach, utilizing differentvaluation methodologies depending on the type of asset. For Terra Networks'cash position, Lehman Brothers Europe Limited used book value as of December 31,2004. For financial investments and interest in other companies, LehmanBrothers Europe Limited used market value, option value or net present value offuture proceeds from the sale of interests subject to an offer or a commitmentto buy from a third party. For the strategic alliance contract between TerraNetworks and Telefonica and Terra Networks' joint venture interests, operatingassets and tax credits, Lehman Brothers Europe Limited used discounted cash flowvaluation, pursuant to which forecasted free cash flows attributable to suchassets were discounted to net present value by weighted cost of capital rates. In addition to being valued on a discounted cash flow basis, as a supplementalcomparison, Terra Networks' Spanish operating assets were also valued by using acomparable companies approach, pursuant to which multiples derived from impliedvalues from transactions involving companies in comparable businesses and fromEBITDA and revenue of comparable companies were applied to Terra Networks'Spanish access business and its other Spanish business. Multiples derived fromsubscriber acquisition costs and gross margins of companies in comparablebusinesses were also applied to Terra Networks' Spanish access business. The result of Lehman Brother's sum-of-the-parts analysis was an implied valueper Terra Networks ordinary share of €3.18. Other Value Effects Lehman Brothers Europe Limited then observed that potential synergies, loss ofhistorical tax credits and the potential ability to realize value from a taxcredit relating to Terra Networks' sale of Lycos Inc. were other potentialsources of value or loss of value not included in the sum-of-the parts analysisof Terra Networks. Accordingly, Lehman Brothers Europe Limited calculated anadjustment to its sum-of-the-parts implied value per Terra Networks ordinaryshare described above to take into account an estimate of the aggregate impactof these other potential effects on value to arrive at an adjusted merger valueper Terra Networks ordinary share of €3.57. Comparable Companies Analysis Lehman Brothers Europe Limited compared Terra Networks as a whole against thefollowing eight other companies: • easynet • freenet.de • Iliad • TI Media • T-Online • Tiscali • United Internet • Web.de Lehman Brothers Europe Limited applied the average multiple of the listedcompanies' enterprise values to forecasted EBITDA for each of 2005 and 2006 toTerra Networks' forecasted EBITDA for such years to calculate implied firmvalues for Terra Networks, and then made adjustments to such firm values forother assets and liabilities. The results of this analysis were implied equityvalues of €3.05 and €3.18 per Terra Networks ordinary share based on TerraNetworks' forecasted EBITDA for 2005 and 2006, respectively. Lehman Brothers Europe Limited noted that, while the review of comparablecompanies served as comparative information, due to the different profitabilityand risk profile of Terra Networks, the comparable companies analysis should notbe deemed a meaningful valuation methodology. Broker Views Lehman Brothers Europe Limited also reviewed brokers' target prices for TerraNetworks ordinary shares in reports published between April 2004 and February 8,2005. Lehman Brothers Europe Limited adjusted two of the target pricespublished in April 2004 for the €2.00 dividend on Terra Networks ordinary sharespaid in July 2004. The average of these target prices was €3.00 and the medianwas €3.00. Telefonica Valuation As noted above, Lehman Brothers Europe Limited was not provided with anynon-publicly available business or financial information, including financialforecasts, for Telefonica. Therefore, Lehman Brothers Europe Limited analyzedTelefonica's valuation using a market-based approach. Broker Views Lehman Brothers Europe Limited reviewed brokers' target prices for Telefonicaordinary shares in reports published between November 11, 2004 and February 21,2005. The average of these target prices was €14.92 and the median was €14.55. Historical Share Price Performance Lehman Brothers Europe Limited reviewed the historical share price performanceand trading volumes of Telefonica ordinary shares from May 25, 2003, the launchdate of Telefonica's 2003 tender offer for Terra Networks shares, through toFebruary 14, 2005, the date that Telefonica announced its intention to make anoffer for a business combination transaction with Terra Networks. LehmanBrothers Europe Limited also calculated the average market price of Telefonicaordinary shares for the one-month, six-month and one-year periods prior toFebruary 14, 2005 and for the period from May 25, 2003 to February 14, 2005. Thefollowing table sets forth the results of this analysis: Period Average Share Price (•)1 month........................................................ 14.026 months....................................................... 13.051 year 12.67Since Launch of Tender Offer on May 28,2003................... 11.52 Relative Valuation Lehman Brothers Europe Limited performed a relative analysis of the historicalshare price performance for both Terra Networks and Telefonica by comparingmarket prices of Terra Networks ordinary shares (as adjusted for a dividendpayment of €2.00 per share on July 29, 2004) to market prices of Telefonicaordinary shares during the period from May 28, 2003 to February 1, 2005. LehmanBrothers Europe Limited also calculated the average ratio of the market price ofa Telefonica ordinary share to the adjusted price of a Terra Networks ordinaryshare for the month of January 2005, the six-month period of August 2004 throughJanuary 2005, the one-year period of February 2004 through February 2005 and forthe period from May 25, 2003 to January 4, 2005. The following table sets forththe results of this analysis: Period Average Ratio1 month..................................................... .4.49:16 months..................................................... 4.45:11 year ..................................................... 4.30:1 Since Launch of Tender Offer on May 28,2003.................. 4.02:1 Lehman Brothers Europe Limited noted that the ratios set forth in the tableabove were not adjusted to include the effect of the anticipated cash dividendof €0.60 to be paid to Terra Networks shareholders, including Telefonica, priorto consummation of the merger. Public Market Valuation of Consideration Lehman Brothers Europe Limited then analyzed the implied offer price for theproposed merger based on the exchange ratio of 4.5:1 for the proposed merger,the high and low market prices for Telefonica ordinary shares during the onemonth period prior to February 22, 2005 and the market price on such date, andadding the effect of the €0.60 anticipated dividend on Terra Network ordinaryshares. The results of this analysis are set forth in the table below: Low High As of February 22, 2005Implied Terra Networks Share Price in Offer (•)................. 3.59 3.84 3.69 Lehman Brothers Europe Limited observed that the range of the implied offerprice set forth in the table above is greater than the adjusted merger value of€3.57 per Terra Networks ordinary share discussed above under the heading "-Terra Networks Valuation - Other Value Effects". Miscellaneous Lehman Brothers Europe Limited is an internationally recognized investmentbanking firm and, as part of its investment banking activities, is regularlyengaged in the valuation of businesses and their securities in connection withmergers and acquisitions, negotiated underwritings, competitive bids, secondarydistributions of listed and unlisted securities, private placements andvaluations for corporate and other purposes. Terra Networks' Board of Directorsselected Lehman Brothers Europe Limited because of its expertise, reputation andfamiliarity with Terra Networks and its industry generally and because itsinvestment banking professionals have substantial experience in transactionscomparable to the merger. As compensation for its services in connection with the merger, Lehman BrothersEurope Limited received a fee of €1 million upon delivery of its opinion. Inaddition, Terra Networks has agreed to reimburse Lehman Brothers Europe Limitedfor reasonable out-of-pocket expenses incurred in connection with the merger andto indemnify Lehman Brothers Europe Limited and its related parties for certainliabilities that may arise out of its engagement by Terra Networks and therendering of Lehman Brothers Europe Limited's opinion. Lehman Brothers Europe Limited and its affiliates in the past have provided, andcurrently provide, services to Terra Networks and Telefonica, including inconnection with mergers and acquisitions other than the proposed merger. Anaffiliate of Lehman Brothers Europe Limited has provided a two-year €100 millionrevolving credit facility to Telefonica which remains undrawn as of the date ofLehman Brothers Europe Limited's opinion. In the ordinary course of itsbusiness, Lehman Brothers Europe Limited and its affiliates may actively tradein the debt or equity securities of Terra Networks and Telefonica or theiraffiliates for their own accounts or for the account of their customers and,accordingly, may at any time hold a long or short position in such securities. SUMMARY OF OPINION OF CITIGROUP GLOBAL MARKETS LIMITED Terra Networks retained Citigroup Global Markets Limited to act as its jointfinancial advisor in connection with a possible business combination transactionwith Telefonica. In connection with its engagement, Terra Networks instructedCitigroup Global Markets Limited to evaluate the fairness, from a financialpoint of view, to the holders of Terra Networks ordinary shares (other thanTelefonica and its affiliates) of the exchange ratio. At the February 23, 2005meeting of the Board of Directors of Terra Networks, Citigroup Global MarketsLimited delivered its oral opinion to the Board of Directors of Terra Networks,subsequently confirmed in writing, to the effect that, based upon and subject tothe qualifications and assumptions set forth therein, as of the date thereof,the exchange ratio of 2/9ths of an ordinary share of Telefonica for eachordinary share of Terra Networks was fair, from a financial point of view, tothe holders of Terra Networks ordinary shares (other than Telefonica and itsaffiliates). In connection with rendering its opinion, Citigroup Global MarketsLimited assumed, among other things, payment of the proposed dividend of €0.60per Terra Networks ordinary share to be paid to all Terra Network shareholdersprior to the merger. Citigroup Global Markets Limited's opinion is directed only to the fairness,from a financial point of view, of the exchange ratio to the holders of TerraNetworks ordinary shares (other than Telefonica and its affiliates) and is notintended and does not constitute a recommendation to any Terra Networksshareholder as to how such shareholder should vote at the annual generalshareholders' meeting of Terra Networks. Except as described below, nolimitations were imposed by Terra Networks or Telefonica upon Citigroup GlobalMarkets Limited with respect to the investigations made or procedures followedby it in rendering its opinion. Although Citigroup Global Markets Limitedevaluated the financial terms of the merger and participated in discussionsconcerning the determination of the exchange ratio, Citigroup Global MarketsLimited was not asked to and did not recommend this exchange ratio, which wasthe result of negotiations between Terra Networks and Telefonica. In connection with rendering its opinion, Citigroup Global Markets Limited,among other things: • reviewed a draft dated February 23, 2005, of the merger plan; • held discussions with certain senior officers, directors and otherrepresentatives and advisors of Terra Networks concerning the businesses,operations and prospects of Terra Networks; • examined certain publicly available business and financial informationrelating to Terra Networks and Telefonica as well as certain financial forecastsand other information and data relating to Terra Networks, including informationas to Terra Networks' material tax attributes, which were provided to ordiscussed with Citigroup Global Markets Limited by the management of TerraNetworks; • reviewed the financial terms of the merger in relation to, among otherthings: • current and historical market prices of Terra Networks ordinary sharesand Telefonica ordinary shares, • the historical and projected earnings and other operating data of TerraNetworks and Telefonica (Citigroup Global Markets Limited, however, was notprovided with any non-publicly available business or financial information,including financial forecasts, for Telefonica); and • the capitalization and financial condition of Terra Networks andTelefonica; • considered, to the extent publicly available, the financial terms ofcertain other transactions which Citigroup Global Markets Limited consideredrelevant in evaluating the merger; • analyzed certain financial, stock market and other publicly availableinformation relating to the businesses of other companies whose operationsCitigroup Global Markets Limited considered relevant in evaluating those ofTerra Networks and Telefonica; • took into account, among other factors, the proposed dividend of €0.23per Telefonica ordinary share in respect of 2004 and the proposed distributionby Telefonica of one Telefonica ordinary share for each 25 Telefonica ordinaryshares, in which the holders of Terra Networks ordinary shares will notparticipate, and the proposed dividend of €0.60 per Terra Networks ordinaryshare to be paid by Terra Networks to all holders of Terra Networks ordinaryshares; and • conducted such other analyses and examinations and considered suchother information and financial, economic and market criteria as CitigroupGlobal Markets Limited deemed appropriate. In rendering its opinion, Citigroup Global Markets Limited assumed and relied,without assuming any responsibility for independent verification, upon theaccuracy and completeness of all financial and other information and datapublicly available or provided to or otherwise reviewed by or discussed withCitigroup Global Markets Limited and upon the assurances of the management ofTerra Networks that it was not aware of any relevant information that had beenomitted or that remained undisclosed to Citigroup Global Markets Limited. Withrespect to financial forecasts and other information and data relating to TerraNetworks, including information as to Terra Networks' material tax attributes,provided to or otherwise reviewed by or discussed with Citigroup Global MarketsLimited, Citigroup Global Markets Limited was advised by the management of TerraNetworks that such forecasts and other information and data were reasonablyprepared on bases reflecting the best currently available estimates andjudgments of the management of Terra Networks as to the future financialperformance of Terra Networks and the expected realization by Terra Networks ofits material tax attributes. At the request of Terra Networks' Board ofDirectors, Citigroup Global Markets Limited also retained independent counsel ofinternational standing to advise Citigroup Global Markets Limited on certainmatters relating to the material tax attributes of Terra Networks and the effectof the merger on those attributes, and Citigroup Global Markets Limited reliedon that advice. Citigroup Global Markets Limited's opinion relates to the relative values ofTerra Networks and Telefonica. Citigroup Global Markets Limited did not expressany opinion as to what the value of the Telefonica ordinary shares actually willbe when issued pursuant to the merger or the price at which the Telefonicaordinary shares will trade at any time. Citigroup Global Markets Limited didnot make nor was it provided with an independent evaluation or appraisal of theassets or liabilities (contingent or otherwise) of Terra Networks or Telefonica(other than material tax attributes of Terra Networks, referred to above), nordid Citigroup Global Markets Limited make any physical inspection of theproperties or assets of Terra or Telefonica. Citigroup Global Markets Limitedwas not requested to, and did not, solicit third party indications of interestin the possible acquisition of all or a part of Terra Networks. CitigroupGlobal Markets Limited expressed no view as to, and its opinion does notaddress, the relative merits of the merger as compared to any alternativebusiness strategies that might exist for Terra Networks or the effect of anyother transaction in which Terra Networks might engage. In particular,Citigroup Global Markets Limited took into account the fact that Telefonicacurrently controls Terra Networks. Citigroup Global Markets Limited's opinionwas necessarily based upon information available to Citigroup Global MarketsLimited, and financial, stock market and other conditions and circumstancesexisting, as of the date of its opinion. Citigroup Global Markets Limited's opinion and financial analyses were only oneof many factors considered by Terra Networks' Board of Directors in itsevaluation of the merger and should not be viewed as determinative of the viewsof Terra Networks' Board of Directors with respect to the merger or the exchangeratio provided for in the transaction. In preparing its opinion, Citigroup Global Markets Limited performed a varietyof financial and comparative analyses. The preparation of a financial opinion isa complex analytical process, involving various determinations as to the mostappropriate and relevant methods of financial analysis and the application ofthose methods to the particular circumstances and, therefore, a financialopinion is not readily susceptible to summary description. Accordingly,Citigroup Global Markets Limited believes that its analyses must be consideredas a whole and that selecting portions of its analyses and factors or focusingon information presented in tabular format, without considering all analyses andfactors, could create a misleading or incomplete view of the processesunderlying its analyses and opinion. The following is a summary of the material financial analyses performed byCitigroup Global Markets Limited in connection with the preparation of itsopinion and presented to the Board of Directors of Terra Networks at its meetingon February 23, 2005. Historical Share Price Performance Citigroup Global Markets Limited reviewed the relationship between movements inprices of Terra Networks ordinary shares and Telefonica ordinary shares and theimplied offer price for the merger for the period from July25, 2003, the date onwhich Telefonica officially announced to the CNMV the number of Terra Networksordinary shares it acquired in the tender offer, through February 11, 2005, thelast trading day before Telefonica publicly announced its intention to make anoffer for a business combination transaction with Terra Networks. The impliedoffer price for the merger was calculated by multiplying the adjusted Telefonicashare price by the exchange ratio of 2/9 and then adding €0.60 for the effect ofthe anticipated dividend on Terra Network ordinary shares to be paid beforeconsummation of the merger. The adjusted Telefonica share price was arrived atby subtracting the anticipated cash dividend of €0.23 from the Telefonicaunadjusted share price and then adjusting the result for the anticipated stockdividend on Telefonica ordinary shares of one share for every 25 outstandingshares, in which cash and stock dividends Terra Networks shareholders will notparticipate. Citigroup Global Markets Limited also adjusted the Terra Networksshare price for the €2.00 cash dividend per Terra Networks ordinary share paidin July 2004 in the period prior to the payment of such dividend. In addition, Citigroup Global Markets Limited compared the implied offer pricewith the trading price of a Terra Networks ordinary share on February 11, 2005(the last trading day prior to the public announcement of Telefonica's intentionto make an offer) and the one-, three- and six-month trailing averages in theperiod prior and up to February 21, 2005, in the case of Telefonica, and up toFebruary 11, 2005, in the case of Terra Networks. The following table setsforth the results of this analysis: Terra Networks Implied Offer Premium Ordinary Share Price Price (•) (•)February 11, 3.19 3.58 12%2005.............................................Last Month Trailing Average.............................. 3.11 3.56 14%Last 3 Month Trailing Average........................... 2.96 3.49 18%Last 6 Month Trailing Average........................... 2.90 3.35 16% Precedent Transactions Analysis Noting that Telefonica currently controls Terra Networks, Citigroup GlobalMarkets Limited compared the premium that the implied offer price for the mergerrepresented over the price on the last trading day before announcement and thethree- and six-month trailing averages thereof with the premia on similar lasttrading days and for similar trailing periods represented by • the cash consideration for four recent de-listing tender offers bySpanish companies; • the consideration in three recent mergers involving significantshareholders (owning less than half of the equity) of Spanish companiesacquiring the remainder of the equity of those companies; and • the consideration for two recent offers by controlling shareholders(owning in excess of half of the equity) of European internet service providersto acquire the remainder of the equity of those companies. The precedent transactions considered by Citigroup Global Markets Limited werethe following: Spanish De-Listing Offers Date Announced CompanyApril 22, 2002 Hidroelectrica del CantabricoDecember 9, 2003 Aceralia Corporacion Siderurgica SAMay 31, 2004 Centros Comerciales Carrefour SAJune 4, 2004 Cementos Molins SA Spanish Significant Shareholder Mergers Date Announced Acquiror TargetApril 16, 2002 FCC Portland ValderrivasJuly 1, 2003 ACS Grupo DragadosAugust 1, 2003 Metrovacesa Bami Offers by Controlling Shareholders of European ISPs Date Announced Acquiror TargetFebruary 23, 2004 France Telecom WanadooOctober 9, 2004 Deutsche Telekom T-Online With respect to the financial information for the precedent transactions and thecompanies involved therein, Citigroup Global Markets Limited relied oninformation available in public documents. The following table summarizes themedian premia (discount) offered in these transactions over the price on thelast trading day before announcement and the three- and six-month trailingaverages thereof and, in the far right column, sets forth for comparativepurposes the same information for the implied offer price in the proposed mergerbetween Terra Networks and Telefonica:Period Median Spanish Median Spanish Merger Median European ISP Implied Offer Price De-Listing Offer Consideration Premia Premia Premium For Proposed Premia (Discount) Merger 1 day (2.2)% 9.3% 8.6% 12%3 month 2.7% 2.4% 17.3% 18%6 month 7.0% 7.0% 19.0% 16% Citigroup Global Markets Limited observed that none of the precedenttransactions was identical to the proposed merger of Terra Networks andTelefonica. Terra Networks Valuation Discounted Cash Flow Analysis Citigroup Global Markets Limited's primary methodology for reviewing the valueof Terra Networks was a sum-of-the-parts discounted cash flow analysis for eachof Terra Networks' individual operating assets and certain non-operating assets. Citigroup Global Markets Limited applied country-specific discount rates basedon weighted average cost of capital assumptions to calculate the net presentvalue of Terra Networks' management's forecasted free cash flows from itsoperating assets, the benefits of future tax savings relating to net operatinglosses and payments to be received by Terra Networks under its strategicalliance agreement with Telefonica. Citigroup Global Markets Limited appliedgreater discount rates, however, to calculate the net present value of apotential additional tax credit resulting from the August 2, 2004 sale by TerraNetworks of Lycos Inc. as Terra Networks' ability to realize value from thiscontingent asset is speculative and difficult to predict. Citigroup GlobalMarkets Limited then adjusted the value of Terra Networks to reflect TerraNetworks' net cash (including amounts due from Telefonica under tax sharingarrangements) and other non-operating assets (including investments inunconsolidated and other non-wholly owned affiliates and anticipated proceedsfrom dispositions). The result of this sum-of-the-parts discounted cash flowanalysis was an implied value per Terra Networks ordinary share of €2.90 to€3.71. Comparable Companies Analysis Using publicly available information, Citigroup Global Markets Limited reviewedthe relative share price performance from July 2003 to February 2005 of TerraNetworks and the following five publicly held European internet serviceproviders, as well as a market-weighted index comprised of such companies: • freenet.de • Iliad • Telecom Italia Media • Tiscali • United Internet Citigroup Global Markets Limited also compared the listed companies' multiplesof firm value (equal to equity value plus straight debt, minority interest,straight preferred stock, all out-of-the-money convertibles, less investments inRelated Shares:
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